Balance sheet recession

By fmiren | Is recession coming | 13 Sep 2023

Balance sheet recession is one kind of economic recession that differs from other “ordinary” recessions. It is an environment in which private sector pays down its debt. Since this implies less corporate spending or investing, it can lead to contraction of economic activity.

Imagine the mid-1990s Japan where private sector has a high level of debt. When asset prices including commercial real estate and TOPIX stock index crashed in the early 1990s, the corporations found themselves in an unpleasant situation where they had too much debt and a lot of assets that lost value aggressively in their balance sheet. That’s why this type of recession is called “balance sheet recession”.

The interesting feature of balance sheet recessions is that the corporate sector refuses to borrow though interest rates are too low. Conventional economic theory teaches that the most important reason companies exist is that they make money in a more efficient way than other entities. So when the cost of borrowing is low, we should expect corporations to borrow more money to put it to good use. In this typical thinking there’s no explanation for a company paying down its debt when rates are low or even at zero. However, this is exactly what happened in Japan in the 1990s.

Another characteristic of balance sheet recession that contradicts traditional economic thinking is that monetary policy doesn’t work. Since private sector aggressively services its debt, cutting interest rates will not incentivize companies to borrow. This is a problem coming from the lack of borrowers, not from the lack of lenders. Therefore, in contrast with other types of recessions, monetary policy will be ineffective in balance sheet recessions.

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