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How Balance Sheet Recessions Affect the Global Economy: Lessons from Japan, the US, and China



What is a balance sheet recession and why should you care? A balance sheet recession is a type of economic downturn that occurs when a large portion of the private sector is trying to reduce its debt rather than spending or investing. This can happen after a burst of an asset price bubble, such as the housing bubble in the US or the stock market bubble in Japan, that leaves many households and businesses with negative equity (their assets are worth less than their liabilities).

A balance sheet recession is different from a normal recession, where monetary policy (lowering interest rates or injecting liquidity) can stimulate demand and revive the economy. In a balance sheet recession, people with negative equity are not interested in borrowing more money, even at very low interest rates, because they want to repair their balance sheets and restore their credit ratings. Moreover, lenders are also reluctant to lend to those with impaired balance sheets, especially if they have their own balance sheet problems.

As a result, the private sector as a whole becomes a net saver rather than a net borrower, and aggregate demand falls sharply. This creates a deflationary spiral, where falling prices and incomes make it harder for debtors to repay their debts, further depressing demand and prices. The economy can get stuck in a prolonged slump, as happened in Japan for more than two decades after the collapse of its asset price bubble in the early 1990s.

The term “balance sheet recession” was coined by Richard Koo, the chief economist of Nomura Research Institute, who has studied the Japanese experience extensively and warned about the risks of similar scenarios in other countries. He argues that in a balance sheet recession, the government has to play a crucial role by running large fiscal deficits to offset the private sector’s savings surplus and support aggregate demand. He also advocates for debt restructuring and forbearance policies to help debtors recover from their negative equity and resume normal economic activities.

According to Koo, many Western economies have entered a balance sheet recession after the global financial crisis of 2008-2009, which was triggered by the burst of the US housing bubble. He points out the remarkable similarities between house price movements in the US this time and in Japan 15 years ago1. He also notes that massive injections of liquidity by central banks in the US and the UK have failed to prevent contractions in credit available to the private sector and have produced only minuscule increases in the money supply2.

Koo warns that if governments try to reduce their deficits too soon or too fast, they will aggravate the balance sheet recession and cause further damage to the economy. He cites the examples of Japan in 1997 and 2001, when premature fiscal tightening led to deeper recessions and higher public debt ratios. He also criticizes the austerity policies imposed on some European countries, such as Greece, Spain, and Portugal, which have suffered from severe balance sheet recessions and high unemployment.

More recently, Koo has claimed that China is also in a balance sheet recession, as its private sector has been deleveraging since 2016 after a massive credit expansion and investment boom3. He argues that China’s economic slowdown is not due to trade tensions or structural reforms, but to the private sector’s shift from maximizing profits to minimizing debt. He suggests that China should adopt fiscal stimulus measures to support domestic demand and avoid deflation.

A balance sheet recession is a serious challenge for any economy, as it can lead to long-term stagnation and social unrest. It requires unconventional policies that go beyond monetary easing and address the root cause of the problem: excessive private sector debt. By understanding the concept of balance sheet recession and learning from the experiences of Japan and other countries, we can better cope with this phenomenon and avoid its worst consequences.

I hope you find this blog post helpful. If you have any questions or feedback, please let me know. 😊

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