Abstract: In this paper, the author aims to correct four misunderstandings of the “balance sheet recession” theory. First, a plunge in asset prices is neither a sufficient nor a necessary condition, but only a trigger for balance sheet recession. Second, balance sheet recession is an explanatory framework for a particular state of an economy, rather than simply a concept. Third, the policy implications of balance sheet recession are more important than its explanatory power. Fourth, loose monetary policy is critical to escaping from balance sheet recession.
New household loans in April registered a negative growth, which has stoked concerns that household balance sheets might further contract and China may encounter a balance sheet recession in the future.
A balance sheet recession is a particular type of recession attributed to severe damages to the balance sheet of businesses and households that forces them to save more while consuming and investing less to pay down debt and deleverage.
Currently, there are considerable discussions on balance sheet recession, many of which are insightful. But based on my observation, there are four common misunderstandings. For example, if balance sheet recession stems from a plunge in asset prices, does that mean we don’t need to worry about its occurrence as long as there is no sharp asset price correction? Or, if traditional monetary policy is not effective in responding to balance sheet recession, does that mean monetary easing is no longer needed?
This paper aims to clear up these common misunderstandings to better understand the theory of balance sheet recession and the current economic state.
1. A plunge in asset prices is neither a sufficient nor a necessary condition, but only a trigger for balance sheet recession.
A balance sheet recession is essentially caused by sudden and serious imbalances in balance sheets that force the private sector to reduce liabilities to rebalance balance sheets. Due to the rigidity of liabilities, such imbalances are mainly caused by the changes on the asset side.
Changes on the asset side might come from the changes in the actual value of assets, i.e. the collapse in asset prices, or from the changes in the subjective valuation of assets.
For example, if future cash flows generated by a certain asset are found or expected to decline sharply, valuation of the asset will be adjusted significantly downward, thus making the structure of a balance sheet imbalanced.
Therefore, if a balance sheet used to be robust enough, a plunge in asset prices may not lead to a balance sheet recession. Conversely, even if asset prices do not plummet, other factors can also cause balance sheet imbalance and trigger a balance sheet recession.
2. Balance sheet recession is an explanatory framework for a particular state of an economy, rather than simply a concept.
According to Richard Koo, balance sheet recession cannot be directly observed.
He emphasized that balance sheet problem is a hidden state. Many businesses seem to have a healthy balance sheet but actually don’t, which he learnt about during his private communications with some of the Japanese companies
After reading several classic reports of Richard Koo, it can be found that his observations mainly focus on fund flow statements instead of balance sheets. On the contrary, research based on mainstream frameworks prefers looking into balance sheets, such as the House of Debt authored by American scholars Atif Mian and Amir Sufi .
The reason for focusing on fund flow statements is that the main way to repair balance sheet is to increase savings by reducing outflow. The increased savings can be used to pay down debt, or just serve as saving assets. Either way, this will help rebalance the balance sheet.
In other words, lowering liabilities is not the only manifestation of balance sheet recession. What is more worth noting is the behavior that the private sector continues to reduce spending to increase savings, except that most of the time the increased savings are used to pay down debt.
Once this behavior becomes commonplace, it will bring about persisting shortage of aggregate demand and downward pressure on the economy. Richard Koo provided an explanatory framework for this particular behavior and called it “balance sheet recession”.
A typical case in point is the Olympus scandal in 2011.
Olympus Corporation is a Japanese manufacturer of high precision optical equipment and a representative of Japan’s high-end manufacturing. It was once the top camera manufacturer globally, and its status at that time was no less than today’s Apple. Like other Japanese companies, Olympus bought a lot of stocks in the 1980s. When Japan’s asset bubble burst in 1989, a huge financial hole of around 100 billion yuan appeared in its accounts. In the next 20 years, three executives stealthily covered the previous losses with some of the revenue. For instance, they fabricated a large amount of consulting fee for the cover-up, which obviously could not be made public. In 2011, Olympus designated a British CEO. The newly appointed CEO noticed that something was wrong with the financial statement, and started to investigate, eventually forcing the board to oust him from his position. But before long, the cover-up was revealed, driving down the stock price of Olympus by 70% in just a month.
