Preston Pysh  3:48  

The thing that really kind of grabs your attention with that is that this book requires close study. For anybody who pays very close attention to macroeconomics, Larry Summers is probably one of the best economists in the entire world. I think that people that are running the Fed are definitely listening to what he has to say. 

Stig Brodersen  4:29  

What I find funny is that Richard Koo is making a lot of different comments about the people he’s meeting and one of the people he’s talking about. With Summers, he’s actually saying, “Well, Summers wasn’t really thinking back in 2008, but then he finally came back to his senses in 2009. and suggested the right thing for the Americans to do.” 

Preston Pysh  5:02  

I think it says a lot about Larry Summers being able to change his mind and his opinion after seeing some different thoughts out there. I really think that Richard Koo has this right. And s,  we’ll get into some of the thoughts right now. 

The book kind of starts off describing what is a balance sheet recession, because that’s the term that he has basically come up with that he had used in his previous book whenever he was describing what was happening in Japan. He also uses it again here. 

What he’s really saying about a balance sheet recession is, and Stig and I have kind of talked about the mechanics of this in some of the previous episodes, but what’s really happening is that you have a downturn in the economy. What you really got going on is you have all the asset prices, specifically, houses and buildings and corporate headquarters, those types of assets, those that lose a significant amount of value. So it’s on the tail end of a housing bubble or a real estate bubble. 

They lose so much value, and so people are in debt. It’s hard for them to fix that problem. So let’s just take an example. Here in the United States, let’s say you bought a house for $300,000 back in 2007 or 2006 timeframe, if you bought at that price point. Then you went through the recession in 2008 to 2009, you might have lost almost 40% of the value on that house. 

So if you had a $300,000 house, next thing you know, it might be worth only 250,000, or somewhere around there. That’s really hard for a person to recover from. It might even be down in some locations like Las Vegas and Miami, a couple places that got hit really hard, it might have gone clear down to like $200,000. 

For a family that would have just taken out a loan to buy that house, and maybe they didn’t have a lot down. Now the husband might get relocated somewhere else. Now they’ve got to sell that house for an enormous loss. That’s what is causing a lot of heartache for a family.

Let’s say the family just had a modest 20% down on the house when they first bought it. So that person might have $40,000 in debt, but they now have to pay off as they go and they’re searching for another house. Now they’ve got to rent. It’s like a compounding impact there. 

And so, when this happens across the entire country where everybody’s got this enormous debt that they’ve got to try to pay down, that’s what Koo’s referring to as a balance sheet recession, because even though that person can go out and now take a loan at 0%, which is where you were at post the 2009 timeframe, you could go out and take a loan for 0%, but no one’s doing it. 

The reason that they’re not doing it is because the banks aren’t lending it to him, which is a completely different piece of this. The part that Richard Koo is trying to get at is people aren’t taking out loans, because they’re still trying to pay down the loss that they had on these large tangible assets from the last recession. 

Stig Brodersen  8:10  

I think it’s really important for you guys out there to understand because you might be thinking, so if he has $40,000 in debt, why is this not a good thing that he’s trying to pay off that debt? It is but on an individual basis, it’s fantastic that you want to repair your own balance sheet by paying off your debt. 

The problem is that one man’s spending is another man’s income, as Ray Dalio used to say. So when the whole country is doing that, at the same time, that’s really the problem with the balance sheet recession. 

There was no one to increase productivity or even just to maintain productivity in the country, because they’re not spending anything, which again, leads to more people getting unemployed and less money in the economy. We have this bad spiral all of a sudden,

Preston Pysh  8:54  

That’s really kind of the essence of this balance sheet recession that he was talking about is that you have an asset bubble, you have people that lost a lot of the value on very large purchases, like $100,000 type purchases. They’re trying to repair that debt on their balance sheet on their personal balance sheet or on their corporate balance sheet. This is on a private level and on a corporate level as well. 

And so, they’re trying to repair that and when they actually do repair it, they’re not going to take out more debt. They’re not going to take out more risk in order to grow their business until they pay that down. That’s why you see these really low interest rates persist, because no one’s going out there and lending in the United States during this last one, which I think is a little bit different than what happened in Japan. 

