Thursday, March 19, 2009

When will the recession end?

The old-fashioned answer is "When the market clears". That is, when gluts are eliminated, balance sheets repaired, debts repaid and pent-up demand builds to the point where it can't be postponed and people spend again and the economy rebounds.

The biggest threat to markets not clearing is the banks' balance sheets. As the BoE noted in it's Feb09 inflation report:

"UK banks need to restructure their balance sheets,reducing their overdependence on wholesale financing and realigning the scale of their loans relative to their deposit base.That in turn will require adjustment to private sector balance sheets — in part by the non-bank financial sector, but alsothrough higher saving and lower spending by households and companies"

But of course to do this, the banks need money to repay their wholesale loans. The best way to do this is have the household sector repay some of their debt, which in turn allows the bank to use the money received to repay some of their wholesale debt. But whenever someone suggests this (I've been writing posts urging people to repay their debt since early Feb), the Paradox of Thrift is invoked. When Bush urged Americans to "go shopping" in the 2001 recession, he was invoking the Paradox of Thrift. Greenspan urging Americans to invest in housing and abandon the traditional American 30-year fixed year rate mortgages in favour of variable-rate mortgages, so they saw a rise in disposable income (temporary as long as interest rates remained low), was also acting on the Paradox of Thrift and trying to keep consumption going.

It's perfectly true that if everybody stops spending (households, businesses and government), the economy spirals down in a vicious cycle. However, lets get a few things clear. This is not the 1930's. In the UK at least, we now have a full-blown welfare state, and government spending automatically increases in a downturn on things like unemployment benefit, housing benefit, mortgage help and so on (the so-called automatic stabalisers), which support a degree of consumption in the economy. And governments can always expand spending beyond that on public works (the Olympics-related spending being an example).

As long as government stands ready to take up the slack, there isn't any danger of a spiral down. But recovery depends on the private sector clearing - without the private sector clearing you get a stalemate and stagnation.

The best way to illustrate this is the Japanese example. Japanese businesses took on a tremendous amount of debt in the 1980's. Their debt to equity ratio was 4 (they were financing about 20% of assets with equity and 80% with debt). In US companies in the 80's the ratio was 1.02 (equity was financing 49.5% of assets). When Japan went into recession in the early 1990's, after some hesitation the Japanese government embarked on a Keynesian expansion. As Stephen King points out, they managed pretty well to avoid a collapse 1930's style: "growth was very low but not entirely absent; unemployment rose, but not too far; and per capita incomes were maintained at a high level by international standards.". It was a success, as they prevented the spiral down.

But they still lost a decade in stagnation and barely-there growth, and in the meantime the government debt kept climbing (Japan's debt as a % of GDP is forecast to be 217% in 2009). People focus on the stupendous Japanese government debt and shudder and claim that thus we shouldn't go down that path. But their government debt rose so much only because it took so long for the private sector to clear. If they had cleared in about five years instead of a decade, they wouldn't have the public sector debt they have now.

The problem was not in the government action (they did what they had to do), but in the private sector which took forever to repay debt and thus "clear". Worse, in a deflationary situation, debt becomes harder and harder to repay as incomes and corporate revenues fall, so the longer you leave it, the worse it gets.

The conclusion must therefore be that we should encourage our private sector to clear as fast as possible, while letting the government take the strain. Those whose disposable income has increased thanks to interest rates being cut should do their bit for their country (and themselves) and repay debt as fast as possible, including overpaying their mortgages if they are allowed by their mortgage terms. We'll have a few bad quarters, but at some point a tipping point will occur. The banks will clear their wholesale loans and start to think about profits again (which they can't make unless they lend again). When households repay their debts they will find disposable income jumps as their monthly debt commitments disappear, and they will spend some of the money freed up. Pent-up demand will build (purchases of things like cars can only remain at current depressed levels if existing cars last about 27 years, which they are not designed to do). Obviously it will help a lot if those who have no debt carry on spending as normal and are not panicked into drawing in their horns.

What happened in Japan was that corporations hesitated to clear their debt and carried on like zombies, while some Japanese households who had no debt cut back on spending in a panic. If we do this the other way round (people with debt clear it at speed while people with no debt continue as normal), we should be out of this recession as rapidly as we got into it. Of course if this doesn't happen, this could drag on for years.


Anonymous said...

So, in the words of the wartime poster "Keep Calm and Carry On". This will help at the margins but overpaying mortgages won't solve the banking crisis. There is too much toxic debt on the balance sheets. The Japanese zombie banks couldn't lend because they were propped up rather than forced to deal with their non-performing debts. Once that was done then their economy started moving (slowly) again.

The government really needs to tackle the toxic debts of the banks. I fear only a bad bank solution (or Willem Buiter's good bank will get to grips with the bad debts and allow banks to restart lending. The government's Asset Protection Scheme is both costly and doesn’t force the transparency needed to reassure the markets and fix the underlying problem.

snowflake5 said...

