I am shamelessly stealing this post from the CrawlingRoad forums because it is, in my opinion, the best post I have read describing the current economic situation in the US:
A recession is what happens when businesses produce more than the market is willing to consume at current prices. As a result, inventories accumulate, prices fall, profits are pinched, the economy contracts and the excess inventory is eventually soaked up, at which point prices stabilize and the economy begins to expand again.
A so-called "balance sheet recession", or what historians might call a depression, is a different animal altogether. A balance sheet recession occurs when businesses and individuals collectively realize (normally in response to the collapse in the value of an asset class) that the value of their assets is actually much lower than they previously thought, while the debt that has been taken out against those assets is exactly the same as it was before the crisis began. The response to a balance sheet recession is the slow process of paying down debt to the point that the debt and the value of the underlying assets are more in harmony. As you might imagine, if more of a nation's income is being re-directed to paying down debt, there is less income available for current consumption, which looks like a recession, but tends to last much longer than a garden variety recession.
What can be done to short circuit a balance sheet recession? One option it to try to restore asset prices to previous bubble levels. This approach always fails, since bubble prices are by definition unsustainable. Another option is to provide for the orderly liquidation and/or re-pricing of debt to levels that more nearly match the value of the underlying assets. Since this approach basically requires that all financial institutions take enormous losses, in a system where financial institutions are able to exert significant control over the political process (e.g., giving discount mortgages to members of Congress is one of countless examples), such an approach is also extremely unlikely to occur in a timely manner (though over time, of course, un-repayable debt will not be repaid).
The market and public have not yet fully grasped the difference between a balance sheet recession and a garden variety recession. Thus, many are patiently waiting for demand to take up the slack capacity in the economy, which is not going to happen any time soon (if ever). An Austrian economist would say that what has happened is that artificially low interest rates over a long period resulted in a structural misallocation of capital accross the entire economy. When people began to realize that there was a misallocation of capital (e.g., too many McMansions in the sunbelt states), it wasn't just a matter of reallocating the capital elsewhere since the capital was no longer liquid and the non-productive assets that resulted from the misallocated capital had giant liens against them in the form of debt.
I cringe when I hear people say that Bernanke isn't going to allow deflation to occur. To me, that is the central banker equivalent of the rooster saying that he isn't going to let the sun rise. Bernanke seems like a very intelligent and humble man, but I think history will show that he was like a brave firefighter spraying water into an approaching tsunami. What he is doing may mitigate matters in some way, but the basic set of effects that have already been set in motion are going to take a long time (perhaps a generation) to fully play out.
There you have it folks - double-dip, depression, second recession, call it what you want- we are going through a balance sheet recession, and we're looking at years before housing or the economy in general will recover.
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A recession is what happens when businesses produce more than the market is willing to consume at current prices. As a result, inventories accumulate, prices fall, profits are pinched, the economy contracts and the excess inventory is eventually soaked up, at which point prices stabilize and the economy begins to expand again.
A so-called "balance sheet recession", or what historians might call a depression, is a different animal altogether. A balance sheet recession occurs when businesses and individuals collectively realize (normally in response to the collapse in the value of an asset class) that the value of their assets is actually much lower than they previously thought, while the debt that has been taken out against those assets is exactly the same as it was before the crisis began. The response to a balance sheet recession is the slow process of paying down debt to the point that the debt and the value of the underlying assets are more in harmony. As you might imagine, if more of a nation's income is being re-directed to paying down debt, there is less income available for current consumption, which looks like a recession, but tends to last much longer than a garden variety recession.
What can be done to short circuit a balance sheet recession? One option it to try to restore asset prices to previous bubble levels. This approach always fails, since bubble prices are by definition unsustainable. Another option is to provide for the orderly liquidation and/or re-pricing of debt to levels that more nearly match the value of the underlying assets. Since this approach basically requires that all financial institutions take enormous losses, in a system where financial institutions are able to exert significant control over the political process (e.g., giving discount mortgages to members of Congress is one of countless examples), such an approach is also extremely unlikely to occur in a timely manner (though over time, of course, un-repayable debt will not be repaid).
The market and public have not yet fully grasped the difference between a balance sheet recession and a garden variety recession. Thus, many are patiently waiting for demand to take up the slack capacity in the economy, which is not going to happen any time soon (if ever). An Austrian economist would say that what has happened is that artificially low interest rates over a long period resulted in a structural misallocation of capital accross the entire economy. When people began to realize that there was a misallocation of capital (e.g., too many McMansions in the sunbelt states), it wasn't just a matter of reallocating the capital elsewhere since the capital was no longer liquid and the non-productive assets that resulted from the misallocated capital had giant liens against them in the form of debt.
I cringe when I hear people say that Bernanke isn't going to allow deflation to occur. To me, that is the central banker equivalent of the rooster saying that he isn't going to let the sun rise. Bernanke seems like a very intelligent and humble man, but I think history will show that he was like a brave firefighter spraying water into an approaching tsunami. What he is doing may mitigate matters in some way, but the basic set of effects that have already been set in motion are going to take a long time (perhaps a generation) to fully play out.
#housing