Comparing Crises

WORSE AND WORSER
Robert Madsen

In "The Japan Fallacy" (March/April 2009), Richard Katz argues that it is wrong to see the economic stagnation Japan suffered in the 1990s as a precedent for what is now happening in the United States. The U.S. crisis, he says, is smaller in scope and has elicited a more forceful government response; it will therefore prove significantly less damaging. But his focus on the U.S. economy is misplaced: it is not North America but rather the entire world that is on the verge of a Japanese-style disaster.

OF SAVINGS AND BUBBLES

Both Japan's "lost decade" and the current global debacle stem from a combination of excess savings and the deflation of immense asset bubbles. Japan's troubles began in the mid-1980s, when the baby-boom generation entered late middle age, the stage in life when people everywhere save a high proportion of their incomes in anticipation of retirement. The chronic elevation of the national savings rate that ensued was problematic inasmuch as savings are by definition foregone consumption, which implies weaker domestic demand and lower GDP growth. This problem was not immediately evident because a combination of loose monetary policy, innovations in financial technology (zaitech), and bad regulation led to the inflation of an asset bubble and a boom in corporate investment. Along with big trade surpluses, these developments sustained overall demand and rapid GDP growth through the end of the decade. But in 1989-91, the bubble collapsed, traumatizing the Japanese people and reinforcing their predilection to save even as corporations gradually started paying down their debts. The loss of investment caused by this deleveraging both revealed and exacerbated the underlying shortfall in consumption.

This insufficient demand was the key to Japan's lost decade. Textbook economic theory suggests that a country with too much savings should export that capital, essentially lending money to foreigners to buy the goods and services that cannot be sold in the home market. Countries such as Singapore and Switzerland have done this in the past, running current account surpluses nearing one-tenth of their GDPs for extended periods of time. But Japan was so massive a commercial power that the rest of the world could not absorb the requisite volume of funds: the country's external surplus was effectively limited to half the level necessary to keep GDP expanding at its potential growth rate. The other half of the capital stayed pooled up inside Japan, where the corresponding lack of demand undermined industrial output, prices, and interest rates. The country was in danger of succumbing to a full-scale depression.

A WORLD AWASH IN CAPITAL

The same pattern of excess savings, temporarily concealed by a bubble but then aggravated by its bursting, characterizes the world today. As recently as a year ago, the consensus was that the so-called global financial imbalances were caused by excessive spending in the United States and a few other profligate economies. To finance their overconsumption, these countries sucked copious funds out of more frugal economies. An equally valid explanation, however, focuses first on the parsimonious countries. Among these were China, Japan, and other aging nations, in which people saved much of their incomes in preparation for retirement; the states of the developing world, which emerged from the financial crises of the 1990s determined to accumulate huge piles of foreign reserves for use in the event of future turmoil; and those commodity exporters whose earnings grew dramatically during the boom of recent years. The upshot was much more money flowing into international capital markets than would otherwise have been the case.

These surplus savings posed the same threat to the world that they had previously represented for Japan: if not neutralized by countervailing demand from somewhere, they would produce intense deflationary momentum and a prolonged recession. It was in this sense fortunate that the United States and the other high-consuming countries persisted in running big current account deficits. The extra capital generated in East Asia and the developing world was amplified by largely unregulated financial innovation and increases in leverage -- a pattern that recalls Japan's experience in the 1980s. The money poured into the most liberalized markets, including the real estate sectors in Australia, Spain, the United States, and the United Kingdom. Households in those countries then used the appreciation in the value of their homes to finance additional consumption, effectively absorbing the surplus liquidity and providing the demand necessary to propel global GDP growth.

In 2007-9, this ultimately unsustainable pattern started to unravel in a largely unanticipated way. Most observers had reckoned that investors would eventually lose faith in an ever more deeply indebted United States and withdraw their money from its markets, thereby triggering a dollar crash that would increase U.S. exports and curtail imports. The current account deficit would thus contract significantly. What actually happened, however, was a more harmful resolution of the imbalances, one affecting exclusively the import side of the ledger. The adjustment started when trouble manifested in the U.S. subprime market, revealing that a range of financial institutions in the United States, Europe, and elsewhere had assumed dangerously large volumes of debt. Like their counterparts in Japan in the 1990s, these firms reacted by selling assets and calling in loans. As the value of market securities began to erode, other lenders saw their balance sheets deteriorate and decided that they, too, needed to raise cash. The resulting wave of asset sales has so far wiped out close to $15 trillion in U.S. wealth alone, which has caused consumers to expand their savings severalfold. Because of this sudden reduction in demand, the U.S. current account deficit will decline from its 2006 peak of six percent of GDP to less than two percent of GDP in 2009 and will remain depressed for several years.

