Recently, the term balance sheet recession came up on media in China and Taiwan. They are aware of the similarity of China’s housing and stock market deflation with Japan’s, more than 20 years ago. What actions China will take in response?
Balance sheet recession is a concept developed by Richard C. Koo. Mr. Koo is the Chief Economist of Nomura Research Institute, with responsibilities to provide independent economic and market analysis to Nomura Securities, the leading securities house in Japan and its clients.
He surveyed Japanese business after the asset bubble in early 1990’s and found that businesses and households did not borrow money to take advantage of the near-zero interest rate environment as predicted in economic textbook. On the contrary, they paid down their debts. In accounting, a balance sheet consists of two sides of equal value: the value of assets on one side balanced by amount of liabilities and owner’s equity on the other. When the assets value collapses, liabilities to outside parties remain the same. Only the owner’s equity comes down. Value reduction was so drastic that equity was negative in some cases. There were not enough assets to cover liabilities. The business and household became technically bankrupt. Prudence demands that debtors pay down their debts. Japan’s culture is tolerant: it did not force them into bankruptcy. Debtors were able to remain in business to generate cash to pay creditors.
This was described in Mr. Koo’ book, The Escape from Balance Sheet Recession and the QE Trap, published in 2014.
In the book, Mr. Koo calculated that the destruction of asset value in the bubble deflation was equivalent to three years’ pre-bubble GDP. Yet, Japan was able to maintain and even increase its GDP, helped by government fiscal policy. In the case of the U.S., the onset of the Great Depression in early 1930’s destroyed one year’s pre-depression GDP and in just four years, U.S. GDP plunged 46%. Japan was fortunate as its businesses were able to continue its normal, producing goods for the export market.
Mr. Koo explained the logic of what happened as a fallacy of composition. That individuals taking prudent action might lead to different or illogical consequences as a group. In this incidence, the deleveraging might lead to depression if not because of government’s (supposedly unwise) deficit spending. Government fiscal stimulus was required to support the economy, even though it increased public sector debt.
Quantitative easing did not help as business and individuals had no appetite to borrow no matter how low the interest rate came down.
Japan’s action was against IMF and Wall Street experts’ advice. Mr. Kee explained that outside experts did not have Japan’s interest in mind. Institutional economists just follow the textbook. They are not personally affected one way or another. Wall Street firms loves any resultant chaos, they can pick up the pieces for cheap.
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China now faces similar asset devaluation and demand stagnation. The country’s leadership plans to solve this problem with more “high quality” production. Whether such products have a market at home is one thing. Western countries, China’s traditional export market, are putting up restrictions to EV and solar panels. Western experts advise helping Chinese consumers. But President Xi is against western countries’ consumerism. He knows China better than foreign commentators.
Looking at it in another way, the fact of businesses and individuals paying down their debts is a microeconomic prudence. The accumulation of so many same actions (or inaction) becomes the macroeconomic phenomenon of recession. Going to the root cause is a natural way of solving a problem. This may allow Mr. X to overcome his ideological impasse.
It is worth remembering that China did not espouse “capitalist market” economy right away. It adopted “commodity market” first, an ideological neutral euphemism.
