Deleveraging and balance sheet recession

Richard Koo has a nice article in The Economist about balance sheet recession. He has there very interesting point:

The private sector will not be responding to the talk of inflation or inflation targeting because it is responding to the fall in asset prices, not consumer prices.

In times of deleveraging households are repaying their debt and they do everything to minimize borrowings. But if the value of their debt is too high, it becomes impossible to repay it. So the only choice is default. This chart summarize it nicely. Too bad I don't know the source of it.

The gap between the the value of debt and value of properties is too large and without asset prices inflation it cannot be solved. So the only way for FED is to inflate and print money...

Original article from Koo is worth reading:

Is America facing an increase in structural unemployment? No, America lacks the necessary commitment to stimulus.

THERE is no reason for structural unemployment to increase following an ordinary recession or financial crisis. However, the US today is suffering from a balance sheet recession, a very rare ailment which happens only after the bursting of a nationwide debt-financed asset price bubble. In this type of recession, the private sector is minimising debt instead of maximising profits because the collapse in asset prices left its balance sheets in a serious state of excess liability and in urgent need of repair. When the private sector is deleveraging even with zero interest rates, the economy enters a deflationary spiral as it loses aggregate demand equal to the sum of unborrowed savings and debt-repayments every year. If left unattended, the economy will continue to contract until either private sector balance sheets are repaired, or the private sector has become too poor to save any money (=depression). The last time this deflationary spiral was allowed to materialise was during the Great Depression in the US.

In this type of recession, monetary policy is largely useless because people with balance sheets underwater are not interested in increasing borrowings at any interest rate.  There will not be many lenders to those with impaired balance sheets either, especially if the lenders themselves have balance sheet problems. The private sector will not be responding to the talk of inflation or inflation targeting because it is responding to the fall in asset prices, not consumer prices. The money supply also contracts when the private sector de-levers because bank deposits, the largest component of money supply, shrinks when the private sector draws down its deposits to pay back its debt. During the Great Depression, the US money supply contracted 30% mostly for this reason.

Since the government cannot tell the private sector NOT to repair its balance sheets, the only thing the government can do to keep the economy going is for the government to borrow and spend the unborrowed savings in the private sector and put them back into the economy’s income stream. In other words, fiscal stimulus becomes indispensible in a balance sheet recession. Moreover, the stimulus must be maintained until private sector deleveraging is over.

The problem is that in a democracy, it is extremely difficult to maintain fiscal stimulus during peacetime. As can be seen in the US, UK and in so many democracies around the world today, the demand for fiscal consolidation overwhelms the policy debate once the initial fiscal stimulus manages to stabilise the economy. Not realising the critical danger posed by private sector deleveraging at zero interest rates, those who push for fiscal consolidation argue that a big government is a bad government and that the wasteful deficit is jeopardising the future of our children and grand-children. 

When the deficit hawks manage to remove the fiscal stimulus while the private sector is still deleveraging, the economy collapses and re-enters the deflationary spiral. That weakness, in turn, prompts another fiscal stimulus, only to see it removed again by the deficit hawks once the economy stabilises. This unfortunate cycle can go on for years if the experience of post-1990 Japan is any guide. The net result is that the economy remains in the doldrums for years, and many unemployed workers will never find jobs in what appears to be structural unemployment even though there is nothing structural about their predicament. Japan took 15 years to come out of its balance sheet recession because of this unfortunate cycle where the necessary medicine was applied only intermittently. 

The real impediment to a sustained recovery from a balance sheet recession therefore is the inability of orthodox academics and policy makers to accept the fact that the private sector is minimising debt and that their aversion to fiscal stimulus based on the assumption that the private sector is maximising profits is unwarranted. If Japan had known that it had actually contracted a different disease and kept its fiscal stimulus in place until the private sector balance sheets are repaired, it would have recovered from the recession much faster and at a much lower cost than the 460 trillion yen or $5 trillion it eventually took to cure the disease.

Corporate savings glut

One of my favorite bloggers, Yves Smith, wrote some weeks ago interesting article about corporate savings glut. Opinion that corporates have big savings can be true, but honestly, is it right to force corporates into savings or tell them what to do with their savings. Plus if they invest more, who will buy their production if households are saving too?

Our New York Times Op Ed on the Corporate Savings Glut: "

Rob Parenteau and I have an op-ed at the New York Times today. Rob’s last post here argued energetically that the now-established trend of the corporate sector to save, as opposed to invest in growth, in advanced economies, and even most emerging economies, was tantamount to capitalists abandoning their traditional role. It reminded me of an article I had written in 2005, “The Incredible Shrinking Corporation,” for the Conference Board’s magazine Across the Board, on how companies were trying to starve themselves into attractive- looking performance though the then-unprecedented act of saving in a time of economic expansion, which is tantamount to disinvestment. Rob’s post made further key points about the macroeconomic implications of corporate savings (given the norm of households savings as well) and made some policy recommendations.

I wish the headline were different (”Are Profits Hurting Capitalism?“), since the article is clearly about the corporate savings glut.

Rob and I thought readers would be interested in the how the draft we submitted compared with the edited version. The draft was titled “It’s the Corporate Savings Glut, Stupid! The Hysteria of Marching to Austeria”:

A series of disappointing data releases in recent weeks, including flagging consumer confidence and meager private sector job growth, is leading more and more experts to worry that the recession in the US and abroad is coming back. At the same time, many policymakers, particularly in the Eurozone, are slashing government budgets, which they contend will lower debt levels, and thereby restore investor confidence, reduce interest rates, and promote growth.

