Zeev's Turnips Patch-No Politics (ZEEV)

[Smart_Money]

U.S. likely will avoid Japan-style recession

http://www.yomiuri.co.jp/index-e.htm

Jesper Koll Special to The Daily Yomiuri

A specter is haunting world financial markets--the threat of the United States falling into a Japan-style deflationary trap. The bad news is that the markets are right to be worried and, in the current environment of mounting distrust in corporate leadership, may very well be forced to assume the worst for a while longer.

The good news is that the risk of the U.S. economy falling into a Japan-style decade of stagnation is relatively low. A key reason for this is the fact that U.S. policymakers have studied Japan's lost decade in great detail. Learning from Japan is a key reason for my relative optimism. The United States may perhaps have a couple of years of subpotential growth, but a lost decade is unlikely.

First, let us look at the similarities. They seem striking on first appearance. The Nasdaq Composite Index has fallen more than 70 percent from its March 2000 peak--a plunge almost exactly as devastating as the Nikkei Stock Average's drop from its December 1989 high.

Moreover, the recent revelations about U.S. accounting fraud and corporate greed bear striking resemblance to corporate governance issues uncovered in Japan during the 1990s. While the details differ, the net effect is still the same--public trust in the stock market has been severely undermined.

In this respect, Japan and the United States now face a common problem. Both are struggling to overcome a stock market bubble legacy. Trust, once broken, is difficult to regain.

Fortunately, there are some big differences. From an economic perspective, the main difference is that Japan is the world's largest creditor nation, while the United States is the world's biggest debtor.

What this means is that the United States is doomed to succeed. If U.S. productivity is not the highest in the world or if the prospective return on assets in the United States is not better than elsewhere, global funding for U.S. growth will dry up.

Put another way, the permanent threat of a funding shortage is a powerful stick that keeps U.S. leaders under permanent pressure to implement policies that guarantee the highest return on savings.

Japan is the exact opposite. It is the world's largest creditor nation. Every day, there is more money coming into the system than going out. As such, there is no natural sense of urgency. Japan's macro-economic funding surplus allows savings to be allocated into nonproductive resources and is a key factor contributing to the low rates of return. As long as Japan remains a net surplus nation, it has the resources to "muddle through."

If the United States' permanent need to secure funds makes it doomed to succeed, Japan's excess savings allow it to be lazy. Put another way, Japan is like a spoiled college student who gets sponsored by the parents to keep up the family tradition, no matter what the academic performance, while the United States is the student who constantly has to earn his scholarship money with good grades, day in, day out.

To be sure, there are obviously many more differences between Japan and the United States. For example, when I came to Japan in 1986 to do economic research for a postgraduate degree in economics, there were only two economics faculties in the country that were not completely dominated by Marxist professors. Japan's ideological focus on the promotion of market-based resource allocation has always been limited at best. The United States obviously is at the other end of the spectrum with its faith in free-market allocation.

However, regardless of the ideological framework, the laws of economics apply equally in both countries, and the creditor-debtor difference pulls the two economies in fundamentally opposite directions--muddle through versus urgent action.

Learning from Japan's lost decade has been high on U.S. policymakers' agenda. The best summary of the extensive research done recently comes from the U.S. Federal Reserve Board of Governors in a report published at the end of June. The title says it all: "Preventing Deflation: Lessons from Japan's Experience in the 1990s." (The paper can be found on the Fed's Web site, International Finance Discussion Paper 729.)

There are four main points, all of which have significant implications that, to some extent, already have been incorporated in U.S. policy actions.

The report's first finding was that, "Japan's sustained deflationary slump was very much unanticipated by policymakers and observers alike and this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation."

This is not just diplomatic niceties. Outside of a few Cassandras, the possibility of a very serious downturn was consistently underestimated here. The first lesson is that policymakers always should plan for a worst case scenario.

The report's second lesson is: "We found little evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to support the economy fell off significantly."

This is important because if the Japanese policymakers had recognized the severity of the slump earlier, their policy tools would still have been strong enough to avoid it. Specifically, the Fed researchers' models suggest that additional interest rate cuts of about 200 basis points before 1994 may have prevented deflation from occurring in the second half of the 1990s.

Third is the bad news: "Once inflation turned negative and short-term interest rates approached the zero-lower bound, it became much more difficult for monetary policy to reactivate the economy." In other words, once deflation starts, policymakers become impotent.

And finally, the conclusion: "We draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero and the risk of deflation is high, stimulus--both monetary and fiscal--should go beyond levels conventionally implied by baseline forecasts of future inflation and economic activity." In other words, anticipate the worst and act fast and decisively even if it goes beyond the limits of what is conventionally acceptable.

Have U.S. policymakers acted on their findings from Japan's negative experience? I think the answer is yes. Interest rates have been cut at an unprecedented speed and real interest rates have been negative for an unprecedented nine-month period.

In Japan, real interest rates were never negative because the Bank of Japan cut rates slower than the decline in prices. From an economist's perspective, this bodes well for the United States' chances of avoiding a prolonged Japanese-style recession.

Koll is chief economist of Merrill Lynch Japan.