A Lost Decade?

The one issue that seems now to be occupying the minds of the better analysts is how soon will this crisis be over and what will be the engine of recovery? To that end I highly recommend Martin Wolf’s piece in today’s Financial Times: FT.com / Columnists / Martin Wolf – Japan’s lessons for a world of balance-sheet deflation

The growing concern is that the stimulus just signed into law here in America is hopelessly inadequate for the task. The gap between potential GDP and actual GDP dwarfs the rather timid effort of the Obama administration, and given the ridiculously slow nature of the American political system along with the extraordinarily backward ideology of some of the participants in that process, we are unlikely to get another package too soon.

Which brings up the inevitable question: if the textbook is being ignored because of the lack of political will, what within the private sector will get us moving again?

Quick answer: nothing.

The economy is awash with debt. During times of asset deflation debtors typically, and rationally, seek to pay down debt rather than spend. That merely sets up the process identified by the American economist Irving Fisher back in the 1930’s: the rational response of the individual produces exactly the opposite effect from that we require for recovery. Asset deflation has a tendency to plunge economies into the economic equivalent of a black hole. Stuff goes in, but nothing comes out.

As long as debt reduction remains the paramount concern of consumers and businesses our only hope for growth is government borrowing on a grand scale.

The Japanese experience from the 1990’s is being used as the closest approximation to where we seem headed. A decade of very low or even flat growth while debtors steadily paid down their loans. Japan’s ‘Lost Decade’ was the cause celebre in Paul Krugman’s recent book on Depression Economics [the book is here: Depression Economics], and has been studied widely. The general view now is that even though the 1990’s were tough for Japan their government’s policy was a fair success: the situation could have been a whole lot worse. It took a massive run up in government debt, almost tripling in ten years, and a good amount of luck, for the Japanese economy to get back to growth in 2002/2003.

The good news is that America is not quite in the same hole. The bad news is that the American debt problem extends into the financial sector as well as households. This means we have to overhaul two major sectors or our economy, not just one. As Wolf says: balance sheets matter.

Building from the Wolf article, Krugman has some analysis this morning to show the various contributions to growth that finally rescued Japan. Krugman’s Chart. His point is that it was Net Exports [he uses the abbreviation ‘NX’ for ‘Net Exports’ which is the standard notation for this statistic] having the biggest impact in the eventual Japanese recovery. Unfortunately, as he notes, we cannot expect that to happen here if the entire world is in recession, there would be no one to import our goods, so consequently no export led recovery. So we are left looking at a grim prognosis.

Eventually the analysis always points back to the same thing: huge, and I mean huge, public debt.

And in that vein the stimulus package was a vapid flop. We need more and we need it now.

But since that won’t happen, we are more and more likely to be fumbling our way through our own ‘Lost Decade’.

Not a pretty picture. But a testimony to the poverty of our willpower.