Balance Sheet Crises: Causes, Consequences, and Responses

Being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which [they] frequently watch over their own. --Adam Smith Balance sheet crises, in which the prices of widely held and highly leveraged assets collapse, pose distinctive economic challenges. An understanding of their causes and consequences is only recently developing, and there is no agreement at all on effective policy responses. A preliminary purpose of this article is to examine in detail the events that led to and resulted from the recent U.S. housing bubble and collapse, as a case study in the formation and propagation of balance sheet crises. The primary objective of the article is to evaluate similar events around the world with a view toward assessing the economic performance of countries that have pursued varied alternative policies. We propose that the Great Depression beginning in 1929 and the Great Recession starting in 2007 were both household-bank balance sheet crises--events that were quite distinguishable from the recessions appearing between them. Each episode, we hypothesize, was preceded by unsustainable rises in expenditures on construction of new housing units and in mortgage credit for purchases of new and existing homes. In both cases housing values rapidly collapsed by, more than 30 percent but mortgage debt obligations fell only very slowly, so that housing equity fell sharply. (1) Between these two economic calamities were 12 smaller recessions. Nine of the ten recessions between World War II and the Great Recession were led by declines in new housing expenditures and in all of those the interaction between Federal Reserve monetary policy and the housing-mortgage market was a clearly discernible feature. Federal Reserve monetary policy between the fall of 1979 and the summer of 1982 is a prominent example of this interaction effect, and an excellent "natural experiment" on the impact of monetary policy on the mortgage and housing markets. Examination of the normal impact of monetary policy and the contrast with economic conditions in the aftermath of the housing bubble suggests why monetary policy has had so little effect on the money supply and the economy over the past five years. When households are awash in debt, banks face a continuing legacy of impaired assets mad damaged balance sheets, and there is a large inventory of unsold and foreclosed homes hanging over the housing market, low short-term interest rates don't stimulate lending to nearly the extent that they do in normal times. Consequently, monetary policy doesn't have its normal effect during a balance sheet crisis. We also provide direct evidence from other countries that fiscal stimulus has not been a part of the recovery process in many countries that have had robust growth soon after a balance sheet crisis. In fact, most countries that have recovered rapidly have first contended with a rapid increase in government deficits but have soon reduced both government expenditures and government deficits. Widely differing approaches have been taken regarding the recognition of losses on the impaired assets of financial institutions. One approach is to shore up financial institutions and allow them to slowly recognize past losses. The opposite approach is to force lenders to recognize losses, even to the point of wiping out equity holders and forcing "haircuts" on bondholders. We evaluate the effects of confronting balance sheet problems, especially in financial institutions, by contrasting Sweden, which aggressively addressed the impaired conditions of its banks, with Japan, which allowed its banks to stretch out recognition of losses on bad assets for over a decade. Sweden recovered quickly while Japan languished for over a decade. Market currency depreciation is a prominent feature of recovery in many countries. We discuss and chart three disparate examples--Finland, Thailand, and Iceland--that illustrate and explicate their significant, and common recurring, features. …