Lessons from Japan's slump
US policymakers take note: Let markets clear.
A little knowledge can be not just dangerous but grossly misleading. That is the right conclusion to draw from the latest, surprisingly reassuring data about the US economy and from the interview in Thursday's Wall Street Journal in which Sen. Hillary Rodham Clinton warned that America must avoid a "Japanese-like situation."
Senator Clinton should have researched what actually happened in Japan after its financial crash before using the bogeyman of a Japan-style malaise to support her proposal that taxpayers' money be used to bail out holders of troubled mortgages. She claims that Japan's mistake was to rely excessively on monetary policy to rescue its economy, rather than on fiscal and other measures. The truth is the exact opposite.
Japan's stock market collapse began in January 1990 and continued throughout that year. The property market followed, with a lag. Yet the Bank of Japan did not try to prevent this financial crash from damaging the real economy by cutting interest rates, as the US Federal Reserve has done spectacularly during the past three months. To the contrary, Japan's central bank carried on raising interest rates until September 1990 and did not make its first cut until July 1991.
In fact, it did not begin using monetary policy as an aggressive tool to arrest the slump until deflation had set in toward the end of the 1990s. Japan did do two things: It used a massive increase in public spending to try to rescue indebted firms and inject money into the economy; and it helped banks conceal the extent of their losses and bad-debt burdens, to prevent markets from clearing at painfully low prices.
The best that can be said about the Japanese experience is that its vast fiscal stimulus may have averted a deep recession at the price of a long stagnation. It also greatly delayed the necessary restructuring of the country's banking system and, by providing huge cash flows to political lobbies, greatly delayed political reform – a mistake from which the country is still suffering.
The circumstances of Japan in 1990 and the United States today are, of course, different. Nevertheless, some parallels that can be drawn may be instructive.
One is a bearish indicator that should make economists and financial markets cautious about US economic data. In Japan in the early 1990s, it took an amazingly long time for the collapsing financial system to drag the economy down. Indeed, for two years, some commentators claimed that the crisis was a mirage.
It took so long for the underlying impact to become visible because the first losers in Japan's stock market crash were financial: banks, insurance companies, and other institutional investors. The damage to the real economy came when private companies and consumers began to find their credit conditions worsening and their debt-service costs unaffordable.
So far, given the magnitude of events in US and European credit markets and in the US housing market, the economic data are quite mild.
The real lesson from Japan is: Be careful in jumping to judgment. We have yet to see how US consumers will respond to declines in house prices and to job insecurity; we have yet to see how far the write-offs by banks and investment banks will feed into changing credit conditions for private companies.
The other lesson is that not allowing markets to clear, or at least reach some sort of new equilibrium, risks storing up even bigger problems for the future. The biggest differences between the US and Japanese economic and financial systems lie in flexibility, transparency, and rapid adjustment to new realities. America at its best is a mark-to-market, take-your-punches economy, whereas Japan was and is a coverup economy.
That is why the thought of direct federal intervention in the housing and mortgage markets makes me squirm. To socialize the problem in that (massive) way would be profoundly un-American and, worse, could help turn recession into stagnation, as it did in Japan.