WHY THE BALANCE SHEET RECESSION WILL NOT LAST AS LONG AS JAPAN’S
In a recent story I pointed out that Richard Koo said it was not significant that the USA has been faster to respond to the current balance sheet recession. Now, he was primarily referring to the ineffectiveness of monetary policy during a balance sheet recession and the fact that it doesn’t matter how quickly you cut rates or implement QE during this sort of recession. I largely agree with these comments. But I think it’s important to note that the USA has a slightly different form of balance sheet recession and is responding to it with fiscal stimulus more quickly than the Japanese did. This, in my opinion, is unlikely to result in a balance sheet recession as long as Japan’s.
Just to review – it’s important to note that Japan’s debt crisis existed primarily at the corporate level. In his superb book, The Holy Grail of Macroeconomics, Koo explained the situation:
“Indeed, this leverage issue was another reason Japanese firms moved to pay down debt during the 1990s. Exhibit 2-2 shows leverage ratios at Japanese and US firms. Japanese businesses used to be extremely dependent on debt financing relative to their Western counterparts. In the first half of the 1980s, for example, leverage ratios at Japanese firms were five times those at US corporations. But no one thought twice about this at the time, because the economy was rapidly expanding, and asset prices were surging higher. Few were worried about debt levels under these circumstances. After all, the use of borrowed money to acquire assets raises few eyebrows as long as the economy is expanding and the value of corporate assets is rising. If anything, companies were commended for taking on more debt because greater leverage translated to a higher return on equity.
But this cycle began to reverse when the bubble burst in 1990, and the Japanese economy entered a period of low growth and falling asset prices. Companies carrying heavy debt loads still had to service this debt even as earnings declined, putting their survival in jeopardy. In effect, firms had to pay down debt starting in 1990 not only to put their balance sheets in order, but also to bring leverage down to a level benefitting an era of lower growth. In this sense, too, Japanese firms have made substantial progress in reducing leverage over the past 15 years.”
These are very important points. You could essentially replace “households” with “businesses” in the above paragraph and you’d be describing the situation in America today. And that’s the exact difference. Our balance sheet recession is a household debt crisis whereas Japan’s was a corporate debt crisis. As I’ve often said over the years, effective policy needs to focus on households and not banks. This was always a household debt crisis and not a banking crisis. And while America’s banks are still distressed (although they’re in far better condition than they were in 2008), American businesses are actually very healthy today and I think that is proving to cushion the downside during this recession.
As you can see from the above chart Japanese businesses were grossly overleveraged. And while US households suffered a massive bubble the leverage was nowhere near the same levels. If we look at household liabilities to disposable income we can see that the problem is by no means good, but it is becoming more stable by the day:
This is a large part of my estimate for 2013/14 being the end of the balance sheet recession. Given recent trends, the cash flows of households should begin to support organic recovery long before the de-leveraging was done in Japan. While we are likely to suffer several more years of weak growth we don’t yet need to fear another lost decade.
Further supporting this theory of a shorter balance sheet recession is US house prices. Richard Koo notes that Japanese corporations were struck by declining asset prices. The fact that they had an equity AND housing bubble at the same time served as a double whammy in this regard. The USA, on the other hand, suffered the equity market bubble more than 10 years ago. So the impact in recent years has been more concentrated on the collapse in real estate prices. As I’ve previously noted, I think the majority of the price declines are behind us in housing. This is confirmed by price trends in Japan as well (see below). This should stop the uncontrolled bleeding that has caused so much imbalance in recent years.
Lastly, the USA was faster to implement the all important fiscal policy that Richard Koo prescribes. Contrary to political fearmongering and claims that fiscal stimulus has destroyed jobs, the CBO and the sectoral balances prove that fiscal stimulus has aided in helping the household sector during this de-leveraging (common sense is all it should really take to understand this, but politics and confirmation bias cloud people’s judgment). This “recovery” has been largely stimulus driven. It has not been organic by any means, but that is the nature of the balance sheet recession. If government doesn’t fill the spending void, the bad decisions of the few who caused the debt bubble end up causing the rest of us to suffer a depression alongside them.
In the USA President Bush actually initiated fiscal stimulus before the crisis really hit. In February 2008 he implemented the Economic Stimulus Act of 2008. This was obviously not that effective, but was followed up by the massive stimulus package after the collapse (please see the bipartisan CBO’s details on the effects of the stimulus). The Japanese, on the other hand, did not implement fiscal policy until almost three years into their crisis. Over the ensuing 6 years Japanese stimulus was a stop and start process with political bickering inbetween (which is beginning to ring all too familiar as our politicians bicker over the debt ceiling).