Devon Chap, the "toxic" debt on on bank balance sheets is worthless only on a mark-to-market basis (i.e. they can sell it on at the moment) but the idea that all these loans will default is wrong. Most of these toxic assets are US sub-prime debt that our banks purchased, but the Obama government has announced plans to stop the rise in US foreclosures, which means that these debts may not all turn toxic after all.

The banks' chief problems at the moment are cashflow related - they need to refinance their wholesale loans in a market that doesn't want to let them roll these over. One solution is government injecting capital. Another solution is banks getting money by expanding the margins between the rates they lend at and the rates they pay savers (they are already doing this). The third source is borrowers repaying debt which the banks can use to repay their wholesale loans. The third can happen pretty quickly if mortgagees co-operate, which should get us past the cashflow problem. The side effect is that households will benefit if they carry lower debt too.

Anonymous said...

I'm aware that over the medium term the some or perhaps all of the value of the toxic debt might be recovered. The problem is that right now it is an unknown quantity and it could pull down the holding insititutions. The uncertainlty as to who holds what risk is holding back wholsale lending. Would you lend to someone who might not be able to pay it off?
The likelihood of recovering value from the toxic debt would be increased by a bad bank. Then the debts of different insititions could be aggregated and like assets bundled togtehr. That was the US took in the 1980s Savings and Loan crisis and they recovered much of the cost.
According to BoE figures mortgage lending is already negative as more is repayed than is lent. The trouble from a banks perspective in encouraging mortgage overpayment is that future cashflow is hit since they will lose revene on the future interest foregone.
For individuals repaying debt is sensible right now, even if you are having no problems servicing it since quantatitive easing will lead to higher inflation in the medium term. That said personal loans should be repaid before mortgage debt. The RBS has been cutting its mortgage rates but personal loan rates have not come down. That's government targets for you.

Robert said...

What rubbish, if Obama turns around and says OK people in these homes will not have to repay these debts or will take longer periods it will leave the banks holding debts it cannot move.

But the silliest comment is repay your debts, most of the people I see coming into the office cannot repay the debts, I had one idiot after we told them the amount of debts they had, said it's OK I know I'll get another credit card. The world has changed the poor want to live the life of the rich they want a plasma TV a nice new car and a home to live in, something Thatcher Blair and Brown wanted these people to do, the repayment of these debts cannot be done in a day or a week or a year, and many may never get out of debt.

snowflake5 said...

Devonchap: "I'm aware that over the medium term the some or perhaps all of the value of the toxic debt might be recovered. The problem is that right now it is an unknown quantity and it could pull down the holding insititutions."

The solution to that is to abandon the "mark-to-market" valuation, which is something the French are proposing. The current rules are idiotic and creating false problems.

AS for bank's "future" profits - if they don't survive the current crisis they will all get nationalised and existing shareholders will get wiped out. So if you were an existing shareholder the urgency is getting the wholesale loans paid off without govt help, not worrying whether capital repayments by mortgagees are hurting future profits. As an aside, banks have chosen to widen margins rather than lend - overpayment would essentially tell them that consumers are not willing to put up with that, and force them to seek profit from normal lending instead. Also, the economy in general would benefit if people repaid their loans.

Robert - Obama is not proposing to say that people won't need to repay their debts!!!!! LOL. He is proposing to make it easier for people to do so. I refer to previous posts on the US mortgage situation - namely that in the USA they have non-recourse mortgages (unlike in Britain), where people can simply walk away from their mortgage debts without a backward glance, and the lender can't do a thing about it. Which means that in the existing situation, American lenders are losing hand over fist as Americans simply default without recourse. Making them repay their debts on the other hand stabalises the market. Geddit? Current American situation = unlimited losses, Obama solution = limited losses.

As for your anecdotes of people who can't pay debts - everyone lives in their own bubble. For every person like you who lives amongst people who can't pay, people like me exist among people who can pay. If you can overpay (and many can due to the interest rate cuts), you should - and there are enough people in the country who can to make a difference.

Anonymous said...

The recession in civil liberties will end the moment the noxious Labour Government gets booted out of office; I imagine the boost in morale will help the economy no end as well.

Anonymous said...

Abandoning the "mark-to-market" valuation only helps at the sidelines. If a debt is bad, a debt is bad, no matter how you value in on the balance sheet. It only makes things look better.

Your take on the current crisis is fairly unique. There are few economists or politicians tackling the recession calling on the solvent to pay down their debts.

Anonymous said...

I suppose the investigation into Jacqui Smith's expense claim for porno films will be called wan@ergate?

snowflake5 said...

Devon chap - it's simple: the banks borrowed short in the wholesale markets to lend long to mortgagees and others. They can't roll over the wholesale loans in the current climate, and they can't sell assets (their mortgage book) to other parties because no one has money to buy. However when the mortgagees themselves repay their loans, the banks are essentially exchanging the asset(the loan) in return for cash, which they can use to pay down the wholesale loans.

As for the point of getting solvent people to do this - well who else has the money? The government can borrow in the markets backed by their ability to raise tax, but there is a limit to this if you are not a reserve currency (and sterling isn't). That leaves solvent households as the only people with spare cash. Of course these solvent households will become even more solvent once their debts are paid down - but that isn't a bad thing.