The Japan Syndrome Goes Global

October 15, 2010

Stephen S. Roach Morgan Stanley Asia

I am increasingly worried that the world economy is at risk of falling into a Japanese-like quagmire. As Japan now enters what could arguably be its third lost decade, there are striking similarities with problems that are now afflicting other leading economies in the developed world—namely, the United States and Europe. Moreover, if we’re not careful, the Japanese disease could continue to mutate—infecting other major economies, including those in Developing Asia. We must be attentive to these risks. This is truly a stunning development. The “Japan problem” has long been the subject of analysis by academics and the broader policy community. Steeped in denial, researchers and policy makers have insisted for years that the glaring mistakes of Japan were so painfully obvious, that they would be relatively easy to avoid.

Unfortunately, that does not appear to have been the case. In fact, it is now debatable as to whether there was ever a clear understanding of the true Lessons of Japan and what they might imply for macro policy management in the modern world. In the aftermath of the Crisis of 2008–09—and the Great Recession it spawned—a legacy of post-crisis debt and deleveraging is now increasingly global in scope. These very visible manifestations of the Japanese disease can no longer be taken lightly.

An unwillingness to connect the dots and address these tough questions is not a good sign for the post-crisis world. Mark Twain famously observed, that while “history doesn’t repeat itself, it often rhymes.” In the current tough

global climate, it is the rhymes we now have to fear the most. Tragically, the real Lessons of Japan may increasingly be found in the mirror—unless we crack the denial and rethink some of the core premises of the orthodox approach to macro stabilization policy. That is the subject of my remarks to you today.

The Fed in DenialDenial is deepest in the one central bank that should have known better—America’s Federal Reserve. In a widely celebrated paper written in 2002, some 13 research economists of the Federal Reserve Board spelled out in great detail how easy it would be for others to avoid the Japan problem.1 The gist of the paper was that while it is next to impossible to avoid asset and credit bubbles, the fatal mistake made in Japan was to move too late—and too feebly—to counter the risks of a post-bubble shakeout. Ergo, it followed that all the Fed—or for that matter any other central bank—had to do to avoid a Japanese-like outcome was to move powerfully and quickly in the immediate aftermath of the bursting of a major bubble.

Curiously, this same conclusion was very much evident in the pre-Fed research agenda of Professor Ben Bernanke while he was at Princeton University. In a series of papers co-authored with NYU Professor Mark Gertler, Bernanke argued that monetary policy was best disposed to clean up after the bursting of asset and credit bubbles—rather than to move against them before they came to an ignominious end.2 This body of work was crucial in providing the intellectual foundation for then Fed Chairman’s Alan Greenspan’s stated avowal to condone bubbles and deal with them after the fact. In a now famous “mission accomplished” proclamation in 2004, Greenspan argued that in the aftermath of the bursting of the equity bubble the Fed had every right to feel vindicated in following the Bernanke strategy.3 And, of course, Bernanke’s views as

1. See Alan Ahearne, Steve, Kamin, Joseph Gagnon, and others, “Preventing Deflation: Lessons from Japan's Experience in the 1990s,” International Finance Discussion Papers 729, Board of Governors of the Federal Reserve System, Washington, D.C., 2002.

2. See, for example, Ben Bernanke, Mark Gertler, and Simon Gilchrist, “The Financial Accelerator in a Quantitative Business Cycle Framework,” National Bureau of Economic Research (NBER) Working Paper 6455, 1998 and Bernanke and Gertler, “Monetary Policy and Asset Price Volatility” NBER Working Paper 7559, 2000.

3. In Greenspan’s words, “There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful.” See his remarks at the Annual Meetings of the American Economic Association, San Diego, January 2004.

Note: This speech was presented by Mr. Roach at the World Knowledge Forum in Seoul on October 12.

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an academic economist became the operative construct in guiding him as Greenspan’s successor when he faced the massive credit and housing bubbles that culminated in the Great Crisis of 2008–09.