Since global exports of capital must mathematically equal global imports of capital, creditor countries will see their current account surpluses shrink. This is already evident. Japan's surplus will probably drop from a high of 4.8 percent of GDP in 2007 to just 1-2 percent of GDP this year. Beijing announced in March that China's exports fell by 26 percent between last February and the previous February. Comparable results should be expected for Germany and other major trading powers, as well as for the smaller economies that depend on these countries. This year, accordingly, promises to be the first since 1945 in which global GDP actually decreases.

THE JAPANESE RECOVERY

Given that the world today suffers from a shortage of demand similar to that which afflicted Japan in the 1990s, what lessons can be gleaned from Tokyo's attempts to recover? With consumption and investment decreasing and strong growth in net exports precluded by foreign opposition, the only source of new demand available to Japan at that time was the state. So the government budget swung inexorably from a slight surplus at the beginning of the decade to an ever-larger deficit. Tokyo recapitalized its banks in 1998, and a few years later the central bank lowered short-term interest rates to zero and embarked on a modest program of quantitative easing. But these measures only managed to stabilize the financial system, while enormous deficits -- between 1989 and 2003, Japan's national debt rose by the equivalent of its 2003 GDP -- filled the gap in demand and generated an average annual economic growth rate of about one percent.

Japan began a stronger recovery in late 2002. Domestic reforms contributed marginally to this improvement, but progress was primarily the doing of the surge in growth in China, the United States, and East Asia, which began buying more exports from Japan. The ensuing expansion in Japan's trade account produced roughly one-third of the country's GDP growth over the next several years, and corporate investment designed to meet future overseas demand also contributed significantly. Prime Minister Junichiro Koizumi and other Japanese leaders took credit for the commercial efflorescence, de-emphasizing the crucial dynamic from overseas and arguing that they had finally imposed the requisite structural reforms. But this was not true. When the collapse in U.S. consumption eviscerated global demand in late 2008, Japan's exports, industrial output, corporate profitability, and investment plummeted in sequence. The country is now poised for a 5-6 percent contraction in GDP this year, its worst performance since 1945 and a powerful rebuttal to the claim that sagacious policy was responsible for the 2002-7 recovery.

A GLOBAL RECOVERY?

The world now stands roughly where Japan did in the early 1990s, when it had made some progress on its task of reducing leverage but was far from done. The question is whether the United States and other countries are doing enough today to stabilize the world economy and precipitate growth in similar circumstances. Largely ignoring the international aspects of the financial crisis, Katz focuses on Washington's policies, explains that they are more aggressive than Tokyo's were at first, and concludes that the United States will therefore recover more quickly. This analysis, however, rests on four dubious propositions.

The first is the belief -- stated explicitly about the U.S. economy and implied about the world -- that the present challenge is less grave than that which confronted Japan almost 20 years ago. The opposite may in fact be the case. In the United States, the investment banking industry has been decimated, hedge funds and private equity groups are faltering, the automobile industry is in deep trouble, financial fraud has proved widespread, and an estimated eight million homes are now worth less than the mortgage debts associated with them. These factors, and the popular anxiety they cause, partly explain the sudden rise in household savings. And there are other hidden dangers, as is suggested by the fact that the investor Warren Buffett, the insurance company AIG, and other significant market participants have sold insurance against further declines in securities prices -- and then used the funds thus raised to make additional leveraged investments. Meanwhile, Washington is saddled with big deficits and major commitments in Afghanistan, Iraq, and elsewhere. In some respects, therefore, the United States' position today may be weaker than Japan's was in the early 1990s.

Furthermore, Japan's illness occurred in a relatively benign international environment. To be sure, the yen was strong and foreigners criticized the trade imbalance, but the world was growing and overseas demand was generally strengthening. The first decade of this century would in fact bring a prodigious expansion in the foreign appetite for Japanese exports.

Since the same is not true of the world today -- there is little chance of a boom in exports to other planets -- the only solution is an upturn in spending somewhere within the system. Ultimately, this means stronger consumption and more corporate investment in China, Japan, and the developing world. The likelihood is small, however, that such a change will materialize within the next several years now that the deleveraging process has destroyed, according to a March 2009 report by the Asian Development Bank, nearly 40 percent of the world's total wealth. Persistently weak consumption and investment, deflation, and protracted stagnation therefore remain likely.

