Monday, September 22, 2008

Will the US be like the Japan of the 1990's?

The most important event to destroy the modern macro orthodoxy was the Japanese bust that became their lost decade. The idea of liquidity traps was almost thrown out of many textbooks as a Depression artifact and not relevant for thinking modern central banking. Japan tried to control interest rates and provide support for the economy but nothing worked until the rate targets were abandoned and a policy of inflating the economy was applied without any constraints. Government debt sky-rocketed during this period but it was a the reflation policy that made a difference. Zero interest rates were the target. It should be noted that it took years before the Japanese government tried to bail-out the banking system which was a contributor to the length of the crisis. Procrastination made matters worse.

Unfortunately, the reflation strategy with a slow bail-out was a long and hard road and should send sobering chills to American citizens. Housing values are only 40% of their 1990. The main Japanese stock index is still down 70% from its peak. Japan's national debt topped 100% of its overall economy. The debt of the US is now at about 40% of the total GDP ($9.5 trillion on a $14+ trillion GDP). The $700 billion bail-out actually will not be that large on a relative basis but that is assuming that the plan works.

The Japanese analogy is real but the hope is that faster action will mitigate some of the long-term harm of the current credit crisis.

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