There were a few who were deeply suspicious of this line of reasoning. I count myself among them, having argued early on in the Era of Excess that asset and credit bubbles—and the global imbalances they spawned—could only end in tears.4 Bill White, Economic Advisor and long the head of economic research at the Bank of International Settlements, was very much in the same camp—underscoring the dichotomy in the monetary policy debate between those who believed in cleaning up after the bursting of bubbles (Bernanke and Greenspan) and those of us who felt that monetary authorities should lean against the wind of these major distortions before it was too late.5 In contrast to the Bernanke-Greenspan approach, which maintained that the “next Japan” could be avoided by aggressive post-bubble monetary accommodation, White and I argued that the real lessons of Japan were to avoid these insidious bubbles in the first place.

One would think that the post-bubble, post-crisis mess that the world now finds itself in would be enough to settle this debate once and for all. Alas, that has not been the case. Predictably, politicians have rushed to embrace the quick fix in the aftermath of the Great Crisis. Yet from the Dodd-Frank bill in the US to Basle III in the international arena, the fix has been focused on re-regulation. Monetary policy—its theory, strategy, and tactics—have gotten off far too easy. Until that changes, I am afraid that the world has yet to learn the most important lessons of Japan.

When is a Bubble a Problem?Since the tulip mania of the 17th century, bubbles have been a constant feature of market systems. The psychology of fear and greed makes it next to impossible to avoid speculative excesses. However, many central bankers seem to have taken the inevitability of the next asset bubble too far—arguing that they are impossible to spot ahead of time. It follows, that pro-active policies aimed at deflating asset and credit bubbles before they do damage would be very difficult to implement if the authorities are not convinced in the very existence of a bubble.

In looking back at the massive bubbles over the past decade, it is rather hard to accept the premise that they were tough to spot. That was especially the case in the US, with the hyperbolic increase in the NASDAQ Index in the late 1990s, as well as an unprecedented surge in national property prices and credit markets in the 2004 to mid-2007 period. One of

the most disturbing features about each of these episodes is that the Chairman of the Federal Reserve—steeped in his ideological convictions that markets always know best—led the charge in denying that they were bubbles. He argued that the NASDAQ bubble was well supported by the productivity renaissance of a New Economy. Housing bubbles could only be local—never national. And the unprecedented tightening of credit spreads was an outgrowth of stunning advances in financial innovation.

The subsequent bursting of each of these bubbles dispels these conjectures and fits the script of behavioral finance to a tee. As Professors Akerloff and Shiller have stressed, every era of excess always has a seemingly compelling story behind it that seems to rationalize lofty valuations.6 Unfortunately, those stories quickly turn to fiction when the bubble bursts. The tragedy in each of these instances is that the official storyteller was Federal Reserve Chairman Alan Greenspan. In abdicating the responsibilities of the objective and disciplined central banker who was supposed to “take away the punch bowl just as the party gets going,” 7 Greenspan played a very different role as a cheerleader in supporting the stories that rationalized the excesses during a period of unprecedented froth. That, together with his ideological biases against using monetary policy to address problems in asset markets, left the United States lurching headlong toward disaster.

But it’s not just common sense in knowing when to use policies to address the perils of asset and credit bubbles. There is also a science to the discipline. The dangers of bubbles can be identified by a quantitative metrics that are grounded in the rate of change of asset price increases (i.e., the second derivative) as well as in the growth of leverage that any bubbles spawn. By those standards, ever-rising price appreciation of US homes and NASDAQ-type equities were clear warning signs in the US during the past decade, as were near-hyperbolic increases in equity margin credit and home mortgage loans.

