Fixing 'balance sheet recessions'

Nomura's Economist Richard Koo coined the term 'balance sheet recessions' to refer to recessions that are triggered by deleveraging of private sector balance sheets.

Mr. Koo observed about these recessions that monetary policy isn't effective at ending them as the act of deleveraging interferes with the monetary policy transmission mechanism (lower loan rates are suppose to stimulate borrowing, but when private sector is reducing debt, it is not interested in borrowing).

He proposes that the solution to a balance sheet recession is for the government to increase its spending until such time as the private sector has finished reducing its debt.  The government does this by deficit spending and increasing its debt.

The goal of the government spending is to keep GNP up so that the economy doesn't slide into a recession with all of the negative consequences that would have.

Regular readers know that there is an alternative way to achieve Mr. Koo's goal that has the benefit of ending the balance sheet recession without greatly increasing government debt.

The alternative is to adopt the Swedish Model and require the banks to absorb upfront the losses on the excess debt in the financial system that they would ultimately realize if they went through the long process of default and foreclosure on the bad debt.

Under the Swedish Model, the real economy is protected as balance sheets are deleveraged with minimal impact on private sector demand.

Simply by writing down the debt to levels that the borrow can afford, money that would go to debt service can instead continue to flow into the economy.