WHEN WILL THE BALANCE SHEET RECESSION END?
Despite the seemingly strong activity in the economy in recent months there is trouble lurking beneath the surface. Don’t get me wrong – we have a real recovery on our hands (see here), however, it remains fragile and largely driven by government intervention. Beneath the surface the balance sheet recession lurks.
As the housing bubble grew the US economy experienced an unprecedented growth in debt. This generated an imbalance as debt levels far outstripped disposable income. This environment was sustainable as long as asset prices continued to climb, however, once prices deteriorated debtors were left with an imbalance. As a result, a balance sheet recession ensued as demand collapsed under the weight of households who preferred to pay down debts rather than spend. The impact is magnified by corporations that cut costs (read, fire workers) as demand collapses and they attempt to protect margins. Real sustainable recovery cannot ensue until the indebted sector of the economy returns their balance sheet to a state of normalcy.
The government’s response to the crisis was massive and far more effective than most presumed. But it was not a cure. It was merely a temporary fix. The following updated sectoral financial balances diagram shows what has occurred over the last 15 years. It’s undeniable that the government response via huge deficits is having a positive impact on the private sector balance sheet:
(Figure 1)
The bright side is that things could have been much worse. Even better, we haven’t fallen for the fear mongering from the hyperinflation/USA is bankrupt crowd who are helping to cause so much destruction in the nations of Austeria. The problem is that this government intervention is not a cure. Aggregate household debt levels are still too high as evidenced by the debt:disposable income levels (see figure 2). This means we could still be several years from sustained private sector growth. As I like to say, the public sector is not yet ready to pass the baton to the private sector.
(Figure 2)
At the current trajectory it’s not unreasonable to assume that the balance sheet recession will last well into 2012 and potentially longer. While a 1:1 ratio is “sustainable” by my estimates, it would be comforting to see levels closer to the historical levels in the 80% range. If that is the case we could see the impact of the balance sheet recession persist far longer than anyone believes. The obvious upside risk is a dramatic improvement in the labor market. On the other hand, our government is now explicitly encouraging fiscal imprudence in an attempt to “keep asset prices higher than they otherwise would be”. This sort of policy has the very real potential to increase instability and turn recovery into bubble. Other exogenous risks (Europe, China, housing prices, etc) also pose substantial risks to the downside. For now, I think it’s safe to assume that the recovery will remain fairly fragile well into 2012, but given the size of the deficit and potential for labor market improvement we could see continued economic strength.
In sum, it’s clear that government intervention has been sufficient to defer the negative effects of the balance sheet recession. In the near-term, that is a net positive, however, the risks are substantial. If the balance sheet recession persists into 2013 or longer then the obvious risk is a substantial decline in the deficit. Austerity would almost certainly expose an overly indebted household sector and send the economy back into a tailspin. With the deficit projected to be $1.5T this year it’s comforting to know that we are not repeating the mistakes of Japan, however, it’s important that we not get too complacent as the balance sheet recession lurks underneath a seemingly rosy surface.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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97 Comments
Moneta – in your step 3, the 1 trillion that was “created” is destroyed again when it is given back to the government for the bonds, isn’t it?
No it was not. Fed buys MBS. Pimp & Co. gets cash for stinky MBS. With cash buys treasuries. With cash from Pimp & Co. government gets to keep on spending… that’s the deficit.
All in all, Fed gave government to spend.
And their trick of using the investment banks to keep people in the dark is working like a charm… most people obviously still refuse to believe that they are monetizing the debt.
The GDP would not be 14 trillion is the government did not do QE.
the balance sheet recession will end after the pop of the now forming paper bubble in…in…in….EVERYTHING ….but western currencies maybe….probly brought on by some political convulsion.
Eur peripheral defaults bringing down paris n hamburg banks….china awash in empty buildings bust.
i am sorry this isn’t over….i really am.
US n Eur shoulda took that swedish bank model in ’08.
the can runs out of road.
I also believe the US can print all the money it can, thus has no funding problem. But this also has consequences such as misallocation of capitial, shrinking productivity and a general lack of trust leading to a decline in living standards.
From the bottom up I look at debt/gdp. When you include all debt and entitlements, the ratio is huge. This ratio needs to contract so either debt drops or GDP rises.
I believe debt will be maintained at all costs (to prop up assets) but entitlements will get cut and GDP will rise quickly though inflation mostly. CPI won’t reflect the true cost of inflation.
When this ratio gets back in line, that’s when the balance sheet problem will be resolved.
Agreed. That’s what my original article was all about!
…junk economics based on a bankers view of equilibrium in an economy
Kind Regards
From the bottom up
—–
Top down.
Well, since the US is NOT making the mistakes of Japan,
And -
Since this time IS different,
The balance sheet recession MUST be over!
When the US spends they simply credit bank accounts and where does that go ?
As reserve and then if it use as QE its called a swap by the Fed and its no longer increasing the money supply.
I don’t care how it’s called, Changing money for Toxic Assets is simply shortchanging the public. IF I take a blood bath in the market there is no QE to bail me out.
Any new T bills purchases above what the fed could not purchase if the money was convertible will end up as devaluation sooner or later
Cullen
“Today, it is impossible to monetize the debt. The Fed could purchase up every outstanding tsy bond in existence and it wouldn’t matter at all to how much money the govt can or cant spend…..
“Money printing is always done by tsy. And it is done in the form of deficit spending. This is independent of the Fed open market operations.”
I think I’m finally getting my head around this. The money is created by deficit spending. The Treasury may choose/or not to cover some this by issuing treasuries. These are put on the market, but these days that market is weak. So the Fed takes some of these out of the market and puts them on their books (QE2). Interest on these is given back to the Treasury. So when people add this up its seems like the Fed is printing money. But I see how it’s difficult to argue that the Fed is not printing money because the Fed and Uncle Sam have a husband/wife like relationship. It actually doesn’t make any difference who is doing the printing in a practical sense. It all started with the deficit spending. Is the diluting the amount of US dollar/reserved currency in the world? Is this deficit spending like a fire hose in a pool or rain in the ocean?