[I found this kind of a fascinating take on Japanese macro policy in the 90s, which I've never heard anything but disparaged in the West. I'm not sure it offers a workable model to the US even theoretically, though, since our fiscal balance and external balance and currency value starting points couldn't be more opposite.]
January 23 2008 Financial Times
Insight: Japan's lessons could ease crisis By Richard Koo
The echoes are eerie. Ben Bernanke's gradual change of tone during the past year and this week's massive cut in interest rates seems to parallel that of Japanese officials back in 1992. At that time, an initial period of denial was replaced by the shocking realisation that the damage caused by the bursting of the bubble could take years to repair.
Clearly there are differences between the Japanese and US bubbles, but the key cause of the economic downturns remains the same: the private sector has become more concerned with its financial health than maximising profits. Companies and individuals have made the logical decision to concentrate on repairing balance sheets. The consequences of those actions can cause the whole system to collapse. In the arcane world of economics it is known as a fallacy of composition.
In Japan during the 1990s, it was corporations that rushed to pay down debt after the commercial real estate they had bought with borrowed funds lost 85 per cent of its value. Their need to eliminate the debt overhang meant there was nobody left to borrow from the banks, even though interest rates were effectively zero, creating a significant shortfall in demand.
This time, in the US and parts of Europe, it is banks and households struggling to regain their financial health. Although some top-tier banks have obtained funds from sovereign wealth funds, thousands of ordinary banks that have no such access will now be forced to slash lending and other activitiestomeet capital adequacy requirements. We face a significant credit crunch that will not be solved by central banks' monetary easing or liquidity injection because the key constraint is lack of capital, not lack of funds.
If the Japanese experience is any guide, the housing market in these countries may not respond to the monetary easing either. With the housing price futures market in Chicago indicating that prices will continue to fall well into 2011, there is little reason for people to buy houses now, given the asset will be still cheaper in the future. Valuations will need to fall to a level that properly reflects the discounted cash flows provided by rents.
When the private sector is more concerned about regaining balance sheet health than maximising profits, a great deal of conventional economics becomes irrelevant. In such a situation, only fiscal policy can lift the economy. Japan managed to keep its GDP above the peak-bubble levels throughout the past 15 years in spite of an 85 per cent fall in real estate values. The government achieved this by borrowing and spending, which more than compensated for the damage wreaked by household and corporate debt repayment. It also eliminated the credit crunch by injecting capital into the banks in 1998 and 1999.
US and Europe, which could be facing similar economic downturns, would do well to line up policies along the above lines. Even though there are talks of tax cuts in the US, there is a high probability that a significant portion of these will be saved or used to cut debt. In the current situation, therefore, increased spending will be far more effective. Capital injections are likely to meet resistance from those who argue that bankers stupid enough to get involved in the subprime mess do not deserve taxpayer's help. But when the whole economy begins to implode as a result of a credit squeeze, watching bankers struggle to recapitalise themselves might be satisfying, but it is economically unsound.
Lastly, by mobilising fiscal policy, Japan kept its problems within its borders. This in spite of numerous foreign economists, including Paul Krugman, urging the government to weaken the yen and harness foreign demand. This point is particularly important today because if all the countries affected by the subprime crisis tried to export their way out of recessions, there would be a global fallacy of composition just like in the 1930s. In other words, while an export-driven policy might make sense for each country, collectively, the outcome would be disastrous. In order to avoid that outcome, international bodies such as the G7 and the IMF should require individual countries affected by this crisis to mobilise fiscal policies so as to keep their problems inside their own borders.
The writer is chief economist at Nomura
Copyright The Financial Times Limited 2008