Money Sage (archive)

Not yet. But we are getting closer and closer to the infection point.

What, precisely, is the Japanese disease? The Japanese disease is the ailment which brings an economy as close to a classic depression as is possible in the Keynesian era -- the post-Depression era where the core of economic wisdom is the following: in the face of economic contraction where aggregate demand is sinking, the government borrows, borrows, borrows, and spends, spends, spends. This is popularly termed: DEFICIT SPENDING.

The great English economist demonstrated, in both theory and practice, that deficit spending on a sufficiently great scale could contain economic contraction within certain limits. In truth, since World War II, which marked the actual apogee of deficit spending, is conventionally ignored in analyzing the impact of deficit spending, we look to the 1930s as the great experiment and revealer of truth about the therapeutic/curative power of deficit spending. Deficit spending -- along with certain structural reforms which we shall come to in a moment -- did indeed contain and partially roll back the acute economic crisis known as the Great Depression. The Roosevelt Administration, however, regressed to the orthodox economic thinking of the time after the worst of the crisis was passed. It trimmed, then eliminated deficit spending in the sacred quest for a balanced budget. Result: recession and a new bear market in stocks. From the macroeconomic point of view, the outbreak of war in Europe was a godsend: the need to rearm Britain and then to aid Russia, and finally, to arm our own forces following our entry into the war provided a stupendous economic stimulus, fuelled in large measure by a huge ramp-up in government borrowing and spending.

Without the war, all would have been well had the Roosevelt Administration persisted in, and become much more aggressive in, deficit spending. Building bridges that lead to nowhere, if financed by heavy government borrowing IS HIGHLY BENEFICIAL to the economy. Admittedly, it would be far better to borrow and spend money developing productive assets. Nevertheless, it is the very act of heavy government borrowing and spending which provides a crucial safety net for the economy when a depression threatens. As a contemporaneous sidelight, we want to note that the employment of exceedingly heavy deficit spending to finance roads which led nowhere by the Japanese government subsequent to the real estate and stock market collapses, and the onset of a general deflation, SERVED AS AN INDISPENSABLE AND INVALUABLE COUNTER to the mighty contractionary and deflationary forces which threatened in the past 15 years to plunge Japan into a classic Depression, with consequences worse, by orders of magnitude, than those the Japanese people have actually suffered.

In an economic/political environment where the Keynesian response to economic contraction and deflationary threat are regarded as LEGITIMATE -- even Nixon, as president, noted: "We are all Keynesians now" -- modern societies possess a critically important buffer to the onset of a classic depression.

There are, in addition, certain structural reforms in the financial system. Of prime importance is the institution of deposit insurance. Government-guaranteed deposit insurance -- backed ultimately by the government's power to tax and the government's ownership of the printing press -- preclude the risk of depositor panic. Such a classic money panic, more than anything else, counter-transmutes the inevitable down-phase of the business cycle from recession into massive depression. It is the sudden disappearance of capital -- and the attendant unmeetable demand upon inevitably illiquid banks that they make good, immediatly, on their obligation to the entire generality of their lenders (i.e., depositors)-- which creates a sudden monster vacuum which sucks the guts out of an economy at warp speed.

Other aggregate demand-sustaining reforms -- old age pensions, unemployment insurance, continuing government subsidies to the poor, children, the ill, etc. -- similarly serve to contain the impact of a financial typhoon.

Finally, and of prime importance, is the proper behavior of the central bank. This institution occupies the crucial mediating position between the financial system and the economy. If it acts PROMPTLY, IN A SUFFICIENTLY AGGRESSIVE manner, to counter a developing asset deflation, then a general depression can be averted. And if it does not? In that case, WATCH OUT BELOW.

Let us return to Japan. The essential preconditions for the Japanese depression (we use this term to describe the lingering, enervating, impoverishing illness which can protract for many years in the era deficit spending and minimal aggregate demand maintenance via income transfer programs) are as follows:
--a prior period of prosperity, characterized, in its latter phases, by
--a speculative surge mushrooming into a speculative mania, resulting in
--asset prices (real estate and/or equities) reaching astronomical levels, bearing no relationship to underlying value or income-producing capability), leading
--the central bank to tighten monetary policy until it sees RESULTS, in the form of
--asset price implosion and economic contraction.

