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Friday, January 21, 2011

Balance Sheet Recessions

The topic of balance sheet recessions and what to do about them has been discussed quite a bit recently. This is something I wrote on this topic about a month ago:

Balance Sheet Recessions, by Mark Thoma: As this year comes to a close, and as we finally begin the recovery stage of the recession, it’s a good time to look back and ask how policymakers could have improved their response to the downturn. What can we learn from this recession? How can we do better the next time a large financial shock hits the economy?

There are many ways policy could have been improved; providing more help for state and local governments is high on the list, but I’ll focus on another way: using fiscal policy to help households make up for losses from the recession. This is an important, but too often ignored aspect of recovering from what are known as “balance sheet recessions.”

Recessions can occur for a variety of reasons. For example, oil price shocks, stock market crashes, housing bubbles, monetary shocks, and productivity shocks can all lead to economic downturns. However, curiously, while the effects of a recession differ depending upon the cause, the response of policy – fiscal policy in particular – tends to be the same. This is undesirable, since a policy tailored to the specific type of recession would result in a speedier recovery. Monetary policy is better on this score, particularly nontraditional policy, but even this could be improved along these lines.

One way to distinguish recessions is through differences in their effects on balance sheets, in particular those of households and banks. For households, the collapse of a housing bubble, which also tends to cause a stock market crash, results in a decline in home equity as well as the loss of retirement and education savings. When combined with the loss of jobs due to the recession, and the fact the debts do not decline with the fall in asset values, the effect on balance sheets can be devastating – much larger than, say, the balance sheet impact of an oil price shock. Households have no choice but to set aside part of their income to both rebuild the asset side of the balance sheet and to pay down their debts.

This is one of the main reasons why recovery from these “balance sheet recessions” is notoriously slow. As households rebuild their balance sheets, resources are directed away from consumption, and the reduction in aggregate demand is a drag on the economy. It takes a long time for households to recover what is lost, and the recovery will be slow so long as this rebuilding process continues. Fiscal policy attempts to restore the lost aggregate demand, and that is important, but it does very little to directly address the household balance sheet issue.

The same cannot be said about bank balance sheets. The effect on bank balance sheets also varies with the type of recession, and a financial collapse brought about by bad loans is particularly severe. The present recession is an example of this, and policy has done a good job of preventing even worse problems from developing by rebuilding financial sector balance sheets through the bank bailout and other means.

But household balance sheets have not received as much attention. We could have helped households rebuild their balance sheets, and this would have helped banks by lowering the default rate on loans. Instead, we left households to mostly solve their problems on their own, and then helped banks when households could not repay what they owed.

When a balance sheet recession hits, one of the keys to a quick recovery is to use the federal government’s balance sheet as a means of offsetting the deterioration in the private sector’s financial position. But we shouldn’t just focus on banks. Household balance sheet problems are every bit as severe, and in total every bit as systemically important as the balance sheet problems of banks. We’ll recover faster from balance sheet recessions if we pay attention to all private sector balance sheets instead of focusing mainly on the problems of banks.

The perception that the government bailed out undeserving wealthy bankers while leaving households to fend for themselves is a big part of the backlash against the policies put into place to help with the recession. That perception is correct, for the most part, and it will stand in the way of repeating this policy the next time there is a financial collapse. When the next balance sheet recession hits, and another one will hit no matter how hard we try to avoid it, we need to do a better job of helping households. Not only is this good economics – we will recover faster with this policy – the politics of helping households are far superior to those associated with bailing out banks.

Balance sheet recessions take a large toll on the finances of banks, households, and state and local governments, and policymakers – fiscal policymakers in particular – must do a better job of taking such factors into account as they respond to downturns in the economy.

    Posted by on Friday, January 21, 2011 at 09:09 AM in Economics, Financial System | Permalink  Comments (27)

          


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