But the most important quantitative test of the potential macro perils of a bubble comes in the distortions it creates on the real side of an economy. On that basis, as can be seen in Figure 1 on page 3, the bubble-related distortions in the US economy stack up much worse than they did in Japan. Back in the late 1980s, Japan’s bubble-infected capital spending sector peaked at around 20% of GDP—up more than five percentage points from its pre-bubble norm. By contrast, America’s bubble-infected homebuilding and consumer spending sectors collectively peaked at around 76% of US GDP in 2006—up about six percentage points from pre-bubble norms. On this basis, alone, it would

4. See, for example, Stephen S. Roach, “Original Sin”, Morgan Stanley Global Economic Forum, April 2005 and “From Bubble to Bubble” Morgan Stanley Global Economic Forum, June 2005. 5. See William R. White, “Should Monetary Policy Lean Against Credit Bubbles or Clean Up Afterwards?” A paper based on remarks before the Monetary Policy Roundtable of the

Bank of England, September 2008.6. See George A. Akerloff and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press, 2009. 7. This statement can be attributed to former Fed Chairman, William McChesney Martin, who also maintained that the Fed’s “purpose is to lean against the winds of deflation or

inflation, whichever way they are blowing.” See Robert P. Bremmer, Chairman of the Fed: William McChesney Martin and the Creation of the American Financial System, Yale University Press, 2004.

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hardly be shocking if the post-bubble hangover in the United States was more serious than it has been in Japan. After all, the scope of damage in America afflicted a broad swath of its real economy that was nearly four times the size the bubble-infected segment of the Japanese economy.

Figure 1: Bubble-related Distortions

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Asset bubbles that distort the real side of an economy are especially insidious in that they take years to work off. In the case of Japan, the corporate investment binge led to an overhang of excess capacity that persisted well through the mid-1990s—exacerbating the deflationary tendencies stemming from a mismatch between excess supply and demand. In the case of the US, it’s not just the lingering depression in residential homebuilding activity that is so disconcerting. A legacy of sharply elevated household debt burdens and subpar saving rates points to a post-bubble shakeout in the growth of personal consumption expenditures that could last for at least another 3 to 5 years. A key lesson from Japan is for the authorities to be especially mindful of the lethal interplay between asset and credit bubbles and related distortions in the real economy. That lesson was totally lost on the Federal Reserve over the past decade.

The BOJ’s “Story”The Bank of Japan played its own unique role in fostering the Japanese equity and property bubbles of the late 1980s. At the time, Japan was embroiled in a very contentious global currency debate—not unlike that which is currently raging over the Chinese Renminbi. The great powers concluded that a weak yen—and its counterpart of a strong dollar—were major destabilizing forces in the global economy. The so-called Plaza Accord was reached in September 1985, forcing Japan to come to grips with the “endaka” of a strong yen policy—which pushed its currency up some 50% against the US dollar over the next two years.

Unfortunately, the stronger yen did little to reduce Japan’s outsize structural current account surplus (see Figure 2). But the strong yen played an important role in leading to a major policy blunder by the Bank of Japan. Fearful that

sharp yen appreciation would wreak havoc on exports and on the real side of the Japanese economy, the BOJ eased monetary policy aggressively in anticipation of such an impact. That overly accommodative policy stance then set the stage for massive liquidity-driven asset bubbles, which finally burst with devastating consequences in the early 1990s. Japan’s post-bubble aftershocks were exacerbated by the combination of a dysfunctional financial sector and a bubble-dependent nonfinancial corporate sector that was caught in an interlocking web of cross-holdings of plunging equity shares (the “keiretsu” system). Two lost decades later, and the unwinding of these bubble-related excesses is still evident in Japan.

