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.