You had the Fed mandate to banks that they had to be very choosy with whom they’re lending money to. I think that just kind of compounded the duration of these interest rates that we’re seeing. 

One of the things that I really want to talk about that Koo does a great job discussing is the difference between fiscal policy and monetary policy. People hear those terms a lot and they might not necessarily understand what the difference between them really is. 

I think a lot of people probably think that they’re interchangeable, but they are not. So let’s talk about fiscal policy.

Fiscal policy is really government spending, how is Congress spending the money? If they’re going out, and they’re doing public work type projects, or they’re building dams, or they’re doing things that are spending government dollars, that is referred to as fiscal policy.

When you talk about monetary policy, that’s talking about the reserve ratio. That’s what the central banks are doing, specifically in the United States. That would be the Fed, what is the Fed doing to lower interest rates to buy back bonds and all that kind of stuff to spark the economy. 

Those two things have to work hand in hand. When you’re talking fiscal policy, that’s Larry Summers, when he used to work back at the Treasury. When you’re talking monetary policy, that was Ben Bernanke.

Now, what Koo says in his book, and I think this is really the key point, is the difference between using fiscal policy versus monetary policy. Koo says that he doesn’t think that monetary policy during a balance sheet recession really does too much. 

The reason that he says that is because it’s kind of like this flash in a pan kind of scenario where it has a really big impact real close to the event whenever you do quantitative easing. 

However, as soon as you do that, what happens is that you see a lot of that money, leave the country and go worldwide, with other countries that come in with investment, and the money just kind of flows right out of the country. You don’t get a long term impact of that whenever you’re exercising monetary policy.

Stig Brodersen  12:07  

What Koo is actually saying is that monetary policy, under normal circumstances, can solve problems, for instance like cycles, if you bought a cycle, you can use monetary policy. 

Monetary policy, as Preston was saying, is really not a long term thing. It’s definitely not the solution when you have a balance sheet recession. More or less, fiscal policy is the only solution. It’s a very expensive solution because when the government starts to spend and clear the tax revenues, then they will build up the total debt in the country. 

No matter how you twist it, there will be a price. According to Koo, the least painful price should be fiscal policy.

Preston Pysh  12:58  

Koo is a strong proponent of using fiscal policy. What he’s saying and it kind of goes back to the FDR model that they had in the Great Depression, where FDR was trying to increase the construction of roads into really kind of improve the country by spending a lot of money and sparking the economy. Koo totally endorses that. 

When he looks at Japan, he says that’s the biggest issue that they had for over a decade. All they thought that they could do was adjust the monetary policy and not spend any money on the fiscal side of the house. All the money was just basically flying out of the country into other markets around the world. 

He’s saying that in order for countries to solve this, they need to spend money on projects within the country. Let’s take that as an example. Let’s say that the United States decides to increase their military spending. That would be a form of fiscal policy where they’re going to spend more money on the military, maybe building new military assets. 

Whenever they spend that money, that money is then given to an American company, and then that American company pays their American citizens who are working for them. And so, the money just kind of stays more stateside and it dwells there longer, as you can see. 

Now, if they just adjust the reserve ratio, and you can now borrow more money, you could have an outside country come in and borrow money within the US and then that money is being pushed outside of the country. 

Where this really gets interesting, and this really gets challenging is every country around the world since 1971, when we came off the gold standard, has been in a race to print more money through monetary policy. They’re basically trying to devalue their currency in each country around the world in order to spark spending because that increases their GDP within their domestic country. That just adds a whole new variable to this. 

I think it is really quite interesting where there’s an incentive to just use monetary policy because in the short term, it’s going to help that GDP get boosted and you’re going to have spending because the currencies are getting devalued in the country.  

I really think that kind of gets at the root of the global competition that’s happening right now, with this monetary policy versus fiscal policy debate that you’re seeing. It’s a very complex problem as you can see. As we’re talking through this, it gets very complicated. 

However, it’s something that I think people really have to understand to be successful as they navigate these markets because if you don’t understand it, I think there’s a potential for you to really get caught up in the weeds and you’re not seeing the overall big picture. 

That’s where I really found this book very useful, because Koo does a great job describing when you should use this and how you should use it. Basically, the effects of using it, which not all the effects are really good. We’ll get into that as we go into some of the other chapters here. 