Figure 2: Post-Bubble Policy Blunders

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Source: International Monetary Fund

Needless to say, the lessons of the Japanese experience—especially the currency piece of its policy blunder—can hardly be lost on today’s China. Once again, a global consensus has formed around the need for a major economy to revalue its currency in order to address global imbalances. China, by resisting the advice for an immediate and large RMB revaluation in favor of a more gradual approach, appears to have learned the lessons of Japan quite well in this key regard. By contrast, US politicians and many leading economists who support the radical RMB solution for an unbalanced world—a sharp one-off adjustment in the value of the Chinese currency—appear to have learned little from this painful aspect of Japan’s mistakes some 25 years ago.8

The Monetary Policy ConundrumTime and again, history points to the key role that monetary policy has played in setting the stage for asset and credit bubbles and in shaping the post-crisis landscape. In modern times, this role is very much an outgrowth of The Lessons of the 1930s—a Great Depression whose severity and duration is widely thought to have been exacerbated by monetary policy blunders of epic proportions. Memories of that single episode has surely guided the Bank of Japan since the early 1990s, and is very much the case today in conditioning post-crisis policy responses of central banks in the US and Europe. As Ben Bernanke said on the occasion

8. See Stephen S. Roach, “Cultivating the Chinese Consumer,” op-ed feature in The New York Times, September 29, 2010.

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of Milton Friedman’s 90th birthday in assessing the causes of the Great Depression, “We (the Fed) did it…but we won’t do it again.” 9

Unfortunately, there is a dark side to those searing memories. Led by Paul Volcker and the Fed, inflation targeting central banks were brilliant in winning the war against the Great Inflation of the 1970s. They have not been so brilliant, however, in managing the subsequent peace. As disinflation converged on price stability in the early 2000s, inflation-targeting central banks were already pushing policy rates toward very low levels. But then, fearful of a replay of the deflationary 1930s, a series of bubbles and crises prompted even greater aggressive monetary easing. As a result, nominal policy interest rates moved to extremely low levels; in the case of the Fed, the real federal funds rate was below average for all but one year since 2000 and actually fell into negative territory for half that ten-year period. (see Figure 3). That marks the most aggressive policy accommodation by the US central bank of the modern post-World War II era.

Figure 3: Bubbles and the Monetary Policy Conundrum

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There were two major consequences of this outcome: First, low nominal interest rates became the sustenance for an increasingly greater profusion of liquidity-driven asset and credit bubbles. Second, as bubbles expanded and then burst in a low interest rate environment, a depression- and deflation-fixated central bank pushed policy rates down toward the “zero” bound—leaving it with little in the way of traditional ammunition to fight subsequent crises. As Figure 4 shows, the Fed adopted an asymmetrical policy bias to guard against a post-crisis deflation—much quicker to ease in the aftermath of the bursting of bubbles then it was to normalize policy rates once the dust supposedly settled.

Figure 4: Asymmetrical Fed Policy Bias

DATe FeD FuNDS TArgeT

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Reduction 475 bps

Number of Cuts 11 over 12 months

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Speed Per Month -40 bps

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Source: Author's calculation based on Federal Reserve statistics.

In retrospect, that may have been a critical tactical error. With deflation fears reinforced by the Japanese experience of the 1990s, the Federal Reserve felt its asymmetrical policy bias was entirely appropriate. After all, went the argument, better to worry about the post-bubble deflationary downside than an incipient reacceleration of inflation. That could well be the single greatest flaw of a narrow and mechanistic inflation-targeting policy rule—a framework that does not allow for the unintended consequences of low nominal interest rates in spurring a steady string of asset and credit bubbles that could well compound deflationary risks over time.

9. See remarks by then Governor Ben Bernanke, “On Milton Friedman’s Ninetieth Birthday,” University of Chicago, November 2002.

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Source: Bank of Japan, Federal Reserve, Bank of England, and European Central Bank

From bubble to bubble, the asymmetrical policy bias forced modern monetary policy into the great unknown. Out of traditional ammunition with policy rates near zero, central banks then turned to unconventional tools to combat the latest strain of crises—namely, the liquidity injections of quantitative easing (see Figure 5).10 Yet as Richard Koo points out in his seminal study of Japan’s post-bubble deflation, there is no evidence that such a cure works—at least, certainly not in the Japanese case.11 Ironically, by embracing yet another round of quantitative easing in September 2010, Japan does not appear to have learned its own lessons very well. Nor does it appear the Federal Reserve has learned this lesson particularly well on the eve of its so-called QE2 endeavor—a widely expected move to a second round of quantitative easing in the United States.

