Lately, much of the economic debate has been force-shifted by the economic pundits to observations of a financial rebound framed merely as a consequence of a manufacturing recession, when the core of the issue is and continues to revolve in a balance sheet recession context. As the later has a unique set of deflationary threats over and above the usual framing of the output gap as perceived by Ben Bernanke et al, who keep trying to convince US consumers that the 2008-2009 period is nothing to write home about, we would like to present a research piece by Nomura's Richard Koo, who does an admirable job of recapitulating just why America and China are set to recreate the Japanese experiment of several "lost decades" and still running. What we can expect, if America does not change its course: at least three years of lost GDP, if not much more.
As Koo frames them, the key features of a balance sheet recession are the following:
- A balance sheet recession 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 order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.
- With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers.
- The sum of savings and debt repayments end up becoming the leakage to the income stream.
- The deflationary gap created by the above leakage will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money (=depression).
- In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.
Keep this presentation in mind as you consider the $1 trillion+ and rapidly rising excess reserves with Fed Banks: that is the single biggest threat to Bernanke's reflation approach. No matter how much money the Fed Chairman keeps on pumping into the system, the new "frugal" normal as defined by Rosenberg, will force consumers to stay away from any and all incremental borrowing for an indefinitely extended amount of time.
The one critical take home message is that GDP growth in a balance sheet recession/depression is indicative of absolutely nothing except government largess, and future massive funding needs.
And here is the terrifying quantification of the lost 17 years in Japan: 1.5 quadrillion yen, or 3 years worth of Japan GDP!
All this and much more in the attached presentation:
For those interested in more, here is a recent video conference with David Koo discussing the economic outlook.