The winter of 1981-82 was a grim one for the U.S. economy. After a nasty recession in 1980, there had been a brief, hopeful period of recovery–but by early 1982 it was clear that a second, even worse recession was underway. By late that year the unemployment rate would rise above 10 percent for the first (and so far only) time since the 1930s. So bleak was the prospect that in February the New York Times Magazine ran a long article (by Benjamin Stein) titled “A Scenario for a Depression?” which suggested that “the nation has arrived at a new spot on the economic map where the old remedies–or what we thought were remedies–have lost their power and the economic wise men have lost their magic.” Stein and many others worried that after nearly a decade of disappointing performance, the U.S. economy might simply fail to respond to monetary and fiscal policies, that a self-reinforcing downward spiral of pessimism and financial collapse might already be out of control.
Fortunately, however, it turned out that the old remedies were just as powerful, the nostrums of the economic wise men just as magical, as always. The Federal Reserve Board, which had been following a strict monetarist rule, reversed course in mid-summer and opened up the monetary taps. Interest rates came down, the stock market rose, and by early 1983 the economy was unmistakably on the mend. Indeed, as the workers and factories left idle by the slump went back to work, output soared: Real GDP grew almost 7 percent during 1983, and in 1984 Ronald Reagan was triumphantly re-elected under the slogan “It’s morning in America.” It wasn’t: Once the slack had been taken up, growth slowed again, and over the ‘80s as a whole the economy actually grew a bit less than it had in the ‘70s. But the surge in 1983 was a spectacular demonstration of the way that a sufficiently expansionary monetary policy can reverse a depressed economy’s fortunes.
The biggest single question now facing the world economy is whether the same magic can work in today’s Japan.
In some important ways, Japan today bears a strong resemblance to the United States in that frightening summer of 1982. Like the United States then, Japan has some serious long-term problems: a slowdown in productivity growth, an ossified management culture, a troubled financial sector (Stein’s article talked at length about the looming problems of the savings and loan industry). But overlaid on these long-term difficulties is a severe recession. Japan’s unemployment statistics notoriously understate the true extent of joblessness, but even so the current 4.4 percent rate is the highest in the 45 years the number has been published. Depending on whose estimates you believe, the economy is operating anywhere from 6 percent to more than 10 percent below its capacity. That means that Japan’s “output gap” is probably comparable to that of the United States 17 years ago. So if Japan can somehow persuade its consumers and business investors to start spending again, there is room for several years of rapid growth–even if the “structural” problems remain unsolved.
T here is, however, one big difference between America then and Japan now. Japan can no longer use conventional monetary and fiscal policies to get the economy moving. Whereas U.S. interest rates in early 1982 were in double digits–and could therefore be sharply reduced–Japanese short-term interest rates have been below 1 percent for years, apparently leaving little room for further cuts. And Japan’s government is already deeply in debt, already running huge deficits. The experience of the past few months (in which the prospect that the government would have to sell vast quantities of bonds to finance its deficits temporarily led to a tripling of long-term interest rates) suggests that any attempt to stimulate the economy with even bigger deficit spending will do more harm than good. So it might appear that there are no easy answers, that nothing short of a total restructuring of the Japanese economy can turn it around.
But over the past year a growing chorus of Western economists has argued against this fatalistic view. On one side, they have worried that unless something dramatic is done to increase demand Japan may go into a deflationary tailspin; that the expectation of falling prices will make consumers and businesses even less willing to spend, worsening the slump and driving prices down all the faster. On the other side, they have argued that radical, unconventional monetary policy can still be effective–that even if short-term interest rates are near zero, massive monetary expansion can still push up demand. Some economists–namely, yours truly–have even argued that Japan should try to get out of its deflationary trap by creating expectations of inflation.
Until very recently, these arguments seemed too outlandish to receive support from more than a handful of Japanese officials. But the events of the last few weeks suggest that there has been a sea change of opinion inside the Bank of Japan–a change similar to, but even more striking than, the abandonment of monetarism at the Fed during 1982. After years of warning about the risks of inflation and the importance of sound policy, the BOJ has suddenly begun flooding the market with liquidity. The overnight rate at which banks lend to each other–the equivalent of our “Fed funds” rate–has been driven down literally to zero. Banks now charge each other only for the administrative costs of making the loan. And still the expansion continues. It’s still a bit hard to believe, but it looks as if Japan’s central bank has been radicalized–that is, it has finally seen the light, has finally understood that in Japan’s current state adhering to conventional notions of monetary prudence is actually dangerous folly, and only monetary policy that would normally be regarded as irresponsible can save the economy.
There are, of course, big risks in any such radical policy departure. My own view is that the biggest risk is that the new policy will not be radical enough, for it is a characteristic of deflation-fighting that half-measures get you nowhere. Suppose, for example, that the Bank of Japan were to try to convince the public that the future will bring inflation, not deflation. But that the target inflation rate is too low, so that even if everyone believed that target would be achieved, the Japanese economy would remain seriously depressed. Then deflation would continue–and the policy would ignominiously fail.
But if the BOJ is determined enough–and if people like me have analyzed Japan’s plight correctly–then six months or a year from now Japan may be on the road to an economic recovery more dramatic than anyone would now dare to forecast. By sometime next year, the Land of the Rising Sun may, at least for a while, live up to its billing. You heard it here first.