A major problem with zero policy rates and quantitative easing is that they end up being the functional equivalent of a narcotic. Once the patient get used to the drug, withdrawal is painful and prone to relapses. And so it is with post-bubble, deflation prone economies. Policy normalization—the only way for an economy to avoid yet another bubble and crisis—is exceedingly difficult to pull off. And by continually upping the ante on stimulus—from traditional actions to unconventional measures of increasingly dubious quality—central banks run the risk of keeping the patient in the recovery room for an interminable period of time. In economist terms, all this underscores the well-known impotence of monetary policy in extricating a post-bubble or post-crisis economy from a liquidity trap. Needless to say, that is an important lesson of the 1930s, as well as an equally important lesson from Japan.

The Fiscal OptionThe impotence of monetary policy in the current climate is a truly staggering development. Yes, aggressive central bank easing undoubtedly played a major role in arresting the devastating crisis of late 2008 and early 2009. However, the same tactics have been largely ineffective in sparking a solid recovery—that is, a rebound strong enough to make a major dent in the high rates of unemployment in the crisis-battered developed world. This has been an unacceptable outcome for job-fixated politicians. And so, the heavy artillery of the fiscal policy option has now been deployed—and with these weapons comes a legacy of sovereign debt overhangs that puts today’s post-crisis world in an even more problematic state.

Japan, of course, has been the poster child of the policy struggles to reflate a post-bubble economy. It began its first lost decade in the 1990s with a public sector debt-to-GDP ratio of around 50% (see Figure 6 on page 6). But now in the aftermath of multiple fiscal stimulus initiatives, that same sovereign debt ratio has quadrupled, rising to 200% of GDP. As Figure 6 also shows, the US has embarked on a path that eerily resembles that of Japan’s in the early 1990s; moreover, based on the latest projections of the US Congressional Budget Office, America’s public sector debt could well soar to nearly 90% of GDP by 2020—remaining very much on track with the ominous projection of Japan’s post-bubble debt trajectory.12

10. Here as well, this policy response was foreshadowed by then Governor Ben Bernanke is assessing the Fed’s “unconventional” policy options in the aftermath of the bursting of the equity bubble in the early 2000s; see his November 2002 speech before the National Economists Club in Washington, D.C., “Deflation: Making Sure “It” Doesn’t Happen Here.”

11. See Richard C. Koo, The Holy Grail of Macro Economics: Lessons from Japan’s Great Recession, Wiley (2009). 12. It should be noted that the CBO projections are dependent on relatively optimistic baseline projections for the US economy – namely, real GDP growth averaging about 3% over

the next decade—broken down into a 4.4% surge over 2012-14 followed by more modest gains of 2.4% over 2015-20; a shortfall from that path – more likely than not during 2012-14, in my view, would push public sector debt ratios up a good deal higher over a relatively shorter period of time. See Congressional Budget Office, The Long-Term Budget Outlook, June 2010 (revised August 2010).

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Figure 5: Central Banks and Quantitative easing

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Figure 6: Post-Bubble Debt Trajectories

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The US, of course, is not alone in pushing up its sovereign debt ratios in the aftermath of the Great Crisis. This is where Europe enters the equation (see Figure 7). Two key factors are at work here—the lack of fiscal discipline in the pre-crisis period, especially for Ireland and for several Southern European economies (Greece, Portugal, Spain and Italy) but also the exposure of the broader European banking system to toxic mortgage products. There is, of course, a major and important difference between Europe, on the one hand, and Japan and the US on the other hand—the lack of post-bubble damage to the European economy. Time will tell if that tempers the downside to European growth.