Most importantly, we have not allowed ourselves to be talked off the edge of the cliff by those who fear the USA is going bankrupt. Unfortunately, the risk of fiscal austerity poses a serious threat to my optimistic end date for the balance sheet recession. I am probably naively hopeful that austerity turns out to be less negative than some currently think, but I do acknowledge that this is an enormous downside risk. As Warren likes to say, “because we think we are the next Greece, we are becoming the next Japan”. I sure hope not.
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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48 Comments
Thanks for a very informative article – which even a simple Farmer can understand!
‘simple’ I’m sure you’re joking and if you are one God bless you. Your mass production gives me leisure time.
Today’s American farmer is part economist, part engineer, part veterinarian, part meteorologist, physically fit and well balanced mentally.
@John C: in my travels, which always begin and end flying out of / into Chicago, I wind up sitting next to a lot of farmers. there’s not a group of people more in tune to what is *really* going on, and who can see straight thru the BS and talk at the issues and solutions at hand.
As Viejo says, today’s farmer is more well-rounded than most any profession one can think of — economist, business owner, in tune with politics, budgets, technology, deal-making, financial hedging instruments, not to mention being hard workers and massive risk-takers.
The farmers I run into are all these things, and have a sort of ‘street smarts’ they just don’t teach in schools. They are cut from the same cloth as the (former) traders in the Chicago Pits. One difference from the traders would be that, like you John C, most all are incredibly modest.
I always hate to generalize, but as a whole, and from my experience, there’s not a profession / group of people / mindset that I have more respect for than that of the American farmer.
Hats off to you.
I admire the huge federal subsidies farmers get, as it allows them the leisure time to rail against big government.
And farmers are the producers of the one import to China they can not make 100% themselves. They are losing huge sums of farmland every year to desertification. Some day there is going to be big drought in China and the American farmer will come to their rescue and we will get back some of those treasuries that they don’t think so much of these days. Keep your eyes open. Georgia pecan growers are now finding out that the health food hungry Chinese love pecans more than walnuts.
And I left out part lawyer and part environmentalist.
Good article. One point – total private sector debt surged not just due to the real estate bubble but also due to financial sector debt (non-bank financials borrowing from banks).
See Morgan Stanley’s chart:
http://paul.kedrosky.com/archives/2009/03/us_total_credit.html
Deleveraging in the non-bank financial sector might also be contributing to contractionary pressure on bank balance sheets.
“Stimulus” is really an indirect means to allow the debt-slaves to pay down their onerous debt, isn’t it? But the trouble is that “bridges to nowhere” and “hole digging and filling” give the deficit hawks plenty of ammunition.
An honest approach would be to admit that the government backed counterfeiting cartel, the banking system, has driven the population into onerous debt. Then it would be obvious that a debt Jubilee or better a bailout of the entire population was called for.
@F. Beard
What bridges to nowhere and hole digging and filling are you referring to aside from cash for clunkers and the dum idea of supporting RE prices?
I had nothing particular in mind, just government make-work in general.
Bush’s stimulus checks were a surprisingly good idea. They got the money directly to the victims of the bankers (the entire population) with little waste. Obama should reinstate them but call them “Onerous Debt Relief Checks” or some such.
Why beat around the bush? If household debt is the problem then:
1) Abolish the means that drove Americans into debt.
2) Abolish the debt or give Americans (including savers) the money to pay it off.
I suggest that a universal bailout is best since it would give an equal amount to savers too. It would fix everyone in nominal terms, including the banks. As for inflation risk, that could be muted by metering the bailout checks to just replace existing credit as it was paid off.
Beard,
Nobody forced the US consumer to overleverage themselves. Prudent people did not spend money they did not have. While the banks are certainly part of the problem, the abdication of personal responsibility implicit in your blame of the banks is both irresponsible and unproductive.
The total abdication of personal responsibility which society has embraced is massively driving up the cost of doing business in the US as companies are forced to keep teams of egregiously expensive lawyers on hand to protect them from a population who wants to sue somebody every time natural selection runs its course. I mean really, have you looked at some of the warnings on products these days?
The problem extends beyond the corporate world. Life Without Lawyers would be a good place to start.
Nobody forced the US consumer to overleverage themselves. WellRed
The banks are essentially a government backed counterfeiting cartel. Those who don’t borrow from the cartel are priced out of the market by those who do by negative real interest rates.