Let’s quickly just talk about a couple of the different countries that Koo mentions in the book: US, Japan, and Europe. 

In the US, one of the things that Koo’s biggest concern is is the amount of quantitative easing that the US used and what the long term implications of that will be. So did quantitative easing solve the problem that we had from 2008 to 2009? Absolutely. 

He thinks that it will definitely work, as far as stimulating the economy and getting it back into a position that is functioning. I think if we didn’t take some of the steps we had in 2009, that we probably would have had something disastrous on our hands.

But for Koo which is, which is a little bit scary, what he talks about is, whenever you use this much QE there can potentially be and we don’t really know, because no one’s ever done something like this before. There could potentially be a major side effect to using so much quantitative easing. 

In his book, Koo has a chart where it shows how if you just let things run its natural course, how it goes down, how it’ll come back out, and the interest rates that are associated with that overall 10 or 20-year period. He would probably argue that that’s probably more of what you saw over in Japan, because they didn’t quite manipulate things nearly as bad as what you saw in the US. 

However, in the US, what he’s showing with this chart is that his prediction is because we use so much quantitative easing, that maybe during the next recession, or the next pullback that you’re going to see, long term interest rates really increase. 

If you see that happening, you’re still in this condition where you have this deflationary pressure still putting pressure on the GDP within the United States. What that impact of long term interest rates rising will have is that you are actually going to have a very depressed position during the next recession. That’s his concern. 

Koo’s wondering how that’s going to impact us in the long term. We really don’t know and he doesn’t really know because this experiment has never been done before. I found it ironic at the Davos talk in Switzerland where that was the name of the convention. Basically the convention was, “How much longer can the experiment go?” Do you remember what the exact phrase was? 

Stig Brodersen  18:16  

I can’t remember.

Preston Pysh  18:17  

It was something like “Let’s end this experiment.”

So you saw a very similar theme with the way Koo was approaching this. I think that he’s very optimistic in the near term with how the US handled things but I think his concern is really what’s going to happen next. and what’s going to be the implications of the US using so much quantitative easing. Also, the long term impact of that.

Whenever you look at Japan, you can see that Japan is maybe on the verge of actually coming out of this but their real problem. I don’t think he really addresses this well in the book. I could be wrong. I want to hear Stig’s opinion, but I don’t think that he addressed it really well on how in the world do they solve this massive amount of debt to GDP that they’re sitting on? 

Like he talks about how it was such a great thing for the way that they basically emerged out of this. It wasn’t really pretty. He does lay out a lot of the issues that they had as far as using monetary policy for too long and not using fiscal policies. However, he doesn’t really lay out the path forward other than it’s going to take them 50 years to potentially reduce their debt burden at this point. That was one of the parts of that issue I had with the book. 

Stig Brodersen  19:33  

Yeah, so that was also something that really puzzled me because I have  been looking at the same charts as you. The debt in Japan is just enormous. Imagine living in a country where they would be looking at the US and thinking, “Oh, my God, if we only had as little as debt to GDP as they had in the US.” Not a good country to live in, I guess.

Preston Pysh  19:56  

Well, that’s what I found really kind of crazy about in the book was he’s really pushing this fiscal spending piece in order to solve the problem, but in order to use fiscal spending, the government has to take on an enormous amount of debt. So it’s like, “Okay, so what’s the next step after that? How does the country then reduce their enormous debt burden without keeping interest rates like nothing forever?”

Stig Brodersen  20:20  

Yeah, I was actually looking for the same paragraph as you, I guess this is what we should do now. He’s saying, in a short paragraph, that the solution is probably to have our economy grow faster, because if the economy grows faster, that’s a way of paying our debt. 

To me, however, it’s just hard to see how you can grow the Japanese economy at that speed while you’re actually paying off this debt. I guess that was my main issue. 

One thing he keeps saying is that what they did really well in Japan, was really to do this whole fiscal policy thing, where the worst example is the US after the Great Depression. 

He’s saying back then you actually saw GDP drop of 33%, which is a lot, of course, and you didn’t see that in Japan actually didn’t see that at all. That was because right when the crisis hit, they started spending so much money that you didn’t see a drop in the GDP.

