Is this a balance sheet recession?

This is my Perspective column from this week’s Fund Strategy magazine.

It has become widely accepted that the world is trapped in a peculiar “balance sheet recession” in which companies are preoccupied with paying down debt. A good reason to treat a critique of the idea seriously.

The critical appraisal comes from Andrew Smithers, one of the City’s leading analysts, in a recent paper published by his consultancy.* It marshals evidence to counter the widely held notion that corporate deleveraging is taking place in America and Britain. A secondary argument, although also important, is that it is a myth that corporate balance sheets are in good shape.

This a key debate as the stakes are high. The idea of a balance sheet recession is often used to justify Keynesian measures such as high fiscal spending. But if the diagnosis is wrong it also calls into question the proposed cure.

In contrast, Smithers argues that current high levels of corporate leverage mean that there is a substantial risk of another financial crisis. Such a possibility clearly needs to be examined carefully.

To investors the claim that corporate balance sheets are in fact weak is almost as serious. It runs counter to a widespread assumption about the underlying health of companies.

Yet it would be wrong to judge the notion of a balance sheet recession by its policy implications. The fundamental question is whether it is right or not. Any practical conclusions should follow later.

Before examining Smithers’ critique it is necessary to outline the original theory first. It is most closely associated with Richard Koo, the chief economist at the Nomura Research Institute, based initially on the miserable experience of Japan. Koo has outlined his views in a book, The Holy Grail of Macroeconomics (Wiley 2008), although there are also many speeches and papers available on the internet.

The central thrust of Koo’s argument is that in a balance sheet recession companies are preoccupied with minimising debt rather than maximising profits. In a sense they are therefore violating one of the fundamental norms of the market economy.

For individual companies such behaviour makes sense. It is rational for them to use their cash flow to reduce high debt levels. It is also beneficial to bankers for excessive debt to be lowered.

The problem is that what is sensible for individual companies can cause trouble for the economy as a whole. If deleveraging becomes widespread the economy can stagnate. Economic activity is constrained by the level of debt in the economy.

This is where governments come in. By keeping public spending high they can, in Koo’s view, compensate for the reduction in corporate spending.

It is not surprising, given the country’s woeful economic experience for many years, that Koo developed the idea of a balance sheet recession in relation to Japan. But he has also argued that it applied to America’s Great Depression from 1929 and to the current plight of the developed economies.

Others have endorsed the thrust of Koo’s argument without accepting all details. For example, Paul Krugman, a Nobel laureate and New York Times columnist, while agreeing with its substance, is much more sanguine about the potentially positive impact of monetary policy.

Smithers’ critique of the idea is empirical. He implicitly accepts that it could happen in principle but argues it is not going on in practice. A key part of his argument is American and British companies are buying back shares rather than reducing debt. This contradicts the notion of a balance sheet recession.

Smithers also rejects the associated idea that corporate balance sheets are in good shape. If they were there would be no incentive to deleverage in the first place.

If he is right then the policies being pursued by many western governments are doing more harm than good. High fiscal deficits will not lead to improved corporate balance sheets. Another serious financial crisis is likely.

It is not possible to make a definitive judgment here but some points on the debate are worth raising. For a start the dispute between Smithers and Koo are essentially about facts: do they bear out the notion of a balance sheet recession.

But there are also more fundamental analytical questions to be examined. Even if companies were really focused on deleveraging it would not necessarily follow that this was the underlying cause of the economic downturn. Profitability may not be at the forefront of their concerns but its importance cannot disappear entirely in a market economy.

The Great Depression of the 1930s certainly looked much more like a classic crisis of profitability. Although current accounts often focus on the Wall Street crash of October 1929 the downturn involved a savage restructuring of the real economy. Indeed industrial production in America had started to fall before the crash itself.

The current crisis also has peculiar features that are not explained by the notion of a balance sheet recession. These include the relative lack of economic restructuring and the reluctance of the political class to take decisive action.

A thorough debate on the notion of a balance sheet recession is particularly important to have in the current climate.

* Deleveraging: more of a myth than an issue. Smithers & Co. Report No.415. 13 February 2013.