the lost decade

January 2, 2009

In the last few months there have been scores of comparisons of this crisis with the Japanese “lost decade” and the Great Depression of the early 20th century. But what, if anything, have we learned from these disasters?

Of course there are similarities between the current crisis and both episodes. N Roubini’s description of the Japanese economy of the 90s reads scarily like a description of the current environment [at least] in the UK. In particular, the UK exhibits all symptoms that Roubini finds in Japan of the late 90s:

* Poor growth: The UK economy has been shrinking, and is also forecast to shrink further. The same is true for the US and most Eurozone economies. Growth expectations on the BRICs are getting revised downwards every week or so.

* Fiscal problems: Increasing budget deficit, with the 2008 figures being double the 2007 ones. The Debt/GDP ratio jumped from about 35% to nearly 45%, well above Gordon Brown’s self imposed ceiling of 40%. [national statistics figures]. Granted, these figures are well below the Japanese levels given in Roubini, but our recession just started, while his Japanese figures are essentially after a decade. But if we position ourselves in Japan of 1990, around the beginning of their recession, then the Japanese debt/GDP ratio of 47% is roughly the one we experience today. [OECD data]. The “quantitative easing” implemented by Japan, which is a euphimism for “credit card maxing”, is a policy that is widely advocated today. This led eventually to record debt levels for Japan, which is now established in the top five most indebted countries, in the company of fiscal policy pioneers like Zimbabwe and Jamaica.

* Weak labour market: Unemployment is steadily rising in the UK, with the psychologically important threshold of three million unemployed now forecasted, a value reached in 1982 and back in the 1930s.

* Weak trade: UK is a net importer, to the tune of $120 billion. A retreating stirling will therefore have a large impact on future current account deficits. Under other circumstances a weak currency would boost exports, but unfortunately three quarters of the UK GDP are in the services sector, with a large chunk in banking and finance which is hit the most. The collapse of the stirling, which is now near parity with respect to the Euro, indicates just that.

* Loose macro policy: Monetary policy is loose, with interest rates at very low levels and expected to drop further. A fiscal expansion is on the cards, as an attempt to help growth.

All these are symptoms that Roubini found in the Japanese economy after a decade of non-growth. The UK, and I guess the US and the Eurozone, are not far out, but our recession has just begun.

Roubini blames the Japanese way of doing things: heavy regulation and government intervantion, the keiretsu system of corporations that are expected to help each other, the concept of job security. Overall, Roubini contrasts the traditional risk averse Japanese to the risk-taking Americans. To save Japan from the spiral she finds herself in, Roubini advocates market liberalization in bank structures, financial derivatives and insurance products, deregulation, and enhanced competition.

But guess what: the current North Atlantic crisis [as W Buiter rightly calls it] is a crisis that exhibits the same set of symptoms, but is concentrated in economies that have been exponents of Roubini’s policy. We have experienced liberal laissez faire, deregulated markets, we were ardent proponents of financial innovation and devised a plethora of tools that were supposed to augment our risk sharing abilities. We worked on the basis that when it comes to government smaller is better, and we even assigned large chunks of the regulatory supervision to rating agents. And we don’t seem to be that far from the Japan of the mid 90s.

A number of economists, including the latest Nobel winner P Krugman, blame Japan’s central bank for not reducing the interest rates to zero fast enough to create inflationary expectations early on. I presume this is behind the unprecedented speed at which the Fed lowered the target rate down to zero.

According to their models the real problem is what is called a liquidity trap: essentially a small inflation is a nudge for people to spend now, rather than next year when the goods will be more expensive. If individuals expect prices to fall, then they might postpone their purchases to take advantage [think of waiting for the post-christmas sales, or waiting three months to buy the memory stick you spotted online, but on a larger scale]. If the majority behave like that, then the cogs of the economy stop turning. Households are just hoarding money, waiting for the prices to fall.

In such models monetary policy is ineffective, which is the case at the moment, where short term interest rates are virtually zero. This is where quantitative easing comes into play, with the government boosting demand [since households are in the liquidity trap and are unwilling to do so]. By spending money, the government creates inflation and pushes households out of the liquidity trap: they now see things getting more expensive and start purchasing again.

Japan tried it 10 years ago, amassed a huge debt, and is still in recession.

So what have we learned? (1) The underlying system is irrelevant: having a liberalized system with swaptions, credit default swaps and CDOs does not offer any protection. (2) Inflation targeting can work against the stability it was devised to enhance. (3) Japan was in that predicament and tried both monetary and fiscal measures. She is still there, but with a huge debt burden on top of low growth. At least Japan is a net exporter, something that we are certainly not.

There are many other ideas floating around: from droping fiat money and getting back to a commodity backed currency system, to the Fed pegging not only the risk free rate of return, but the whole yield curve and even an equity index like the S&P500. There is this quote on opinions and assholes, but I will not dwell further on it as there is some debate going on regarding its validity.


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