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High levels of indebtedness or the bursting of a real estate or financial asset price bubble can cause what is called a "balance sheet recession". This is when large numbers of consumers or corporations pay down debt i. The term balance sheet derives from an accounting identity that holds that assets must always equal the sum of liabilities plus equity. If asset prices fall below the value of the debt incurred to purchase them, then the equity must be negative, meaning the consumer or corporation is insolvent.
Economist Paul Krugman wrote in that "the best working hypothesis seems to be that the financial crisis was only one manifestation of a broader problem of excessive debt—that it was a so-called "balance sheet recession". In Krugman's view, such crises require debt reduction strategies combined with higher government spending to offset declines from the private sector as it pays down its debt. For example, economist Richard Koo wrote that Japan's "Great Recession" that began in was a "balance sheet recession".
It was triggered by a collapse in land and stock prices, which caused Japanese firms to have negative equity , meaning their assets were worth less than their liabilities. Despite zero interest rates and expansion of the money supply to encourage borrowing, Japanese corporations in aggregate opted to pay down their debts from their own business earnings rather than borrow to invest as firms typically do.
Japanese firms overall became net savers after , as opposed to borrowers.
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Koo argues that it was massive fiscal stimulus borrowing and spending by the government that offset this decline and enabled Japan to maintain its level of GDP. In his view, this avoided a U. He argued that monetary policy was ineffective because there was limited demand for funds while firms paid down their liabilities. In a balance sheet recession, GDP declines by the amount of debt repayment and un-borrowed individual savings, leaving government stimulus spending as the primary remedy.
Krugman discussed the balance sheet recession concept during , agreeing with Koo's situation assessment and view that sustained deficit spending when faced with a balance sheet recession would be appropriate. However, Krugman argued that monetary policy could also affect savings behavior, as inflation or credible promises of future inflation generating negative real interest rates would encourage less savings. In other words, people would tend to spend more rather than save if they believe inflation is on the horizon.
In more technical terms, Krugman argues that the private sector savings curve is elastic even during a balance sheet recession responsive to changes in real interest rates disagreeing with Koo's view that it is inelastic non-responsive to changes in real interest rates. A July survey of balance sheet recession research reported that consumer demand and employment are affected by household leverage levels.
Both durable and non-durable goods consumption declined as households moved from low to high leverage with the decline in property values experienced during the subprime mortgage crisis. Further, reduced consumption due to higher household leverage can account for a significant decline in employment levels.
Policies that help reduce mortgage debt or household leverage could therefore have stimulative effects.
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A liquidity trap is a Keynesian theory that a situation can develop in which interest rates reach near zero zero interest-rate policy yet do not effectively stimulate the economy. In theory, near-zero interest rates should encourage firms and consumers to borrow and spend.
However, if too many individuals or corporations focus on saving or paying down debt rather than spending, lower interest rates have less effect on investment and consumption behavior; the lower interest rates are like " pushing on a string ". Economist Paul Krugman described the U. One remedy to a liquidity trap is expanding the money supply via quantitative easing or other techniques in which money is effectively printed to purchase assets, thereby creating inflationary expectations that cause savers to begin spending again. Government stimulus spending and mercantilist policies to stimulate exports and reduce imports are other techniques to stimulate demand.
Behavior that may be optimal for an individual e. Too many consumers attempting to save or pay down debt simultaneously is called the paradox of thrift and can cause or deepen a recession. Economist Hyman Minsky also described a "paradox of deleveraging" as financial institutions that have too much leverage debt relative to equity cannot all de-leverage simultaneously without significant declines in the value of their assets. During April , U. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged.
Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash.
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And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms—and indeed essential to return the economy to a normal state—nevertheless magnify the distress of the economy as a whole. There are no known completely reliable predictors, but the following are considered possible predictors. Analysis by Prakash Loungani of the International Monetary Fund found that only two of the sixty recessions around the world during the s had been predicted by a consensus of economists one year earlier, while there were zero consensus predictions one year earlier for the 49 recessions during Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.
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Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow. Monetarists would favor the use of expansionary monetary policy , while Keynesian economists may advocate increased government spending to spark economic growth. Supply-side economists may suggest tax cuts to promote business capital investment. When interest rates reach the boundary of an interest rate of zero percent zero interest-rate policy conventional monetary policy can no longer be used and government must use other measures to stimulate recovery.
Keynesians argue that fiscal policy —tax cuts or increased government spending—works when monetary policy fails. Spending is more effective because of its larger multiplier but tax cuts take effect faster.
For example, Paul Krugman wrote in December that significant, sustained government spending was necessary because indebted households were paying down debts and unable to carry the U. This would be fine if someone else were taking up the slack. What the government should be doing in this situation is spending more while the private sector is spending less, supporting employment while those debts are paid down.
And this government spending needs to be sustained Some recessions have been anticipated by stock market declines. In Stocks for the Long Run , Siegel mentions that since , ten recessions were preceded by a stock market decline, by a lead time of 0 to 13 months average 5. The real-estate market also usually weakens before a recession.
Since the business cycle is very hard to predict, Siegel argues that it is not possible to take advantage of economic cycles for timing investments. During an economic decline, high yield stocks such as fast-moving consumer goods , pharmaceuticals , and tobacco tend to hold up better. There is significant disagreement about how health care and utilities tend to recover.