Is the current "Financial Crisis" a "Balance Sheet Recession"?

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John James replied on Sun, Jan 15 2012 3:40 AM

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This is just scary.  This video illustrates everything that is wrong with the world economy and is a microcosm of exactly why we are in the situation we are in.

It's incredible.  It really shows how incredibly smart people could come up with such insane explanations and recommendations...you have to be that smart to come up with something so ridiculous.  (I went into this here).

There is quite a bit to debunk there, and I don't really feel like going through all of it, but basically the whole notion of "balance sheet recession" is just nonsense.  It's something created in the minds of whiz-kid economists so that they can make their failed models fit with reality.  That's how it works.  They make a model to describe how the world works, then the world in reality plays out drastically different than the model says it should (or could), and the geniuses use their smarts to come up with very clever explanations as to how they weren't wrong.  It's usually either one of two things:  (a) they reframe the data (or their previous conjectures about the economy) such that they get to say "See? Things played out exactly like I would have expected"...even when it's the exact opposite of that.

Paul Krugman could teach an entire course on this.  See here for a perfect example.  (And of course you can catch a whole series of these at Bob Murphy's site, as well as Bill Anderson's blog, devoted entirely to Krugman's nonsense.  For specific "Krugman Kontradictions" as Murphy calls them, see Krugman's article at the Mises Wiki).

That's one way they deal with being empirically wrong.  The other way is (b), just a simple "oh...we weren't wrong.  Our models are right.  It's just that this situation is different."  As you can see, this is the technique used by Koo.

There has been plenty of writing on the case of Japan.  For an excellent (and very extensive) look into the reality of Japan's "lost decades" see here:

The Myth of Japan's Lost Decades

Other writings:

Recovery in Japan

The Rise and Fall of the Japanese Miracle

Explaining Japan's Recession

A Japanese Lesson

Japan's Bust: An Austrian Critique of the Fed's Explanation

The Japanese Currency Intervention

But without getting too far into it, notice how Koo always starts an explanation or a hypothetical with the problem already occurring.  For example, at 3:24 he rhetorically asks "why did it happen?"  And goes on to give his answer.  He admits that it wasn't that everyone just went all berserk.  He says "during the bubble days, they borrowed tons of money to invest in all sorts of assets, thinking that they're going to make more money.  [The] asset price bubble collapsed, liabilities remained...so they realized 'we have more debt than what you can show on the asset side'..."

Uh.  Great.  So, where did this bubble come from?  Where did they get all the money to bid up all these assets to these insane artificial levels?  How was it possible for everyone to be paying such high prices, enough to shove them even higher and higher, to a point at which a bubble is inflated?  And why did it pop?  Why did asset prices drop all of a sudden?

He doesn't explain any of this.  He doesn't even venture to begin to ask these questions.  He just starts the story in the middle (or, really, at the end) by basically saying "oh yeah these people bought this stuff, and it was a bubble.  Then the bubble burst and they all of a sudden were upside down, with liabilities far outpacing their assets."  And then he just goes on to extrapolate his theory from there.  The problem with this is, if you start with a faulty foundation, all further explications are faulty.

So why does he start in the middle?  Why doesn't he explain those fundamental issues of how the bubble came about in the first place and how and why it popped?  Basically it's two reasons.  1) He can't answer those questions.  And people who are trying to put forth the presumption that they know everything don't usually ask themselves questions they don't have answers to.  And 2), those questions aren't necessary (or even relevant, evidently) to his theory.  His explanation works without them.  (In fact, that's why it works...that's the only way it can work is if he ignores those fundamental points.)  So why should be bother with them?

For his explanation (and prescription) to work, he can't ask (and therefore doesn't need) those questions or their answers.  It's kind of like looking at a burning city, and saying "see, you had this burning building, and it was so close to this other building, that that building caught fire too...and the flames just spread throughout the area, until it engulfed the whole block.  And then, you see, the weather had been very dry, and it was very windy that day, so the wind actually helped to shove the flames outside the block and beyond.  That tire yard and carpet warehouse were actually quite conducive to feeding the flames, so they only made things worse.  There was so much on fire, and the flames were so big, no amount of water could do much to quell them...etc. etc."

Well, that's great...but...why was there a building on fire in the first place??  And why didn't it get put out earlier, when the flames were small enough that water could quell them?

"Quiet son, I'm explaining how the city burned down.  If you're patient I'll explain how to use various technologies to guide the fire in safer directions in the future...."

You get the idea.

So again, for the reality of Japan, see the links above.  For our crisis, you can see here.

