A long, shaky bridge to recovery
The lessons of Japan’s stumbling path out of deflation and recession suggest that government spending can help stave off an extended recession, but it may take years not months and require an unlikely combination of political will and consensus.
That’ll be a lot of bridges to nowhere.
The particular type of recession the United States faces, a balance sheet one, means that cutting interest rates will be really pretty ineffective, and while you can throw everything you have at saving the banking system, you can’t make people and businesses borrow and put the money to work. They too have their own balance sheet problems, having loaded up on debt and holding as they are assets like real estate and stocks that have fallen in value.
Banks too are about to get whacked by another hit to their assets, as corporations respond to newly lousy economic conditions by, well, defaulting.
In short, it’s a negative self-reinforcing cycle that low interest rates do little to break and that is bigger, though related, to the problems in the financial system.
Government spending can break the cycle. Not tax cuts, which will only go to pay down debt or are saved into a banking system that isn’t working, but actual bricks and mortar. Think the New Deal’s Works Progress Administration super-sized or Japan building highways and bridges over seemingly every river, stream and rivulet.
“It was the fiscal stimulus that actually helped end the Great Depression, not the monetary policy,” said Richard Koo, Tokyo-based chief economist at Nomura Research Institute and author of The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.
“I don’t think it will be over quickly. I am recommending at least three to five years seamless medium-term fiscal stimulus measures to give enough time for the private sector to repair its balance sheet.”
Three to five years is an eternity in political life. It is an absolute sure thing that incoming President Barack Obama will design and implement a pretty chunky fiscal stimulus package even if President Bush does not pass one in his waning days in office. But think about how difficult it will be to maintain both the will and power to maintain a huge borrow and spend program for several years.
Koo thinks that Japan, which was facing a far more serious destruction of assets, derailed its recovery with premature fiscal reform. “If we had known in advance that this kind of recession will never be over until private balance sheets are repaired and fiscal stimulus is needed to keep the economy growing, we could have done it in seven or eight years perhaps instead of 15,” he said.
NEITHER A PRIVATE BORROWER OR A LENDER WILL
Between 1998 and 2007 credit extended to the private sector in Japan dropped by about 100 trillion yen, but massive government borrowing from banks of 106 trillion yen kept money moving in the economy.
Near zero interest rates were ineffective in Japan because people and business refused to borrow, continuing to pay down debt to repair balance sheets that had been hurt badly by the fall in the value of assets like stock holdings and real estate.
Very low interest rates are needed, certainly, but what they do is to keep the banking system and debtors on life support, giving them the time they need.
Of course, resolving to borrow multiple hundreds of billions of dollars is one thing, finding someone to lend it to you can be quite another.
China approved a huge stimulus package worth 4 trillion yuan ($586 billion) through 2010 to boost domestic demand. China will plough money into infrastructure and social welfare as well as other key sectors. This has raised some fears that China may become a less avid buyer of Treasuries, or even a seller.
But that ignores the fact that in both countries people will be forgoing investment or paying down debt. In other words there will be a new pool of money available domestically to finance increased government borrowing on both sides of the Pacific ocean.
“China’s fiscal stimulus will offset a fall in domestic investment more than it reduces China’s purchases of U.S. debt,” economist Brad Setser, who follows central banks at the Council on Foreign Relations, wrote in his blog. blogs.cfr.org/setser/
“Chinese banks that previously were lending to China’s property developers will be lending to China’s government instead. And the rise in the U.S. fiscal deficit will offset a fall in borrowing by American households and firms. As a result it won’t need to be financed as heavily by the rest of the world.”
Even so, there is no doubt that the United States remains dependent on China’s continued desire to buy and hold its debt.
But the bigger job for the U.S. will be at home. If what is needed is several years of stimulative spending, the U.S. is going to need a level of consensus and resolve that to me just doesn’t seem likely.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund —