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Japans lessons for a world of balance-sheet deflation

By Martin Wolf, Financial Times, February 17 2009

What has Japans lost decade to teachus? Even a year ago, this seemed an absurd

question. The general consensus of informedopinion was that the US, the UK and otherheavily indebted western economies could notsuffer as Japan had done. Now the question ischanging to whether these countries willmanage as well as Japan did. As I have notedbefore, the best analysis of what happened toJapan is by Richard Koo of the NomuraResearch Institute.* His big point, thoughsimple, is ignored by conventional economics:balance sheets matter. Threatened withbankruptcy, the overborrowed will struggle topay down their debts. A collapse in assetprices purchased through debt will have a farmore devastating impact than the samecollapse accompanied by little debt.

Most of the decline in Japanese privatespending and borrowing in the 1990s was,argues Mr Koo, due not to the state of thebanks, but to that of their borrowers. This wasa situation in which, in the words of JohnMaynard Keynes, low interest rates andJapans were, for years, as low as could be were pushing on a string. Debtors kept

paying down their loans.How far, then, does this viewpoint inform

us of the plight we are now in? A great deal, isthe answer.

First, comparisons between today and thedeep recessions of the early 1980s are utterlymisguided. In 1981, US private debt was 123per cent of gross domestic product; by the thirdquarter of 2008, it was 290 per cent. In 1981,household debt was 48 per cent of GDP; in2007, it was 100 per cent. In 1980, the Federal

Reserves intervention rate reached 1920 percent. Today, it is nearly zero.

When interest rates fell in the early 1980s,borrowing jumped (see chart below). Thechances of igniting a surge in borrowing noware close to zero. A recession caused by thecentral banks determination to squeeze outinflation is quite different from one caused byexcessive debt and collapsing net worth. In theformer case, the central bank causes the

recession. In the latter, it is trying hard toprevent it.

Second, those who argue that theJapanese governments fiscal expansion failedare, again, mistaken. When the private sectortries to repay debt over many years, a countryhas three options: let the government do theborrowing; expand net exports; or let theeconomy collapse in a downward spiral ofmass bankruptcy.

Despite a loss in wealth of three timesGDP and a shift of 20 per cent of GDP in thefinancial balance of the corporate sector, fromdeficits into surpluses, Japan did not suffer adepression. This was a triumph. Theexplanation was the big fiscal deficits. When, in1997, the Hashimoto government tried toreduce the fiscal deficits, the economycollapsed and actual fiscal deficits rose.

Third, recognising losses andrecapitalising the financial system are vital,even if, as Mr Koo argues, the unwillingness toborrow was even more important. TheJapanese lived with zombie banks for nearly adecade. The explanation was a political stand-

off: public hostility to bankers rendered itimpossible to inject government money on alarge scale, and the power of bankers made itimpossible to nationalise insolvent institutions.For years, people pretended that the problemwas downward overshooting of asset price. Inthe end, a financial implosion forced theJapanese governments hand. The same wastrue in the US last autumn, but the opportunityfor a full restructuring and recapitalisation ofthe system was lost.

In the US, the state of the financial sector

may well be far more important than it was inJapan. The big US debt accumulations werenot by non-financial corporations but byhouseholds and the financial sector. The grossdebt of the financial sector rose from 22 percent of GDP in 1981 to 117 per cent in the thirdquarter of 2008, while the debt of non-financialcorporations rose only from 53 per cent to 76per cent of GDP. Thus, the desire of financialinstitutions to shrink balance sheets may be an

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even bigger cause of recession in the US.

How far, then, is Japans overallexperience relevant to today?

The good news is that the asset pricebubbles themselves were far smaller in the USthan in Japan (see charts below). Furthermore,

the US central bank has been swifter inrecognising reality, cutting interest ratesquickly to close to zero and moving towardsunconventional monetary policy.

The bad news is that the debate overfiscal policy in the US seems even moreneanderthal than in Japan: it cannot bestressed too strongly that in a balance-sheetdeflation, with zero official interest rates, fiscalpolicy is all we have. The big danger is that anattempt will be made to close the fiscal deficitprematurely, with dire results. Again, the USadministrations proposals for a public/privatepartnership, to purchase toxic assets, lookhopeless. Even if it can be made to workoperationally, the prices are likely to be too lowto encourage banks to sell or to represent a bigtaxpayer subsidy to buyers, sellers, or both.Far more important, it is unlikely that modestlyraising prices of a range of bad assets willrecapitalise damaged institutions. In the end,reality will come out. But that may follow alengthy pretence.

Yet what is happening inside the US is far

from the worst news. That is the global reachof the crisis. Japan was able to rely on exportsto a buoyant world economy. This crisis isglobal: the bubbles and associated spendingbooms spread across much of the westernworld, as did the financial mania andpurchases of bad assets. Economies directly

affected account for close to half of the worldeconomy. Economies indirectly affected, viafalling external demand and collapsing finance,account for the rest. The US, it is clear,remains the core of the world economy.

As a result, we confront a balance-sheetdeflation that, albeit far shallower than that inJapan in the 1990s, has a far wider reach. It is,for this reason, fanciful to imagine a swift andstrong return to global growth. Where is thedemand to come from? From over-indebtedwestern consumers? Hardly. From emergingcountry consumers? Unlikely. From fiscalexpansion? Up to a point. But this still lookstoo weak and too unbalanced, with muchcoming from the US. China is helping, but theeurozone and Japan seem paralysed, whilemost emerging economies cannot now riskaggressive action.

Last year marked the end of a hopeful era.Today, it is impossible to rule out a lost decadefor the world economy. This has to beprevented. Posterity will not forgive leaders

who fail to rise to this great challenge.

* The Holy Grail of Macroeconomics (John Wiley, 2008)

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