Why do some conservative economists think that the policies used to revive the US economy after 2008 might not
be entirely helpful in restoring economic prosperity?
THE WEB-BASED QUESTIONS Part I.
Robert Jacob Samuelson, a leading columnist for the Washington Post, discusses why Japan’s economic crisis should be considered as a cautionary tale for the United States in one of his articles. Read the article by visiting the following website:
What caused the asset price bubble in Japan during the 1990s?
Do you think that the main reason behind the recent housing bubble in the United States was similar to that in Japan?
ANSWERS TO STUDY QUESTIONS
SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS
During the decades of the 1970s and 1980s the story of Japan was one of phenomenal growth in their economy and prestige in the world. After the devastation and humiliation of World War II, Japan rebuilt itself on an ethic of hard work, a focus on education, an impression of loyalty between employees and employers, a very high saving rate, and a dedication to producing quality manufactured goods for export to the United States and other countries. During this period, Japan became the second largest economy in the world by producing the types of innovative products that were both inexpensive and well-constructed.
One of the problems economists face when comparing the economic activity between countries is that while it is tempting to convert everything into one currency so you can compare trillions of dollars of GDP to trillions of dollars of GDP, there are problems associated with any method you use in performing the comparison. For instance, if you simply use the exchange rate between currencies, you can leave the inaccurate impression that a sharp increase in the rate of growth or a sharp decline in the rate of growth was felt by people in that country. If the exchange rate rises or falls by 5 percent and economic activity in inflation-adjusted terms in that country was 3 percent, this can be reflected as either wildly expansionary growth or similarly draconian contraction.
$18 trillion. For a country of roughly the same size as California, that was at the time more than the combined
total of all real estate in the United States. Between 1991and 2005, the total value of all real estate had
declined to less than half that.
Stock prices fundamentally reflect the present value of future expected profit streams and stock market bubbles occur when the prices of stocks reflect a “me too” or “ better buy now before the price goes up” attitude among investors rather than a straightforward analysis of future profits. In late1989, the Nikkei average or the Japanese stock exchange was standing at nearly 39,000. At those levels, stocks were significantly overvalued relative to the profits those firms were generating. Like all bubbles before this one and after this one, it burst and stock prices fell drastically.
Real estate prices and stock prices fell drastically in Japan in 1990s. The two effects built upon one another. As stock prices were plummeting, those with stock purchased on margin calls had to shed themselves of real estate in order to meet those margin calls. Those who found themselves underwater in their homes had to sell off their stock holdings to pay off the loan amounts that the sale of the land did not cover. With this massive decline in wealth in Japan, personal and corporate bankruptcies hit record highs. People who thought they had saved sufficiently to retire were now in no position to retire and, paradoxically, raised their rates of savings dramatically. While that may have been a good idea for them as individuals, it was catastrophically bad for the overall economy.
The principal problem that policy makers failed to recognize was, first, the degree to which the real estate bubble was indeed a bubble; their late reaction, and, as it turns out, overreaction to it; their failure to see the interconnections between the real estate bubble that was collapsing and the stock market bubble that was also collapsing; their failure to appreciate the problems of combatting a deflationary spiral; and (to many liberal U.S. economists) their constant underfunding of stimulatory actions while spending those stimulus funds on the wrong types of things.
The attempts to restore the Japanese economy were constant. However, the Japanese government committed many of the classic errors in carrying out the discretionary fiscal policy. Inflation-adjusted government consumption spending increased during the first year of the recession but not by nearly enough to have any substantive impact and then fell to 20 percent below its pre-recession levels during much of the period. Public investment in infrastructure increased quite rapidly, but, in the era of modern capital driven infrastructure spending, employed relatively few people. Worse, an expectation of zero inflation or negative inflation created an insurmountable problem of expectations management.
The bursting of a clear bubble in the real estate sector set off a process that threatened the health of banks both in Japan in the 1990s and the United States in 2008 and 2009.
Several policies were adopted by the US government and the Federal Reserve after the financial crisis of 2008-2009 such as the Troubled Asset Relief Program, the stimulus package, the extension of the tax cuts within the stimulus package as well as the extension of the Bush-era tax cuts. The Federal Reserve also introduced the quantitative easing program. The then chairperson of the Federal Reserve, was of the opinion that while it will take time for the issues that resulted from the housing bubble to work their way through the system and they will remain in the economy for a protracted period, the actions taken, with the AIG takeover by the Federal Reserve, the TARP program that saved several leading banks from being declared insolvent by their regulators, and the sustained push by the Federal Reserve to buy long-term federal treasuries and mortgage-backed securities will keep the deflationary pressures at bay.
From the moment the financial crisis hit, around Labor Day 2008, the Federal Reserve has injected $2.5 trillion in liquidity into the system. Initially, their actions were to lend financial institutions significant sums to make sure they were sufficiently capitalized to withstand the pressures associated with defaulting loans. As that money has been paid back, they have purchased more than a half trillion dollars in long-term debt and this has increased the fiscal deficit significantly. It is exactly this that makes some conservative economists think that these programs might not be entirely helpful in restoring economic prosperity. They are not worried that this will give rise to deflationary pressure as witnessed in Japan but they are worried that this might lead to inflation. They think that as the money that is lent in this regard is money in the system that would not otherwise be there and that more money will be chasing the same number of goods, inflation will be the result. It is not the deflationary expectations that are holding back aggregate demand in their minds; it is that businesses lack the confidence they require to invest in future production.
The Japanese economy has been suffering from periodic bouts of deflation since the 1990s. Deflation causes people to postpone purchases, expecting items to become cheaper. It also deters borrowing, because debts have to be repaid in more expensive currency and is thus harmful for the economy. If the Bank of Japan decides to ease credit, inflation will occur. Higher inflation would cause the yen to depreciate, reviving exports by making them cheaper. To generate higher inflation, the Bank of Japan would inject money into the economy. Some extra cash would go into consumer spending; some would go into the stock market. All these will help in reviving the economy.
Japan’s poor economic performance ever since the bursting of the asset bubble has relevance for America’s tepid recovery from the financial crisis. This is because Japan faces three major structural problems and each of these problems has an American counterpart.
First, the country’s basic economic model is broken. That model was export-led growth. It worked well until the mid-1980s when the yen’s rising value made exports much more expensive. Japan has yet to create an adequate substitute. The U.S. counterpart is consumption-led economic growth.
Japan’s second problem is an aging and falling population. Already, nearly one out of four Japanese is 65 or older; the birth rate of 1.4 (meaning 1.4 children for each Japanese woman) is well below the replacement rate of about 2. This weakens the domestic market and raises government spending on the elderly. The United States has a similar problem, though milder.
Finally, both Japan and the United States have huge government debts — reflecting slow growth, aging populations and “stimulus” programs
The Bank of Japan had lowered interest rates from 5 percent in 1985 to 2.5 percent by early 1987.
Japanese banks, which had previously lent mostly to corporations, now had ample funds to lend at a time when their major corporate customers were flush with cash thanks to their trade surpluses and the availability of worldwide equity markets, which competed directly with Japanese banks.
So the banks began freely lending to Japanese firms and individuals, who purchased real estate, which increased the paper value of land assets. This created a vicious cycle in which land was used as collateral to obtain further loans, which were then used to speculate on the stock market or to purchase more land. This drove up the paper value of land further, while the banks continued to grant loans based on the overvalued land as collateral.
There was little questioning by either the government or the banks themselves over how the loans would be repaid or what would happen once land values started dropping.
Answers may vary but students should mention the fact that extremely low interest rates are one of the main causes of the housing price bubble in Japan as well as in the United States.