3. The policy implications of balance sheet recession are more important than its explanatory power.
Generally speaking, academic research tends to focus on the theory’s ability to explain the reality. Although the framework of balance sheet recession has great explanatory power for the Japanese economy, its policy implications are more important.
If we go back to the book Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications, Koo argued at the outset that Japan’s fiscal policy was very effective. Without such a strong fiscal stimulus, Japan would not only have faced the “l(fā)ost decade”, but would also have directly experienced a great depression.
Why did Richard Koo emphasize the policy implications so much? To understand that, we need to understand his opponents’ ideas. In fact, Koo proposed the balance sheet recession theory with a purpose in mind. In his view, there are two groups of opponents. Only by knowing his opponents can we better understand Koo’s intention.
The first group is “structural reformists”, represented by Naoyuki Yoshino and Hayashi Fumio. Naoyuki Yoshino used to serve as dean of the Asian Development Bank Institute and senior adviser at the Japan Financial Services Agency. Hayashi Fumio is a professor of economics.
The structural reformists argue that the main reason for the protracted recession in Japan is that the reform is not strong enough to increase the growth rate of total factor productivity. Hayashi also co-authored an article with the Nobel Prize winner Edward Prescott on this topic. Their idea also echoes the slogan of then Prime Minister Junichiro Koizumi in 2001— “no growth without reform”.
The second group favored the “debt deflation” theory, represented by Ben Bernanke and Paul Krugman who further developed Fisher’s theory. Briefly, they suggested the use of extremely loose monetary policy to turn real interest rates negative by reducing nominal interest rates to zero while increasing inflationary expectations. With inflation, the economy is bound to take off. There are many complex mechanisms involved and more information about the cited works can be found in the reference section.
For the “structural reformists”, Koo’s comment can be summarized as one word — “silly”; and for “deflation theorists”, “na?ve”.
4. Loose monetary policy is critical to escaping from balance sheet recession.
Although Koo said that traditional loose monetary policy is ineffective in coping with balance sheet recession, the statement has a premise: monetary policy has done all it can do but is still not sufficient, which requires strong and continued fiscal stimulus. In other words, loose monetary policy itself will certainly not work.
However, without the support of loose monetary policy, it is simply impossible to get out of balance sheet recession.
The reason is simple. Fiscal stimulus requires large fiscal deficits that depend on bond issuance. Without loose monetary policy, the cost of bond issuance will be extremely high, and due to the rigidity of the cost, the debt burden will pile up in the future.
Therefore, robust and continued fiscal stimulus naturally entails loose monetary policy.
Reference
1. Mian, Atif. and Sufi, Amir. House of debt. University of Chicago Press. (2014).
2. Yoshino, Naoyuki, and Farhad Taghizadeh-Hesary. "Causes and Remedies for Japan’s Long-Lasting Recession: Lessons for the People’s Republic of China." (2015).
3. Hayashi, Fumio, and Edward C Prescott. "The 1990s in Japan: a lost decade." Great Depressions of the Twentieth Century Minneapolis: Federal Reserve Bank of Minneapolis Federal Reserve Bank of Minneapolis, 2000:206–235.
4. Fisher, Irving. Booms & Depressions: Some First Principles. CreateSpace Independent Publishing Platform. 2010
5. Bernanke, B. S. "Japanese Monetary Policy: A Case of Self Induced Paralysis." Institute for International Economics Special Report Japan’s Financial Crisis & Its Parallels 1(2000):1-31.
6. Bernanke, Ben S. "Some Thoughts on Monetary Policy in Japan: Remarks before the Japan Society of Monetary Economics, Tokyo, Japan." the Federal Reserve System. http://www. federalreserve. gov/boarddocs/speeches/2003/20030531 (2003).
7. Krugman, Paul R., Kathryn M. Dominquez, and Kenneth Rogoff. "It's baaack: Japan's slump and the return of the liquidity trap." Brookings Papers on Economic Activity (1998): 137-205.
8. Koo, Richard. Balance sheet recession: Japan's struggle with uncharted economics and its global implications. John Wiley & Sons, 2003.