Figure 7: The great Debt Hangover

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At the same time, European policy makers have a very different perception of the post-crisis policy normalization debate than do authorities in the US and Japan. Europe appears to be taking the imperatives of fiscal consolidation far more seriously—seemingly determined to come to grips with excess sovereign indebtedness and being far more determined to do that than counterparts in Japan and the US. It remains to be seen if Europe actually has the political will—and the economic capacity—to deliver on this front. If it does, that could go a long way in breaking the shackles of a post-bubble Japanese-like sovereign debt trap. For the US, under current policies and political circumstance, such an escape route seems far less likely.

The US also suffers from another major deficiency—a lack of domestic saving. As can be seen in Figure 8, the US national saving rate has consistently run at only a little more than half the rate in Japan. Japan’s surplus saving has served the nation well—enabling it to finance its fiscal burden at home. America’s deficit saving position—underscored by a chronic shortfall in its current account balance—puts the US in an entirely different position. The US has become increasingly dependent on foreign lenders such as China, Japan, and Germany to fund its domestic saving deficiency. In an era of open-ended outsize budget deficits, a saving-short US can only turn even more dependent on foreign credit. That’s not exactly a comforting outcome in an era of mounting tensions between the US and China—the foreign lender who has stepped up the most in recent years to plug America’s saving gap.

Figure 8: Post-Bubble Saving Buffers

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A Way Out?The post-crisis world is obviously in a deep hole. To the extent that the other major economies of the developed world—namely, the United States and Europe—have been afflicted with some symptoms of the Japanese disease, it is wishful thinking to hope for a quick and easy way out. Contrary to accepted “wisdom,” the heavy artillery of monetary and fiscal policy won’t defer or offset the powerful deleveraging now at work in the post-crisis world.

In a post-bubble era, American consumers are perfectly rational in shifting away from asset- and debt-driven saving and consumption strategies back toward the income-driven models of yesteryear. And with that shift comes a likely and protracted consolidation in the growth of consumer demand. For Europe, it’s less of an American-style private sector deleveraging and more of a public sector consolidation. But either way—private or public sector deleveraging—aggressive monetary and fiscal easing seems unlikely to light a fire under an otherwise sluggish recovery.

To the extent that is the case, policymakers should think long and hard about deploying yet another dose of hyper stimulus. Whether it’s the latest round of quantitative easing

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now under way by major central banks or the polarizing tax cut debate in the US, there is a limited likelihood these measures will achieve meaningful traction in the real economy. The authorities would be much better off not wasting the next stimulus on policies that won’t work and better disposed toward taking actions that are directed at providing support to the true victims of this recession—namely, the structurally unemployed and underemployed.

This is a time when we need to take a tough look inside ourselves and raise serious questions about the strategy and design of traditional stabilization policies. The daisy chain of bubble-prone policies needs to be broken once and for all. So far, regulatory reform has dominated the agenda—especially the Dodd-Frank bill in the US and Basle III in the international sphere. However meaningful those regulatory initiatives are—and that, of course, remains a subject of intense debate—they don’t address the monetary policy conundrum that links the US and European experiences back to the dreaded Japan syndrome. I fear that unless regulatory reform is accompanied by a rethinking of monetary policy, another crisis is far more likely than not.

The only way to prevent such an outcome is to address the thorny but important issue of policy mandates—for monetary and fiscal authorities, alike. Specifically, I have long been in favor of an explicit hard wiring of “financial stability” into the policy mandates of central banks.13 Only then would monetary authorities have the political cover to attack asset and credit bubbles before they had dangerously destabilizing impacts on markets and wealth- and credit-dependent economies.

Yes, a financial stability mandate would complicate life for central banks such as the Federal Reserve, which is already operating under a dual mandate, focused on full employment and price stability. It would require the Fed to be both eclectic and creative in acting on the concerns required of a financial stability mandate—in effect, following the “leaning against the wind” tactics more recently advocated by Bill While and originally envisioned by former Fed Chairman William McChesney Martin. It would be up to the central bank as to how to implement actions consistent with this new objective—whether to use the policy rate or existing regulatory tools such as margin requirements as a signaling mechanism for equity markets or loan-to-value ratios as a restraint on mortgage markets. But when major asset and credit markets get out of line as they have repeatedly during the past decade, the financial stability mandate would force the authorities into action.

