Balance sheet recessions: another economic fallacy?

Financial capital forms an integral part of any modern economy. In an ideal world, banks should act as intermediaries that channel the savings of households and firms to borrowers. These borrowed funds can then be used for many purposes that improve society: purchasing the first family home, funding business expansion, acquiring a competitor and investing in R&D, to name a few.

A recent book by Richard Koo of the Nomura Research Institute proposes that the breakdown in the flow of funds from savers to borrowers has been at the centre of many of the world’s major economic contractions, from the Great Depression to Japan’s Great Recession between 1990 and 2005.[1] Mr Koo calls his theory the ‘balance-sheet recession’ and believes that the failure of economists to recognise it has led to policy errors in the past, and perhaps currently in the US. As a consequence of this error, Mr Koo writes that “we are experiencing not only an economic crisis but also a crisis in economics”.

With a statement as grandiose as Mr Koo’s, it is worth examining the rigor of his theory and whether it can explain persisting economic stagnation in the US and Japan.

Deflationary gaps

Balance-sheet recessions arise in the aftermath of an asset bubble. This was seen in the 1929 US stock market crash and the 1990 Japanese real-estate bubble. During an asset bubble, corporate and household balance sheets are highly leveraged as funds are borrowed to invest in assets. As the bubble bursts, the value of assets collapse, whilst debt remains fixed. In some instances, as the value of liabilities can far exceed assets, households and businesses spend several years repaying debt.

During this period, there is a contraction in aggregate demand equal to the sum of savings and debt repayment in the economy. As the restoration of balance sheets can be ubiquitous, the economy is at risk of entering a deflationary spiral. This part of Mr Koo’s theory seems to resemble Keynes’ ‘paradox of thrift’. The idea is based on the fallacy of composition: inferred savings are beneficial to the whole because savings benefits the individual. This inference is fallacious because the more individuals save, as oppose to invest, GDP and the total amount of savings in the economy contracts.

Mr Koo argues that although saving imposes downward pressure on interest rates, a fall in the rate does not encourage investment during a balance-sheet recession. This is because businesses shift their behaviour from profit maximisation to debt minimisation, whereby there is no demand for new loans even at the zero bound. In addition, savings from lower rates are used to repay existing debt and not for spending. This is part of the reason why Mr Koo believes monetary policy is impotent during a balance sheet recession.

The primacy of fiscal policy

Mr Koo argues that the only panacea is for fiscal stimulus to fill the deflationary gap. This is achieved by increasing government expenditure to the value of private savings and debt repayment in the economy. This process must continue until balance sheets are repaired and the private sector starts borrowing again.

The corollary of this is that any reduction in fiscal stimulus, whilst the deflationary gap persists, will certainly result in recession. For example, Mr Koo explains that fiscal consolation in 1997 Japan, under the Hashimoto administration, pushed the economy back into recession because the private sector had no yet finished repaying debt.

The evidence

Any theory, however sound, is only as good as the data that can be provided to support it. Admittedly, Mr Koo provides an array of compelling evidence that links the fall in the demand for loanable funds (borrowing) to the Japanese recession from 1990-2005. This is also further supported by data provided by the St Louis Fed which shows lending/borrowing declining for more than 15 years and which currently remains flat (see below).

The theory is also consistent with Japan’s consumer price index whereby the nation’s emergence from deflation in 2013 coincided with prime minister Shinzo Abe’s unprecedented fiscal stimulus. This suggests increased government expenditure plugged the deflation gap in Japan.

Undoubtedly the lack of borrowing in Japan over the past two decades, and perhaps in the US since 2008 (see above), has some part in explaining the slow recoveries in both economies. But it is difficult to accept that declining borrowing and debt repayment in Japan is primarily attributed to the bursting of an asset bubble that occurred 25 years ago.

It is reasonable to assume that businesses without sufficient cash flow to repair their balance sheets quick enough would lose support from shareholders and soon become bankrupt, with the exception of the few zombie companies that continue to linger within Japan’s economy. In addition, the Bank of Japan’s massive quantitative easing program in 2013 led to a significant resurgence in Japan’s share prices, which would have improved some balance sheets.

Although there are shortfalls, Mr Koo’s work has an overwhelmingly positive aspect. It focuses attention on a rather neglected aspect of the economy: the demand for loanable funds. Lending/borrowing, essential for funding business investment and household expenditure, still remains weak since the beginning of the global recession in 2008. Mr Koo’s ‘balance sheet recession’ may become a significant contribution to macroeconomics if it is used as a stepping stone to better understand the causes of decreased private sector borrowing. An aging population and business pessimism may be some areas that merit closer investigation.


[1] Richard C. Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Wiley, 2nd ed, 2009)