Sunday, September 12, 2010

Household balancesheets in the Great Recession

Richard Koo, an analyst with the Nomura Securities, has argued that the the current recession is characterized by a combination of falling asset prices with high indebtedness among both businesses and households, which in turn forces them to stop borrowing and pay down debt. In such "balance sheet deflation", which is strikingly similar with Japan's experience in the nineties, the economy plunges into virtual bankruptcy as borrowers start defaulting, the government inevitably emerges as borrower and spender of last resort. He has argued that the battered balance sheets of businesses and households can be repaired only with fiscal policy, especially since monetary policy has lost traction.

A nice graphics (via Mark Thoma) captures the extent of damage suffered by household balance sheet during the current recession in comparison with earlier ones. In both the 2000 and current recessions, while asset prices dropped (due to stock market and real estate collapses respectively), liabilities have remained constant, thereby battering the balance sheets.

As can be seen, household balance sheets suffered the worst damage in the past two recessions, which were asset-bubble crash induced ones. In both cases, the declines were much larger and more long-drawn out. This also means that unlike earlier recessions the quick V-shaped recovery is less likely since the households have to spend time repaying debts and repairing their balance sheets (through higher savings) before consumption can return to normalcy.

In this context, Mike Konczal points to the distributional dimension of this balance sheet crisis that clearly indicates that unlike those at the top and bottom (whose debt burdens have not changed much), those at the 20%-90% range of household income range have been badly bruised, both in terms of debt as a share of assets and incomes.

In other words, the "consumer debt problem in the economy really is a debt problem for the middle class", one that has the potential to "sap middle-class families’ spending power for perhaps years to come".

Further, the middle-class has suffered more than the wealthy from the housing crash because middle-class families tended to rely more on their homes to build savings through rising equity, whereas the wealthier had a much larger and more diverse portfolio of assets — stocks, bonds, etc. — which have mostly bounced back significantly this year.

In the circumstances, and I am inclined to Konczal's arguement in favor of lien-stripping - "the most sensible way to get through this debt is to have well designed mechanisms for writing down housing debt, where homeowners take a penalty and creditors get an excessively large claim on future housing price appreciation". Such measures are more effective than tax cuts in so far as tax cuts in repairing the balance sheets in so far as it directly addresses the debt problem. Mark Thoma points to Joseph Stiglitz who has advocated mortgage write-downs,

"For one out of four US mortgages, the debt exceeds the home’s value. Evictions merely create more homeless people and more vacant homes. What is needed is a quick write-down of the value of the mortgages. Banks will have to recognize the losses and, if necessary, find the additional capital to meet reserve requirements."

And as Mark Thoma writes,

"Japan made the mistake of allowing balance sheet problems for both households and banks to linger and the result was a prolonged recession. We seem to have gotten the message about banks... but the message that households need just as much attention seems to be harder for policymakers to get. We need policies to stimulate demand, and on top of that, we also need policies that accelerate balance sheet repair. One without the other gives up important synergies, and prolongs either the length or the depth of our problems."

Konczal also makes the case that since the upper 10% of income earners do not face such problems (in fact, their leverage and income-debt ratios appear to have improved), they could provide the spending power to help fuel an economic recovery. It also means that any tax cuts for them would only provide benefit them without any incremental benefit for the economy.

Update 1 (18/8/2011)

Household balance sheets remain over-leveraged in the US, indicating that it will be some time before recovery can really kick-in.

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