James Saft

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.

By Jim Saft

With tax credits for house buyers gone and tough new banking regulations on the way, expect lending in the United States to come under significant pressure.

Demand for mortgages, kept artificially high through the end of April by juicy credits for first-time and other buyers, has now crashed and, at least to judge by the fundamentals in the housing market, should stay low. Loans to consumers too will be getting, appropriately, more expensive, at least in part due to costs imposed by new financial regulations, which while if anything not tough enough from a prudential point of view will without doubt make banking less profitable.

Supply of loans to businesses will also be hit, and demand should remain slack.

Europe won’t just be exporting deflation to the rest of the world, it will export serious trade tensions as well: first between the United States and China, and, possibly, eventually between Europe and the United States.

The austerity required to get Greece and other weak euro zone nations’ budgets in shape will exert a powerful deflationary force, as many countries which formerly imported more than they exported will be forced to cut back.

As well, the euro has dropped very sharply. Germany’s quixotic campaign against speculators — banning naked short selling against government debt and government credit default swaps — gave the euro its latest shove downward, but the trend has been strong for months. The euro is now about 15 percent below where it started the year against the dollar, making U.S. exports less competitive and adding to pressure on the United States to be the world’s foie gras goose: being force-fed everyone else’s exports while its own unemployment rate remains high.

Fear of lending to banks is rising again in Europe, as even a 750 billion euro zone rescue package proves not enough to stem fears that the banking system will prove the weak link when southern European nations can’t meet their obligations.

Strikingly many European and British banks are now being forced to pay more to borrow money in the interbank markets than before the joint European Union, International Monetary Fund and European Central Bank package was announced two weekends ago.

That deal, which should insulate highly indebted countries such as Greece, Spain and Portugal from funding pressure for the next two years or so, was effective in driving down the extra interest those countries had to pay to borrow as compared to Germany. Tellingly, it was less effective, even counter-productive, in restoring calm to the markets in which banks fund their short-term borrowing needs.

If government debt is the new subprime, it may just turn out that Greece is a Florida condo while the United States is a single-family house in a nice mid-Western suburb, the kind of place that fell 15 rather than 50 percent.

In considering the Greek, or European, sovereign debt crisis, the common line of argument, which is true if incomplete, is that the U.S. is far more different than similar; it possesses its own currency, which just happens to be the world’s primary reserve unit, its economy is stronger and more flexible and its institutions better developed and more credible.

All true, but there is a funny feeling that investors, prompted by Greece but also having looked at better credits like the U.S., are doing a fundamental reevaluation of the risks of lending to governments. This may end at Greece, it may end at Portugal, it may end at Britain, but it is not over yet.

Far from setting a trap for the “wolfpack,” Europe’s $1 trillion bailout package amounts to a full employment act for speculators, or should that be the reality-based community, for the foreseeable future.

Hoping to tame markets it accused of “wolfpack behavior,” the European Union on Monday unveiled a 750 billion euro package intended to avert a rolling sovereign debt crisis that has engulfed Greece and threatens to spread widely among the weaker euro zone countries.

The package can’t be blamed for being too simple: it contains loans from the International Monetary Fund, an EU emergency fund and euro zone governments, as well as an interesting undertaking by the European Central Bank to buy bonds in order to restore liquidity to supposedly poorly functioning parts of the bond market. In a move straight out of a Russian fairy tale, Spain and Italy, to name just two, are pledging money towards a package that may well be used to bail themselves out. Maybe they should have put up even more money.

The dollar may hang by the slender thread of the U.S. recovery, but this is probably enough to make it the major currency of choice.

It is not so much that the dollar is strong, but that the case for its major peers — the euro, pound and yen — is so weak.

The euro zone faces tremendous pressure; Greece may, just, have been rescued, but it, along with Portugal, Spain, Ireland and Italy are unleashing powerful deflationary forces making quantitative easing by the European Central Bank a real possibility. Further contagion within the euro zone is also a  strong possibility, meaning market risk will compound fundamental risk.

– James Saft is a Reuters columnist. The opinions expressed are his own –

To look at sterling and gilts, you would hardly know that Britain is sailing into a general election which will likely deliver a weaker government with a diminished ability, if not will, to grapple with high debts, an uncertain role in the global economy and an aging population.

It is impossible to say what will be the result on Thursday, nor what deals may be made between the surging Liberal Democrats, a bedraggled Labour party which will still have a significant wodge of votes and the Conservatives, who must be both hoping that their hour has arrived and that that hour does not prove to be Monday morning at 8 a.m., pouring with rain and all the trains are late.

To look at sterling and gilts, you would hardly know that Britain is sailing into a general election which will likely deliver a weaker government with a diminished ability, if not will, to grapple with high debts, an uncertain role in the global economy and an aging population.

It is impossible to say what will be the result on Thursday, nor what deals may be made between the surging Liberal Democrats, a bedraggled Labour party which will still have a significant wodge of votes and the Conservatives, who must be both hoping that their hour has arrived and that that hour does not prove to be Monday morning at 8 a.m., pouring with rain and all the trains are late.

There is a huge range of scenarios — a weak minority or majority government or a coalition of some form — but the common denominator across almost all likely outcomes is that all raise the risk of a weak government unable or unwilling to push through aggressive deficit-reduction measures.