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Smiling Dave replied on Sun, Jan 15 2012 10:39 AM

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Here's how wikipedia explains a balance sheet recession:

Balance sheet recession

The bursting of a real estate or financial asset price bubble can cause a recession. For example, economist Richard Koo wrote that Japan's "Great Recession" that began in 1990 was a "balance sheet recession." It was triggered by a collapse in land and stock prices, which caused Japanese firms to have negative equity, meaning their assets were worth less than their liabilities. Despite zero interest rates and expansion of the money supply to encourage borrowing, Japanese corporations in aggregate opted to pay down their debts from their own business earnings rather than borrow to invest as firms typically do. Corporate investment, a key demand component of GDP, fell enormously (22% of GDP) between 1990 and its peak decline in 2003. Japanese firms overall became net savers after 1998, as opposed to borrowers. Koo argues that it was massive fiscal stimulus (borrowing and spending by the government) that offset this decline and enabled Japan to maintain its level of GDP. In his view, this avoided a U.S. type Great Depression, in which U.S. GDP fell by 46%. He argued that monetary policy was ineffective because there was limited demand for funds while firms paid down their liabilities. In a balance sheet recession, GDP declines by the amount of debt repayment and un-borrowed individual savings, leaving government stimulus spending as the primary remedy.^[7][12]

^{Lrt's see it again with my comments in bold:}

Balance sheet recession

The bursting of a real estate or financial asset price bubble can cause a recession.

Yes and no. As JJ pointed out, a bursting of a bubble requires, by definition, a bubble in the first place. By definition again, a bubble is an untenable situation, doomed to burst. So yes, the bursting of  the bubble can cause a recession, AE definiately agrees with that. But again, as JJ pointed out, the real cause of the whole cycle is whatever caused the bubble, which Koo doesn't discuss.

For example, economist Richard Koo wrote that Japan's "Great Recession" that began in 1990 was a "balance sheet recession." It was triggered by a collapse in land and stock prices, which caused Japanese firms to have negative equity, meaning their assets were worth less than their liabilities.

Correct, as far as it goes. See above.

Despite zero interest rates and expansion of the money supply to encourage borrowing, Japanese corporations in aggregate opted to pay down their debts from their own business earnings rather than borrow to invest as firms typically do.

Very true. However, you say that as if it's a bad thing, which it isn't. It's exactly what they should be doing.

Corporate investment, a key demand component of GDP, fell enormously (22% of GDP) between 1990 and its peak decline in 2003.

Absolutely, no corporate investment means no increased production, because where else is increased production going to come from. The question is, that under normal circs, recessions don't last 13 years according to AE, if the economy is left to itself. But of course the Japanese economy was not left to itself.

Japanese firms overall became net savers after 1998, as opposed to borrowers.

So they paid off their debts?

Koo argues that it was massive fiscal stimulus (borrowing and spending by the government) that offset this decline and enabled Japan to maintain its level of GDP.

Oh absolutely. But GDP is just a number. If the govt taxed everyone 100%, printed up trillions of dollars, and borrowed trillions more,  then spent it all on cocaine parties for Obama, that would show up as a positive in GDP. But it is of no benefit to the economy, as I hope everyone understands. So maintaining ones GDP is not neccessarily a good thing.

In his view, this avoided a U.S. type Great Depression,

Non sequitor. See above.

in which U.S. GDP fell by 46%.

That's like saying "I hit the guy with a hammer and broke his arms and legs, but I saved him from getting his skull smashed [by me].

Japan only suffered from govt spending, as every economy must [One must study a bit of AE to know why this is so]. Left to its own devices, it would have been better off.

He argued that monetary policy was ineffective because there was limited demand for funds while firms paid down their liabilities.

Monetary policy is always ineffective, or rather always bad for the economy [Again, knowledge of AE required here]. Maybe he means the delay of the inevitable bust was not posponed by monetary policy, because the Japanese quite rightly paid off their debts instead of borrowing more.

Now there is a subtlety here. In fact two subtleties.

1. Sometimes a business should be borrowing money and expanding [if there is money to be made doing so], sometimes it should be paying off its debt [if expansion will not earn a profit given the state of the market for the business's product]. It is a pure business decision dependent on the highly individual situation the company is in. Certainly no economist or govt beaurocrat knows what's right for a copmpany. It's owners and management have a much better idea of what to do. That's why they are the ones running the company and the beaurocrat and economist aren't. So Koo's assumption that paying down debt as opposed to expansion was a sad event and a big mistake is itself sad and a big mistake.

2. Koo is also making a huge error assuming [with no foundation] that if GDP is zero, things are bad. An economy does not always need growth. Soemtimes it needs creative destruction, as it fixes up the blunders made in the past. For example, if the govt subsidized the horse and buggy industry heavily, and many buggy factories were built, there nothing to do but put some time and resouces into destroying those factories and recycling their components into something useful, like auto factories. There will be a decline in buggy sales, firing of buggy makers, in short a recession, but it must be done.

In a balance sheet recession, GDP declines by the amount of debt repayment and un-borrowed individual savings,

Which, again, is not neccesarily a bad thing.

leaving government stimulus spending as the primary remedy.^[7][12]

One more remedy like that and the patient will die.