What, today, counts as economic policy success? The G20 finance ministers, pictured, promised over the weekend to "take whatever action is necessary until growth is restored." That, though, is a rather weak formulation. Even after the Great Depression, growth eventually made a welcome return. The bigger concerns surely relate to the length and depth of the current downswing and, importantly, the likely pace of growth once the world economy bottoms out. Merely promising a restoration of growth at some unspecified future point doesn't quite do the trick.
Policymakers will doubtless stress their intention not to repeat the mistakes of the 1930s. They will insist there will be no "Great Depression Mark II". That, also, is not a particularly challenging goal. During the Depression, US economic output fell by approaching 30 per cent. The unemployment rate for male workers rose to 25 per cent. So if, this time around, output falls by, say, 10 per cent while unemployment rises to 15 per cent, would policymakers be able to declare success? Somehow, I doubt it.
Naturally, there's a desire to avoid descending into the protectionist madness which characterised the 1930s. In the words of the G20 finance ministers, "we commit to fight all forms of protectionism and maintain open trade and investment." At the same time, though, there's a commitment to supporting financial institut-ions through injections of capital. The use of taxpayers' money to support banks in this way is almost guaranteed to create a "home bias" in bank lending, leaving countries around the world which are particularly dependent on cross border bank lending flows acutely vulnerable. Already, the emerging economies have experienced a collapse in syndicated lending volumes. There may be more bad news to come.
Underneath all this, there is, I believe, the need to re-examine the meaning of success. Avoiding the Great Depression would, only in some weak sense, be good news. I'm not convinced, though, that there will be any early return to "business as normal", if normality is defined by the economic and financial experiences of the last couple of decades. Over this period, we've seen huge increases in household debt, a massive expansion of cross-border capital flows, a widening of global imbalances and an exponential increase in the supply of exotic financial products which, in many cases, have turned out to offer the same degree of safety as quicksand. Take all these things away, and how is the world economy likely to perform?
Funnily enough, we may already have an answer. It's called Japan. The late-1980s were an extraordinary period for Japan: rapid growth, remarkably low unemployment, the achievement, for the most part, of price stability and unusually plump returns for investors in stocks and land. Seemingly, Japan had discovered the elixir of economic success. Other countries looked enviously at Japan's achievements and tried to embrace some of its management ideas. Yet, in a few short years at the beginning of the 1990s, the story went badly wrong. Having enjoyed growth in economic output of around 4 per cent per year in the late-1980s, Japan bumped into an unexpected constraint: growth slumped to around 1 per cent per year, the banking system began to melt down and both equity and land prices began a seemingly never-ending decline.
All the while, policymakers and investors kept asking the same question: "When will growth return?" Every so often, the activity numbers would pick up a bit, and forecasters would scramble to raise their growth projections for the year ahead, happily declaring that recovery was finally on the way. Mostly, though, they were using the wrong benchmark. The simple truth is that Japan lost the capacity to grow in the 1990s, held back by a rapidly ageing population and a moun-tain of debts which, as time went by and asset values collapsed, became more and more difficult to cope with.
Criticism of Japan has been remark-ably vocal over the last twenty years. In 2002, for example, economists at the Federal Reserve produced a paper titled "Preventing deflation: lessons from Japan's experience in the 1990s". The authors concluded that "Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation." In other words, had Japan's policymakers recognised the risks of deflation, they could have come up with some kind of magic macroeconomic policy formula allowing a swift return to "normality". This, though, is the stuff of fairytales. First, it's not easy to anticipate major macroeconomic collapses. The consensus of economic forecasters believed at the beginning of 2008 that the US economy would expand in 2009 at a 2.7 per cent rate. Now, the same forecasters believe the economy will shrink by more than 2.0 per cent. Second, even though today's policymakers do recognise the risks of deflation, it's not obvious they have a framework in place to deal with the problem. So-called unconventional policies are all very well but you'd be hard-pressed to find a central banker who could tell you with any conviction precisely how much money to print or how many assets to buy.
Third, critics of Japan's economy have always implicitly assumed that, with the right policies, Japan would have grown more quickly while avoiding the worst excesses of deflation. I'm not sure this is true. Given the scale of the financial bubble in the late-1980s, the alternative to years of stagnation might have been even worse: a Japanese version, perhaps, of the Great Depression. Yet Japan managed to avoid a major economic collapse: growth was very low but not entirely absent; unemployment rose, but not too far; and per capita incomes were maintained at a high level by international standards. Despite everything, Japan remains a rich and wealthy country.
The single most important lesson from Japan's experience is not so much the failure to use the full arsenal of macroeconomic weaponry but, instead, the limitations of macroeconomic weapons in general. Japan may initially have been slow to act but, ultimately, successive governments delivered ever-larger budget deficits, consistent with the policy prescriptions being handed out today. Yet, in Japan, increased government borrowing was more than offset by even bigger increases in corporate saving (or, more precisely, debt repayment). The hangover from the 1980s borrowing binge persisted for many years. Fiscal policy merely cushioned the losses. It was unable to kick-start a sustained recovery.
If households and companies are now determined to pay off debt and thus to become more conservative in their future spending plans, policymakers today may end up emulating their Japanese forebears by creating no more than a cushion to limit the downside risks rather than a rocket to boost the upside risks. To this day, we don't know what would have happened in the 1930s had more expansionary policies been pursued. It seems unlikely, though that the roaring '20s could have been followed by the thunderous '30s. Providing a cushion, then, is probably the best we can hope for.Reuse content