Thursday, March 20, 2003
Lessons from Japan's malaise
JOSEPH STIGLITZ
Japan's economy has been in a state of malaise - slow growth alternating with recession - for over a decade, with intense debate meeting policy vacillation.
Some, for instance, prescribe budget deficits to stimulate the economy; others, remembering the Clinton administration's claim that fiscal consolidation underpinned the US recovery in 1993, argue for deficit reduction.
Similarly, some argue that the country needs a mild dose of inflation, while Japan's central bank continues to resist the very idea that inflation could ameliorate any economic problem.
Confusion about what cure to prescribe is caused in part by the fact that different medicines are suited for different problems, whereas much of the policy debate fails to distinguish among them adequately. As one of President Clinton's economic advisers during the critical period of America's economic recovery, I feel obligated to point out that circumstances in the US in the early 1990s were unique.
Normally, deficit reduction in an economic downturn makes a downturn worse - just as the British economist John Maynard Keynes demonstrated 70 years ago. Indeed, thanks to the IMF, we have had ample opportunity to see what happens, both in East Asia and Latin America, when an economy in a downturn tries to balance its budget.
The reason deficit reduction worked in the US in 1993 was that America's banks, whose balance sheets were weak, had large holdings of long-term bonds, the value of which increased as long-term interest rates fell. The fall in interest rates, which spurred business investment, was in part due to the long-term deficit reduction strategy.
Today, Japan faces a problem of deflation, not inflation. During the Great Depression, the great American economist Irving Fisher focused on the adverse effects of falling prices. My own work, with Bruce Greenwald of Columbia University, updates these theories, taking into account the imperfections of capital markets, especially those associated with asymmetries of information.
Keynes worried about price rigidities - the failure of prices and wages to fall when there is excess supply of labour or goods. Keynes' colleague at Cambridge University, A C Pigou, voiced the standard theory of the time: if wages and prices fell sufficiently, then consumers with money would eventually feel well enough off (given how cheap everything had become) that they would start to spend, rejuvenating the economy. Keynes famously retorted that in the long run we are all dead.
Fisher's criticism, however, was even more devastating - and more relevant to Japan's current circumstances: as prices fall, debtors, whose obligations are fixed in nominal terms (that is, in terms of yen) find it increasingly difficult to repay what they owe. In real terms, they are forced to pay back more and more to their creditors.
Some debtors default - the debtor problems then become the banks' problem - while others are forced to cut back their expenditures, deepening the downturn. Falling prices also mean that even when the nominal interest rate is very low, the real interest rate, taking into account the deflation, may be significantly higher, so investment, too, is discouraged. In short, falling prices worsen the economy's situation in the short run.
How can Japan's deflation be reversed? Assume that the Japanese government financed its deficit partly by printing money rather than borrowing. Some individuals and firms who receive this money might simply hold on to the newly minted yen, but others might choose to spend it on goods and services, thereby stimulating the economy. Similarly, higher deposits might simply add to some banks' excess liquidity, but others might find it attractive to lend more, providing a further economic boost.
A carefully paced programme could add enough to aggregate demand to pick up the slack in the economy, and reverse deflation, setting into motion a virtuous cycle. Higher prices would make debtors better off, and they might as a result begin to spend more. More debtors would be able to repay their loans, which might lead the banks to lend more.
Meanwhile, the yen would weaken, helping exports, and even if the real exchange rate did not change much, given Japan's position as a major creditor, the yen value of its foreign holdings would increase, providing still more economic stimulus.
Of course, those infected with inflation paranoia might worry: won't such a policy simply lead to an inflationary spiral? There is no economic research that supports such worries. For countries with low to moderate inflation, moderate increases in inflation do not lead to runaway inflation, regardless of what central bankers may say on the matter.
To be sure, if Japan's government started printing money recklessly - as some countries have done in the past - such worries would be well grounded. But the Japanese government has shown a remarkable record of fiscal responsibility, and could even calibrate the fraction of the deficit financed by issuing money.
What would be the impact on confidence in the Japanese economy of such fiscal stimulus? There is nothing that undermines confidence in an economy so much as recessions; and there is nothing that undermines confidence in a government's ability to manage the economy so much as ongoing failure to address either the extremes of inflation or persistent stagnation.
Restoring growth would be good for Japan, good for Asia, and good for the world economy. Perhaps more importantly, the lessons gleaned from a policy of determined stimulus would be invaluable for other countries facing similar problems.
(The author is Professor of Economics and Finance at Columbia University and the winner of the 2001 Nobel Prize in Economics.)
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