I recently returned from a trip to Japan, but there is little new I can say about its economic situation. In fact, in some ways Japan reminds me of Thailand – there is nothing exciting about its economy, and the only exciting thing about the country is its nightlife. However, investors should remember that there are many factors other than GDP growth that affect stocks, bonds and currencies. So, while I am not excited about Thailand and Japan economies, I do like their stocks – I see decent dividends and limited downside risk in Thailand stocks (however, some stock or sector picking might be required), and I like Japan stocks purely from a contrarian point of view. Japan stocks have been in a secular bear market for two decades and there is little (especially bullish) interest in them.
The real reason I am mentioning Japan is that my trip there reminded me of an interview with Richard C. Koo that I read some time ago (the full interview is available at http://www.zerohedge.com/sites/default/files/Wheeling%20@%20Weeden.pdf). The focus of the interview is Koo’s “fascinating and unconventional” observation on differences between cyclical recessions and “balance-sheet recessions”:
The key difference is that in the typical cyclical recession, private sector balance sheets are not badly affected and people, at the most fundamental level, are still forward-looking. So, when you bring interest rates down and people are still trying to maximize profits, there will be some response to those lower interest rates. People borrow money, they purchase something and the economy starts moving forward. … [in balance sheet recessions], after an asset pricing shock, after a bubble bursts, the private sector’s balance sheets are under water. When that happens, the first priority of people in the private sector becomes to minimize debts instead of to maximize profits and if there are enough underwater balance sheets around, even if you bring interest rates down to zero, still nothing happens. People with balance sheets under water won’t be increasing their borrowings and there will not be too many willing lenders to those guys, either. So the effectiveness of monetary policy goes out the window, exactly as happened during the Great Depression in the U.S. and in Japan during the 1990s — and as is happening in the U.S. this time around. It’s a case of actions that are perfectly rational on the micro level turning disastrous when engaged in at the same time by an entire economy.
Mr. Koo then explains benefits of “successful” fiscal policies of the Japanese government over the last 20 years (Japan’s GDP didn’t crash during its recession which started in the 1989 and, according to Mr. Koo, Japanese private sector stopped deleveraging in the 2005) and gives us his magical cure for the “balance-sheet recessions”:
The private sector must repair its balance sheets before outsiders find out how bad its financial health actually is. In order to retain credit ratings and so forth, the private sector has no choice. It has to repair its balance sheets by paying down debt. My argument is that, if the government did nothing to counter this situation, the economy would shrink very, very rapidly. Debt repayment and the savings of the private sector would end up stuck in the banking system because there would be no borrowers even at very low interest rates. So the economy will be losing demand equivalent to household savings plus corporate debt repayment each year. That is how I think the U.S. got into the Great Depression in the 1930s. But the ray of hope here is that if the government comes in and borrows the money which now is just sitting in the banking system and puts it back into the income stream through government spending, then there’s no reason for GDP to fall. That’s what is needed in times like this, when the government cannot tell the private sector not to repair its balance sheets.
Firstly, I find Mr. Koo’s ignorance of economic theory truly remarkable, but unfortunately, the same can be said about most modern-day economists. The Austrian School of Economics has long maintained that every credit expansion must eventually lead to over-investments and then to breakdown and debt deflation, and every major book on the business cycles at least mentions the monetary theory of the business cycle. In Inflation (London, 1933), Irving Fisher claimed that
…if liquidation, for some reason, gets into a stampede, it wipes out (i.e. deflates) credit currency, which lowers the price level and reduces profits, which force business into further liquidation, which further lowers the price level and reduces profits, which force business into further liquidation – and so on and on: a tail-spin into depression… We now come to the paradox that if the debts get big enough, the very act of liquidation puts the world deeper in debt than ever… Each dollar represented in the unpaid balance grows faster than the number of the dollars is reduced by liquidation. Such is the essential secret of a great depression.
