The US heading for Japan-style chronic deflation? One economic visionary
predicts just that
Special report: George Bush's America
Special report: Japan
Larry Elliott, economics editor
Wednesday March 14, 2001
The Guardian
In normal circumstances, a warning from the new president of Harvard that
America today looks suspiciously like Japan 10 years ago would barely be
worthy of mention. Academics often say controversial things just to be
noticed.
These are not normal times, with Wall Street gripped by a severe bear market
and yesterday's darlings - the dot.coms - going bust in droves. This was no
ordinary president of Harvard, either, but Larry Summers, who until the middle
of January was treasury secretary of the United States and rated as one of the
most brilliant economists of his generation.
Mr Summers has thought a lot about Japan, regularly lecturing hapless Japanese
officials at international gatherings about their failure to take the measures
necessary to restore health to Asia's first and most successful tiger economy.
Now he is out of political office he can afford to posit a frightening
scenario: that America could become the new Japan.
Speculative bubbles
On the face of it, this seems laughable. The US economy is still growing,
albeit at a slower pace, after its longest period of expansion since records
began in the 1850s. Unemployment is historically low and American companies
are world leaders in the new technologies. The same could have been said of
Japan at the end of the 1980s, when the country was enjoying full employment,
had been growing strongly since the end of the second world war and boasted
many of the world's biggest companies. For Sony, Toyota and Nissan then, read
Microsoft, Intel and Cisco now.
Both saw the emergence of speculative bubbles at a time when inflationary
pressure was weak. Even when the Nikkei-Dow was racing towards 40,000 and land
prices in Tokyo were going through the roof, inflation was only rising at
about 3% a year, similar to the US over the past year. This was unusual in the
post-war period, when developed countries became accustomed to relatively high
inflation, but a regular feature of economic life in the 19th century when
there were clearly defined business cycles driven by the interplay of
technical advance, profitability and speculation. Mr Summers has suggested
that the US, like Japan, could be returning to an older type of economic
cycle.
During the Victorian era, when labour was relatively weak, the cycle would
kick off with rising demand which fed through into higher profits. The
increase in profits would stimulate higher investment and higher productivity,
driving down unit costs, keeping inflation under control. This was the benign
phase of the cycle, seen in Japan in the mid-1980s and the US in the mid-90s.
Then the problems began.
Attracted by the lure of high profits and confident that the good times would
last for ever, investors would finance enterprises with no chance of making a
decent return. At some point, invariably far too late, reality set in. The
speculative bubble was pricked and much of the unprofitable investment was
scrapped as the economy went into recession. Fearful of the future, consumers
saved more and spent less, pushing prices lower.
This is where things went seriously wrong for Japan. Policymakers were slow to
recognise that the fall in the Nikkei was both permanent and serious, and
initially tightened policy rather than easing it. This blunder of enormous
proportions turned low inflation into outright deflation - a period of falling
prices.
Japan's policymakers found that deflation, once entrenched, was hard to cure.
The normal remedy for boosting growth - cheaper borrowing - is much less
effective when prices are falling because it is impossible to make real
interest rates low enough. Instead, Japan was forced to fall back on fiscal
policy, injecting larger and larger doses of public spending into the economy
in an attempt to boost demand. This had a limited success and the effects are
now wearing off.
Could the US follow this pattern? There is no reason why not, particularly if
policymakers are slow to wake up to the risks. Even if they respond quickly,
there is trouble ahead. One feature of the stock market boom of the late 90s
was that Americans used speculation as a substitute for saving. As times take
a turn for the worse, the fear is that they will start to save more, adding to
the squeeze on corporate earnings and profits. Even economists who believe the
US is going through a "phoney" recession, with the real downturn yet to come,
say it will take more than a few months of retrenchment to work off the wild
excesses of the past few years.
'Crashing share prices'
Charles Dumas, at Lombard Street Research, says that even after the 60% drop
in the Nasdaq in the past year the bear market has further to go. "At any
stage, crashing share prices could precipitate either a sharp upswing of
consumer savings or serious financial trouble in over-leveraged America - or
both."
For the time being, there are good reasons for thinking that America will not
be faced with a Japan-like slump. First, the likelihood is that policy will be
loosened far more quickly than it was in Japan. America is still mentally
scarred by the Great Depression of the 1930s; so much so that policymakers are
quick to act whenever there are signs of a recession. Fed chairman Alan
Greenspan has already cut rates twice this year and will undoubtedly cut them
again next week. The daily dripfeed of economic bad news means George Bush is
already finding it much easier to sell his package of tax cuts to Congress and
the country at large.
Second, the severity of the Japanese bust was exacerbated by the slump in land
prices, which is still not over. Property was used as collateral for loans,
with the result that Japan's financial sector is sitting on mountain of bad
debts.
Third, America's hire and fire culture will ensure that the corporate sector
takes the measures necessary to restore profitability more rapidly than under
Japan's consensual structure. Lay-offs by Motorola and Cisco are evidence that
this process is already under way.
Some titans of industry lionised for their wisdom during the market's bull
phase will find the headlines less to their liking on the way down. Mr
Greenspan, too, has his reputation on the line. He will be high on the list of
possible scapegoats if the US really does catch a whiff of the Japanese
disease.
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