The second problematic notion in Katz's article is that countries are still committed to free trade of the sort that so benefited Japan. The truth is more complicated. When they recapitalize their banks, governments understandably insist that those institutions maintain or expand their lending to domestic corporations and households. But since those lenders need to redress their balance sheets, they feel compelled to call in the credit that they have extended to foreign companies. The consequence is the fragmentation of the global financial system and the loss of credit for firms that borrow heavily from abroad. Hoping to protect their own citizens, governments also try to ensure that their fiscal stimulus is directed toward domestic actors rather than international ones. Unless they are interrupted soon, these politically logical but economically regrettable tendencies may eventually Balkanize the global trading system. Such a development would render recovery more difficult for both the United States and the world.

Third, Katz seems to believe that Tokyo's efforts at bank recapitalization, monetary easing, and fiscal spending were responsible for the 2002-7 recovery. That notion is belied both by the importance of exports and outward-oriented investment in that period and by the economic disaster that is now enveloping Japan.
Katz's fourth questionable argument is that U.S. authorities have acted more rapidly than the Japanese government did. This is superficially true. It took Tokyo a decade to arrive at an aggressive set of stimulus policies that ultimately proved inadequate, whereas the United States has achieved the same feat in just 18 months. Former President George W. Bush's small stimulus scheme; President Barack Obama's package, which delays most of its expenditures until after 2009; recapitalization programs whose details keep changing; and quantitative easing that has yet to stabilize asset markets or ameliorate disinflationary pressures -- these hesitant policies cannot stop deleveraging within the United States, let alone interrupt the more damaging global process.

Early indications regarding Washington's emerging strategy are also ambiguous. On the one hand, the administration has said it wants to triple the International Monetary Fund's funding in order to support eastern Europe and other regions as well as to persuade the European Union to join a worldwide program of fiscal easing. This clearly makes sense. On the other hand, the White House's expectation that U.S. GDP will grow by 3.2 percent in 2010 and then rise to four percent in subsequent years is risible. Also curious was Treasury Secretary Timothy Geithner's statement to Congress in early March that the government must not spend too much lest it "crowd out" corporate investment. This erroneously presupposed that in two or three years there would be significant new private-sector demand to be displaced. Such groundless fears of overheating the economy and creating inflation merely confuse the public and complicate the formulation of appropriate stimulus policies. The United States' actions may at this point look bolder than those that Japan, Germany, and other industrialized economies are now taking, but they are by no means enough.

Although Katz is right that Washington's response has been faster than Tokyo's was in the 1990s, it would be a mistake to conclude that strong GDP growth will resume anytime soon. The ad hoc policymaking and official vacillation displayed by the Bush and Obama administrations resemble nothing so much as the behavior of Japan's leaders in the early 1990s, even as the scope of this tragedy and the nascent protectionism it has engendered invite comparisons with the early stages of the Great Depression. With its arsenal of modern fiscal and monetary weaponry, today's world should be able to avoid a reprise of that debacle. Nothing done so far, however, inspires much confidence.

KATZ REPLIES
Richard Katz

Robert Madsen presents the widely shared view that excess borrowing caused the current global economic crisis and that the crisis cannot end without a painful purging of much of this debt.

I certainly agree with him that strong GDP growth will not return anytime soon. Having refused to apply the needed ounce of prevention, the U.S. government will have to reach for pound after pound of the cure. I also agree that so far the Obama administration's actions have been insufficient, particularly in curing the financial gridlock. But I do not see how Madsen can simultaneously blame Barack Obama for not doing enough and argue that "Washington is saddled with big deficits and major commitments in Afghanistan, Iraq, and elsewhere." If the inference is that this somehow constrains Washington's ability to use fiscal stimulus, then this would perpetuate precisely the false idea that hamstrung Japan. Obama's substantial stimulus package would have been even more potent and front-loaded except that the search for a few Republican votes caused Obama to acquiesce to scaling back a planned expansion of unemployment compensation and aid to cities and states.

To claim that "the ad hoc policymaking and official vacillation displayed by the Bush and Obama administrations resemble nothing so much as the behavior of Japan's leaders in the early 1990s" simply ignores the fact that for years Tokyo denied that there was even a problem to be solved. The United States now has an activist president and an activist Federal Reserve chair, who, if one measure proves inadequate, will go on to another. Such activism is critical, and it was for Japan, too. I have long stressed that there was in Japan then a lot less real structural reform than advertised. As a result, the country's post-2002 recovery was inordinately dependent on exports and thus very vulnerable to a global downturn. Nonetheless, Madsen ignores a crucial point: Japan would have been hard-pressed to gain from global growth if the Koizumi administration had not resolved the country's decadelong bad-debt problem (see "How Able Is Abe?" March/April 2007).

