Pursued Economy

CHAPTER 2Balance Sheet Problems Create a Shortage of Borrowers

As is noted in Chapter 1, entities that have stopped borrowing because of negative equity will not resume borrowing until their balance sheets have been repaired. Depending on the size of the bubble, this can take many years. For example, if the borrower in Chapter 1 who was $200,000 underwater has an after-tax income of $150,000 and a savings rate of 20 percent, she is saving $30,000 per year. If she can earmark two-thirds of that amount, or $20,000, for addressing her debt overhang, it will still take her ten years to clean up her balance sheet.

And with so many people trying to restore their financial health at the same time, the economy will be in constant danger of entering the sort of deflationary scenario that is described in Chapter 1. If the resulting recession reduces the income of the person in the example, she will have even less money to pay down debt and will therefore need more time to fix her balance sheet. The recession may also push house prices lower, which would make the process even more difficult. Both factors—reduced income and falling asset prices—can easily extend the time needed for balance sheet repairs.

One nasty characteristic of balance sheet recessions is that they are largely invisible and inaudible. After all, businesses will not want to admit that their balance sheets are underwater if they think they can patch up their balance sheets within a reasonable time frame. And that is ...