Kate Welling is a terrific financial journalist and has had a sterling reputation for years, on her own and at Barron’s. In my opinion, she has just burnished it with this tremendous interview with former Federal Reserve and current Nomura economist Richard Koo. Koo’s book, The Holy Grail of Macro Economics, Lessons from Japan’s Great Recession, discusses how a balance sheet recession is different from a typical cyclical recession. It’s a long article, but you’ve got to read the whole thing to really understand his thesis. This is a five-star article, in my opinion.
Koo’s argument is that in a balance sheet recession, businesses and consumers direct their free cash flow toward paying down debt and saving, rather than on maximizing profits. Koo’s thesis has visceral appeal: we’ve all seen this happening on a micro level within our own circles of acquaintances. During the deleveraging process, the typical rules of macroeconomics and monetary policy do not apply. For example, cutting interest rates should, in theory, stimulate loan demand and thus stimulate the economy. But even with U.S. interest rates near zero, there is no loan demand. Why? Koo’s contention is that, although it may be partly because of a lack of creditworthy borrowers, it’s largely because people are busy rebuilding their balance sheets-they are not interested in borrowing money at any price, even a low one. Koo’s interview is the first discussion I’ve seen by an economist that explains this phenomenon very well-because it also happened in Japan after their asset bubble burst in 1989.
Here’s where it gets interesting: there could be lots of unintended consequences in the market if policy levers do not operate as expected. Assuming that action x will lead to outcome y in the way we are used to expecting may not be applicable. Basing investment decisions on such assumptions could be very dicey. Using relative strength to power a trend-following process may be very useful, since trend following does not require any assumptions about policy outcomes. Global currency relationships may also become prominent as different countries respond to their situations in various ways. We’ve already seen this to some degree with the Euro/Dollar cross during the Greek situation. With policy responses in flux and with unpredictable outcomes potentially in store, a systematic global tactical asset allocation process may be the best defense for investors.
read the entire interview over the weekend, makes alot of sense and very interesting. it would be nice to know what mr koo’s thoughts are following the euro crisis.
[...] In an earlier blog post, I cited some arguments by economist Richard Koo, who contends that monetary policy levers [...]