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The most common point of comparison for our current economic crisis is, far and away, the Great Depression. The Depression is most often bracketed with some version of the phrase, “but we’re unlikely to see a depression, just a recession,” whatever that’s supposed to mean. And, fortunately for us, with the addition of Christina Romer, we now have two scholars of the Great Depression on our nation’s economic policymaking team.
But in many ways, a more relevant comparison may be the Japanese “lost decade” of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth. This is the Nikkei 225 index from 1980 to the present.
At a high level of generalization, the causes of the bubble were similar to those we have just seen. Loose monetary policy (in late 1980s Japan, and in the U.S. this decade) and high savings levels (by Japanese households in Japan’s case, China and oil exporters in ours) created a large pool of money looking for investments to buy. Rising prices encouraged speculation in both real estate and stocks. Poor underwriting standards – due to some combination of government direction of investment and self-dealing within industrial and financial conglomerates – and an unconditional willingness to lend against real estate as collateral meant that banks made hundreds of billions of dollars’ worth of loans that were sustained solely by rising prices. When prices fell, those loans lost most of their value, crippling banks’ ability to lend to creditworthy borrowers and choking the economy. The lack of credit, combined with the negative wealth effect of collapsing asset prices, dampened economic growth, which averaged 1% per year for the 1990s.
What makes Japan more interesting than the Great Depression is the fact that it happened after the Great Depression, and after all of the academic research into the Depression and what the Fed did wrong. Although there are debates about many of the details, at a high level the conventional wisdom is that the Fed should have loosened monetary policy in the 1930s, making it easier to borrow money and thereby stimulating the economy. What’s interesting about Japan is that despite the benefit of all that academic research – which the Bank of Japan took to heart, lowering short-term interest rates to zero for much of the 1990s – policymakers were unable to restore the Japanese economy to anything like its growth potential for over a decade, and perhaps not even then. Fiscal stimulus was similarly ineffective
One of the major barriers to expansionary policy was the weakness of Japan’s banking system. The asset price collapse and economic slowdown meant that increasing proportions of their loan portfolios became non-performing. Because writing down these loans to their true market values would have caused banks to become insolvent, they kept them on their books, rolling them over (extending bad loans indefinitely) in order to avoid having to take writedowns. As a result, the banks were severely undercapitalized and largely unable to engage in new lending. It was only in 1998 or 2003 (depending on whom you ask) that the government got serious about cleaning up the banking sector, letting weak banks fail or forcing banks to accept new government capital.
Of course, Ben Bernanke knows plenty about the lost decade. There are two major differences between the current policy response and the response in Japan in the 1990s.
First, the U.S. government has moved much more quickly to attempt to fix problems in the banking sector. To some extent, the fact that so many of the bad investments are securities rather than loans, combined with mark-to-market accounting, has had the salutary effect of highlighting the problems; banks have already taken close to $1 trillion in writedowns, although many writedowns may still be hidden on bank balance sheets. This has forced banks’ balance sheet problems into the open, leading to the recapitalization programs announced all over the world in October. For now, though, it’s not clear if these programs have gone far enough. The small scale of the capital injections (capped at 3% of bank assets or $25 billion, whichever is smaller) does not seem to have definitely restored confidence in the banking sector (see the re-bailout of Citigroup, for example), and has left many banks in a position of hoarding their cash rather than lending it out.
Second, the Fed has in just a few months acknowledged that its main monetary instrument – the Fed funds rate – is no longer useful, and has instead hinted at a broader program of quantitative easing, through some combination of printing money and buying all sorts of assets to prop up prices and push down yields. This was a major topic of Bernanke’s famous 2002 speech on fighting deflation, which was written with the Japanese experience in mind. In that speech, Bernanke implied that Japan’s problem in the 1990s was political deadlock that prevented policymakers from taking the decisive steps that were necessary. For better or for worse, we seem to have the political will today to do whatever it takes, and the general consensus is that worries about inflation should be put on hold for now.
That said, we still can’t be sure that we won’t see a replay of 1990s Japan. First of all, while we have the political will to spend large amounts of money, it’s not clear that we have the political will to shut down insolvent banks; the bailout packages so far have been notable for their attention to the interests of existing shareholders. Second, simply because Bernanke is willing to use a broader arsenal of tools, earlier in the crisis, than was the Bank of Japan doesn’t mean those tools will work; we are essentially in uncharted territory for any central bank. Third, Japan managed to create its boom and bust largely on its own, and when it did begin to come out of its lost decade it was largely thanks to exports to a booming world. This time, with more or less the entire world slowing down in unison, there is no external growth engine to bail us out.
The longer this crisis drags on without upticks in personal consumption and inflation, the more comparisons to Japan you are going to see. Let’s hope it doesn’t come to that.