Many years ago, I specialised in coverage of the Japanese economy. In 1990, the big worry was inflation. Although Japan's stock market had begun its long journey south, investors thought earlier overheating would lead to big price increases. This, after all, was an economy which had been expanding at an extraordinary pace. As night follows day, higher inflation was surely inevitable.
A year later, inflation peaked at a modest level. The economy was softening and, before long, the Bank of Japan began to cut interest rates. At the time, I confidently predicted a recovery in Japanese economic growth, figuring that monetary policy would offer some traction. I was wrong. Interest rates fell, and fell some more, yet there was no meaningful recovery. Stock prices rebounded from time to time, sometimes by very large amounts, but to no avail. The economy had simply lost its way, held back by a debt mountain, a hobbled banking system and persistent slippages in land prices.
Too late, I recognised that Japan was in a really big mess. It was suffering from "balance-sheet deflation", whereby attempts to repay debt by companies led to falling demand, lower growth, weaker profits, bad loans, weak banks and falling share prices. This was John Maynard Keynes' "paradox of thrift" writ large. His idea was simple: if everyone attempted to save more – or repay their debts – demand might fall sufficiently to drive incomes down to levels where everyone would actually end up saving less.
I mention all this because, as 2010 progresses, we will discover whether the US, UK and parts of Western Europe are also suffering from Japan-style problems. In one sense, the prognosis is good. Unlike the Japanese, policy-makers on either side of the Atlantic have been quick to offer stimulus in an attempt to prevent the financial rot from spreading too far. Interest rates have come down very quickly, so-called unconventional measures (including the use of the printing press) have been adopted and governments have borrowed as if there were no tomorrow.
This is all good, sensible, Keynesian stuff. But there is also bad news. The scale of the crisis in the Western world has, to date, been far worse than in the early years of Japan's deflation. Japan has come in for plenty of criticism over the years but there was no collapse in economic activity when Japan's problems first began to emerge in the early 1990s. More importantly, despite all the Keynesian ammunition which has been fired in recent quarters, households and companies in the West are increasingly behaving as though they're living in Tokyo.
The case for a Keynesian stimulus rests on the idea that, left to its own devices, a market economy may deliver persistently high levels of unemployment as a result of deficient demand. If demand can be boosted, unemployment can then be removed. The mechanism to boost demand is typically a mixture of monetary policy – lower interest rates to reduce the cost of borrowing and to encourage risk-taking, and the use of the printing press – and fiscal policy. Underlying all this is the idea that, given a short, sharp Keynesian policy stimulus, animal spirits will be boosted to such a degree that the economy will expand to a new equilibrium level of activity, sufficiently robust to bring about full employment. At that point, the monetary and fiscal stimulus can be removed.
To be fair, there are plenty of signs that the stimulus is working: industrial surveys have picked up, businesses are more confident than they were a year ago, consumer confidence has improved in many countries, and economic forecasts are being revised up. Yet all of these were, on occasion, seen in Japan. They typically presaged an improvement in Japan's cyclical fortunes. They did nothing, however, to alter Japan's structural decline.
Ultimately, Japan's problem was a loss of structural growth momentum. Like any economy, Japan had its upswings and downswings, but the really big surprise in the 1990s was a drop in the long-term rate of annual growth to only 1 per cent from around 4 per cent in the 1980s. It was genuinely a surprise because, at that time, very few forecasters and pundits expected it to happen. Knowing, therefore, that the Western world is enjoying a cyclical rebound at the moment is not enough to rule out the risk of a Japan-style outcome.
The pick-up in growth has, so far, been modest given the scale of policy drugs administered to the economic patient. The rise in asset prices has been encouraging, but some assets still look vulnerable, notably commercial real estate in the US. And, as I have already noted, there has been no convincing evidence of either households or companies doing anything other than save. Their animal spirits still look decidedly depressed.
An old-fashioned Keynesian might simply argue that, in these circumstances, monetary and fiscal policy should be loosened even more. But there are three constraints on such an approach. First, some governments may simply not have the mandate to do so: after all, both Labour and the Tories are promising spending cuts once the General Election is out of the way.
Second, some governments may find themselves threatened with pariah status in the international sovereign-bond markets, unable to raise the funds required to maintain large budget deficits for the foreseeable future. Third, the Keynesian response works best if the policy-maker has a good idea of where we are, and where we want to be, in the economic cycle. The scale of the shock seen over the last couple of years suggests this is still very much an unknown. And, if the consequence of the crisis is to leave output and its growth rate permanently lower than before, no amount of stimulus will take us back to a pre-crisis world.
Which brings us neatly back to Japan. Japan's budget deficit has increased enormously over the last 20 years, through a combination of fiscal easing and stagnant growth in nominal GDP, a result of low growth and even lower inflation. Low nominal growth is no good for any government. It leaves revenues depressed and expenditures difficult to control. While it's easy enough to increase spending at a pace lower than the inflation rate, politically it's a lot more difficult to announce cuts in spending in cash terms. Japan has, thus, experienced a widening budget deficit partly in response to ongoing stagnation in the private sector, which left growth uncomfortably low.
The earliest warnings of these problems came from one key indicator: early in the 1990s, Japanese money supply growth collapsed. The collapse was partly a result of the banking crisis but, in hindsight, mostly reflected a drop in demand for funds associated with ongoing balance-sheet deflation. The same collapse has now happened in both the UK and the eurozone (the US is more difficult to judge because the Federal Reserve stopped publishing data on broad money growth a few years ago). While it's true that economies have, from time to time, recovered in the absence of any pick up in money supply growth, sometimes as a result of a big exchange-rate devaluation, I can think of no previous occasion when so many economies have simultaneously experienced a monetary implosion on this scale.
This, I think, is the Achilles' heel of the recovery story. We may be out of the woods cyclically but, structurally, we're still in the middle of a dark forest.Reuse content