By David H Feldman
Originally published March 22, 2001
In many ways, Japan is a special case. Interest rates are essentially zero, banks won’t lend, and people won’t spend. Years of failed fiscal stimulus have left Japan with an enormous public debt. Now the stagnant economy is rapidly sinking into recession yet again. Household spending in January was lower than the preceding January and machinery orders fell nearly 12 percent in January alone. This presents both a challenge and an opportunity for Alan Greenspan as he charts the U.S. response to what is rapidly becoming a global economic slowdown.
The danger to us is not that Japanese spending on American goods will fall, though of course it will. Japan spends nearly ten percent of its income on imports and the U.S. share of that is roughly sixty-five billion dollars annually. A three percent decline in Japan’s income might cost us two to three billion dollars in sales, which is hardly a catastrophe of global proportions. The real risk is a banking meltdown that spreads to financial markets in the U.S. and elsewhere.
Japan’s problems stem from the bursting of its own asset bubble a decade ago. Stock prices and land values are currently well below their 1990 levels. This presents a serious problem for bank balance sheets since land values in major cities back many loans, while stock portfolios valued at inflated purchase prices form much of their assets.
Stock prices have fallen so much that the government may now be intervening in the market using deposits from the huge postal savings system. If this props up stock prices, banks can liquidate some of their portfolios without large losses. Socializing the stock market isn’t new. The same policy was used during the last crisis in 1997. This implicit government backing helps banks to remain solvent while they write off bad loans. It might work if the overall economy were in better shape, but price deflation is spreading in ways that undermine economic growth.
Not all deflation is bad. The good kind comes from opening your economy to lower priced goods from abroad and deregulating your markets to permit more internal competition. Japan has traveled a substantial way down this road, though more internal reform is needed. The bad kind is the partner of falling demand, and it imposes substantial costs.
For instance, the average homeowner who bought his apartment five years ago has seen the value of his asset fall by thirty percent, while his mortgage debt remains unchanged. Economy-wide, this leads people to forego current spending in order to reduce the crushing burden of debt. Decreased consumption then puts downward pressure on wages and prices. Once people expect prices to fall, they have an extra reason to postpone spending, which makes this particular circle quite vicious. So banks won’t lend because low and declining asset prices wipes out their reserves, and households won’t spend because deflation raises their debt burden.
Several years ago Princeton economist Paul Krugman bluntly told the Bank of Japan how to solve this problem. Set a modest but positive inflation target and increase bank reserves (or print money) until you achieve it. This was far too radical for the Bank, which thought it had run out of options as interest rates neared zero. On Monday the Bank finally capitulated and announced it would do just that. It helps that all the traditional cures for recession have failed.
Japan can pursue this remedy all by itself, but the Fed should be a cooperating partner. Significant increases in the Japanese money supply will batter the already weakened Yen. This would likely stimulate the Japanese export sector, but it would also reduce consumer purchasing power. Japan’s problems are internal, with insufficient domestic demand and unfinished bank restructuring, not with external factors like the trade balance or the value of the Yen. And American manufacturing industries are already complaining about how the rising dollar is damaging their profitability. With the US trade deficit nearing a half trillion dollars annually, the time is past when every nation could export its macroeconomic problems away.
Alan Greenspan can help by coordinating a joint loosening of monetary policy with the Bank of Japan. A reasonable goal would be to maintain a fairly stable relationship between the dollar and the Yen. Tuesday’s half point rate cut may not stem the dollar’s rise against the Yen. This may necessitate a larger decrease in U.S. interest rates than he would otherwise have chosen. That is the price of being the world’s preeminent central banker.
David H. Feldman is a professor in the economics department at the College of William & Mary
Copyright © 2001, The Baltimore Sun