The gap that you saw because people stopped spending and companies stopped investing, that was completely filled by the government. The only problem is that they just needed to incur debt, actually, to pay for that.

Preston Pysh  21:31  

It’s funny that what you said there Stig because you said that in order for them to get out of it, they got to spark the economy to have these big years where they have 10% GDP growth? You’re exactly right, that’ll get you out of it. 

However, the question and the thing that amazes me is, that’s what puts you back in it again. I think that’s the reason we’re in the position we are today is because we had an enormous amount of debt back during the Second World War. And so, they adjusted the money multiplier and they created fake growth. 

Okay, it was growth. Everyone during the time for those 30 years would probably say, “Oh, yeah, that was real growth.” But it wasn’t real growth, it was an adjustment in the amount of money that was in the system, because they changed the money multiplier. 

That’s what put us in the position where we had to come down, because you had inflation going out of control. We had a whole episode where we talked about this, but I think you’re right. I think that’s how you get out of it. 

But by getting out of it, you’re actually setting yourself up for the next one. As I look towards the next large cyclic bubble, I don’t necessarily see that happening because I feel like by the time something like that would happen, you’re going to have this total meshing of the world economies. It’s just going to be a different landscape from what we saw in the last 100 years. That’s a whole nother discussion. That’s not something that Koo even talks about in the book. 

So we’ll probably get off this tangent and move on to the next thing. We briefly touched on this, when he talks about this idea of weakening your local currency, your domestic currency in order to spark growth within your country. Let’s talk about this. because we’ve brought it up in passing a few times. 

A lot of people have probably heard the strong dollar is really going to have a poor impact on US companies here in the start of 2015. That’s the one of the themes that you constantly hear. 

And so, I think for a lot of people they might hear, well isn’t a strong dollar really good for the US? That’s what I think people would naturally think, but the problem with that is that when you have a stronger dollar, it’s very expensive for countries outside of the US to be able to buy products from the United States. 

When that happens, your exports are going to be hurt. hurt.You’re not going to be able to make as much money because you’re not going to be exporting nearly as much as you would if the dollar was really weak. 

Countries have been at this for decades. At this point, like I said earlier, back in 1971, when we came off the gold standard, you didn’t have the currency pegged to anything. When the currency is not pegged anything, you can manipulate that currency at will simply by increasing the amount of money in your system. 

So whenever you saw the massive amount of quantitative easing back in 2009, you saw and clearly until recently, there’s been an enormous amount of QE. I don’t think people really realize this. There was more QE done through 2013 and 2014 than there was done during 2009. I don’t think anybody knows that. 

I think that that’s one of the main reasons why you saw the stock market continue to soar, because you had this massive amount of QE that was actually happening. By then in the news, no one was really paying any attention to it. 

When you go back and you look at the Fed’s balance sheet, and you look at how they’re managing this, it was an enormous amount of money between 2013 and 2014. 

What that does is that devalues the currency that devalues the dollar, you get an influx of investment coming from outside the country buying up goods and services. What happens is you have this race amongst different countries. 

Whenever we played that interview with Larry Summers a while back, that was one of the things that he was talking about. He gave the analogy that when one person in the audience stands up, they’re going to see better. But whenever everybody in the audience stands up all at the same time, nobody sees any better. All of your legs start hurting. 

This is what he was referring to in that comment was that whenever Europe and now they’re doing quantitative easing, everybody’s doing this quantitative easing. We’re all in a race to devalue our currency. 

The overall impact is everyone’s standing up and everyone’s legs hurting. We’re not seeing any better. It’s this compounding issue that you’re seeing around the world.  

I think that you’re seeing a lot of people start to talk about it right now. It’s going to be very concerning to see how this actually plays out in the long term, what’s the long term implications of everybody standing up and not seeing any better? That’s where we’ve got some major concerns. 

Stig Brodersen  26:22  

Preston, I thought a lot about this. To all you out there, the reason why we are really into this is also because we’re reading a new book, which is called a “Currency Wars”.

Just really briefly about that, you can look at this as a war, because everyone has an interest in serving their own interest. That’s really the problem here because if your goods are cheaper, then you can grow your economy through your exports. So that would be like the immediate benefits of doing this. 

