LONDON, Dec 9 (Reuters Breakingviews) – The term “balance sheet recession”, coined by Nomura economist Richard Koo, rose to prominence in the aftermath of Japan’s 1980s crisis, and reared its head again in 2008. It describes a toxic process whereby a crash prompts overleveraged households and companies to hoard cash and pay down debts. This makes them spend less money, which only cements the economic slump.
These days, the situation is often the reverse. Western economies like the U.S., Germany and Britain seem to have withstood shocks in recent years partly because of strong corporate and household finances, characterised by relatively low debt and healthy asset values. Call it the “balance sheet no-cession”. It sounds great, and is certainly preferable to the classic vicious cycle. But having a giant economic cushion can also mask longer-term problems.
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A soaring stock market is central to the story. Until the 1990s, the aggregate value of equities was smaller than global annual output; today, it’s 2.7 times larger. That’s odd in one way, since stock prices should have a loose relationship with what the economy’s factories, machines, infrastructure and intellectual property can produce. Yet this so-called productive capital stock has barely grown relative to GDP since the 1970s, and makes up less than 2% of global assets. The upshot is that there’s now a much bigger financial edifice stacked atop the real economy. It makes growth less dependent on whether businesses are investing, and more sensitive to how wealthy households are feeling. It can smooth out swings in GDP, if asset prices stay high, but the trend also sows trouble for later.
The composition of balance sheets is key. When the 1990s dotcom bubble burst, the fallout was limited because very little of the upsurge had been driven by debt. By contrast, the 2000s mania saw private borrowing grow faster than assets, leading to Koo’s balance sheet recession when families and firms were then forced to spend years correcting the imbalance. Today, at first glance, looks like a sounder asset-price boom. Stock markets have pulled further away from GDP, led by U.S. technology giants. Unlike in the dotcom era, however, corporate profit margins remain near historic highs, and equity gains have come alongside far larger cash buffers. And unlike in the pre-2008 mania, net corporate debt to GDP has fallen sharply.
Here’s the rub: healthier corporate and household balance sheets are simply the mirror image of sickly government ones. Since 2008, finance ministries have tended to run much larger budget deficits, particularly in France, Britain and the U.S. This means the state is pumping money into the private economy every year. One fear is that it will all end abruptly if governments suddenly opt for austerity, perhaps prompted by bond investors fleeing sovereign debt. Or, argues McKinsey’s Jan Mischke, central banks may need to tolerate higher inflation to protect financial stability. Whatever the mechanism, it seems reasonable to fear a correction at some point, with the S&P 500 trading at forward price-earnings multiples close to the dotcom peak.
The counterargument is that asset valuations have been high for years, and could stay that way. Also, household net worth has increased so much that it could withstand some pain. Even if equities fell 50% and real estate 30%, U.S. and eurozone families would still hold six and seven times more assets than liabilities respectively, according to Breakingviews calculations, which is very high relative to recent history.
In Germany, carmakers and other industrial companies face an existential threat from China’s latest export push. Industrial production hasn’t recovered, even in energy intensive sectors such as chemicals, which should have experienced a recent reprieve thanks to lower power prices relative to 2022 and 2023. Instead, BASF is shutting plants and may never reopen them. Chancellor Friedrich Merz has a reform agenda, but his industrial policy lacks scale. That’s probably partly because strong corporate balance sheets have dulled the pain of recent economic ructions, including reducing the need for layoffs. Unemployment is half what it was during Germany’s harsh structural reforms in the 2000s, for example.
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Editing by Liam Proud; Production by Maya Nandhini
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