The Balance Sheet Recovery
In the past, deep recessions have been followed by rapid recoveries. Not this time. Real GDP has been growing at a 2.9 percent rate since the end of the recession. The current level of GDP is still below its 2007 peak, after almost three years.
Both consumption and investment, the two private domestic components of GDP, have been contributing to the slow recovery.
Consumption has been growing at a feeble rate, less than 2 percent. An important reason for such slow growth is that the crisis hit household balance sheets hard. The values of both real estate assets and financial assets decreased sharply, which lowered household net worth and raised leverage. To restore their net worth and to repair their balance sheets, households have been saving at a higher rate, delaying their consumption. The saving rate has increased from its pre-recession level of around 2 percent to its current level of 5.8 percent.
Fixed investment has been growing at 4.4 percent, lower than one would expect after a deep recession. More than one factor has contributed. Weak balance sheets and debt overhang have discouraged businesses from investing. The level of uncertainty—about the strength of economic growth as well as future fiscal and regulatory policies—is high. This may have translated into a high level of uncertainty about the future profitability of investment projects and may have led firms to delay investment, waiting for the uncertainty to be resolved.
Some evidence from corporate balance sheets, however, suggests that companies could rapidly expand their investment plans. Corporate profits and cash flows have bounced back to historically high levels, so companies now have ready access to cheap internal funds. In addition, companies are actively raising external funds through bond issues. But rather than use these funds for investment, they are keeping them liquid. Companies are holding a record-high level of about $1,850 billion in liquid assets. The ratio of liquid to total assets is currently 7 percent, the highest level since the 1960s.
There may be several motivations behind this behavior. Companies may prefer a more liquid balance sheet as a form of precautionary behavior, because they perceive the environment in which they operate as riskier. Or they may hold a more liquid balance sheet because they want to have the option to use the funds as soon as the occasion arises—historically, a higher growth rate of liquid assets tends to be followed by a higher growth rate of investment. Also, companies may anticipate that they will need the funds in the near future, for capital and current expenditures as well as for debt repayment, and they are raising the funds now because it is relatively cheaper. The cost of both internal and external funds is currently very low. Borrowing, in particular, will hardly be any cheaper in the future. Long-term bond yields are very low, due to very low risk-free rates and moderate credit spreads. The Aaa and Baa corporate bond yields are currently below 5 percent and 6 percent, respectively, close to their historical lows.
Weak balance sheets and uncertainty have been repressing consumption and investment for a while. Once balance sheets are repaired and uncertainty gets resolved, we may see consumption and investment picking up momentum and sustaining a stronger recovery.