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The Balance Sheet Recession: UK Q2 Housing Equity Injection Largest Since Q2 2011

The American-Taiwanese economist Richard Koo, is the chief-economist of the Nomura Research Institute.

In his theory of the Balance Sheet Recession he distinguishes between the “Yang” phase of the economy and the “Yin” phase (the so-called “balance sheet recession”). In “Yang” times companies want to increase profit and people consume a big part of their pay rises. The mainstream economic principles are fully valid (for details see short-run principles, medium-run and long-run). Check here for his book.

In the “balance sheet recession /Yin” phases economic actors want to reduce debt and costs. Many economic principles are only partially or not valid at all.  Their underlying assumptions, that firms mostly want to maximize profit and that the propensity to consume is considerably higher than zero, are not valid.

The balance sheet recession in regular economic news

British home owner continue to pay down their mortgages. The reduce their balance sheet instead of taking loans against it before the crisis. This reduces the ability for spending and therefore the GDP. The result: low growth or even a small recession.

Before the crisis, the British home-owners took additional consumption loans on their mortgages and reduced the equity of their mortgages. Since the crisis they rather pay down debt. The Brits paid down loans more quickly in times of higher incomes and higher interests (2006-2008), given that many had variable-rate mortgages.

WEDNESDAY, OCTOBER 3, 2012 – 04:52

BOE: UK Q2 Housing Equity Injection Largest Since Q2 2011



The negative figures indicate a continued injection of housing equity by households overall, with the net flow of lending secured on dwellings remaining weaker than their investment in housing.  The flow of secured lending remained positive (Table A).
The decline in HEW – and move to injections of housing equity – since the start of the financial crisis (Chart 1) has not been associated with an increase in repayments of secured debt.  Chart 2 shows that gross secured loan repayments have fallen since that time, which has reflected both lower housing market activity and a reduction in remortgaging. An article in the 2011 Q2Quarterly Bulletin explains that the fall in housing equity withdrawal since the financial crisis is likely to reflect a fall in the number of housing transactions, with little sign that households in aggregate are making an active effort to pay down debt more quickly than in the past (seeReinold, K, ‘Housing equity withdrawal since the financial crisis’Bank of England Quarterly Bulletin, 2011 Q2, pages 127-133)
Gross Payment of Dwelling Loans UK

Click to enlarge: Gross Payment of Dwelling Loans in the UK - Click to enlarge

Housing Equity Withdrawal UK

Housing Equity Withdrawal UK - Click to enlarge


Housing equity withdrawal (HEW) is classed as the balance of effects on the stock of housing equity from:
  1. Changes in the stock of secured lending when households take out or repay debt.
  2. Changes in the stock of housing wealth, e.g. when new properties are built or improvements are made to existing properties.
The stock of housing equity can also change as a result of revaluations of the stock of housing wealth due to changes in house prices, but this is not included in HEW.
For further details on the definition of HEW, please see the Explanatory Notes.
(source: Bank of England)

The bank explains the process housing equity withdrawal before the crisis as follows:

Ways of Housing Equity Withdrawal BoE

Ways of Housing Equity Withdrawal BoE - Click to enlarge

The different types and volumes of housing equity flows since 1994can be seen here. People continue to pay down their mortgages, but there are a lot less first-time buyers and a lot less people who receive further advances, people who sell their property or those who move to a cheaper home and do not reduce the mortgages equivalently (so called “down trader withdrawals”).

Gross Flow Withdrawals Injections BoE UK

Gross Flow Withdrawals Injections - Click to enlarge


Home prices in the UK or in Spain are still overvalued against rents and income by more than 20%, whereas they are already undervalued in the United States or Ireland and still undervalued in Japan.

After busted bubbles in Austria, Switzerland and Germany (especially Eastern Germany) in the late 1990s, home prices are still undervalued in these countries. The biggest overvaluation exists in Hong Kong, Canada and Singapore. Belgian and French real estate still represent misleading shelters from the euro crisis, whereas Sweden, Denmark and Netherlands have already corrected (a part of ?) the wrong prices.

For us it is a question of mentality, that prices are more inelastic in romanic countries (like France, Italy, Spain, Belgium) than in germanic/anglo-saxon states. An example is the rapid fall in Ireland or Denmark, but the rather slow descent in Spain and the still missing one in France and Belgium.


Eonomist House Prices August 2012

Eonomist House Prices August 2012 - Click to enlarge


Have US home prices bottomed out ?

According to Mish Shedlock and Doug Short, inflation-adjusted US home prices have already arrived at its 1994 or 1997 levels; the issue is just that so many people are under-water. Richard Koo will tell the Japanese lesson, namely that after a housing bubble it takes far more years to recover than to build the bubble.