However, the problem is that even though we can predict what is going to happen, because we can never do that with a currency war, what we can predict is that in the end, everyone will be worse off. I think that’s really what’s frightening me and that’s why I really don’t like the direction we’re going in.

I don’t know if this would be good for the US in the short run or for the Eurozone. I don’t think I know that myself, but I know that in the long run, if we continue to devalue a currency to benefit our own population and nothing about the outside world, I know it’s going bad because that would completely destabilize the financial system which serves no one really.

Preston Pysh  27:34  

It’s going to be funny whenever we do the review of “Currency “Wars” because we’ve pretty much talked about all the major themes already in this podcast. So that’s going to be a really short episode.

The last thing that we’re going to talk about in this episode is really the European situation because when you look at Europe, it’s in a completely different situation than Japan or the US simply because you have a conflict of interest.

In that setup, you’ve got countries like Germany that are being very responsible with the way that they spend their money. Then in the same organization, the EU, you have Greece, Spain, and Italy, and you have these countries that are just spending at will. 

There’s an enormous conflict of interest between the countries that are in that European Union. That’s where Koo, in his book, talks about this. I don’t really think that he lays out a good solution at all, other than there’s a major issue with this setup. I don’t see it ending. Well, it’s kind of the way I took it. 

Did you read it any differently, Stig?

Stig Brodersen  28:54  

Yeah,  he has some interesting suggestions for solutions. He was saying that again, that the solution might be fiscal policy. What the problem is in Europe is that we have all these different economies and we have all these different interests. 

What he’s suggesting is that you should have a panel of experts that are able to have the authority to authorize a financial stimulus package if the countries are really close to bankruptcy. For instance, like Greece. 

You will have a central panel that has the authority to just spend as much money as required in a very short amount of time, which is to say in that country. I really liked this argument. I didn’t like it because I thought it was unrealistic, because I don’t think it’s realistic at all.

Preston Pysh  29:46  

I think that’s a terrible recommendation. Go ahead. I’m sorry.

Stig Brodersen  29:50  

I really like this recommendation because it’s really a classical professor in economics argument. He would assume that we have all these governments, they would put down a completely objective panel. They will have to be backed by everyone in the Union to do exactly what is needed related to his models. 

I mean, from a somewhat theoretical point of view, it might make sense, but the problem is that we still have to pay off the debt. The EU has to agree on this. I think  that advice is something that just works in theory. You have no whatsoever chance to work in real life.

Preston Pysh  30:34  

Yeah, I totally agree. It seems like a very good academic solution that will never work. I think that the discussion of what’s happening over in Europe is something that is going to be very interesting to pay close attention to. I think that as we’re looking at what’s going to be the catalyst for the next crash or what’s going to spark the interest of people to maybe start selling the market short and taking their money out?

When you look at Europe, that has a very strong potential to be that catalyst, as you look around and you see what’s going to fall apart first. I really see the European situation potentially being that catalyst, but it’s very hard to say. Who knows what’s going to be the catalyst? But I guess if I was a betting person, that’s probably where I would place my bet.

We had one more economy to discuss in the book, and that was really the sixth chapter, which is China’s economic challenges. The thing that Koo really highlights here is that he thinks that China is in a position to continue to do fairly well into the future. 

However, his main concern is the housing bubble that he feels could potentially pop over there. I know I’ve seen a TV show, maybe it’s Dateline, or I forget what show it was. Anyway, there was a video where they showed entire cities in China that were made that were built and nobody was living in any of the buildings. 

So one of the things that they’re doing over in China is they’re just placing all their money, all the people over there and investing in real estate. And so, there’s an enormous bubble of real estate. 

Now, I also heard that some of those cities had been filled. I don’t know how they could possibly do that in such a short amount of time. Their economy is nothing like here in the United States. 

To be quite honest with you, I haven’t really studied the Chinese economy very much, but I do find it highly fascinating and something that would be really interesting to research more.

Stig Brodersen  32:41  

Now, what I really find fascinating about the Chinese government is that it is extremely flexible-inflexible. Please let me elaborate on this. So when they had this problem, I think it was back in 2008. What they did was they were spending so much money. 

