Policy for a Balance Sheet Recession

Luc Vallee's picture
The Cul de sac of Our Current Policy

The standard tools of stabilization policy are countercyclical monetary and fiscal policy. Both approaches seek to offset fluctuations in spending and income and each derives from the observed correlation between money income and expenditure. These approaches reflect two possible interpretations of the causes of economic downturns: Either it is caused by a drop in spending (which precipitates a decline in money income), or it is caused by a drop in money income (which precipitates a decline in spending).Keynesians view recessions as caused by autonomous declines in private spending (usually investment), interacting with market frictions that impede speedy adjustment; the cure is to raise public spending and deficits to increase aggregate demand.

Monetarist policy derives from Milton Friedman’s observation that nominal income has historically correlated with the broad money supply; the approach is to offset a reduction in the velocity of money – which accompanies all recessions - with an increase of base money. Probably because it is so difficult to disentangle causality between variables that are so highly correlated, neither view has been able to conclusively prevail over the other. It is therefore not surprising the US government reacted to the recent threat of economic meltdown with massive injections of both monetary and fiscal stimulus.

Economists will long debate the efficacy of this policy response but, whatever the results so far, there are constraints that place severe limitations on the effectiveness of traditional policy going forward. The US deficit and the trajectory of US spending is unsustainably high and, as the late economist Herbert Stein famously observed, “what cannot last, will not do so”. Any further fiscal stimulus risks pushing US finances past the tipping point, which would be a reckless gamble. At near zero short term interest rates, traditional monetary policy has become impotent, QE has been ineffective and the Fed has entered uncharted waters with its massive increase in the monetary base, risking inflation once private sector deleveraging ceases and velocity picks up. So neither traditional remedy is available any longer.

Turning to a Neglected Tradition: Irving Fisher and ‘Debt-Deflation’ Dynamics

With US unemployment lodged stubbornly above 9%, what is to be done? Our policymakers, economists and commentators appear trapped in the confines of a paradigm that is no longer viable. Is there any other policy that might help spur recovery, or must we become resigned to waiting it out? The great Yale economist Irving Fisher charted the dynamics of the Great Depression as a downward spiral of declining asset prices triggering margin calls and bankruptcies, begetting further illiquidity, asset price declines and so on. Fisher’s “debt -deflation” theory emphasized the debilitating effects of the interaction of an economy with high leverage confronted with a shock that causes a downward revision in the valuation of key assets. In Fisher’s analysis, the key obstacle to recovery was a high level of nominally contracted debt. In such an economy, shrinking balance sheets force all of the economic actors to reduce spending. Causality runs in a direction opposite that assumed by Keynesians and Monetarists; it is balance sheet constraints that force reductions in spending and income, rather than the other way round.

There has been recent academic work theorizing and documenting a debt –deflation process initiated by the shock of the subprime mortgage meltdown, and various initiatives by the US Treasury and Fed have indirectly, and ineffectively, confronted this problem by attempting to boost asset prices through purchases of toxic assets and illiquid bonds. It is likely the US is embroiled in a Fisherian process, as leverage in the consumer and financial sector skyrocketed in the decade prior to the subprime meltdown.

But so far, there has been little discussion, and no policy action, to address the root cause of the debt-deflation dynamic – the debt contracts themselves. One might suppose this cannot be directly addressed, other than through inflation, because doing so would violate property rights. But this is not correct in all instances.

A New Economic Policy Framework

The two most indebted areas of the US economy are the financial and the residential mortgage sectors. Banks, which bore the brunt of the subprime collapse, have contracted lending for the first time since the Great Depression, as they hoard liquidity to hedge anticipated losses. This credit contraction has not been caused by a lack of borrower demand, as credit expansion has been robust in those areas where credit is available, like the corporate bond market and the non-bank finance market. The US has refrained from requiring banks to recapitalize, presumably out of fear that widespread bond defaults would trigger a capital flight from banks. But banks could restructure their debt, including conversion of debt to equity, to achieve a much lower level of leverage, without requiring infusions of outside capital, and it is within the legal purview of regulators to require such restructuring. Likewise, since the US government, through its ownership of Freddie Mac and Fannie Mae, now owns over half of US residential mortgage debt, it can, directly and indirectly through its ability to set regulatory capital rules for banks, restructure the debt of the residential mortgage market by offering homeowners the option to partially convert their mortgage debt into shared equity. If structured intelligently, such a conversion could actually increase the value of the claims owned by the US and its banks. These policies would spur credit expansion and consumer spending without placing further strain on public finances. So there is a constructive role for policy, within the framework laid out by Irving Fisher. The 1990’s Japanese “lost decade” was ended when the Koizumi government forced its banks to realize losses and recapitalize. A balance sheet recession requires a policy to effectuate a speedy reduction in leverage.

