Balance sheet recession
Empirical methods Prescriptive and policy A balance sheet recession is a type of economic recession that occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving by paying down debt rather than spending or investing, causing economic growth to slow or decline.
It is characterized by a change in private sector behavior towards saving (i.e., paying down debt) rather than spending, which slows the economy through a reduction in consumption by households or investment by business.
If asset prices fall below the value of the debt incurred to purchase them, then the equity must be negative, meaning the consumer or business is insolvent.
[2] High levels of indebtedness or the bursting of a real estate or financial asset price bubble can cause a balance sheet recession.
A large private sector financial surplus (savings greater than investment), a proverbial "hole" in the economy, can develop.
At that point, debtors will face strong pressures from their creditors to “deleverage,” slashing their spending in an effort to pay down debt.
The effects of the emergence of balance-sheet constraints on spending and borrowing will, in brief, be revealed in the huge financial surpluses in the private sectors of crisis-hit economies.
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.
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 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.
[8] Economist Paul Krugman wrote in 2014 that "the best working hypothesis seems to be that the financial crisis was only one manifestation of a broader problem of excessive debt--that it was a so-called "balance sheet recession".
[9] This was driven by a housing bubble, which encouraged Americans to take on larger mortgages and use home equity lines of credit to fuel consumption.
[12] This illustrates the core issue in a balance sheet recession, that an enormous amount of savings was tied up in the banking system, rather than being invested.
A July 2012 survey of balance sheet recession research reported that consumer demand and employment are affected by household leverage levels.
However, the solvency (net worth) of economic actors is a third important element when dealing with a balance sheet recession, as either asset price declines must be reversed or debt levels reduced, or combination of both.
In Krugman's view, balance sheet recessions require private sector debt reduction strategies (e.g., mortgage refinancing) combined with higher government spending to offset declines from the private sector as it pays down its debt, writing in July 2014: "Unlike a financial panic, a balance sheet recession can’t be cured simply by restoring confidence: no matter how confident they may be feeling, debtors can’t spend more if their creditors insist they cut back.