For instance, you know, as Preston was saying, they’re building cities for apparently no use, but they were spending as much as 17% of GDP. That’s a lot of money. So if you’re thinking that the US did a lot of big stuff in 2009, this was more than three times as much compared to the GDP they did in China. They did it almost overnight. 

Koo also jokes about saying that this is probably the only country in the world where fiscal policy works faster than monetary policy, because it’s so easy to agree on. They only have one party, right?

They don’t have to think about what the population is saying. This is definitely not my way of saying that communism is good or the one party system is good.

However, Richard Koo is remarking that it’s really flexible-inflexible in China, because things can go so fast, even though it’s such a huge country. They will just say, “Well, we need to do this.” They then just run a huge deficit one year and just go back to normal. 

Preston Pysh  34:01  

What I think is really interesting about that is you think about that enormous investment that they had made, relative to the debt that they took on, and it was in a fiscal manner. All those dollars and all that money are still sitting in China. It’s not like they just printed some more money, and then it immediately flew outside the country to places like the US or Europe or wherever. S

I think Koo is really bringing up that point and talking about it in a manner to demonstrate how fiscal policy could potentially have a better long term impact then, what a lot the Western countries are doing with their monetary policy and it being short lived.

I will admit there were a lot of times in this book where I was ready to throw it across the room because his ego was just walking out of this thing, but you have to, you have to agree. Correct Stig? I mean, you wouldn’t have brought up that point, if you don’t agree.

I think for anybody who’s trying to increase their knowledge of macroeconomics, and really kind of understand where things are going, potentially, and where things came from, and you’re really using Japan as a model for understanding what’s happening in the US and in Europe, this is a very good book. We liked it. 

In general, there were parts that got a little repetitive, but other than that, I thought it was pretty good.

Sender  36:47  

Hey, Preston and Stig just wanted to start off by saying thank you for all you do. Truly, the information was great. I only started listening to the podcast two to three weeks ago. I’m caught up on all your shows and I visited all your websites and bookmarked everything I could. 

I just wanted to let you know that I grew up in the Pittsburgh area as well and studied mechanical engineering. I really started getting into investing a few months ago. 

I actually have two questions for you guys. You guys provide a great bunch of suggestions for books on investing and becoming successful, but you often think that it’s important to have a foundation in finance and accounting. Do you have any good recommendations on what the best way to build that knowledge is, whether it be books, forums, videos, etc? 

My second question is because I work in the oil industry, with the current low oil prices, and that fuel and energy is typically an expense for most companies, such as airlines, do you think that the low oil prices are further stimulating the economy and increasing our economic inflation? Thank you.

Preston Pysh  37:57  

Dave, great to have your question. Awesome to know that you’re from Pittsburgh. I was flattered by your comments. I don’t know if I’m a good investor, I just have a lot of mistakes and experience from learning from all those mistakes. So you bring up some really good points/ I’m going to address the second one and then Stig can maybe talk about the first one because.

I really want to say something, I totally agree with you. I think that these low oil prices are absolutely stimulating the economy. I think that it’s almost like a form of QE in itself. It’s actually making things persist and maybe stay in this better environment a little bit longer.

My concern is if these oil prices start to come up, which I could see that happening within a year, you’re already seeing the number of rigs decreasing, that’s usually your first indicator. Then, as the supply pulls back and you’re demand stays persistent, you’re going to see that the prices do come up. 

I think whenever you see the prices come up, the impact might not be immediate, but as it persists for a few months, I think that you could see that it will have a really detrimental impact to the economy, especially if the dollar persists in being very strong. 

Stig Brodersen  39:18  

Yes. So I have a few recommendations. I really admire that you want to dig into accounting. I have two books I really like to recommend. The first one is “Reading Financial Reports for Dummies.” I think that it’s really a great book. And I would suggest that book to everyone interested in investing because one of the things this book does is that it’s really good for getting the right perspective as a stock investor. 

The second book is “A Step by Step Guide to Understanding and Creating Financial Reports” by Thomas Edelson. I think what’s really good about that, and when you look at that book as a stock investor, you might be thinking, “I really don’t know how to read financial statements.” I actually think you do because what that is doing is step by step. It teaches you how the different financial statements work together. 

Outro  48:24  

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