The greatest recession, according to many of the smartest guys in the room, could also be the most boring. Words like collapse, crash, flashing signals, are the usual adjectives we use to describe the abnormal. However, the decline of the credit cycle has a new look, and like most trends in the techno-age, it emerged in Japan first.

The private sector began paying down debt after the debt-financed asset bubble collapsed, leaving only debt in its wake. This was both responsible and correct behavior for individual businesses and households, but as a result of their actions the economy as a whole experienced what are known as a fallacy-of-composition problems. A fallacy of composition refers to a situation in which behavior that is correct for individuals or companies has undesirable consequences when everyone engages in it. Japan has confronted many such problems over the past 20 years, and the West has confronted the same problem for the past seven years.

-(Koo, The Escape from Balance Sheet Recession and the QE Trap)

Richard Koo makes the case in the above referenced title that in the aftermath of a debt-financed bubble collapse, the exigency to rehabilitate one’s insolvent balance sheet is so great that monetary policy becomes ineffective. Central banks cutting rates to zero (monetary policy) did not compel companies to take on extra liabilities for fear their books might be scrutinized. In all but appearance, companies and households were zombies, and due to the collapse in demand (for debts or otherwise), a recession followed. Koo continues on to describe the mistakes Japan has made on its 20 year experience with this trap. These mistakes were nearly all due to political intervention or pressure and a desire for normalcy with respect to monetary policy and the national deficit.

As the archipelago continued on its slow recovery, another pernicious feature emerged to derail their best intentions. The debt rivers that began to anxiously flow out from banks of mainland Japan did not nourish Japanese ground, they instead rained upon the soils of their neighbors who graciously supplied cheap labor markets for operations. The inflation that Japan needed, in order to break from the bindings of recession could not be found, the money flowed in aqueducts high off the ground. The thirst of commoners on the ground, and their subsequent dispensation throughout the economy was left wanting, and without it no amount of monetary policy could budge inflation. Without adequate growth and the intermittent monetary/fiscal/political intervention, the deficit grew to the point that it was eventually 2.4 times GDP.

The debt grew so large because for the past 20 years the authorities, the media, and academic economists have refused to lend their support to the only medicine that works during a balance sheet recession – fiscal stimulus – because they do not understand that Japan is in a balance sheet recession. When the government has engaged in fiscal stimulus, these groups have continuously argued that it should be followed by deficit reduction efforts, thereby undermining the forward guidance effect of the spending.

-(Koo, The Escape from Balance Sheet Recession and the QE Trap)

Koo prescribes the same dangers and the same medicine for Western economies. Yet, like in medicine, some treatments may be better than others depending on the patient.

The U.S. deficit is a different creature, with a world of contingencies to consider, a challenged world reserve currency, dire trade deficit, over-leveraged corporate bond market ($700 Bln maturing this year), inaccurate ratings. In a recent interview with Yahoo Finance Jeffrey Gundlach breaks down risks going forward masterfully:

What could begin with a boom, will be followed by the inimitable parade of cheesy overworked televised crisis graphics. The kind that looks stale in a week. But the aftermath (according to Koo), in a global network, could be a massaged slow recovery. Economists would be left scratching their heads and re-convening to explain why their models aren’t working.

Gundlach suggests a noticeable if not significant decline in the standard of living from the risk factors we currently face. If this does in fact occur, then the balance sheet recession and subsequent QE trap may not endure with the duration that Koo elucidates. Domestic labor could become competitive again and capital could be captured at home, bringing the needed flow of funds throughout the economy.

Why doesn’t the domestic economy recover in response to certain fiscal and monetary policy? If there’s no growth there’s no recovery, if the money doesn’t flow throughout, there’s no growth.

Massive deficits (with a side of currency crisis), impotent rating agencies (hiring prosaic paper-weights), and the widespread belief that the market has utterly failed at delivering true price discovery has created so much distortion that, provided the correct catalyst, could make us all purge participants in a domestic if not global marketplace.

If Koo is correct the balance sheet recession may be global. The slow plodding through a period of anemic growth away from a recession could be guided by astute fiscal policy and monetary policy working hand in hand with an abiding deficit (a deficit at 2.4 times GDP has not been detrimental to Japan after all). Ray Dalio has described a recovery that includes imaginative monetary and fiscal policy that could provide for a smoother transition from what would be a classic recession, to instead a kind of steady uninterrupted progress. A skillful balance of tightening and loosening in monetary policy is needed, the prudent fiscal policy portion of this endeavor he reserves his opinion on altogether. The variables are simply too much.

What enters the conversation at this point, and where this narrative will end for now, is the X-Factor. The unknown variable, the elephant/donkey in the China shop that moves with the best intentions – but any creature in an alien and artificial environment can only hope vainly to not leave their mark. This variable is a very important one as every academic with their short-sighted and untested models will soon be mobbing officials that were elected as a protest. They will whisper in their ears their contemporary philosophy and novel cures for what ails their constituents. We could even go so far as to indulge their models.

Politics are reactionary, and provided either of the situations above, the political responses could turn a manageable economic fallout into something catastrophic. Political reactions are impossible to imagine at this present time but we’re already hearing whispers of prohibitive tax rates, new fiscal policy models (MMT), and laws proposed to control corporate allocation of capital. Provided this human variable, while it is possible the greatest recession could also be the most boring, it is not actually likely.