The Balance Sheet Recession
by Charles Lemos, Thu Dec 11, 2008 at 08:05:33 PM EST
In its 4Q08 report released today, the UCLA Anderson Forecast for 2009 is rather grim reading. Widely respected, the UCLA Anderson Forecast predicts that the current recession affecting the US economy will last at least four quarters of negative growth followed by very low growth rates of well under 3% with rising unemployment rates that last through 2010. The UCLA Anderson Forecast unit expects real GDP to shrink by 4.1% in this the final quarter of 2008 and by another 3.4% and 0.8% in the first and second quarters of next year, respectively, as consumer and business spending weaken and as the foreign trade that had propped up growth much of this year sags. Indeed, the trade deficit widened today as exports fell sharply. The unemployment rate, according to the report, is forecast to rise from October 2008's 6.5% to 8.5% by 4Q09/1Q10. Put into meaningful numbers, that's a loss of two million jobs over the next 12 months.
"Because Europe and Japan are already in recession and China and India are suffering from a significant slowdown in growth, the export boom of the past few years will wane," the report said. "Make no mistake the global economy is in its first synchronized recession since the early 1990s."
All that's bad enough but the real fear is the dreaded D word. Deflation, the asset killer. The reality is that commodity and asset prices are overinflated and likely to come down hard as demand for goods and services sags. Since the beginning of the credit crunch in the US in September, world copper prices have tumbled from the record highs of nearly US$9,000 per metric tonne between 2005 and 2007, to around $5,000 per tonne, amid concerns that the global economic slowdown will puncture demand. Copper is a key metal in the electronics and building industries. True, SONY and Dell's sales are hurting but so are Chile's and Zambia's. The punch is global. Locally, home prices continue to plunge. Home prices nationwide, which have fallen more than a fifth so far, may drop by another 15%, and the danger is the decline will be "worse than that," according to Martin Feldstein, a Harvard University economics professor. The market's continued slide threatens to spur more foreclosures.
"The news from the economy is bad," writes UCLA Anderson Forecast Senior Economist David Shulman in a must-read essay entitled, "The Balance Sheet Recession.""The recession we had previously hoped to avoid is now with us in full gale force."
A balance sheet recession is a rare phenomenon, where the vast majority of companies in an economy devote most of their resources to paying off their debts even when interest rates are near zero. In effect, companies are looking to wipe under-performing assets off their balance sheets. Japan's experience from 1991 through 2005 is the main and best known example of a balance sheet recession.
Here's a look from Business Week on what a balance sheet recession is like:
Japanese corporations started cutting back on borrowing as early as 1991, and by 1998 the whole corporate sector was a net repayer of debt. By 2003, the annual debt repayment reached 7% of GDP. Companies paid down debt because they faced a massive fall in asset prices after the collapse of the bubble economy in 1990, with commercial real estate values in major cities plummeting by nearly 90% in some cases. Since these assets were typically purchased with borrowed funds, the collapse devastated balance sheets and left many companies owing far more on properties than they could possibly sell them for.
On the other hand, the main line of business for most companies -- whether building cars, cameras, or precision machinery -- continued to do well. The fact that Japan ran one of the largest trade surpluses in the world throughout this period suggests that its ability to supply quality products at competitive prices was still intact. With business largely healthy, the companies started doing the logical thing under the circumstances: using their cash flow to pay down debt to repair the balance sheet.
DEFLATIONARY PRESSURE. This shift to debt minimization, however, completely disrupts the normal workings of the economy. That's because the corporate sector no longer borrows the funds saved by the household sector, even at ultra-low interest rates. With no one borrowing, those personal savings -- plus the debt companies are repaying -- pile up unused in the banks, effectively shrinking aggregate demand by the same amount. Left unattended, this deflationary gap will continue to shrink the economy until almost everyone becomes too poor to save any money.
In post-bubble Japan, this gap peaked at 8.5% of GDP in 2003. Deflationary pressure of such magnitude will throw any economy into recession, or even outright depression. Furthermore, many companies started paying down debt as early as 1992, when Japan still had inflation, indicating that it was the fall in asset prices, not deflation in output prices, that has been the main concern of Japanese companies.
In this type of recession, monetary policy is ineffective. Even though central bankers typically bring interest rates down in response to a recession, they cannot increase the money supply. That's because nobody is borrowing money, so the liquidity provided by the central bank cannot leave the banking system.
Japan's problems in the 1990s were unique to Japan. The economic situation today isn't. Talk to an Icelander or a Spaniard lately? It will make for depressing conversation if you do. As per blame for all this, Alan Greenspan is a good place to start but it goes deeper than that. Forty years of free market irrational exuberance have taken their toll.