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Why The U.S. Dollar May Be In A Sweet Spot … A Place It Hasn’t Been For A Long Time

 March 24, 2012 03:41 PM

Everyone is rightfully excited over the potential for a strong rebound in the U.S. economy. And there is nothing short of the potential of global recession at stake should U.S. growth sputter. What is the key risk to U.S. growth going forward?

A Balance Sheet Recession

You may not be familiar with the term "balance sheet recession." The reason is because we haven't seen one in the U.S. since the 1930s Great Depression.

So what qualifies as a balance sheet recession, how is it triggered, and why is it so dangerous?

In a balance sheet recession individuals and businesses are more concerned about paying down existing debt than taking on new loans. That increases the demand for cash from individuals and businesses; so even higher levels of cash injected into the economy do not deliver the same punch.

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Meanwhile banks will tend to use the higher reserves obtained from the central bank to bolster capital and deleverage risky loans, and lack incentive to make new loans during this period.

The trigger for a balance sheet recession is a bursting of a major credit bubble. The Credit Crunch was a credit bubble massive in scale, the size of which the U.S. had never seen before.

The risk is a dramatic collapse in asset values. Because of this, households, businesses, and financial institutions must realign existing higher debt levels to the new lower asset values. As this is done, the economy loses a significant amount of demand.

Add it up, and you'll understand why, despite a zero interest rate policy from the Federal Reserve, the real economy is not responding as it normally would.

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How the West Is
Repeating Japan's Mistakes

As I said before, the last major balance sheet recession in the U.S. was in the 1930s. And there are rising parallels between the 30's and the current era. But we have more recent experience with a balance sheet recession — Japan.

The Bank of Japan held interest rates at zero for many years, but few showed up to borrow.

Japanese monetary officials learned monetary policy was ineffective during a balance sheet recession. Fifteen years of deflationary-like conditions in Japan have a way of changing attitudes on economic policy. But even though Ben Bernanke prides himself on his understanding of economic history, the U.S. seems to be travelling down the same path paved by Japan.

Many argue the government must play the role of stimulator of last resort and in doing so allow for large fiscal deficits to give the private sector time to realign their debt levels to asset prices. One such analyst is Richard C. Koo, Chief Economist for the Nomura Research Institute, a person who knows a great deal about the policy mistakes of Japan:

"The U.S.

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