Everyone is rightfully excited over the potential for a strong rebound in the U.S. economy. And there is nothing short of the potential of global recession at stake should U.S. growth sputter. What is the key risk to U.S. growth going forward?
A Balance Sheet Recession
You may not be familiar with the term “balance sheet recession.” The reason is because we haven’t seen one in the U.S. since the 1930s Great Depression.
So what qualifies as a balance sheet recession, how is it triggered, and why is it so dangerous?
In a balance sheet recession individuals and businesses are more concerned about paying down existing debt than taking on new loans. That increases the demand for cash from individuals and businesses; so even higher levels of cash injected into the economy do not deliver the same punch.
Meanwhile banks will tend to use the higher reserves obtained from the central bank to bolster capital and deleverage risky loans, and lack incentive to make new loans during this period.
The trigger for a balance sheet recession is a bursting of a major credit bubble. The Credit Crunch was a credit bubble massive in scale, the size of which the U.S. had never seen before.
The risk is a dramatic collapse in asset values. Because of this, households, businesses, and financial institutions must realign existing higher debt levels to the new lower asset values. As this is done, the economy loses a significant amount of demand.
Add it up, and you’ll understand why, despite a zero interest rate policy from the Federal Reserve, the real economy is not responding as it normally would.
How the West Is
Repeating Japan’s Mistakes
As I said before, the last major balance sheet recession in the U.S. was in the 1930s. And there are rising parallels between the 30′s and the current era. But we have more recent experience with a balance sheet recession — Japan.
The Bank of Japan held interest rates at zero for many years, but few showed up to borrow.
Japanese monetary officials learned monetary policy was ineffective during a balance sheet recession. Fifteen years of deflationary-like conditions in Japan have a way of changing attitudes on economic policy. But even though Ben Bernanke prides himself on his understanding of economic history, the U.S. seems to be travelling down the same path paved by Japan.
Many argue the government must play the role of stimulator of last resort and in doing so allow for large fiscal deficits to give the private sector time to realign their debt levels to asset prices. One such analyst is Richard C. Koo, Chief Economist for the Nomura Research Institute, a person who knows a great deal about the policy mistakes of Japan:
“The U.S. private sector, which was borrowing and investing 5 percent of GDP in 2008, is now saving (including debt repayments) a net 6 percent of GDP in spite of zero interest rates, just like the Japanese a decade ago. This means United States is now squarely in a balance sheet recession and needs substantial and sustained government spending to prevent a deflationary spiral from taking hold.
“More worryingly, U.S. GDP has already fallen below its bubble peak, especially when viewed on a per capita basis, and the unemployment rate is still over 8 percent.”
We found a YouTube interview with Mr. Koo covering the same topic — balance sheet recession and Japan’s lessons — back in 2010. It still seems our policymakers just don’t get it. This is an excellent interview, and I highly recommend you take time to listen: Click here to listen …
“The U.S. lost half of its GDP [the Great Depression balance sheet recession] in just four years from 1929 thru 1933 because everyone was paying down debt, no one was borrowing money. In this type of situation, monetary policy is largely dead in the water.”
The major takeaway here is that growth going forward should continue to disappoint globally as deleveraging continues in earnest.
I have no doubt we will emerge from this balance sheet recession at some point. But for now …
The U.S. Is the Only One
Pulling the Wagon!
Europe is heading into a deep recession it seems, and China’s growth is deteriorating a lot faster than the consensus expected. Thus a slowdown in the U.S. means the global economy could quickly head back into recession.
Global stocks have been screaming higher thanks to all the money flowing from governments and central banks. But all that will likely come crashing down on a U.S. growth disappointment.
Liquidity bidding up those stock prices have pushed up many risk asset classes in correlation (commodities, junk bonds, etc.) even though global growth has not materialized yet. In effect, stocks are bid higher on expectation of good things to come. This tells me key commodities (and commodity currencies) are extremely vulnerable given China’s now precarious condition.
The U.S. dollar seems to be in a very good spot; it can rally on growth or disappointment …
The U.S. is growing faster relative to the primary dollar-competitor nations, and market interest rates are starting to reflect this reality. Thus, the dollar is now getting some growth and yield coverage; neither of which it has had for a long time.
But interestingly, if U.S. growth disappoints, the dollar will likely get what is called, “a major risk bid.”
That happens when money is moving back into the U.S. capital markets — U.S. Treasuries — for safe haven. And the dollar benefits because these big pools of safe haven flow must first convert their holdings into U.S. dollars to buy Treasuries.
So the jury is still out on the U.S. recovery given the negative impact of a balance sheet recession that can take years to overcome. But either way, the U.S. dollar may be in a sweet spot, a place it hasn’t been for a long time.
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