Michael Hudson on Balance Sheets

JisforJunkEconThe evolution of balance sheets are key to the economics of Hyman Minsky, who described an economy with a financial system as one of ‘interlocking balance sheets’. Similarly, Richard Koo, originator of the concept of a Balance Sheet Recession, has written much on its implications for government deficits during the crisis of 2008 and, before that, during Japan’s Great Recession, which led to two decades of economic stagnation.

Until recently, balance sheets tended to be ignored by the mainstream majority of economists. The revival of Minsky’s ideas, alongside the ideas of Koo and post-Keynesians such as Steve Keen and Wynne Godley, have perhaps begun to shift the tide. The work of Michael Pettis, another economist influenced by Minsky, also deserves to be more widely influential.

The two short articles below are taken from Michael Hudson‘s ‘dictionary’ J is for Junk Economics (p.39-40).

Balance Sheet: More than just a bookkeeping concept, balance sheets are a way of viewing the economy as a system, in which every asset has a corresponding liability. Assets and liabilities always go together in an existential binary relationship. One party’s saving is another’s debt. The basic balance is:

Assets = Liabilities + Net Worth

Money, credit and debt would be more clearly understood if teaching economics started by thinking about the economy in terms of balance sheets. Bank checking and savings accounts are a liability by banks to their depositors. But not all monetary debt is expected to be paid. Paper money, for instance, is technically government debt, and appears on the liabilities side of the public balance sheet. To pay it off would require retiring the money in the private sector’s pocket.

Bank credit is created almost exclusively to purchase assets (real estate, stocks and  bonds). The effect is to increase debt/equity ratios for households and industry. In the early stage of the business cycle, asset prices tend to rise faster than the buildup of debt. But rising ratios of debt (liabilities) to net worth make the economy more fragile, while raising the break-even cost of living and doing business, because interest must be paid. In time a crash occurs, leading to negative equity (when debts exceed the market price of assets). When that point is reached, governments must decide whether to bail out the banks or save the economy by annulling the debts.

Balance Sheet Recession: A term coined by Nomura Holdings economist Richard Koo to describe how Japan’s private sector became so debt-strapped that it did not borrow even at zero interest rates after the bubble burst in 1990. Families and businesses were obliged to pay down debt, leaving less to spend on goods and services, deflating the “real” economy and causing a recession. Property prices fell steadily, and the domestic market shrank as right-wing governments raised taxes on consumer goods.

An alternative term to characterize the post-2008 downturn is debt deflation. The plunge in real estate prices led the value of bank mortgages to decline as default rates mounted. These mortgages were the main assets backing bank liabilities to their depositors, bondholders and other counterparties. This shortfall of assets behind liabilities prevented banks from extending new credit. For homeowners, the decline in real estate prices wiped out most of their net worth that had been built up by asset-price inflation leading up to 2008. Payback time had arrived, and the economy stalled. It must continue to stall until the volume of debt is brought back in line with the ability of income and assets to cover what is owed.”


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