Yet many miss the fact that fiscal deficits are a nearly inevitable result of actions by corporations and households. Failure to understand these dynamics and address root causes is sure to make a bad situation worse.

Unbeknownst to most commentators, corporations in the US and many advanced economies have been underinvesting for some time.

The normal state of affairs is for households to save for large purchases, retirement and emergencies, and for businesses to tap those savings via borrowings or equity investments to help fund the expansion of their businesses.

But many economies have abandoned that pattern. For instance, IMF and World Bank studies found a reduced reinvestment rate of profits in many Asian nations following the 1998 crisis. Similarly, a 2005 JPMorgan report noted with concern that since 2002, US corporations on average ran a net financial surplus of 1.7 percent of GDP, which contrasted with an average deficit of 1.2 percent of GDP for the preceding forty years. Companies as a whole historically ran fiscal surpluses, meaning in aggregate they saved rather than expanded, in economic downturns, not expansion phases.

The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies.

Companies, while claiming they maximize shareholder value, increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in financial speculation. They turn their backs on the traditional role of a capitalist – to find and exploit profitable opportunities to expand his activities

Some may argue that lower investment rates are the result of poor prospects, but the data does not support that view. Corporate profits have risen as a share of GDP since the early 1980s, reaching unprecedented levels right before the global financial crisis took hold. Even now, US profit margins are nearly two thirds of the way back to their prior cyclical high, despite a subpar recovery.

What happens when corporations on balance are saving, and households in aggregate try to save too? Families and individuals typically tighten their belts and bolster their bank accounts in bad times; the tendency is even more acute now, since many are trying to pay down borrowings, which is a form of saving,

If households and corporations are both saving, it must be balanced by the other two sectors of the economy, the government sector and the import/expert secto. In other words, the foreign and government sectors must spend more cash than they are taking in. In lay terms, that means running a trade surplus and having the government incur budget deficits.

Therefore, when both domestic households and the corporate sector are saving at the same time, then you need to have a VERY large trade surplus, a very large government deficit, or some combination of the two. There is no other way to square this circle – anyone who tries to tell you otherwise does not understand double entry book keeping, which the West has used for at least the last five centuries with some success.

And what if a government embarks on an austerity program in the face of private sector efforts to deleverage? Income growth will stall, and if the austerity program is large or sustained long enough, falling household wages and business profits can result.

That result might not sound bad, since lower wages and prices would make US goods more competitive abroad. But in economies suffering from a debt hangover, as incomes fall, it becomes even harder to make payments on outstanding loans. Defaults and bankruptcies cascade through the financial system, leading to even more reluctance to borrow and lend. In other words, the result of Austerian fiscal policies, is deflation – falling wages and prices – which can easily snowball into a depression.

So rather than marching toward Austeria by pursuing what are being presented as “sustainable” or “sound” spending policies requiring immediate budget retrenchment – and such assertions can only be made by those willfully blind to the interdependence of cash flows at the macro level – we need to kill two birds with one stone. Rather than blindly marching to Austeria, we need to set fiscal policy to the task of incentivizing the reinvestment of corporate profits in business operations rather than games at the casino.

Possible measures to achieve these aims include:

1) an aggressive tax on retained earnings that are not reinvested with a 24 month period after they have been booked (this provision needs to be designed carefully to defeat efforts to circumvent it through artful accounting);

2) a financial asset turnover tax that raises the cost to management (and others) of speculating rather than reinvesting profits in productive capital investment;

3) a reinvigorated public or public/private investment program that helps speed up the shift to new energy technologies (as scaling up usually induces a drop in unit costs of production).

The entrepreneurial pursuit of profitable growth has been the vital engine of prosperity since the Industrial Revolution. Yet incentives for both managers and investors now favor myopia and speculation, undermining the very operation of capitalism. We need tax and regulatory policies to counter this destructive development, along with wider recognition that government deficits are necessary and salutary if the corporate sector is under-investing to boost its short-term profits and households are prudently refusing to increase borrowing to accommodate it.

When both households and businesses attempt to net save, the adoption of Austerian School fiscal policies in highly leveraged economies, is well nigh certain to bring back our grandparents’ experience of debt deflation and economic depression. We must stop and seriously ask ourselves, in whose interest might these Austerian policies be? None dare call it malpractice, malfeasance, or even outright madness

The NYT op ed is here. Enjoy!

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Some more posts about this topic:

One from The Pragmatic Capitalist:

THE FAILURE OF CAPITALISTS TO ACT LIKE CAPITALISTS: 

Yesterday’s discussion regarding Jeff Gundlach’s opinion that the US economy would default raised an excellent question from a reader.  In the article I mentioned that private sector net savings are government deficit.  Steve Randy Waldman at Interfluidity (in a far more detailed look) beautifully described what I was trying to communicate: net household financial income = current account surplus + government deficit + Δbusiness non-financial assets.  The question from the reader was this: if the above equation is true then where is all the private sector surplus?  This question was masterfully answered by Rob Parenteau the other day on Naked Capitalism.  His conclusion:

“Remember the global savings glut you keep hearing about from Greenspan, Bernanke, Rajan, and other prominent neoliberals? Turns out it is a corporate savings glut. There is a glut of profits, and these profits are not being reinvested in tangible plant and equipment. Companies, ostensibly under the guise of maximizing shareholder value, would much rather pay their inside looters in management handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.

What we have here, in other words, is a failure of capitalists to act as capitalists (emphasis added).”

This fact was best portrayed yesterday by Edward Harrison who writes the excellent Credit Writedowns website.  Edward showed us just how much hoarding is going on at the corporate level:

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And one from Alpha Sources.