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ECONOMIC SCENE: US can avoid Japan's 'lost decade' of deflation

While parallels exist, two American economists believe the US won't relive Japan's decade 'stuck in deflationary economic goo'

By David R. FrancisStaff Writer / September 28, 2009

A businessman walks out from an office building in Tokyo on September 18, 2009. Japan's economy has pulled out of its worst recession in at least 60 years on the back of exports and government stimulus spending, although deflation that marked the nation's "lost decade" between the mid-1990s and 2002 is still a challenge.

Yuriko Nakao/Reuters

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At the height of Japan’s real estate boom in 1989, property prices soared out of sight. Choice locations in Tokyo’s Ginza district fetched $93,000 per square foot. Some said, perhaps exaggerating, that the grounds of the Imperial Palace were worth more than the entire state of California.

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Then the bubble burst and, with a plunge in stock prices and a severe banking and credit crisis to boot, Japan spent most of the 1990s and into 2002 stuck in a deflationary economic goo – its “lost decade.”

Does the same fate await the United States? Happily, no, two analysts say. Although the parallels with Japan are sobering, the severe US slump differs in terms of scale and speed of response.

“The Japanese bubble [in asset prices] was much larger,” says Michael Hutchison, an economist at the University of California, Santa Cruz, and coauthor of “Japan’s Great Stagnation,” a 2006 book. “They had much further to fall.”

Japan’s combined real estate and stock bubbles were three to four times larger than America’s, calculates Andrew Tilton, an economist with Goldman Sachs, a major New York banking firm. So the US financial sector’s losses are likely to be “proportionately smaller,” perhaps adding up to $1 trillion, which is well under 10 percent of the nation’s gross domestic product – its output of goods and services. Japan’s cumulative write-offs over the 1992-2005 period reached 19 percent of its GDP, Mr. Tilton notes.

Another positive factor for the US is the strong and quick rescue efforts of the Bush and Obama administrations and the Federal Reserve.

Japan was “slow to recognize [the problem] and slow to do anything,” says Professor Hutchison. The government did not even reveal the bad shape of Japanese “zombie” banks for years, engaging in “disinformation” to keep the truth from the public.

The US had the advantage of learning from Japan. Treasury Secretary Timothy Geithner worked for the Treasury in the US Embassy in Tokyo when the Japanese economy was running into trouble. Fed Chairman Ben Bernanke, as a Princeton University economist, was also familiar with Japan’s problems.

Their goal, figures Hutchison, was “to avoid at all costs” Japan’s “lost decade.” In the first 18 months of the US crisis, the Fed cut interest rates more than five percentage points to near zero. It injected huge amounts of liquidity into the financial system. It announced plans to purchase financial assets amounting to 9 percent of GDP. The US also helped recapitalize financial institutions holding about half of the aggregate balance sheet of the entire financial system, adds Tilton. On the fiscal side, Congress passed a huge stimulus program worth about 5 percent of GDP.

Japan also spent massive amounts on infrastructure (roads, highways, etc.). But critics charge that much of the money was for “roads to nowhere” and did little long-term good.

The result? Both Hutchison and Tilton expect a US recovery soon, though one “weaker than normal.” Tilton foresees some boost from a revived global economy, which he predicts will grow at a 4 percent rate in 2010, attracting some US exports.

A legitimate risk, he argues, is that once business rebuilds depleted inventories and the federal stimulus package of spending runs out, the economy will slow down again in early 2010.

That would boost pressure to enact a second stimulus. Having avoided Japan’s creeping deflation, Hutchison says, the president and Congress should craft any new economy-boosting package in a much more targeted and directed way than the first one and emphasize infrastructure.