WARNING SIGNALS
Reading Crisis Economics
Focus on: Secular Stagnation
Balance Sheet Recession is the Reason for Secular Stagnation – Richard C Koo
SUMMARY - In this article, Richard Koo argues that the key reason to Secular Stagnation is the bursting of a debt-financed asset bubble, and that such “balance sheet recessions” take a long time to recover from. He explains that when a debt-financed bubble bursts (Subprimes in the US or Sovereign Debts in Europe), people have no choice but to pay their debt with their cash flow, as soon as possible. But if every household in the US or every country in the Eurozone does it at the same time, there will be a problem. Because, on the one hand, everybody is saving and paying its debts. And, on the other hand, nobody is borrowing and spending. This causes therefore a disequilibrium leading to balance sheets recessions. Therefore, the solution to Secular Stagnation caused by balance sheet recession is, for the government, to offset private sector deleveraging with fiscal stimulus.
Richard C Koo
Nomura Research Institute
Source: VoxEU eBook on Secular Stagnation
The Great Recession is often compared to Japan’s stagnation since 1990 and the Great Depression of the 1930s. This chapter argues that the key feature of these episodes is the bursting of a debt-financed asset bubble, and that such ‘balance sheet recessions’ take a long time to recover from. There is no need to suffer secular stagnation if the government offsets private sector deleveraging with fiscal stimulus. However, until the general public understands the fallacy of composition, democracies will struggle to implement such policies during balance sheet recessions.
With the developed economies failing to regain forward momentum after six years of zero interest rates, people are beginning to worry that they may be facing secular stagnation. Although this is an understandable reaction, a large part of the stagnation may be due to the balance sheet recession that these economies are all facing after the bursting of their debt-financed asset price bubbles. And this type of recession takes a long time to overcome, for both economic and political reasons.
The mechanics of balance sheet recession
On the economic front, when a debt-financed bubble bursts, a large number of businesses and households realise that the liabilities they incurred during the bubble days are still on their books, while the assets they bought with borrowed funds have collapsed in value, leaving their balance sheets deep underwater. In order to climb out of their negative equity territory, they have no choice but to pay down debt with their
cash flow as quickly and quietly as possible. In other words, they are minimising debt instead of maximising profits.
Although this is the right thing to do for individual businesses and households, when everybody does it at the same time the economy falls into a massive fallacy of composition problems. This is because in a national economy, if someone is saving money or paying down debt, someone else must be borrowing and spending the same amount for the economy to move forward.
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