BACKGROUND: Although the financial crisis of 2008 generated one of the worst recessions in recent history, recovery came in relatively fast, in less than five years for most developed countries. Nevertheless, annual growth rates have hardly risen above 2% in those same countries. Meanwhile, inflation rates continue to be at their lowest despite unconventional monetary policies driving interest rates toward zero. Economist Richard Koo equates this situation, particularly the one experienced by the Euro Zone, to a balance sheet recession similar to the one afflicting Japan in the last 27 years. Commercial bank credit stagnates because of companies preferring to clean up their balance sheets of any excess debt instead of investing. Therefore, unconventional monetary policies fail to effectively reactivate the economy despite massive liquidity injections, which also results in zombie banks. Koo suggests that active monetary policy is thus useless, and that government expenditures should rise not when the economy grows, but when balance sheets are completely cleaned up. This paper, however, argues that balance sheet recessions are possible precisely because of massive liquidity injections such as those provided by unconventional monetary policies. These policies allow banks to avoid immediately calling back loans, which would trigger a liquidation process of the malinvestments incurred during the unsustainable economic boom preceding the crisis. In this manner, companies can survive by gradually, and discretely scrapping those malinvestments for years to come, while sacrificing an immediate return to business. Instead, more dynamic and flexible financial and labor markets together with more expedited bankruptcy legislation could allow for smoother and faster liquidation processes.
DATA/METHODS: The paper analyzes financial flows data obtained from the central banks and statistics bureaus of the USA, the EU, Japan, and the UK. The methodology consists of the analysis of the financial flows of households, corporations, government, and the foreign sector.
RESULTS: The paper shows that balance sheet recessions are precisely the result of the massive injections of unconventional monetary policies that are supposed to have no effect on them. Although I agree that balance sheet recessions are a drag to economic recovery, the solutions proposed by Koo to get the economy back on track can prove costly and inefficient as they do not drive debt-prone malinvestors out of the market.