When confronted with a balance sheet recession the math regarding economic growth gets relatively simple – either the government spends in times of below trend private sector spending or the economy contracts. For several years now I have maintained that we are in a balance sheet recession – an unusual recession caused by excessive private sector debt. Although this balance sheet recession created the risk of prolonged weakness I have been quick to dismiss the persistent discussions that compare this to anything close to a second great depression - as I showed in 2009 the comparisons were always ridiculous. The much closer precedent was Japan, where the economy actually expanded throughout their balance sheet recession, but a persistent malaise left a dark cloud over the private sector as they paid down debts.
Over the last year I have consistently expressed concerns that the USA was going to suffer the same fate as Japan, which consistently scared itself into recession due to austerity measures. At the time, most pundits were comparing us to Greece and attempting to scare us into thinking that the USA was bankrupt, on the verge of hyperinflation and general doom. I wrote several negative articles in 2009 & 2010 berating public officials who said the USA was going bankrupt and that the deficit was at risk of quickly turning us into Greece, Weimar or Zimbabwe. Nothing could have been farther from the truth. The inflationists, defaultistas and other fear mongerers have been wrong in nearly every aspect of their arguments about the US economy.
US government default was never on the table, the bond vigilantes were not just taking a nap and now, with the passage of the most recent stimulus bill it’s likely that we’ve (at least temporarily) sidestepped the economic decline that was likely to accompany a decline in government spending. Richard Koo, however, believes we are repeating the mistakes of our past. In a recent strategy note he said:
“The situation in Europe is no different from that in the US. I therefore have to conclude that the western nations have learned nothing from Japan’s lessons and are likely to repeat its mistakes.”
I have to disagree here. The most important factor impacting economic growth in the prior year was the USA’s ability to avoid talking ourselves into austerity measures. Unlike Japan in the 90′s, we have not convinced ourselves that recovery was here before it was truly sustainable. This was the single most important contributing factor to Japan’s rolling lost decades. They suffered from a persistent economic malaise as the government withdrew aid just as the private sector appeared to be gaining some traction. And every time this occurred the economy sunk back into recession. Thus far, the USA has avoided this trap.
Mr. Koo is unhappy with the passage of tax cuts, which he believes, will prove far less impactful in boosting the economy. He also compares the USA to Europe, which I currently believe is inaccurate. With regards to the tax cuts, the key during a balance sheet recession is paying down debt – not propping up the economy via government programs. Whether this debt repayment is done through unemployment insurance, jobs programs or tax cuts is relatively semantic. The end goal should always be the same – to fix the balance sheets. I think the recent tax proposal is an adequate policy response given the current state of the US Congress. It’s not nearly as large as the USA needs and it’s not nearly as well targeted as it needed to be, however, it’s one of several things I have asked for in recent years so it would be entirely unreasonable to sit here and stubbornly say that it is a waste just because it’s not exactly what I wanted. Speaking of being reasonable, it is only fair that I admit that several of my pleas have come to fruition in recent months:
- I have consistently pleaded with policymakers to avoid the fear mongering of the deficit hawks and ensure that we don’t repeat the mistakes of Japan and 1937.
- I have asked for tax cuts that help reduce the strain on private sector balance sheets.
- I have asked for a Fed Chief that would admit that monetary policy alone cannot fix our woes.
That’s 3 for 3 in terms of several of my big picture requests – not ideal, but it’s not as bad as it could be. I think things could be far worse than Mr. Koo makes them out to be. As for Koo’s concerns that we have not learned from the lesson of Japan and are increasingly comparable to Europe – I think that’s a bit off the mark. Europe is forcing widespread austerity on the periphery nations and the UK has willingly implemented austerity measures. This is far different from what the USA is doing. The recent tax proposal all but guarantees that true austerity is not in the near future in the USA. His argument regarding Europe’s response is exactly right, however:
“In Europe, unfortunately, both governments and the private sector seem to be focused exclusively on fiscal consolidation. Particularly for the orthodox individuals in charge of the ECB, the EU and the OECD (by “orthodox” I mean they do not understand the mechanisms of a balance sheet recession), fiscal rectitude has become the “only game in town.” They are oblivious to the fact that austerity is a fundamental policy mistake during a balance sheet recession.”
Austerity in periphery nations will continue to drag these countries into economic depression and create extreme risks for the global economy. The lack of austerity in the USA has been soundly backed by recent data trends in the USA. The most notable improvements have been consistent strength in regional manufacturing data & the ISM data. If we look purely at a comparison of ISM Manufacturing with GDP the current levels are consistent with historical GDP growth of just under 4%. This is still largely government/inventory driven, however, it’s a continuing positive development for a country facing economic headwinds.
The ISM data can be particularly volatile and recent leading indicators have shown some marginal warning signs. It would not be surprising to see some moderation in the ISM data in the coming quarters and GDP growth that is below trend. While all of this is fairly good news we are not quite out of the woods yet.
The bad news is, we are Japan, but the good news is we are Japan on “fast forward”. As I described in mid-2009 everything in the USA’s balance sheet recession appears to be occurring much more quickly than it occurred in Japan. So, the good news is that we won’t need government aid as long as the Japanese needed it. In the meantime we must remember that stimulus is not self sustaining recovery. Ultimately, the USA will not be out of the woods until the private sector begins to meaningfully expand, contribute to closing the output gap and help reduce the 9.8% unemployment rate. Based on many macro trends I have said this could be occur as early as 2012, however, any number of exogenous risks could set us back by months or years. Thus far, there are some relatively positive signs coming from the private sector, however, we are still a long ways from sustained private sector recovery.
For now an accommodative Fed, a $1.3T deficit, a general lack of austerity and a tepid private sector recovery is likely enough to sustain economic growth, but not enough to meaningfully close the output gap. This all continues to point to a period of very high unemployment, tepid economic growth and a recovery that feels like a recession. As I said in early 2010 we might be in a technical recovery, but it still very much feels like a recession with a 9.8% unemployment rate. The good news is we’re not talking ourselves off the edge of the cliff. The bad news is the recovery remains tepid and highly susceptible to exogenous risks.