Monday, January 25, 2016

The Balance Sheet Recession That Never Happened: Australia

Probably the most common explanation for the Great Recession is the "balance-sheet" recession view. It says households took on took on too much debt during the boom years and were forced to deleverage once home prices began to tank. The resulting drop in aggregate spending from this deleveraging ushered in the Great Recession. The sharp contraction was therefore inevitable.

But is this right? Readers of this blog know that I am skeptical of this view. I think it is incomplete and misses a deeper, more important story. Before getting into it, let's visit a place that according to the balance sheet view of recessions should have had a recession in 2008 but did not.

That place is Australia. It too had a housing boom and debt "bubble". It too had a housing correction in 2008 that affected household balance sheets. This can be seen in the figures below:


Despite the balance sheet pains of 2008, Australia never had a Great Recession. In fact, it sailed through this period as one the few countries to experience solid growth. And, as Scott Sumner notes, it was also buffeted by a collapse in commodity exports during this time. If any country should have experienced a sharp recession in 2008 it should have been Australia.

So why did Australia's balance sheet recession never happen? The answer is that the Reserve  Bank of Australia (RBA), unlike the Fed, got out in front of the 2008 crisis. It cut rates early and signaled an expansionary future path for monetary policy. It also helped that the policy rate in Australia was at 7.25 percent when it began to cut interest rates. This meant the central bank could do a lot of interest rate cutting before hitting the zero lower bound (ZLB). So between being more aggressive than the Fed and having more room to work,  the RBA staved off the Great Recession.

This experience in Australia speaks to why the balance sheet recession view miss the deeper, more important problem behind depressions: the ZLB. Unlike the RBA, the Fed was slow to act in 2008 and that allowed the market-clearing or "natural" interest rate to fall below the ZLB. Had the Fed acted sooner or had it been able to keep up with the decline in the natural interest rate once it passed the ZLB, the Great Recession may not have been so great (See Peter Ireland's paper for more on this point).

Here is how I made this point in my review of Atif Mian and Amir Sufi's book, House of Debt, in the National Review.
Why should the decline in debtors' spending necessarily cause a recession?

Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds. The creditors could in principle provide an increase in spending to offset the decrease in debtors' spending. But in the recent crisis, they did not. Instead, households and non-financial firms that were creditors increased their holdings of safe, liquid assets. This increased the demand for money. This problem was exacerbated by the actions of banks and other financial firms. When a debtor paid down a loan owed to a bank, both loans and deposits fell. Since there were fewer new loans being made during this time, there was a net decline in deposits [and thus] in the money supply. This decline can be seen in broad money measures such as the Divisia M4 measure. These developments—increase in money demand and a decrease in money supply—imply that an excess money-demand problem was at work during the crisis.

The problem, then, is as much about the excess demand for money by creditors as it is about the deleveraging of debtors. Why did creditors increase their money holdings rather than provide more spending to offset the debtors? ...Mian and Sufi do briefly bring up a potential answer: the zero percent lower bound (ZLB) on nominal interest rates.
The ZLB is a floor beneath which interest rates cannot go. This is because creditors would rather hold money at zero percent than lend it out at a negative interest rate. This creates a big problem, because market clearing depends on interest rates' adjusting to reflect changes in the economy. In a depressed economy, firms sitting on cash would start investing their funds in tools, machines, and factories if interest rates fell low enough to make the expected return on such investments exceed the expected return to holding money. Even if the weak economy means the expected return to holding capital is low, falling interest rates at some point would still make it more profitable to invest in capital than to hold money. Similarly, households holding large amounts of money assets would start spending more if the return on holding money fell low enough to make household spending worthwhile. This is a natural market-healing process that occurs all the time. It breaks down when there is an increase in precautionary saving and a decrease in credit demand large enough to push interest rates to zero percent. If interest rates need to adjust below zero percent to spur creditors into providing the offsetting spending, this process will be thwarted by the ZLB.
 It is the ZLB problem, then, rather than the debt deleveraging, that is the deeper reason for the Great Recession.
Australia never hit the ZLB. That is why it avoided the Great Recession. If we want to avoid future Great Recessions we need to find better ways to avoid or work around the ZLB.


  1. Yep. Trying to remember New Zealand, which IIRC had even higher nominal interest rates than Australia. Don't know if it had a similar rise in house prices and debt.

  2. I'm afraid that this post "is incomplete and misses a deeper, more important story." Australia avoided crisis because of the Government's deficit spending. They injected money into the real economy, thus ensuring that there was enough circulating to allow commercial transactions to continue to take place.

    1. Damian, the US also did a large amount of fiscal spending during the crisis years but it didn't help help that much. The difference between the countries, then, is the ZLB.

  3. Nope. While Australia no doubt had a good policy response , including fiscal ( " Go early. Go hard. Go households.") , they merely postponed the day of reckoning. Had they chosen to pursue a policy of stabilizing economy-wide debt/gdp , they might have had a bit lower growth , but it would have been sustainable. This shows private nonfinancial debt/gdp with (blue) and without (red) gov't debt :

    They added about 5% of gdp per year in total debt leverage from '09-'14 , and that much if not more in 2015. This can't go on forever , and they're nearing the ZLB zombie zone on policy rates. The U.S. performance was better in this regard , as economy-wide leverage has been stable since '09.

    This shows the annual % growth in total nonfinancial debt ( blue , left scale ) and annual % growth of real gdp (green , right ) :

    Australia and the U.S. had similar sharp declines in % growth in debt as a share of gdp , from levels ~20% all the way down to ~8% by 2009 , with less severe outcomes in Aus. , to be sure. Several factors in addition to policy response may help explain this : 1) they had a lower total leverage burden to start with , due to very low gov't debt/gdp , making fiscal stimulus an easier sell 2) inequality of income and wealth is not as stark as in the U.S. People in the bottom 90% of the income distribution regularly got raises in a growing economy. What a concept ! 3) The China life preserver , via mining , etc.

    Their debt load will level off at some point ( the ZLB point ? ), but they'd have been wise to pay that bill earlier , rather than later. They're already at a "new normal" of lower growth , like most everyone else.

    "Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds."

    You and Bernanke are members of a rapidly shrinking group of economists who still talk like that.


  4. Have you compared bankruptcies, defaults, and foreclosures in Australia vs. the U.S.? For every debtor who defaults, there's a creditor whose net worth declines, whose spending is likely to follow, and who may even be pushed into default on his/her own debts. Rather than increased creditor spending, there can be a cumulative downward spiral.

    1. Recall that , for every creditor whose net worth declines , there is a defaulter whose net worth increases ( i.e. whose debts evaporate ). There is no change in aggregate net wealth.

      Ridiculous , right ?

      Welcome to the world of market monetarism.


    2. I think you guys are missing the point. Even Atif Mian and Amir Sufi who wrote "House of Cards" agrees on this point. See this conversation I had with Amir.

    3. David, I can't tell which "point" you're referring to when you say that even Mian and Sufi "agree on this point," especially when Anonymous' point is different than mine. The point I was trying to make is that there's a massive web of debt contracts, and a surge of defaults and bankruptcies and "voluntary deleveraging" in the face of a crisis can become self-reinforcing. Whether the best way to counteract this process is through some means of pushing the interest rate below the ZLB, or undertaking debt-financed public works, or bailing out AIG, etc., is a separate question, albeit an important one.

  5. No, Australia was riding some great commodity prices in 2008, boosting incomes. And the Reserve Bank only woke up after the Treasury started its expansionary fiscal policy. So with commodity prices booming the task for the Reserve Bank and Treasury was not that big.

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