Inflation-adjusted House price index vs. CPI and GDP deflator

Inflation-adjusted House price index vs. CPI and GDP deflator (a must read on Doug Short)

Percentage Underwater United States

Underwater America - Click to enlarge

Richard Koo’s Theory

Koo’s theory is related to economists like Walter Bagehot, Hyman Minsky and Charles Kindleberger, who similarly as Austrian economists introduced a “Boom and Bust Cyle”. The Minskian “Financial Instability Theory” , caused by excesses of the financial sector.


The way economies get into the balance sheet recession is the following (extracts from here):

  • The private sector builds up massive debt levels to buy property and speculative assets.
  • The asset prices rise as demand rises but then eventually the bubble bursts and the private sector is left with declining wealth but huge debt. Often richer, informed investors are able to sell the property early, but the ordinary Joe is often left with his asset “under-water”.
  • The private sector then start restructuring their balance sheets – and stop borrowing – no matter how low interest rates go.
  • All effort is devoted to paying back debt (de-leveraging) and households increase their saving and reduced spending because they become pessimistic about the future.
  • For borrowers who are under-water, a credit crunch might emerge – not because there is enough funds but because banks cannot find credit-worthy borrowers to lend to.
  • Attempts at pumping liquidity into the banks will fail because they are not reserve-constrained. They are not lending because no-one worthy wants to borrow.
  • According to Koo, the only way out of the “balance sheet recession” is via sustained public sector deficit spending.
  • The faltering spending causes the economy to grow very slowly. Especially when public spending helps, a recession and Irving Fisher’s debt deflation does not happen, but it leads to disinflation taking place over years and potentially to deflation, but not to a sudden deflationary spiral.


Koo expects all countries who got stuck in a real estate bubble before 2008, to live a long-lasting balance sheet recession (Yin phase), whereas Japan lives already a Yang phase with rising consumer spending and looming tax hikes to counter the high public spending during the Yin phase.

Central bankers and economists especially in the english-speaking countries and very influential papers like  “The Financial Times” or “The Economist” strongly rely on the economic principles valid in the “Yang” phases and overemphasize economic interventions based on the short-run and on the demand-side.

Here some extracts of  institutes and blogs who support Koo’s balance sheet recession theory:

Attention: The internal data of table “5” is corrupted!


Balance Sheet Recession becomes mainstream, four years too late

Influential main stream economist have a long rejected the balance sheet recession theory. Here an answer from Krugman to Koo’s theory: He disagrees because there must be “also creditors, not only debtors”. Certainly, Mr Krugman, there are now creditors, most of them are in the US or the UK, but they are in the countries with strong trade balances (like China and German) and those with rising real estate prices (Germany or Switzerland or soon Japan). Krugman partially agrees and distinguishes between “patient and impatient market participants”, creditors and debtors.

The White House also looks to be on team balance sheet. See the latest Economic Report of the President (pages 110 to 114):

“The standard approach in economics has been to assume that households consume about the same fraction of the increase in their wealth each year, regardless of its source… The severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these estimates appear too small…

A growing economics literature highlights the importance of household debt balances in influencing the severity of economic slumps… A series of empirical papers attempts to quantify the effect of such deleveraging on consumption (Mian and Sufi 2010; Mian, Rao, and Sufi 2011). These papers broadly suggest that the levered nature of household housing assets amplified the effect of pure wealth losses from the crash in housing prices.”

And finally Mr Mainstream Keynesian, Paul Krugman:

Mike Konczal has an excellent survey of the recent literature on balance sheet recessions; as he says, there is now a lot of empirical evidence supporting the view that we are mainly facing a slump in aggregate demand, which in turn is largely driven by debt overhang. There are strong implications for, among other things, mortgage relief; and in general, macro policy is different under these conditions.

And  this is the presentation from the Roosevelt Institute, the application of Koo’s theory to the United States.

Some first econometric evidence

An overview of recent economic papers give this slide from Mike Konczal:

First research on balance sheet recessions

First research on balance sheet recessions - Click to enlarge

 Details and more on recent economic research

Atif Mian , Amir SufiHow Household Debt Contributes to Unemployment

Case, Quigley, Shiller (2005):  Comparing Wealth Effects: The Stock Market versus the Housing Market

Case, Quigley, Shiller (2011):  Wealth Effects Revisited

Mian, Rao, and Sufi (2011): Household Balance Sheets, Consumption, and the Economic Slump

Doms, Dunn, Vine (2008): Changes in Housing Wealth and Consumption: Did the linkage increase in the 2000s ?


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George Dorgan
George Dorgan (penname) predicted the end of the EUR/CHF peg at the CFA Society and at many occasions on and on this blog. Several Swiss and international financial advisors support the site. These firms aim to deliver independent advice from the often misleading mainstream of banks and asset managers. George is FinTech entrepreneur, financial author and alternative economist. He speak seven languages fluently.
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