Another key difference is that Japan is shrinking, population-wise. America is not.
Japanese household had a lot saving before the downturn, and the US household didn’t have that. The Fed bank transferred a lot money to US banking industry including GE (those are large corporations). To say the American business is doing fine is probably too broad. The housing decline is probably behind us, but the writedown is not. who really knows the balance sheets of our banks? It might work out a little faster than Japan, but we are in the downturn or ‘recovery” for 5 or 6 years already, and “faster” becomes a relative term. Am I missing anything?
Recovery? Don’t talk to me about Recovery. There is no, and never will be a recovery.
This is not a business sector recession.
The driving force in the economic downfall is outsourcing.
The American people as a whole no longer have good jobs, or the prospect of having good jobs in the future.
The bubbles of the 90′s and 00′s were a smoke and mirrors trick to cover up this fact, while big business continued to decimate the American jobs base in order to increase their own profits.
The real truth is that America will never “recover” from this recession, because that would indicate a return to a level we will never see again.
The standard of living in America for the average person is on a downward spiral that will not level out for another decade.
Japan at least has a chance to recover at some point because they started from a lower level to begin with and their population are veracious savers, we on the other hand are toast.
I’m with Warren on this one, “because we think we are the next Greece, we are becoming the next Japan”. Or worse, USA 1937.
Have you been to Japan? It’s not like they are lining up at the soup kitchens. The place is bustling. Unemployment is relatively low. Life is good. Bring it on.
How about none of the above? There is one thing that IS different this time – Peak Oil. Total fossil fuel on a global basis is capped, and that means that total economic growth on a global basis is capped. Global real GDP growth can not exceed the increase in energy consumption plus any increase in energy efficiency. Once energy supplies go into decline, the only real growth can come from energy efficiency. Until solar or some other source can replace a substantial fraction of fossil fuel, this cannot change – and that will take a VERY VERY long time. The energy markets have the longest time constants of any commodity. The sunk infrastructure cost for energy is the highest of any commodity. Cycles in energy last for centuries.
This means that the whole world is like a toothpaste tube or a water balloon. If you squeeze it in one place, it bulges out in another place. Monetary stimulus in one place must result in inflation somewhere, because energy supplies are capped. So we are not Greece, we are not Japan, and we are not US 1937.
Cullen,
Thank you for your very informative work.
Not being an economist, though, I am trying to our understand deficit spending. Could I pose a simple example for your comment?
Suppose there was an independent island economy based upon coconut sales, and that the bottom fell out of the cocunut market. Since some residents were now unemployed, suppose that the government supported the island economy through deficit spending by hiring some to build a decorative wall around the island, by employing others to begin guano production, and by just giving the rest of the unemployed half of their prior wages. Would the make-work employment and transfer payments be inflationary? Would the island economy have been improved or degraded by these measures when the coconut market recovered several years later? Thanks.
Suppose there was a island where the money supply was lent into existence. Eventually the population became so indebted that it could not borrow any more so the growth in the money supply slowed down. As a result, the economy slowed down and some people lost their jobs. This frightened other people who cut buck on their spending and caused other people to lose their jobs. This continued until a large percentage of the population was unemployed merely because the island had a debt-based money supply.
Now imagine that a debt-free source of money appeared and paid people to do silly jobs like dig holes and fill them. Suddenly there is enough money and the economy recovers.
Question? Was it the silly jobs that helped or the debt-free source of money?
We are still in bubble valuation territory according to the valuation measures that have demonstrated statistical relevance over time (hint: TTM and forward PE ratios are statistically useless in forecasting future real total returns to stocks).
Http://www.butlerphilbrick.com/papers/estimating_future_returns_June_update.html
I will take the other side of this any day…Cullen, your rose eyed recovery in 2013/2014 is not going to come. Organic recovery is a joke, the only thing US does is speculative asset bubbles, no organic anything. I will bet that unless there is destruction of debt, we go Japan. And as far as fiscal stimulus, you should go back and read your own MMT primer….spending money does NOT create VALUE. There is still excess of everything in the US and until that gets destroyed or worked in, no recovery.
Cullen,
Good analysis. Although I somewhat doubt the leverage data of US corporate (usual stuff – off-BS and securitization) the general picture is correct.
The assumptions about US consumer deleveraging are quite doubtful though. First of all – in the graph above (liabilities vs. disposable income) what liabilities are counted? Is mortgage included? What income is used – aggregate, average or median? What is the basis for projections – how future taxes and compensation growth are accounted for? How government transfer payments and related increases in government debt are accounted for?
