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Executive Summary

The U.S. business cycles that ended in the last three recessions involved progressively greater and more troubling risk-taking behavior. Each ended with worse financial fallout and a longer period of recession and weak recovery. Much has been written about the bubbles leading up to the commercial real estate deflation in the late 1980s and early 1990s, the crash of the tech stocks and the ensuing bear market of 2000-2002, and the deflation of home real estate and the debacle in mortgage-backed derivatives in 2006 through 2011. Yet analyses of the bubbles’ causes invariably omit a critical point.

The evolution of the economy’s aggregate financial structure has, over decades, altered the playing field for financial decision makers throughout the economy, increasingly skewing their available options toward higher risks, lower returns, or both.

This paper presents two facts that help explain economic and financial performance in recent decades and offers insights into the current business cycle, the 2020s, and beyond.

1. Private sector balance sheets grew faster than income over many decades; thus, aggregate debt grew faster than aggregate income, and aggregate assets grew faster than aggregate income.
2. This disproportionate balance sheet expansion changed financial parameters in the economy, mathematically making financial activity increasingly hazardous and compelling riskier behavior.

The first of these statements is an empirical observation, easily documented. The second is the result of direct logical deduction. Together, they have several consequences:

• From the mid-1980s on—the era of the Big Balance Sheet Economy—financial decision makers have had to choose between progressively lower returns and higher risk.
• Too much private sector debt relative to income has adverse consequences, of course, but so does an excessive total value of private sector assets relative to income. An extreme value of aggregate assets relative to income means meager yields and operating returns on assets, distorted financial decisions, and an economy vulnerable to asset price deflation.
• Each successive business cycle in the Big Balance Sheet Economy era has started with proportionately larger balance sheets and has involved more reckless balance sheet expansion leading to even bigger balance sheets and a worse financial crisis.
• Each successive crisis, with more bloated balance sheets to stabilize, was more difficult to resolve and therefore required the government to engineer dramatic new lows in interest rates, heavy fiscal stimulus, and other measures to stabilize economic conditions. The measures eventually overcame recession and chronic weakness, but in doing so they necessarily caused further expansion of balance sheets relative to income.
• During the 2000s, either the housing bubble or some other set of highly speculative, excessively risky, and destabilizing activities was virtually inevitable.
• Increasingly unsound risk taking has been occurring again in the 2010s.
• The present cycle is almost certain to end badly. Although there are signs that balance sheet ratios are undergoing an extended, secular topping process, they remain extreme and will produce serious financial instability during the next recession.
• There is no nice, neat solution to the Big Balance Sheet Economy dilemma, no blueprint for a politically acceptable resolution. The task of preserving prosperity while shrinking assets-to-income and debt-to-income ratios is, if not outright paradoxical, at least plagued by conflicting forces.
• Government policy cannot prevent serious consequences when the Big Balance Sheet Economy corrects, but it can moderate them and help households, businesses, and the financial system cope with them. However, these tasks would be difficult, politically tricky, and prone to cause some backtracking on balance sheet correction even if policymakers fully understood the economic problem.
• Although the outlook is fraught with uncertainties, individuals and organizations can benefit by taking steps to prepare for, endure, and in some cases capitalize on some of the developments ahead.

The U.S. economy continues to face a bubble-or-nothing outlook. Participants in the economy and markets will keep increasing their financial risk until the expansion breaks down, and the bigger the balance sheets are relative to income, the more severe the breakdown is likely to be.

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