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A Balance Sheet Recession?



July 17, 2012 – Comments (0)

Board: Macro Economics

Author: PosFCF

I recently read a book called: "The Holy Grail of Macroeconmics: Lessons learned from Japan's Great Recession" by Richard Koo. [Here is a short biography of the author.]

In short, and as I understand it, a balance sheet recession occurs when several events occur. The first part is that major asset prices fall. Then businesses find themselves owing more on the assets than they are currently worth in the marketplace and the businesses subtly shift from their normal profit maximization paradigm to one in which paying down debt plays a more substantial role. The banks who are owed the money keep quiet about the imbalance between what is owed and the decreased values of the security pledged for those loans, so the whole scenario doesn't get much press or attention.

The second thing that happens in a balance sheet recession according to Mr Koo is that households find themselves in similar positions and engage in paying off debt and saving more for retirement dues to a decreased value of their retirement savings.

In this balance sheet recession scenario, central bank policies of lowering interest rates to zero have little effect because people are not looking for new loans, they are looking to pay off the existing ones. From this comes the saying that reducing rates is like "pushing on a string".

It is obvious that those who can borrow at lower rates will do so if the rate differential is wide enough, but the borrowing is done just to facilitate the debt pay-off not to engage in either new CAPEX or new spending.

Mr. Koo notes several times in his easy-to-read book that 3 times in the last 20 years political parties have come into power in Japan using the "we must cut the budget deficit" banners. All three times the results of the fiscal cutting threw Japan back into its recession and those same politicians were forced to remove the restrictive measures.

Mr. Koo argues that the Government spending must at least equal the cutback in spending from the private sector in order to prevent GDP from declining.

The book is certainly worth reading and, while there are some obvious differences between the Japanese and other countries, perhaps we don't have to re-invent the wheel in our crisis and can, for once, show that we can take lessons from other countries which have or are dealing with some of the problems we face.

The book has certainly put me into a different space not only about how long our American malaise might last, but also gave food for thought about how that time might be lengthened or shortened by our fiscal policies and those we elect to implement them.

Here is a link to the book


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