Why Was The Great Recession So Great?

It’s no secret that the Great Recession was the most severe economic downturn since the Great Depression, not only for the US, but also the World. I don’t think there is anybody out there who disputes this statement. However, there is of course much argument over whether the “Great Recession” is really much different than other recessions.

The Great Recession in the US lasted from December of 2007 to June of 2009. A recession is nothing out of the ordinary for the US. Up to that point, there had been 11 recessions Post-WW2. However, none of these were really associated with major financial crises. As Kenneth Rogoff and Carmen Reinhart argue, a recession associated with a financial crisis makes the subsequent recovery weaker. This makes total sense and I agree with them (So do most respected economists, with the exception of those on “Team Romney” of course).

However, both sides miss one crucial reason why the recession was so deep and the recovery so weak. While the recession ended in June 2009 and we have been in a recovery since, the misdiagnosis of the severity of the recession has caused traditional policy response to fail and/or under-perform.

What we have been experiencing for the past 4 years is a Balance-Sheet Recession. A balance sheet recession, as coined by Richard Koo, occurs when a nation-wide asset bubble pops, and because of that, falling asset prices leave a debt overhang on the private sector. In the US (and frankly, lots of parts of the world), that nationwide asset bubble was Real-Estate, AKA the Housing Bubble. When housing prices started to fall, people who were in the hole had two options. Pay down debt or default (both inherently deflationary). Given that most rational humans want to avoid bankruptcy, most go in the route of paying down debt. Despite low interest rates (as promised by the $FED), the private sector stays focused on paying down debt and reducing its debt burden. As a result, aggregate demand remains weak and employment high as there are not enough sales (spending).

As you see below, private sector debt grew to 300% of GDP at the peak! Ever since we hit that, we have seen a reduction of private debt.














So, How do we know we are in a Balance Sheet Recession (BSR)? This post gives a great explanation and breakdown of the  BSR, but to sum it up we see the following 5 characteristics with my short quick summarization of each.

  1. Private Sector is Paying Down Debt:  The Private sector was over-leveraged, and now instead of spending/investing, it is paying down (private sector) debt also known as deleveraging.
  2. Monetary Policy is Impotent: Traditional monetary policy responses (lower rates to boost borrowing) is at it’s limits and are not stimulative.
  3. Quantitative Easing Doesn’t Work: Even non-traditional monetary policy response (QEs) will fail because it relies on channels that are ineffective.
  4. Silent and Invisible: Nobody wants to talk about the BSR.
  5. Debt Rejection Syndrome: Nobody wants to borrow again because they have been “scarred” and don’t want to go through the same thing again.

The only way out of a balance sheet recession is through government deficits (and more specifically government spending), because as we know through basic accounting, federal deficits add to net private savings. Deficits make up for demand leakages. If the government were to try and run a smaller deficit/balanced budget/surplus during a balance-sheet recession, it would very likely spiral the economy into a depression where GDP contracts and unemployment skyrockets. The only other critique here of the BSR comes from the “for every debtor there is a creditor” camp, however, that belief was debunked here.

To conclude, we witnessed the worst economic contraction in 2008-2009 since the Great Depression. The combination of a financial crisis and the balance-sheet recession made the recession deeper and the recovery weaker as traditional policy responses failed. The fiscal policy response was solid, but not great. This explains why the recovery has been mediocre.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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