Madsen cites an Asian Development Bank finding from a March 2009 report that 40 percent of global wealth has already been destroyed by the current crisis. The number is dubious. Nowhere does the ADB report say 40 percent. It does posit a global loss of $50 trillion; however, based on other figures in the report, that figure amounts to roughly a 20 percent loss. A substantial part of the $50 trillion comes from currency depreciation. Yet on a global basis, one country's depreciation is offset by another country's appreciation. Beyond that, as the ADB points out, what has been destroyed is not real physical wealth -- buildings, equipment, infrastructure -- but the grossly inflated prices of financial instruments and housing. In the United States' dot-com bust, the stock-market value lost equaled 90 percent of U.S. GDP, worse even than the crash of 1929. Yet the United States at the time suffered the mildest recession of the postwar era. What is most harmful today is not the crash of stock prices but the credit crunch.

Where is the evidence for Madsen's claim of "nascent protectionism" that "invite[s] comparisons with" the 1930s? Who in the U.S. Congress is blaming Toyota or Honda for the woes of General Motors or calling for automobile import quotas, as some in Congress did in the 1980s? Toyota and Honda support a rescue for Detroit, partly because they all rely on the same parts suppliers. When Congress tried to insert a strong "Buy American" provision in the stimulus bill, Obama so watered it down that it is now just a little more forceful than the "Buy American" law that has existed for decades.

I completely disagree with Madsen's view that in seeking the source of the crisis, one must "first" look at the "threat" posed by excess saving in China, Japan, and the like, as well as his suggestion that these countries' excessive saving was somehow responsible for excessive borrowing and irresponsible financial machinations in the United States and elsewhere. Economists have long warned that excess saving was China's and Japan's Achilles' heel. But international imbalances in borrowing and saving were a secondary cause of the current crisis compared to the explosion of unregulated derivatives in the United States and globally and a U.S. housing bubble unconstrained by traditional lending rules. As the bubble expanded in 2003-7, the combined purchases of long-term U.S. securities by China and Japan averaged a mere 1.5 percent of U.S. GDP per year. By contrast, home construction and related expenditures accounted for as much as 25 percent of U.S. GDP growth.

Excess borrowing was a manageable problem. What turned that problem into a catastrophe was that so much of the borrowing was funneled into worse-than-useless projects by a broken financial system that gave financial executives incentives to act like buccaneers. The New York Times reported on December 27, 2008, for example, that top executives at Washington Mutual (WaMu) pressured loan officers to approve mortgage applications even when those officers warned of possible fraud. Pumping out lots of "liar loans" earned WaMu abundant fees, thereby generating high bonuses for its executives. Meanwhile, WaMu left others holding the bag by selling securitized mortgages to the pension funds of teachers and bank tellers. Both political parties share the blame, but this recklessness was openly endorsed by the Republican Party in its 2004 platform when it condemned down payments as "the most significant barrier to homeownership."

How do those who deny the pivotal role of financial deregulation explain the much lower rate of home foreclosures among cases in which traditional regulations were enforced? Among the loans guaranteed by Fannie Mae, most of which met traditional standards regarding down payments and proof of ability to pay, only 0.65 percent were in foreclosure as of the third quarter of 2008, compared with 21 percent for subprime adjustable-rate mortgages.

Is the United States' debt problem today really so severe that it might precipitate a Japanese-style "lost decade" or even a repeat of the 1930s? Aside from those in the automobile sector, most nonfinancial U.S. companies are in good shape. Whereas nonfinancial corporate debt increased at an annual rate of 6.3 percent between 2002 and the end of 2008, total assets (financial as well as land, buildings, and equipment) increased by 6.2 percent. At the end of 2008, these companies owned twice as much in financial assets alone as they owed in debt -- a higher such ratio than during any postwar year prior to 2001. U.S. companies today are also in a far better position than were their Japanese counterparts on the eve of the lost decade. Back then, the ratio in Japan of corporate debt burden to total corporate net worth (financial and physical) was four times as high as in the United States today.

Household debt has increased faster than household income, but again, so have assets. Despite a 16 percent record drop in wealth between the peak in September 2007 and December 2008, U.S. households ended 2008 with an average net wealth (assets minus debt) that added up to 4.8 years' worth of income. That is close to the average net wealth of five years' worth of income that has prevailed in the United States for a half century. Today's wealth destruction is a correction of bubble levels. U.S. households can adjust to this correction just as they did to the correction during the less severe dot-com bust -- so long, that is, as jobs stop disappearing.

For most U.S. firms and U.S. households, unpayable debt is not the cause of the U.S. crisis but its result. The credit crunch is depriving healthy firms and households of needed funding, leading to plunging car sales and millions of layoffs. In other words, the falling economy is transforming healthy firms into vulnerable enterprises that can survive only by slashing core costs in order to reduce debt, and it is making once-solvent households bankrupt. There is no reason to wait ten years to unfreeze the credit system or to underpin the economy through a massive stimulus.