Council of perfection on lost decades

May 27, 2010

Deflation and a lost decade can be avoided it seems; all we need are perfect central bankers, sensible politicians, a biddable electorate and cooperative investors.

Nothing to worry about there, then.

In a speech on Monday, Bank of England Monetary Policy Committee member Adam Posen, a leading expert on Japan’s lost decade of deflation and recurring recessions, laid out Japan’s experience.

The good news: Japan wasn’t cursed, it simply suffered from repeated policy mistakes which choked off growth during recoveries. Deflation was surprisingly persistent but recoveries were punctuated by policy errors which pretty much add up to not having loose enough monetary or fiscal policy.

The bad news: at least on my reading there is every chance that the United States or Britain makes some of the same mistakes, and an even better one that they make up some new blunders of their own.

“Japan’s Great Recession was the result of a series of macroeconomic and financial policy mistakes. Thus, it was largely avoidable once the initial shock from the bubble bursting had passed,” Posen said, speaking at the London School of Economics.

“The UK and U.S. economies are at low risk of turning Japanese in the sense of having recurrent recessions through macroeconomic policy mistakes — but deflation itself cannot be ruled out. The UK worryingly combines a couple of financial parallels to Japan with far less room for fiscal action to compensate for them than Japan had.”

The really good news is that a bursting bubble, in Japan’s case property, does not seem to doom a country to years of underperformance. Posen maintains that what Japan suffered was not a balance sheet recession, one characterized by the paying down of debt to bring it in line with diminished asset values. At first Japan was too slow to marshal the forces of central bank policy against the downturn. That is clearly a mistake the North Atlantic countries have avoided this time.

Sadly though, once recoveries were underway Japan’s policymakers kept pulling the rug from beneath it. In 1997 there was a fiscal cutback which sent the economy sprawling and though efforts in the early part of the next decade were massive and partly successful, they are extremely difficult for the United States or Britain to expect to recreate.

POLITICS MAY NOT COOPERATE

Take for example fiscal tightening. Already Britain is embarking on a round, and while gilts investors will feel it is much needed, there is a genuine chance that it will prove to be premature, or rather that Britain’s bind is not one that will readily respond to “management.”

If Britain does not tighten, as a small open economy it may well find itself without support from its own investors, who might choose to put their money abroad, or without support from global capital, which will think through the same problem in the same way. On the other hand tightening will almost surely damage the recovery in Britain, such as it is, and increase the potentially damaging effect of a sustained period of lousy growth.

The United States appears to be less vulnerable to market-forced fiscal tightening, but the country is deeply divided about the merits of more government spending to support the economy. Even if we accept that more deficit spending won’t drive up interest rates damagingly, there can be no assurance that the United States will be able to get its act together to act on that information. The reality is that policy is limited by and largely formed by politics and politics may well make optimal policy impossible.

The force of the downturn in 2008 allowed central bankers and governments to take quick, massive and decisive action. It will not be as easy in 2011 if more of the same, or even a scaled down version is called for.

The other huge difference between Japan and Britain and the United States is the global economic environment. Japan recovered in the last decade, albeit still with deflation, but did so in a world in which there was a strong and growing market for its exports. Japan was well suited to that world, its export industries were never the problem, they were always relatively efficient and competitive.

More importantly, the demand was there. Now, with the exception of China and emerging markets, that will not be the case. Britain, the U.S. and the euro zone will all be trying to export their way to recovery at the same time.
If Japan in its lost decade was like a man running in the sand, the U.S., and especially Britain may be like a man running in the mud. Uphill.

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