Then the analysis part. It looks like secular growth in 1980 – 2000 was based on increase from 0.6 to 0.85 (not accounting for change in government debt, as I understand). The next, much weaker leg – 2000 – 2008 required increase from 0.85 to 1.25. Why do you think decrease to just 1.0 would be enough to return to “normalcy”? Why not to 0.6? Do you assume that after return to 1.0, the consumers will be able to re-leverage to 1.25 again, driving growth? If not, would the growth be driven by increase in disposable income? What would be the sources of such increase? I, myself, do not see any….
Also, about the quality of deleveraging. I read in many sources that the majority of deleveraging occurred not because of repayment/savings or growth in disposable income, but because of defaulting and write-offs. Will all these consumers be able to le-reverage? I doubt it. And even if they would, do you like such catalyst for growth? It would be recipe for exactly the same disaster in the future.
My feeling, and please correct me if i am wrong, is that your thesis is predicated on strong and sustainable growth in median(?) disposable income. Sorry, but I do not see any catalysts for that, and would be very happy to see your comments regarding this subject.
With the loss of unions the labor force will continue to have an ever lower income, until the wish is, we can compete with China and India on a more equal basis. This does not bode well for consumption or private leverage.
Good point on value. What is the marginal utility of debt?
If it’s not going to make a difference one way or the other, better to default than to string it out.
‘If you’re in a hole, stop digging.’
With some 42,000 or around 10 percent of the factories being moved out of the US those workers won’t be called back, ever.
China, Europe, India and most others have VAT taxes with is essentially a tariff and other means to protect their markets and industries.
Our agreement with China under Nixon was sold as a way for US companies to export many goods to China. China saw it as a way by lowering their exchange rate to move US production to China and export to the US. We made a big mistake.
Another point a blog made is that the US being English speaking with good technology most every other English speaking country has been targeting their exports toward America. China has even taught 300 million Chinese citizens English. Most other countries don’t have that problem. Hardly anybody knows Finnish or Norwegian or Chinese, etc. except for their native populations.
I wonder if there is a “Greed” component to the data signifying the differences and similarities between Japan and America, i.e. Wealth transfer and Differential?
This is very comforting knowing that Japan is still in a recession after 21 years.
We are not Japan. However, the major world economies debt burdens have made each country weaker as debt levels are much higher than in the 90′s. The only major economy where the debt has been spent on infrastructure investment for future productivity is China (empty cities being the exception). Most all other countries failed to put this debt to productive use.
Financial principles dictate that income can remain locked at current levels and given enough time and if the current mentality of paying down consumer debt remains the same AND with no major shocks we will eventually pay down our debts to healthy levels, begin another business expansion through demand pull built on consumer confidence leading to a decrease in unemployment, an increase in income and investment.
For the time being, the transports look awful.
Quark, regarding Japan still being in a recession after 21 years, given the steady population declines in that nation, I wonder if we should look at GDP on a per-capita rather than aggregate basis. By that measure, Japan has improved 50% in the past 12 years: http://www.indexmundi.com/g/g.aspx?c=ja&v=67
With a bit of luck the B/S recession (I like TPC’s acronym!) probably won’t even last til 2014. The US (vs. Japan) is blessed with great natural resources (and good relations with Canada/Australia for some of the remaining non-domestic commodities), a large free-trade zone, and have the luxury of maintaining their “strong dollar policy” … yes, I was kidding, … I mean their weak dollar policy. The only threat to the US would be an oil shock or social breakdown.
In Japan one way of passing risk to someone else is to pay invoices in more 180 days, if you pay in that terms why do I need to get a credit?. You pass th debt unleveraged!!!!!
If it is not the same cash culture the graphics comparison has no sense.
Have a nice day
82% of the consumer debt is mortgages and HE. I cannot find the WAM for all mortgages, but I guess it is 20+ years (does anyone a reference to that info?).
Nothing significant was done to reduce that debt, so I do not think we will be in the clear in 2 years. more like 6 maybe.
Since the gov backs Fannie/Freddie, and already are directly liable, they could in principle reduce the principle at any time (except for sublteties like, accounting losses!). Someone had an interesting proposal to forgive some of the principle, but retain a “call” on the selling price of the home. From a high-level, this seems to help by alleviating some of the balance sheet liability of the consumer (which was already covered by the gov anyways), while giving some upside to the gov if prices recover. This is similar to how Mexico’s Brady bonds were restructed, with a call on their oil revenues (if oil prices went up).
Sorry forgot to add …
… this could happen much sooner than 6 years if they got their act together.
That is a good idea.
I think the shortest path was to let everyone refinance. A lot of owners are stuck with higher rates.
The biggest bang for the buck would have been for the government to ask for free refinancing at lower rates for mortgages at all banks they saved and negotiate “volume” discounts for the banks that did not have to be saved.
That would have been very cheap way to put money back in the hands of homeowners, spur hiring (someone has to process all those modifications), reduce incentives for strategic default and even prevent some of the foreclosures. And as you said since they own a huge part of the outstanding mortgages, it would have been very very cheap end effective solution.
Refinancing does you no good if you are deep underwater by 50% or more. The only real solution is if someone wants to move for job related reasons, they should be able to petition a bankruptcy court to order a short sale that would not consume any of the borrower’s other assets or result in any deficiency judgement. Lots of jobs go unfilled because people cannot move, and this would solve that problem.
I think the analysis would have to consider demographics for both as well, to present a complete picture.
Your thoughts on stabilization are spot on.
Private Sector Credit Market Debt (Total Credit Market Debt Outstanding – Federal, State & Local Debt Outstanding) has fallen from around $44T in Q3/2008 to an increasingly stable level of around $40.5T as of Q1/2011.
Cullen, this has to be the most accurate analysis of the crisis I have read and I read a lot. Thank you for applying sense and reason to such an important topic and thanks for your excellent site.
I think Harrison from Credit Writedowns has the future macro picture better. I for sure see a lot of doom and gloom in the future, and in no way a recovery any time soon.
How in earth are you going to repair balance sheets with massive contraction of aggregate demand and austerians all over the world. Yes, there is deleverage, but not because governments deficit spending (at least from now on) or current account surplus like in Japan, indeed is credit destruction and deflation the only thing that will help deleverage, but also destroy economic activity. And especulative-stimulus monetary police (QE), aka propping up cost-push inflation is even counter productive.
No way, we are heading towards an other technical recession (because half of the world never left the real one, and the other half will be joining soon). This ‘undercover depression’ is just beginning.
Many everyday people have scaled back spending and are paying down debt. Many who cannot see a way to pay down debts- with the exception of a mortgage-within a relatively brief time period will probably foreclosure or stop paying the debt which the banking system then will absorb. This would seem deflationary and overall household debt on a national basis would clear in fairly short order. To me, the wild card is whether or not the U.S. system defaults on government debt if no other soverigns will finance our continued spending and the deleveraging process.
or stop paying the debt which the banking system then will absorb. This would seem deflationary joe
Why? Banks create temporary money (so-called “credit”) when they lend. That temporary money is destroyed when it is repaid. So how can non-payment be deflationary if the banks aren’t lending anyway?
I guess my main gripe about Japan is the level of leverage. According to Koo’s data it was 5X even when the bubble crashed!!
Cullen:
In the past you’ve posted a copy of John Mauldin’s weekly write-up so I know you read them. You’ve not yet posted it this week, presumably because imo it contains so many economic fallacies. Having said that, I would appreciate a short concise analysis written by someone much more intelligent and analytical than I (such as yourself), summarizing in an MMT context, the weaknesses or faults of his approach this week.
Thanks,
Joe
Joe, Mauldin’s primary error is that the does not distinguish between currency users and issuers. He writes some very good analysis, but that is a huge error in my opinion and leads him to many poor conclusions.
“This was always a household debt crisis and not a banking crisis.”
Really!!??? Then perhaps you can explain the $2 Trillion that flowed into the financial system during the past few years. This is a silly statement because household liabilities are assets to financial institutions. Add in Credit Default Swaps and this clearly was a crisis that originated in the financial sector. Where, after all, do you thing the liar loans originated?
“I guess my main gripe about Japan is the level of leverage. According to Koo’s data it was 5X even when the bubble crashed!!”
Funny that my profs at U Chicago taught us that capital structure is irrelevant. Another example that the summation of micro decisions does not create an optimal macro outcome! (Yes, I’ve rejected much of what I was taught).
CR – Ive read a lot of comments disagreeing with aspects of your macro calls. Dismayed… Is a good example. There are others.
I get this. There’s not enough space to cover everything but your assessment of the current situation and the appropriate investments I thought would have tempered some pens.
I appreciate the color you add especially where I can get bogged down with my own hang ups that keep me from profiting when things aren’t so clear. Like now.
Why the balance sheet recession view does not really capture the whole story: http://macromarketmusings.blogspot.com/2011/07/inadequacy-of-balance-seet-recession.html