A recession (economic contraction) is a period of general decline in GDP for two or more
consecutive quarters. A recession is typically accompanied by a drop in the stock market, an
increase in unemployment and a decline in the housing market. Below is a schematic of a
normal business cycle.
By definition a recession is the time period that economic activity is declining between the peak
and trough of the business cycle.
Recessions are not always the function of one obvious cause and physiological factors can play a
significant role in the depth and elapsed time of a recession. For example, if the expectation
develops that economic activity will slow, firms may decide to reduce employment levels and
save money rather than invest. Such expectations can create a self-reinforcing downward cycle,
bringing about or worsening a recession Excess inventories, declining consumer confidence,
domestic and or foreign concerns among other things can also cause or contribute to a recession.
Some describe a recession as an economic retraction which is cause by the Federal Reserve
tightening monetary policy to fight inflation. The tightening cycle continues until the economy
weakens enough to bring down the inflation rate, at which time the Federal Reserve eases
monetary policy and produces an expansion.
Types of Recessions
A Business Recession is a function of factors that business would commonly expect to
experience in a normal business cycle (as described above). With the exception of the Great
Recession all post World War II recessions have been Business Recessions.
A Balance Sheet Recession is caused by a long term debt cycle. In this cycle
people/companies/governments finance their spending by increasing borrowing at rates in excess
of their economic growth rates. This results in debts rising relative to incomes consequently debt
service payments rise relative to incomes. At or near cycle peaks assets are bought on leverage at
high enough prices that their cash flow is not adequate to service debt on a long term basis.
When incomes aren’t enough to service the debt, the reverse process begins. Assets values fall
on a self-reinforcing basis and then debt is either defaulted on (debt is greater than market value
of underlying asset) or restructured. One way or another a significant deleveraging process takes
place.
The Balance Sheet Recession differs from the above schematic in the following fashion
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The slope of the contraction line will be greater and deeper
The troughing process will be flatter and take longer
The slope of the expansion line will be significantly flatter
Latin America in the 80’s, Japan in the 90’s and the Great Depression were the result of the long
terms term cycle and they at least started as a Balance Sheet recession.
Why is Great Recession a Balance Sheet recession?
The graph below presents public and private debt as a % of GDP as well as the fed funds rate.
From 1985 to 2010 total debt at a % of GDP (GDP grew significantly over that time) doubled
from less than 200% to over 400%. That borrowing pulled forward demand and resulted in a
significant increase in value of all assets (stocks, commodities, real estate, etc). A significant
increase in asset values driven by debt is the first phase of the long term debt cycle.
We are now experiencing the second phase of the long term debt cycle. Asset values are
declining and as illustrated in the chart below income available to service the long term debt
acquired is declining. Issues such as Europe or the a hard landing in China may prolong this
phase.
The third phase of the long term debt cycle or deleveraging is also underway (the phases are not exactly
sequential. In general Corporate America’s balance sheet is in good shape and will not be addressed
now. Government and personal balance sheets need to be delivered.
The individual delevers by bankruptcy or restructuring debt, sending less, saving more, and look at ways
to increase income. Individuals are active in all three activities.
Governments delever by raising revenue (taxes), decreasing spending, restructuring debt, and by
devaluing the currency. Washington is in gridlocks over revenues and spending and the Federal Reserve
is printing money and has a zero to negative interest rate policy, both of which reduce the value of the
dollar.
How does this impact your business?
Governments and individuals are deleveraging or at some point will. The deleveraging process results in
lower expenditures which reduces economic activity. As this process plays out, look for on average 2%
plus or minus GDP growth and significantly higher than average unemployment rate for an extended
period of time. If your business is cyclical in nature you may want to plan on slow growth.