Here is an older article that I dug up due to something that I heard on the radio not long ago. If you are a listener to talk radio you know that during the week the topics are political for the most part. But on the weekends you get hosts talking about financial subjects like real estate, mutual funds and other kinds of investments. One of the programs that I like to listen to on the weekends is “Empowered Investing” which is on local station WIND 560 AM here in Chicago. Host Joe LoPresti uses a variety of technical indicators to determine how and when to invest in the markets, and to know what the overall long term trends are, whether they are up or down.
On a recent show he spent some time talking about the general economic conditions that we are seeing today. In particular, many people have been wondering why we are not seeing a lot of monetary inflation given the amount of currency that is being put into the financial system by the government, and why the economy remains in the doldrums despite the very low interest rates that we have at present. One would expect that low interest rates would spur economic activity as people rush to borrow money. And one would think that with lots of new cash in the system that we would be seeing far more inflation than we have. The answer to this mystery is that we are in what is called a “Balance Sheet Recession.” And this phenomenon is very similar to what we saw in the Great Depression of the 30s.
This kind of debt overhang results in what Nomura’s Richard Koo has termed a “balance sheet recession.” From my perspective, it is the clearest and simplest explanation I have seen of why the economy has not bounced back as well as it has from previous recessions, as well as why we can continue to expect sluggish growth going forward.
In a balance sheet recession, the focus of the private sector is to pay down debt and deleverage their balance sheets, rather than to maximize profits and/or spend money. With the private sector de-leveraging, even with interest rates at the zero-bound for several years, any newly generated savings and/or debt repayments by the private sector may enter the banking system, but this money does not exit and simply stays on banks’ balance sheets and/or is parked at the FED. The reason for this is that where consumers are focused on paying down debt, while banks are simultaneously looking to repair their balance sheets, the transmission mechanism between the banking system and the real economy remains broken. This is, I believe, a large part of the reason why the money supply has not been growing, despite the sharp increase in the size of the FED’s underlying balance sheet due to QE.