“This Time Is Different” a recent book by Reinhart and Rogoff addresses eight centuries of sovereign meltdown that we will get to in The Great Recession Part 2 but the title is also appropriate to the notion that the Great Recession is different from other post WW II recessions. The major difference is the Great Recession is a balance sheet recession in addition to being a typically income and spending recession. A balance sheet recession is a more serious event such as occurred during the Great Depression of the 1930s and other 19th century financial panics. In these events the balance sheet of consumers, businesses, banks and in our case today, even the government becomes “upside down” or insolvent. That is, asset values melt down and become less than the fixed liabilities of those sectors thus reducing their wealth. The importance of being upside down is that it changes behavior. Consumer stop consuming in order to rebuild wealth, banks stop lending as they are risk averse and seek to rebuild capital and in our current predicament the government’s debt load constrains it from providing sufficient financial assistance to the private sector to cure either problem.
With both an income and balance sheet recession, the government is called upon to overcome both problems simultaneously which is very difficult to do and strains the resources of the government and by that I mean all the balance sheets of the government including the central bank, the Government Sponsored Enterprises (GSEs) and since other government debt guarantees are called upon in a recession to a greater extent (Fannie, Freddie, The FHA, The FDIC) they become overextended and add to the government’s debt load. As the government becomes strained to fund both income and asset bailouts, it too becomes upside down and the financial terms or ability of the government to continue to raise funds deteriorates.
It might be instructive to spend a few minutes on how we got into the situation in which debt and finance grew faster than income which leads to its ultimate collapse. It really all began some time ago when the less developed countries learned how to attract capital despite their inflationary and depressed economies. Their ability to attract capital to places where wages were exceedingly low allowed them to ultimately become world class exporters of goods and in so doing ran trade surpluses and the developed world with considerably higher wages ran trade deficits. After two decades of the process more fully explained in the Alumni Lecture Introduction: The Driving of the Financial Titanic – Capital from Emerging Markets the less developed countries had become known as emerging market countries and their economic success allowed them to be exporters of capital of which 80% gravitated back to the US. This imported capital became directed by market forces primarily to the real estate sector, both residential and commercial through the purchase of either Residential or Commercial Mortgage Backed Securities that funded the construction and re-financing of a major US real estate building boom. Now the over production of the boom is over and like many booms there remains more product than ultimate end users. Now the growth process is in reverse. The over-built real estate assets are depreciating; the loans that funded the real estate purchases are depreciating and the incentives to pay off the debt decline when the underlying real estate asset has declined in value. Given this state of affairs, the consumer is upside down when their houses depreciate and the banking entities balance sheet is upside down as their holding of real estate securities depreciates. This upside down situation for both the consumer, commercial real estate investor and their bank lenders have changed behavior as all are in the process of deleveraging. For the consumer this implies less spending to retire debt and for the banks less lending to not take the risk of more losses and instead invest in US Treasuries. The implication is standard monetary and fiscal policy expansion doesn’t cure the simultaneous income and asset recession as addressed in the Great Recession Part 1.3.
The process of correcting both an income and a balance sheet recession should be familiar to many here tonight. We in Texas and more generally in the Southwest experienced an income and balance sheet recession from l986 to 1991. In that six year period, we became familiar with the process. Banks were zombie banks running off their loan book and solely in the collection business (as opposed to extending credit) while consumers saved to retire debt. This went on for six years despite the fact that the balance sheet recession engulfed merely 25% of the US economy known as the Sun Belt running from Louisiana across the southwest to Southern California. In that episode the Sun Belt economy was in the process of winding down an energy boom turned into a building boom and it all collapsed when energy prices returned to normal after OPEC went back to market pricing of oil.
What I find instructive and startling is at the time the rest of the US and global economy was otherwise healthy with healthy solvent banks but yet it took six years for the healthy portions of the economy to absorb the excess and cheap resources of the Sun Belt states. That is, there were extreme incentives for businesses to gravitate to where labor, buildings, factories and houses were cheap. One would have thought that corporations would relocate and solvent banks would buy up the insolvent in the Sun Belt. After all, the gravitation of capital and people from the rest of the US to the Sun Belt encountered few barriers. There was no difference in currency, no difference in Federal law, regulation or federal taxes but still it took six years until the resumption of economic expansion largely aided by the tech boom rather than corporate relocations. One also would have thought that bank merger and acquisition (M & A) would have caused non-Sun Belt banks to scarf up all the insolvent Sun Belt banks, a solution the FDIC much preferred than liquidation. This is not to say bank M&As didn’t happen but it took years of outside banks assuming the books of broke banks many to also be driven over the edge as the recession continued and assets continued to decline in value. For one living through this, it was a common experience for local banks to go through 4 or 5 M & As with new signage on the bank, new checks issued but never with an introduction to a loan officer.
Today, we are in the same situation with a host of walking wounded banks but without a portion of the US economy or the global economy to lean on. Today, there is little or no corporate relocation activity to plentiful resources as resources are cheap everywhere and there aren’t any strong banks that will assume distressed books while real estate prices keep falling. While bank M & A is not the only solution to achieve solvency in banking as the public market for bank equity could also address the upside down bank balance sheets but are not doing so as they are being very conservative with their capital when facing additional loan losses. Hence without banks extending credit, with consumers de-leveraging the government’s efforts to re establish income and spending is thwarted by the balance sheet drag of the private sector.