In a textbook cyclical recession, the private sector remains in a forward-looking, profit-maximization mode. When the Federal Reserve lowers interest rates, people borrow money to invest or spend and the economy grows.
There is an unconventional school of thought that says the recent Great Recession was not a typical cyclical recession. Instead, it was like the one that appeared during the Depression of the 1930s and in the 1990s in Japan: a balance-sheet recession. And because that is fundamentally different, it doesn’t respond to the usual remedies.
Richard Koo, chief economist at the Nomura Research Institute, had a front-row seat during Japan’s “Lost Decade” of the 1990s and understands balance-sheet recessions.
Although I haven’t read Koo’s book, “The Holy Grail of Macro Economics, Lessons from Japan’s Great Recession,” I was fortunate enough to come across two interviews where he discussed his decidedly unconventional views, the welling@weeden newsletter (September 2009) and Barron’s (January 2010).
Koo argues that, following an asset pricing shock—such as housing in the United States—private-sector balance sheets can have debts greater than the now-diminished value of the assets. The priority in this situation shifts from maximizing profits to minimizing debts and building savings. During this period of “balance-sheet repair,” people will not borrow additional money to spend or invest, even at 0 percent. Sound familiar?
Further, while this behavior is perfectly rational on an individual, micro level, the results can be disastrous on a larger scale. When the private sector has no appetite for borrowing, the economy loses demand.
To prevent the economy from rapidly shrinking, the government must borrow the money that is sitting idly in the banking system and put it back into the economy via government spending.
And to prevent the economy from contracting when someone is paying down debt or saving money, there must be someone on the other side borrowing that money to spend or invest. Say Nancy has $1,000 of income. She spends $900 and deposits $100 for debt repayment/savings. The $900 becomes income for someone else and continues to circulate in the economy. Normally, the $100 is eventually lent to a borrower, who spends or invests it.
However, if nobody wants to borrow the $100 Nancy deposited, that money is never invested or spent. Assume Tom received the $900 Nancy spent and decides to spend $810 and deposit $90, where it sits in the banking system because nobody wants to borrow it. As this process is repeated millions of times, each household’s income is reduced. The economy enters a deflationary spiral as asset prices fall further, increasing the desire to pay down debt.
Koo says the good news is, it doesn’t have to be this way. However, it will take speedy, substantial and sustained fiscal stimulus to reverse the trend.
The amount the government has to borrow and spend to keep gross domestic product from falling is the full amount of the excess savings in the private sector. With long-term interest rates at historically low levels, the market is giving the government the green light. But the risk is reducing the stimulus before the process of private sector balance-sheet repair has run its course.
This is all tricky in today’s political environment. Believing that government deficit spending and borrowing are good and that spending cuts and debt reduction are evil may seem like Alice-in-Wonderland stuff. Still, Koo’s views are gaining traction and merit serious consideration.•
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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
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