This wouldn’t be the first time that policy mandates have been altered for central banks. As can be seen in Figure 9, such an adjustment has occurred about every 30 years in the United States. In the aftermath of the Great Depression and World War II, the modern-day Fed was initially empowered

by the Employment Act of 1946 to target monetary policy with an aim toward achieving full employment. That worked through the early 1970s until a series of policy blunders gave rise to the Great Inflation. Congress then enacted the Humphrey-Hawkins Act of 1978 adding price stability to the Fed’s mandate—giving Paul Volcker the political cover to push the federal funds rate up to the unheard of 19% threshold that was required to break the back of an insidious double-digit inflation. That dual mandate worked reasonably well for about 20 years but, as detailed above, has now outlived its usefulness. Adding a financial stability mandate would bring the Fed up to speed with the new, complex, and powerful forces that now shape the interplay between the US economy and asset and credit markets.

Figure 9: Fixing Policy Mandates: The uS Case

Great Depression:1930s

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Glass Steagall Actof 1933

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At the same time, a new framework is needed to set hard guidelines for fiscal policy. A rules-based arrangement, such as provided by the Gramm-Rudman guidelines that were in place in the United States from 1985 to 1990, worked surprisingly well in imposing long needed fiscal discipline on the US Congress. Lo and behold, the US actually registered small budget surpluses in the late 1990s for the first time since the 1960s—a development that many partly attribute to Gramm-Rudman “spending caps, or sequesters.” Given the extreme politicization of the budget process in today’s climate, a rules-based fiscal structure seems appropriate in Washington once again. Europe, of course already has such a convention on the books—the so-called Maastricht Treaty requirements of 3% budget deficit ceilings. This threshold, of course, was violated by most European economies from the start. The challenge will be to build a more binding enforcement mechanism into the existing rule. The aftershocks of Europe’s sovereign debt crisis may well be an important catalyst in this regard.

The need to hardwire policy mandates is unfortunate. It is an outgrowth of a policy setting mechanism that has gone awry—underscored by a Federal Reserve that was swayed more by ideology than discipline, and debased by politically-motivated fiscal authorities who have become fixated on short-term stimulus while ignoring longer-term considerations. In this environment, we can no longer count on the promises of policy makers to act in accordance

13. See, for example, Stephen S. Roach, “The Post-Crisis Fix: Regulatory or Monetary Policy Remedies,” a paper presented at a conference sponsored by the Reserve bank of India, “Challenges to Central Banking in the Context of Financial Crisis,” held in Mumbai on February 12-13, 2010.

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with the lessons they have learned from Japan or from the Great Crisis of 2008-09. Mandates serve the very useful purpose of de-politicizing policy deliberations and the ideological biases that can shape their outcomes. The healing of a post-crisis world demands nothing less.

Lessons for the Developing WorldMy remarks today have focused largely on the policy blunders in the major economies of the developed world—starting with Japan but then increasingly evident in the United Sates and Europe. With the recent crisis and its aftermath bearing down so acutely on the so-called advanced economies, it is tempting to give great praise to the developing world for its more astute approach toward policy and risk management. The rapid rebounds of activity and sustained high rates of growth in these so-called emerging economies only reinforces that conclusion.

While I agree with much of the above—especially with policy strategies in the developing world that are now much more attuned to maintaining economic, social, and financial stability—there is an important caveat to this endorsement. Lacking in solid support from internal private consumption, most developing economies remain heavily dependent on exports and external demand to sustain their rapid growth (see Figure 10). That leaves them very much beholden to demand support from the United States, Europe, and, yes even Japan—and on the ability of the major advanced economies to cope with post-crisis hangovers. To the extent the recovery process in the developed world is long and arduous—typically the case for crisis-torn economies 14—export-led developing economies will eventually face major challenges of their own. Today’s great currency debate over the RMB only underscores those challenges.

