1.3 Deleveraging and balance sheet cleaning

This thread of the debate relates to the role of financial variables. In the foregoing the relation of savings, investments and interest rates closely followed the usual textbook and generally mainstream real economy explanation. By contrast – as was convincingly presented by Borio and Disyatat, and Borio 17 –interest rates are essentially shaped by monetary factors, which cannot be deduced from the real economic analysis and the development of the savings and investments in the real sense, which characterise the debates described above. To put it briefly, these monetary attributes are shaped by banks’ lending activity, as well as by the central banks’ and the economic policy’s supervisory and macroeconomic stabilisation policy. insufficiently

prudent lending practices of banks and the lax macroeconomic and supervisory policy may easily

lead to financial and real economic overheating both at the domestic and international level, as the lending capacity of the banking system is not restricted by the (“real”) savings available in advance.

In this approach, the present crisis developed due to the credit boom and the debt overhang, and the protracted nature of the crisis is the consequence of the previously accumulated debt. Indebted agents are striving to adjust their balance sheets: a precondition for this is to save a higher portion

Table 1-1 Comparison of balance sheet recession and secular stagnation balance sheet recession Secular stagnation

Cyclical, non-durable Structural, durable (began before the crisis) Financial variables: Real variables: – excessive lending – demography – indebtedness – technology – balance sheet adjusment – innovation – sectoral reallocation – investment behaviour

Source: MNB of their income than before, which can be used for repaying their debts, while refraining from new borrowing. Since within each country several sectors – households, the government, banks – and in the global economy several indebted geographic regions are simultaneously trying to deleverage, the result is weak domestic and foreign aggregate demand. Poor aggregate demand also has a dampening influence on output, which results in a close to stagnation situation (Table 1-1).

Richard koo – whose name is linked with the term of “balance sheet recession” – states that in times of balance sheet recession agents strive to minimise their losses rather than to maximise profit. 18 He believes that this is the reason why the real economy is responding poorly to the stimulus applied by the central banks. When a company plans investments, and contemplates whether it is worth responding to the anticipated demand growth by capacity expansion, investment activity can be influenced by the level of interest rates, as an important cost component. In such cases, the central bank’s interest rate policy can have an impact on the cyclical situation of the economy via investments and other interestsensitive expenditures. However, when companies or even households are concerned about repaying their previous loans, they will not contemplate new borrowing and as such the low interest rates have no influence on their expenditures. According to koo, in the crisis fiscal policy should act as the last resort provider of aggregate demand, which would help reduce the outstanding debt of the private sector. In the period of balance sheet recession, the efforts of private agents are aimed at increasing their savings. The growth decelerating impact of the synchronised deleveraging complicates the implementation of this effort, as one can save less from the decreasing or slowly increasing incomes, and the debt-to-income ratio decreases more slowly. In such a situation, income growth may be accelerated by the continued indebtedness of the budgets, under low capacity

17 Borio and Disyatat (2011) and Borio (2015), and Tily (2012). See more details in the first chapter of the MNB Growth Report of 2014 (MNB 2014) and in Szalai (2014) 18 koo (2014) in: Teulings and Baldwin (2014).

utilisation the fiscal multipliers are high, public sector spending does not crowd out private spending, and thus they do not increase the interest rates and the threat of inflation is also small. 19 According to koo, Japan got caught in the trap of secular slow growth, because it used fiscal policy timidly, fearing that the high government debt would be unsustainable.

The weak aggregate demand explanation of Borio 20 and his colleagues also emphasises the backwash of the balance sheet recession. The crisis was caused by the process during which the interactions of the real economic and the financial cycles were recognised neither by the private agents, nor by the economic policymakers. The economic policymakers – ignoring the excessive flexibility of the banking system – aimed at smoothing the real economic path, and at the same time tried to judge whether the economy was on a sustainable path based on their inflation projections. However, inflation appears to have less and less reliable predictive power with regard to the sustainable financial growth rate, and when the overheating – which developed in addition to the price stability – threatened to lead to financial instability, rapid and firm measures were taken to avoid the crisis. Economic policy became asymmetric, because during the boom it paid little attention to preventing the build-up of financial instabilities, and it failed to perceive the overheating in the economy, but it took firm measures to avoid the negative consequences. According to Borio et al. 21 it was due to this asymmetric policy that during the crises the debts did not unwind and the next cyclical financial overheating started from higher debt levels.

According to Borio et al., the bad cycles of the repeated overheating and overcooling, developing under ever increasing outstanding debts and showing larger swings,

can be prevented by a more symmetric economic

policy: the central banks should cool the overheating already in the build-up phase. In order to do this, they should modify their strategy properly within the existing monetary policy mandates. However, if a financial crisis occurs anyway, they should understand that – as in the current situation – the possibilities of fiscal policy are limited in crisis management. Initially, it may be useful to permit an increase in the deficit to mitigate the crisis, but over time this instrument becomes blunt and it can only generate additional indebtedness and a financial bubble. Hence, they believe that the fiscal policy’s existing room for manoeuvre should be used for cleaning the private sector’s debts and the balance sheets of the banking sector, rather than for a general increase in aggregate demand. They mention the rapid and efficient management of the bank crisis by the Scandinavian countries as a positive example from the early 1990s, when during the crisis these countries quickly nationalised the banks, consolidated their bad debts and finally re-privatised them without suffering any budgetary loss.

19 For more in Table 1-1 20 Borio (2014) 21 Uo.