Richard Koo, chief econ­o­mist of Nomura Research Insti­tute, rose to promi­nence early last year with the pub­li­ca­tion of his fas­ci­nat­ing book, Bal­ance Sheet Reces­sion. He has just been inter­viewed by the bril­liant Kate Welling at Welling@Weeden. Although I have not yet set eyes on the inter­view, I am sure it is top class. How­ever, Richard Rus­sell (Dow The­ory Let­ters) last week pro­vided a taste of the dis­cus­sion in his newslet­ter, some of which has been worked into this post.

Koo defines a bal­ance sheet reces­sion as one that emerges “after the burst­ing of a nation­wide asset price bub­ble that leaves a large num­ber of private-sector bal­ance sheets with more lia­bil­i­ties than assets. In this type of reces­sion, the econ­omy will not enter self-sustaining growth until private-sector bal­ance sheets are repaired”.

Accord­ing to Koo, Amer­i­can con­sumers are suf­fer­ing from a bal­ance sheet prob­lem and will not increase con­sump­tion until their per­sonal finances are back in order. The banks are not lend­ing mainly because nobody wants to bor­row and, fur­ther­more, the banks want to build their own bal­ance sheets (raise cash) and get rid of toxic garbage.

Koo says it’s up to the gov­ern­ment to make up for the pri­vate sector’s prob­lems by spend­ing and con­tin­u­ing to run deficits. Thus we would be “buy­ing time” through gov­ern­ment spend­ing while the pri­vate sec­tor has time to repair its bal­ance sheets. He claims it is absolutely nec­es­sary for the gov­ern­ment to spend and run deficits. If the gov­ern­ment cuts back on its spend­ing and stim­u­lus, the US econ­omy will swoon and more money will be lost than was lost dur­ing 2008–2009.

Again, when asked what would hap­pen if the gov­ern­ment cuts back on its fis­cal stim­u­lus, Koo replies: “Until the pri­vate sec­tor is fin­ished repair­ing its bal­ance sheets, if the gov­ern­ment tries to cut its spend­ing, we’re going to fall into the same trap Franklin Roo­sevelt fell into in 1937 (a crush­ing bear mar­ket) and Prime Min­is­ter Hashimoto fell into in 1997, exactly 70 years later.

“The econ­omy will col­lapse again and the sec­ond col­lapse is usu­ally far worse than the first. And the rea­son is that, after the first col­lapse, peo­ple tend to blame them­selves. They say, ‘I shouldn’t have played the bub­ble. I shouldn’t have bor­rowed money to invest — to spec­u­late on these things.’

“But a sec­ond col­lapse affects every­one, not just the bub­ble spec­u­la­tors, and it also sug­gests to the pub­lic that all the efforts to fight the down­turn up to that point — all the mon­e­tary eas­ing, the low inter­est rates, quan­ti­ta­tive eas­ing — have failed and even fis­cal pol­icy has failed. Once that kind of mind­set sets in, it becomes ten times more dif­fi­cult to get the econ­omy going again. So the fact that Larry Sum­mers was talk­ing about ‘tem­po­rary’ fis­cal stim­u­lus had me very, very wor­ried. That whole Larry Sum­mers idea that one big injec­tion of fis­cal stim­u­lus will get the US out of the reces­sion, and every­thing will be fine there­after, prob­a­bly led to Pres­i­dent Obama’s say­ing he’s going to cut his bud­get deficit in half in four years.”

In sum­mary, Koo’s mes­sage is that we will have an all-out reces­sion if gov­ern­ment spend­ing and the bud­get deficits are cut back before con­sumers’ bal­ance sheets have been restored and they start buy­ing again. Does any­body still expect the econ­omy to be coaxed back to recov­ery with­out pain?

Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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