Is it just me or does Richard Koo look smarter and smarter as the recovery drags on? The chief economist at Nomura Research Institute argues that what we’re experiencing is not a typical downturn. It is a “balance sheet recession,” to borrow a phrase he credits his former New York Federal Reserve colleague Edward Frydl with. That is to say we are in the midst of a deleveraging process in which consumers and businesses are either paying down debt or despite their relatively healthy balance sheet, choosing not to take on additional debt.

Both scenarios hurt economic growth, of course. What’s more, periods like this one are easily misread by policymakers. So bad decision-making extends the recovery process, unnecessarily. Koo says that happened in the 1930s during the Great Depression and in Japan during its so-called Lost Decade in the 1990s.

Koo updated his important book The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession to include commentary on the current downturn. His theory can get a bit wonky, so I’m going to have a crack at summarizing the highlights:

• Monetary policy doesn’t work to reverse a balance sheet recession. Remember that monetary policy is intended to move interest rates up or down by controlling the supply of money. While it is conventional to lower interest rates as a means of restarting growth during a typical recession, that won’t work now because the private sector won’t take advantage of low interest rates. Businesses focus on paying off debt. Even when they’ve got their debt under control, they remain unwilling to borrow.
• Tax cuts don’t work either. Consumers – certainly those in the U.S. – have adopted a similarly cautious stance. The drive to get one’s financial house in order overrides the opportunity to spend unexpected tax savings.
• Saving takes money out of the economy. Say a family saves $100 of every $1,000 of income its members earn. In a normal economy, that $100 goes into banks and investment companies, which in turn lend the money to companies. Those companies spend the money, which means that all of the original $1,000 is spent back into the economy ($900 by the family and $100 by the companies). In a balance sheet recession, companies aren’t prepared to borrow. Low interest rates – even an interest rate of zero – won’t change their minds. So the $100 saved by the family doesn’t get borrowed by companies, and therefore doesn’t get spent. Economic activity drops. In fact, this gets worse and worse because now only $900 of the original $1,000 is circulating. If the next family saves $90 of its $900 in income (and no company wants to borrow that $90), there’s just $810 spent back into the economy. And so on. Koo reports that during the 1990s in Japan, 10% of gross domestic product was sitting idle in consumer bank accounts.
• Fiscal policy is effective. It makes sense to hike government borrowing and spending. If companies won’t borrow that $100 from families and put it to good use, governments should. That will ensure the full $1,000 is recirculated ($900 by the family and $100 by the government). This adds to government debt of course, but the revenue hit suffered by governments during a significant recession is worse. Koo estimates that the Japanese government would have had to spend about ¥200 trillion during its Great Recession instead of the ¥315 trillion it ended up spending if it had followed his advice.

I’m really glossing over Koo’s arguments here, so I’ll end with two useful links. This one features a video of him explaining the balance sheet recession idea. This one features a presentation Koo made last year on why an austerity program in the U.S. will have a negative result.