Lost Decade, Found Wisdom

Rapidly changing technology brings new products into the home at a pace never seen before. Rising home prices lure renters into buying and tempt homeowners into moving up. A sea of new lending instruments fuels both a boom in consumer purchases and an explosion of investment derivatives.

If that sounds like a description of the last eight years, it is. It's also a description of America in the 1920s.

Eighty years ago, consumers were eager to own vacuum cleaners, radios, and refrigerators -- just as consumers today lust after DVRs, flat-screen TVs, and the latest computers. And in both cases stores and banks extended more and more credit to keep the debt-driven action going. Thanks to efforts both then and now to free the financial institutions from regulation and "creativity" among lenders, the pool of available debt became staggering.

For most of the nation's history, the burden of debt was equal to about half the gross domestic product. Only twice did that debt rise so sharply that more money was owed than the total of all the goods and services produced by the national economy. Once was in 1929. The other time was in 2008.

In both cases the increase in debt was rapid, shooting up in less than a decade from normal levels to unsustainable heights. The result in both cases was a fragile, debt-driven economy -- a tower of spun sugar, ready to shiver apart at the first stiff breeze. The structure of the Great Depression and the Great Bushwhack are remarkably similar. Both are outgrowths of Laissez-faire purists driving down barriers to greed and of government neglect.

Even though there are conservative sources that now try to paint the Great Depression as nothing more than an ordinary recession grown fat on a mishandled recovery, the facts are very clear. Starting in 1929, the economy suffered an extraordinary four year decline, creating an event whose severity was unmatched at the time -- and which will hopefully remain unmatched in the future. The crash of 1929-1932 did not begin to recover until Franklin Roosevelt took office and implemented the first programs of the New Deal. Those programs, and the immediate positive effect they had on the struggling economy of the 1930s, serve as the model for the stimulus package that President Obama is pushing forward today.

There's little doubt that the current economy has much in common with that of the 1930s. However, after seventy years in which the conservative media has done much to muddy every fact concerning that tough decade, it's hard to argue either the cause or the consequences of the Great Depression without running into walls of FUD. We can be grateful that there have been no matching periods in the years between then and now, but from the position of making economic arguments, it would certainly be nice to have more than one example with which to work. As it turns out, we do; one that happened just a decade ago and ten thousand miles away.

For many Americans, there was a kind of unspoken satisfaction in hearing news accounts of Japan's economic woes during the 1990s. Only a few years before, the news had been full of tales of how America had surrendered its position at the center of the world economic stage to Japan. Japanese electronics had already replaced old familiar names on the shelves. Japanese cars had developed a reputation for reliability that domestic autos couldn't match. American managers were looking to Japan for lessons on how they could capture some of Japan's extraordinary burst of productivity. And scaremonger authors like Michael Crichton were warning that within a few years Japan would buy up America and turn it into a franchise of Japan, Inc.

Instead the Japanese economy seemed to run out of steam just as they were becoming the focus of the world's envy. While America under Bill Clinton was experiencing a decade with a strong, growing economy and other nations, such as China, were expanding at a breakneck pace, Japan could only tread water. Their "Lost Decade" of little or no economic growth became a cautionary tale... but no one seemed very clear on either the cause of the economic slowdown or the reasons why the Japanese economy was slow to recover from what at first seemed like just another business cycle recession.

In 2003, economist Richard Koo published Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications. In this work, Koo documented how the Japanese response to their economic growth in the 1980s was a period of both increasing consumer spending and massive growth in real estate prices. The price of land in Japanese cities reached a point where it was doubling many times faster than incomes. Still, so many Japanese had become wealthy that the price of real estate seemed to have no limits. One woman spent more than a million dollars to buy a strip of land only a few inches wide, so that she could expand her driveway to fit her new luxury car.

Koo's work pointed out just how Japan had gotten itself in trouble by running up asset values and growing debt. America, in the middle of a growing real estate bubble and debt disaster, wasn't listening.

In Japan during the 1990s, as with tulips and the seventeenth century Dutch, there came a day when assets failed to sell for the expected price. Immediately, individuals and corporations began to be more frugal in their spending... and the bubble burst. Spectacularly. Real estate values fell 87%. Consumer spending plunged. The Lost Decade (which would actually last for a good fifteen years) was on.

In his new look at that crisis, The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession Koo revisits the lessons of Japan's economic experience and ties them into the Great Depression. In this book, he spells out something that should have been obvious, but which many economists (and perhaps all Republicans) have failed to grasp: economic models built to model boom times are worthless in recessions. Worse than worthless, actually, as the same factors that can cause a bubble only serve to aggravate the problems once the down cycle has begun.

What Koo shows is that, both in America in the 1930s and in Japan in the 1990s,companies and individuals had gotten their balance sheets into such a mess that there was only one agent with enough clout to keep the system from complete collapse: the government. Not all the actions of the Japanese government were effective. Just as happened recently in the United States, the Japanese equivalent of the Federal Reserve Bank chopped interest rates in an effort to restore market liquidity. In fact, Japan cut it's rate to zero. It didn't work. Frightened companies with mounting debt and shrinking sales were in no mood to take loans, even if those loans were free of interest.

What did work? Well, the right will tell you that stimulus failed.

For conservative American commentators, the Japanese government's response shows the folly of fiscal stimulus spending. Charles Krauthammer, among others, has said "the Japanese tried huge infrastructure spending in the '90s and got nowhere."

Koo shows that the numbers reveal a very different picture.

Counting the value of real estate and stocks, Japan lost wealth equivalent to three years' worth of gross domestic product. It was "just about the largest loss of wealth in human history in peacetime," Koo says. ... With private borrowing and spending frozen, the Japanese government stepped in, spending on highways, bridges and other infrastructure, and running up big deficits. Where the Japanese government erred, Koo says, was in worrying about those deficits. It cut back prematurely on the stimulus. The economy faltered, and the government had to resume spending.

Still, by 2005, companies had repaired their balance sheets and the Japanese economy was marching forward — until the latest crisis.

In both the Great Depression and the Lost Decade, it wasn't stimulus that failed. Only when the government put deficit concerns ahead of stimulus efforts (as the United States did in 1937) did recovery falter.

Conservatives want to paint President Obama's response to the economic crisis as a blow to free enterprise, but Koo's work shows that Obama's response is not only the correct response, but the one that free enterprise needs if it's going to survive. Until business can clean up it's act, government must step in to hold up the faltering economy. When business has recovered, it will be time for corporations to carry more of the economy forward while government gets the chance to trim the debts it took on during the downturn.

The example of the Lost Decade reinforces the lessons of the Great Depression. Not only can Japan's experience help us find our way to recovery more quickly and with fewer missteps, it can also help us avoid falling into this trap again. Three times is more than enough.