This recovery is unfolding like no other in recent memory.
Government debt has brought the world to the edge of a brand new financial crisis, in a stark reminder that the biggest economies of the world are only three years past a major financial system failure. The financial crisis and ensuing recession saddled many governments with an unprecedented level of debt, as they spend money to fix insolvent banks, soften the blow for millions of unemployed and try to stimulate growth.
Other debt crises over the past three decades have typically involved smaller countries, including Canada in the early-to-mid-1990s, that were able to lean on the larger economies of the world to drive growth while they took steps to clean up their own books.
But unlike earlier predicaments, this one is not borne of a normal, cyclical recession, where the economy expands and then contracts when supply exceeds demand and business inventories get too high.
Rather, the U.S. and Europe – still by far the world’s two most important economic blocs – are mired in a so-called balance-sheet recession, where the combination of too much debt and too little confidence suppresses demand for a long period of time. These kinds of recessions are much harder to pull out of, as Japan has discovered since its real-estate crash two decades ago.
That has left policy makers in the United States and Europe trying to dig themselves out of debt while stimulating their economies with a dearth of tools.
Now, investors are waking up to just how intractable this type of economic crisis can be.
“The pity of it is that there’s no easy fix,” said Robert Kessler of Kessler & Associates. “They could say everyone will have to tighten their belts and change their lifestyle; and once [public]debts are paid down, you’re going to have a better country. Okay, so call me in 10 years.”
The description of the balance-sheet recession was popularized by influential Japanese economist Richard Koo when Japan ran into a similar situation. Corporations and consumers follow a credit binge by focusing on reducing their debt, which can take a decade or more to work out.
Banks sit on their money, borrowing dries up and demand shrinks, leaving public-sector spending as the only alternative. In Japan, heavy deficit-spending in the 1990s prevented a full-blown depression that could have seen the Japanese economy shrink by as much as 50 per cent. But Mr. Koo has argued the government made a critical error by attacking its deficit in 1997 and again in 2001, prolonging the slump.
The whole concept of a credit recession is deleveraging. When governments withdraw stimulus, as is now occurring in the U.S., Europe and elsewhere, it makes the problem worse, as Mr. Koo notes. Coming out of an ordinary recession, consumer spending picks up, as does corporate investment. Production expands to meet growing or prospective increases in demand and job growth occurs. Governments can withdraw stimulus in the knowledge that business will take over the reins of economic expansion.
But in a balance-sheet or credit recession, businesses continue to retrench, even when capital is plentiful and cheap.
Canadian investor Stephen Jarislowsky has described a balance-sheet recession as fundamentally different than a cyclical recession. “A balance-sheet recession is where you have a big bubble, and everybody and his brother has to de-lever in order to become really solvent again. By that, I mean they have to get debt off their balance sheet.
“The more everybody [reduces debt] the deeper the recession becomes, unless it’s counteracted by fiscal spending.”
When Canada and Sweden faced significant debt worries in the early 1990s, both countries were able to count on the growing world economy – fuelled by U.S. expansion and a rapidly growing technology sector – to give themselves momentum. In Canada’s case, deep spending cuts undertaken by Ottawa, along with the introduction of the Goods and Services Tax in 1991, helped pay down debt and return the government to surplus much faster than had been anticipated.
“Canada was definitely better positioned to deal with its deficit situation in the ’90s, [for]three reasons: We did have a strong U.S. growth performance to lean on, our deficit was significantly smaller as a share of GDP, and much of the deficit was due to outsized interest costs,” said Douglas Porter, deputy chief economist at the Bank of Montreal.
“There’s next to no room for that now in the U.S. – it will require very real restraint for and extended period of time. Given the political climate, not to mention the high starting point for U.S. unemployment, that looks like a very tall order indeed.”