Although I wish today’s economists had a bit more knowledge of economic theories (or had more moral integrity), I would rather like to focus on Mr. Koo’s recipe for solving the problem of debt deflation. I would like to remind readers of an argument put forward by W. Ropke in Crises and Cycles (London, 1936):
The credit expansion setting of the boom going proceeds by way of the interest rate being “too low”. The too low interest rate invites a general increase in investment which then leads to the mechanism of the boom drifting on towards its ultimate debacle… The expansion of credit in the boom expressing itself in the too low interest rate leads to an over-expansion of the economic process and by introducing a general over-investment disrupts the equilibrium of the economic system. It allows more to be invested than is saved and makes available the necessary increase in money capital from credits which do not originate from savings but are created out of nothing through the banking system… The demonstration that the credit expansion of the boom leads to over-investment provides at the same time a proof that the capital formation induced by credit creation, and the extension of production that it sets going, lead to a painful reaction expressing itself in the crisis and depression. This reaction can indeed be postponed by a further increase of the credit supply but only at the price of a corresponding aggravation of the ultimate reaction. An “eternal boom” is therefore out of the question. (Emphasis added)
This reaction of debt deflation has indeed been something that has continually been postponed in the United States since the WWII – while a buildup of the leverage has always been associated with economic expansions, the government policies provided support during cyclical recessions. This prevented frequent depressions associated with the pre-WWII period, but at the same time, the balance sheet imbalances were never fully unwound. As the leverage in the system grew, so did grow the threat of debt deflation and the pressure on the government to reflate the demand no matter what. However, an “eternal boom” is out of the question – as the consumers and the companies took more and more leverage, they required increasing support from the government policies, as is seen from the recessions becoming increasingly severe and being triggered at lower and lower short-term rates. It appears that we have finally reached the zero-hour, when no matter how low the interest rates are, the private sector is no longer willing to increase its leverage.
Mr. Koo claims that debt deflation in private sector can easily be solved by more debt inflation – only this time in public sector. However, the question is what will happen after this last piece of ammo in government’s hands is expended. Mr. Koo’s assumption is that the public debt inflation will allow us to get over the current recession and we can expect continuation of happy times afterwards. As I mentioned above, he points to Japan as an example of a country that successfully survived balance-sheet recession by sticking to this cure. My main objection to this argument is that Japan’s problems are anything but resolved – the private sector debt has simply been replaced with the huge public sector debt and we can only guess what the future will bring. While one must acknowledge that there were countries in the past which have successfully reduced its public sector debt through massive spending cuts (Canada is an example, although a bull market in commodities certainly helped in that case), I find that scenario unlikely either in the Japan or the U.S. case. The demographic pictures of both countries are rapidly deteriorating, interest payments alone will make it hard to reduce debt, and growth prospects of both economies are weak. It is thus a more likely scenario that the next recession will trigger a complete collapse of the system and will finally purge all the excesses that have built up over the last few decades.
While the next recession is probably a couple years away, it is likely to be at least comparable to the Great Depression and investors should thus start preparing for this scenario. I don’t advise shorting the market (at least not yet), but rather advise to think about what the governments usually do when the system starts collapsing – they nationalize retirement savings, and enact exchange and capital flows controls (I will skip the issue of wars for now). Most investors believe this could never happen in the U.S., but one only needs to look at the history to see that it has happened to many great empires in the past – everything changes, and one should never become complacent. The fact is that investors’ assets are becoming increasingly unsafe in the U.S. and they should take actions to mitigate this risk. I realize that an overwhelming majority of investors think that even suggesting this scenario is crazy, and that advising them to reduce or stop 401K payments and move their cash and assets overseas would be a waste of energy, but at the very least, I would advise everyone to open a non-US bank account and make sure they can easily wire their cash to this account. This requires minimal amount of energy and money, and it will provide at least some security in case of emergency. Opening an overseas account can take some time and research, and once the collapse starts, it will be too late to do this (this is especially true for the U.S. citizens since fewer and fewer institutions are willing to accept them as customers). More bearish investors are advised not only to limit their exposure to U.S. securities, but also to make sure the custodianship of their non-U.S. securities is with entity that is not in the U.S. jurisdiction.
Disclosure: No positions.