Too optimistic, you're saying?

My view is that, if this is a full-fledged balance sheet recession and we see U.S. households increasing savings rates and deleveraging happening all over the economy, it will be very difficult to convince people to change that behaviour quickly. Because with everybody doing it all at the same time, the economy will be weak, asset prices will be weak and that just pushes the goal of repairing private sector balance sheets even further away. Once the U.S. has fallen into this type of recession, it will be in there for a while - and fiscal stimulus will be needed for the whole period, if you want to keep GDP from falling.

Let's back up for just a second here and explain what you mean by a "balance sheet recession." What made the Great Depression and Japan's Great Recession different, in your view, than the garden variety cyclical recession?

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.

But, in a balance sheet recession?

In these cases, 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 will not be increasing their borrowings and there won't 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.

So there's a fallacy of composition at work?

Exactly. But the government cannot tell people not to repair their balance sheets, right? 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.

David Fuller's view The arrival of this interview is timely because Richard Koo is a heavyweight thinker and has a unique background, as you will see on reading his comments. His view is persuasive and the opposite of those high-profile money managers who have presumably bought their 'out of the money' put options on US Treasuries and other countries' debt, and are now beating the drum for higher yields.

I share many of the latter group' views regarding the long-term outlook for long-dated yields, as veteran subscribers may recall. We have seen the market's reaction to Greece's debt problems and UK gilt yields have recently experienced a potentially important upside breakout. US 10-Year Treasury yields remain rangebound but are edging higher within their 3.15% to 4% band once again. This pattern also has V-bottom with right-hand extension characteristics, as taught at The Chart Seminar. Euro-Bunds have only edged up from the lower side of their current range but also show potential base formation characteristics.

Ultimately, we all have to make up our own minds and the final arbiter in terms of our thinking at Fullermoney is market action, revealed by charts. Currently, technical action favours the bond bears, although not conclusively as long-dated yields are still ranging in a number of instances.