Written by Dan Aronoff Contributor at The Sceptical Market Observer

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malek's picture

The article seems to imply we can stage a deleveraging (which is the ultimate goal) without a lot of pain involved.
I would file that under wishful thinking.

mind_imminst's picture

Deflation, bankruptcy, clear the debts. It has to be done. That is the only way out (or some miracle invention that makes energy costs go to near zero in short order).

dolly madison's picture

Sounds good, but they don't choose to do anything that sounds good.

sasebo's picture

Anybody ever heard of Peter Schiff & Austrian economics? They are the only branch of economics to accurately predict the cause of subprime bubble & crash.

suteibu's picture

Koizumi forced a zero interest rate policy and additional QE.  His 5 1/2 year term was noted for economic growth fueled by increasing debt and bridges to nowhere even as he cut welfare benefits and raised premiums.  He changed employment laws which allowed companies to turn full time employees into part time, no benefit employees, a segment that now comprises about 35% of the workforce.  It was, in effect, a bailout for the companies which shifted the burden of benefits from the companies balance sheets to the welfare system which is now 50% funded by the annual budget.

He sought to privatize the Post bank at the behest of his BFF Bush, something that Obama seeks to accomplish through the TPP free trade agreement...all of those trillions of yen of household savings just waiting for a little Wall Street magic, you know.

The idea that banks were forced to realize loans is somewhat of a misstatement as they continued to be capitalized through the BOJ.  (Even Bank of Tokyo-MUFJ, the one bank to survive the asset bubble burst relatively unscathed, paid income taxes this year for the first time since 2001, Koizumi's first year in office.)  He was Bush, Jr., spurring short term growth with debt while accomplishing little to reform Japan for the long term.

It's kind of hard to see why he is used as an example.  He didn't end the first lost decade, he began the second lost decade.

Ying-Yang's picture

Good article Luc... The moment Paulson spoke of TARP and how the sky would fall. I listened carefully past the possibilty of crashing markets and riots in the streets to how he would use TARP to address the MBS debacle.

The framework you illustrate above is roughly what I thought he would do with the money. TARP was approved against the wishes of the public yet there was little out cry when he used TARP to save the chosen few. This period of time sticks in my mind as a historic moment in American history.

TARP was a financial coup d'etat and an integral step towards globalization for elites.

Thanks for your information!

disabledvet's picture

this slowdown appears to be primarily price related. i'm not sure i blame the Fed either. it sure appears to me to be the spending spree that came on the back of the collapse which Tom Keene so ably pointed out at the time "didn't involve job creation." i think a calamity is clearly in the cards in the debt markets because without job creation and with higher food and energy prices across the board there doesn't appear to be "final demand" for paying for both the health plan and the stimulus. add in wars in Afghanistan and now Libya and it's really hard to see how this process gets reversed exactly. frankly i see neither another round of QE nor the Fed tightening. I see them bascially sitting on their hands while events play themselves out. critical for equities will obvioulsy be a continued push maximizing margins. any blow up in the debt market however can make a quality equity space rarified indeed. the power of global capital is so enormous we need the Federal Government to function as aggressively as possible to at a minimum miitgate its deleterious effects and at the maximum provide some type of meaningful safety net. We need both now more than ever. I can see how "USA inc" can be a constructive force--but i am unclear at this point how the Federal Government can help this along to "braoden the base" as they say. clearly "small is beautiful" in this environment since fear of large (debt) numbers now matter. the exception of course is treasuries...which represents a form of bad news not good since the fundamental tenet of the Fed policy was to get the money out of treasuries to get risk capital back and working.

Pay Day Today's picture

Worth checking out Steve Keen's debtdeflation website


Also what Koo had to say about a 'balance sheet recession'


mayhem_korner's picture

Monetarist policy derives from Milton Friedman’s observation that nominal income has historically correlated with the broad money supply; the approach is to offset a reduction in the velocity of money – which accompanies all recessions - with an increase of base money.

As I read this, it implies a mischaracterization.  It reads that Friedman would support money printing, which he absolutely would not (see: http://www.youtube.com/watch?v=qmndhS-Qf20).  Strict monetarists recognize interest rates as the lever to influence the money supply, and would not advocate direct intervention in the monetary base through printing.  

The ongoing "monetary stimulus" is in my view nothing more than an extension (i.e., financing) of the Keynesian spending spree.  The Federal government would seize up absent the Fed Reserve intervention to finance it and, moreover, to keep interest rates from shooting to the moon and imploding everything under the weight of the debt.

Predictably, though, it has failed and it is only a matter of time before gravity wins out...