Top economists and policymakers in the U.S. say that they are focused on the domestic troubles, but I have a feeling these days that their minds are often wandering off thousands of miles away to the Far East, for example, towards a country that has been in an economic funk for two decades, the cause of which sounds awfully familiar to Americans. It all started with a real estate bubble, which first exploded and then created a huge financial crisis. It was retained within the country’s borders, but the havoc it wreaked surpassed the size of the initial impact.
Which country’s cautionary tale this is? Japan’s. How well does it translate to North America? Too well, I’m afraid.
As the recovery in the U.S. loses wind, more economic theorists are coming up with theses that the slower growth we are experiencing now in North America seems very much like an overture to the Japan-like economic melancholy, manifested through recurring recessions of various degrees, lackluster recoveries and, more importantly, an environment of declining prices.
Of course, this is not the outcome anyone was hoping for and it is receiving more and more attention. Particularly attuned to the changing mood is the bond market. For example, government bond yields are flashing signals at full blast that months, quarters and even years of slow growth are ahead of us. In the U.S., yields on two-year government notes decreased below 0.5% last week for the first time ever. The reason for the drop was more than disappointing U.S. unemployment numbers.
Again, a parallel with Japan could be drawn. Japan is very familiar with this “bond-yields-sinking” feeling, having to endure it for over 20 troublesome years. And, even after all that, the recent decline of Japan’s 10-year government bond yield below one percent to its seven-year low was doubly disappointing, at least to the country’s economists and policymakers. It must be fatiguing fighting something for so long with everything you’ve got and still seeing little to no results.
You could say that the Federal Reserve Chairman, Ben Bernanke, has been almost obsessed with Japan and what happened with the country’s economy. He publicly committed to “doing [in America] all the things I told the Bank of Japan to do.” And if the obsession before was to do everything humanly possible to avoid Japan’s mistake, the obsession these days is whether it will be enough to stave off disaster.
Here is what might be keeping Bernanke awake at night. First, just like the U.S., Japan also experienced huge peaks and lows, driven by super inflated values in the real estate market. When Japan’s real estate market imploded in the early 1990s, it more or less paralyzed the country’s banking system. Two decades later, it is still convalescing and still not looking peachy.
During mid-1990s, prices in Japan started falling precipitously and have been combating deflation ever since. Since that time up until last year, Japan has reverted into some recessionary form or another five times. In 2009, the country’s GDP, adjusted for inflation, was lower than in 2004.
I have to say, while parallels exist and are definitely scary, prices in the U.S. are still increasing, albeit barely. In June, core inflation increased 0.9% compared to June of last year. Still, the current price environment in the U.S. is among the lowest in the past four decades. The good news — for now — is the fact that prices are at least stable and there is still some chance for the economy to heal itself. But if the prices start declining more aggressively, the overall economy could start on a very unpredictable and unstable path.
Believe it or not, deflation, and not inflation, has the power to keep economists wide awake every night. What likely frightens them, as it frightens me, is the potential to get caught in a whirlwind downward spiral, caused by lack of demand, which, in turn, triggers declining prices because consumer spending has dried up and all everyone wants to do is put away money, depressing the economic activity even more.
Incidentally, Japans deflation did not follow this scenario. True, prices have declined in Japan, but not as much as it was expected. They have been declining by a modest one percent every year, pulling the country more through a low-grade fever than through a violent infection.
However, just because Japan did not end up with the worst-case scenario, it does not mean that it did not end up in very bad circumstances. While Japan is not likely to sink like Atlantis, it is not exactly a growth-producing machine either. This has created an uncomfortable situation for a country with significant personal savings rates and the unusual amount of social cohesion.
Japan’s most likely saving grace is the fact that there is still strong global demand for its products. It is a significant cushion providing Japan with the safety net the country needs. That cannot be said for U.S. exports, however. On the other hand, the U.S. response to the financial crisis was much faster and more aggressive than Japan’s. Additionally, although today’s bank lending is a far cry from the pre-2008 crash levels, U.S. banks are still lending, albeit anemically, while Japan’s seem to have gone on a permanent holiday.
How this story will play itself out in the U.S. remains to be seen. Making predictions about where the prices are going to go is impossible to make at this stage. The U.S. is dealing with a mountain of debt that will take a seriously long time to unwind, potentially at a price of losing an entire decade, perhaps two, like Japan.