Japan in 1990 and the US today

Andrew Smithers
Nikkei Veritas - Market Eye column, 15th May 2009

Most recessions are due to central banks raising interest rates. Although these recessions, which are usually mild, are unwelcome, they have positive results. Not only can they prevent inflation becoming a problem, they stop asset prices rising to bubble levels and discourage an excessive build-up of debt. When central banks fail to act and allow asset and debt bubbles to arise, mild recessions are postponed at the cost of major recessions thereafter. When asset prices then fall, banks find themselves in difficulties and cut back on their lending. When asset prices fall from excessive heights, they do not recover when interest rates fall. Economies become difficult to manage and the resulting recessions tend to be particularly severe.

To get economies to recover from this unusual type of recession requires large increases in government budget deficits and major injections of capital into the banking system. While this is generally understood, these programmes are difficult to implement. They meet a lot of incomprehension and political opposition. It is also impossible to know in advance how strong the measures must be to achieve recovery. Even if the political obstacles are surmounted and enough is done to stimulate growth, both the injection of liquidity and the budget deficits leave legacies. Excess liquidity must be withdrawn and government debt levels reduced. It is difficult to achieve either of these without either inflation picking up or the economy falling back into recession and deflation.

The current position in the world economy is that considerable fiscal stimulus has either been injected already or, as in the case of Japan, is proposed. Although no one can know, enough may already have been done. There is, however, an unusual degree of unanimity among economists that banks remain woefully undercapitalised.

Economic forecasting largely consists of examining similar times in the past. As similar occasions to those of today are rare, current forecasts are even more than usually prone to error. Guidance may, however, be drawn from the way in which the Japanese economy developed after the collapse of share and house prices in the 1990s.

In doing this, it is important to note the differences as well as the similarities between the US today and Japan 20 years ago. The key points of resemblance were the extremely high levels of debt and asset prices. Among the contrasts were the high level of savings and the current account surplus of Japan in 1990, compared with low savings and a current account deficit in the US today. In addition, Japanís excessive debt levels in the private sector in 1990 were confined to companies, whereas they are found in the US today in both the household and corporate sectors. The background provided by the general state of the world economy was also much better in 1990 than it is today.

It is therefore clear that the problems facing the US and world economies are significantly worse today than Japanís were in 1990. This does not, however, mean that the current recession will be more drawn out or the recovery less vigorous, as this depends not only on the problems but on the vigour of the policy response. But, as the refinancing of banks is generally agreed to be inadequate, caution rather than optimism seems to me to be justified.

Japan did not recover quickly after 1990, despite the fact that the problems it then faced were less acute than those faced by the US today. Japan failed to deal adequately with its underlying structural problem of over-investment. Although investment has fallen as a proportion of GDP, it has not fallen enough to match the decline in Japanís trend growth rate.

The US today has the mirror image of this problem. The household savingsí rate needs to rise and the budget deficit needs to fall. The former is almost certain, as it is the natural response to the collapse of share and house prices. Getting the budget deficit down to reasonable proportions will, however, only be possible if the current account deficit is more or less eliminated. This will depend on demand elsewhere in the world economy and on a competitive exchange rate for the US dollar. These conditions may prove just as difficult to achieve as the opposite adjustment has been for Japan since 1990.