Figure 10: A Bubble-Dependent Developing World?

15

25

35

45

55

65

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Exports Consumption

as % of GDP GDP Shares of Developing Asia

Source: IMF and Morgan Stanley Research

Consequently, the developing world also has to be acutely sensitive to the lessons from Japan. That’s especially the case since those lessons point to powerful external headwinds that will undoubtedly constrain what has long been the key source of foreign demand for exports. The good news is that Asia seems to have learned very important lessons from its own pan-regional crisis of the late 1990s.15 Since then, policymakers have been quick to build firewalls between the real economy and bubbles in asset and credit markets. That trend is especially the case in China but is also evident in other economies in the developing world. Nevertheless, today’s resilient export-led economies cannot afford to bask in a post-crisis complacency. If they fail to stimulate internal private consumption, they could well be left quite vulnerable to the repercussions of Japanese-like aftershocks in the developed world.

Rethinking the Lessons of JapanIt’s been nearly a quarter of a century since the seeds were sown for the Japanese debacle. Over that ensuing period of time, there has been great debate over the lessons of that painful experience—a debate that has an unmistakable sub-text: Can it happen to us?

Well, guess what? It did. Sure, there is a unique flavor to the multitude of problems that have afflicted Japan as it now moves into what could well be its third lost decade. No two economies are alike and it is unfair to superimpose the Japanese experience—chapter, line and verse—on the United States or Europe. But the similarities with the US are striking: massive asset bubbles, insolvent financial systems, bubble-related distortions to real economies, and enormous debt overhangs. And in the case of Europe, the sovereign debt crisis is very Japanese-like in its ultimate implications.

That puts the lessons of Japan in a very different light. With the benefit of hindsight, I would stress several key lessons from the painful rhymes of recent history that must be taken seriously as the world struggles to extricate itself from a post-crisis slump:

• While asset and credit bubbles cannot be prevented, they must be viewed as potentially serious threats to financial stability and to asset- and debt-dependent economies.

• Monetary policy must play the key role in leading a pre-emptive assault on bubbles—once bubbles are judged to raise serious macro stability risks on the basis of objective quantitative metrics.

• Financial stability mandates are necessary in order to insure that central banks are disciplined, apolitical, and free of ideology in dealing pre-emptively with the perils of asset and credit bubbles.

14. See Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.15. See Stephen S. Roach, “The Asian Way,” op-ed in the International Herald Tribune, September 14, 2010.

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• Cross border repercussions of asset bubbles must be taken seriously—especially by export-led developing economies, such as those in Asia.

Contrary to the view of many, the Great Crisis didn’t have to happen. I reject the excuse offered by many of the apologists that it was a once-in-a-century tsunami that would have occurred in any case – that policy makers could have done little to forestall the outcome. Yet nothing could be further from the truth. Defensive and steeped in denial, policy makers are ducking responsibility.

The recent crisis is a painfully visible manifestation of the greatest failure of central banking since the 1930s. Out of basis points, relying on dubious quantitative easing strategies, and still agnostic when it comes to coping with asset and credit bubbles, monetary policy has become the weak link in the daisy chain. Yet in the rush to re-regulate, central banks have largely been let off the hook. Nor are ever-profligate fiscal authorities exactly a beacon of hope in this crisis battered world.

Out of the darkness of the 1930s, a new approach to fiscal and monetary policy was borne. That renaissance is now over. The Great Crisis of 2008-09 demands a rethinking of the strategy and tactics of orthodox stabilization policies. Glaring shortcomings in our policy architecture must be addressed if the world is ever to learn the most important Lessons of Japan. As day follows night, a failure to learn these lessons almost guarantees another crisis in the not-so-distant future.

Mr. Roach is a member of the faculty at Yale University and Non-Executive Chairman of Morgan Stanley Asia. He is the author of The Next Asia (Wiley 2009).

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