In the case of Japan, it was the FAILURE of the central bank to RECOGNIZE the DEFLATIONARY threat which led it to FAIL to act appropriately. The Bank of Japan (BOJ) drained TOO MUCH LIQUIDITY from the banking system, and kept REAL, i.e., inflation-adjusted, interest rates MUCH TOO HIGH FOR WAY TOO LONG. As a consequence of this gross policy failure, and DESPITE the subsequent orgy of deficit spending, the existence of bank deposit insurance, and aggregate-demand maintenance government transfer programs, Japan went into a 20-year depression. Japan's share of the global economy shrank from 18% to 8%; Japanese families were trapped in multi-generational mortgages which, because of the 90% PLUS decline in apartment and house prices, exceed the market value of their properties by 200, 300, 500%. The value of their equity investments has shrunk by 70% since 1989.

To take the analysis one level deeper, let us consider the monetary and economic consequences of the BOJ's WRONG MONETARY POLICY. By adopting and maintaining too restrictive a policy for too long, in the context of a collapsing monster real estate/stock market bubble, the BOJ caught itself in a classic LIQUIDITY TRAP. A liquidity trap occurs when the rate of inflation has sunk to zero, or less. In such an instance, the central bank LOSES ITS ABILITY TO STIMULATE THE ECONOMY INTO RECOVERY. The reason for this is simple: the central bank can only take rates down to ZERO. If prices are actually flat, or falling, then the LOWEST REAL INTEREST RATE THE CENTRAL BANK CAN SET IS POSITIVE. Since it is normally necessary to bring rates at least 2 points below the rate of inflation in order to incentivize borrowing, and the spending and investment which hopefully will follow in its wake, the central bank has lost its ability to produce the necessary stimulus via interest rates.

This then, is where Japan sits, today, more than a decade after the general deflation began.

And America? There are pluses here the Japanese did not have, giving the central bank more room for error. (Of course, we must very seriously and very regretfully note that the FED seems to be very adept at multiplying its policy errors, thereby steadily eroding its margin for ADDITIONAL ERROR).

What are these positives?
1.Our real estate bubble burst at a much, much lower point than the Japanese real estate bubble; all other things being equal, the collapse will be far less severe;
2.The American public is much less patient and tolerant of economic pain than the Japanese public; the media is less restrained. Consequence: American politicians will turn up the heat on the FED a lot quicker, and a lot more powerfully, than was the case in Japan;
3. Important economists and public figures have demanded action from our slothful, intellectually deficient central bank: the public clamor is rising.

The wretched performance of the FED in failing to fulfill its regulatory responsibilities vis-a-vis the subprime poison, did, of course, allow the real estate bubble to inflate far beyond manageable levels, and it did magnify the risks attendant upon the inevitable collapse.

This profound negligence was amplified by an incompetent monetary policy, driven by the emotional, hysterical, and groundless monomaniacal obsession of many FED "policymakers" with the most lagging of all economic indicators -- inflation. This assures a much greater level of economic pain for a much longer period than would otherwise have been the case.

In the final analysis, the FED is much less insulated from political and public pressure than was the BOJ. Our people and our society have a very different temper. Thankfully, the de-mystification of the FED is proceeding rapidly now.

Finally, the key to FED policymaking is the personality and character of the key decision-makers. As we have said repeatedly, these are weak, weak men. In posts we wrote as far back as last summer, we predicted that they would cave. And caving they are.

We would venture the following prediction about FED policy: they will AGAIN take interest rates TOO LOW and will produce TOO MUCH LIQUIDITY, OVERCOMPENSATING for their prior over-restrictive policy, just as they created too much liquidity in 2002 and 2003.

Our bottom line for monetary policy, and we mean this very seriously, and are unable at present to offer any alternative:
MONETARY POLICY IS FAR, FAR TOO IMPORTANT TO BE LEFT TO THE FEDERAL RESERVE.