Avoiding an American Lost Decade

In February of this year, I wrote a study (co-authored with Mike Flynn) about the lessons of the Japanese “Lost Decade.” At the end of the 1980s, Japan faced a very similar situation to ours: an asset bubble burst, the economy went into recession, and the financial sector stumbled. In that study we argued (as did others in separate publications) that if American didn’t properly learn the lessons of the Lost Decade, that we too would suffer a similar long night of economic malaise. Unfortunately, the warning has not been heeded.

Japan spent most of the 1990s screwing around with monetary policy, increasing taxes on its citizens, and spending trillions on stimulus projects. Sound familiar? The result was 10-years of stagnant economic growth, out of control unemployment, and national debt rising to double the rate of GDP, all while the rest of the world laughed at the nation that appeared to be returning to empire status. And that is where we are headed.

Over a year after the start of the crisis, we’re still on a road towards more economic pain. The question at hand has become: is the U.S. economy turning Japanese? That is the question Christopher Wood, author of “The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s,” asks in The Wall Street Journal this morning:

With the U.S. government stepping in to keep markets from clearing, today’s U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump. […]

[In post-bubble Japan] banks took years to be cleaned up as a result of regulatory forbearance. The same kind of forbearance is preventing America’s increasingly distressed commercial real-estate market from clearing. Similarly, as was the case with Japan, monetary-base growth has exploded in the U.S. over the past year courtesy of the Fed, while bank lending is declining. This is why there is every reason to fear that America is already in a Japanese-style liquidity trap.

I agree with Wood that we are facing a long period of economic decline and malaise, not a rapid takeoff in the economy. We are not the trough of a V-shaped, or even a U-shaped recession. There are still many things buried in the economic infrastructure of America that need to get sorted out before we have a full recovery. We are facing a W-shaped, double-dip recession… or worse. Consider this:

1. A recovery of the stock market does not necessarily translate into recovery for the real economy. While the Dow is up 50% from its low in March 2009, other indicators, such as unemployment and consumption numbers, haven’t been positive.
2. The Wall Street recovery doesn’t have a stable base. It is being driven by confidence in big firms, but that confidence stems largely from (and is at least dependent on) the government bailout of major financial institutions. And a recovery propped up by “too big to fail” policy is a recovery destined to fail.
3. There are still significant problems in the banking industry. Toxic debt is still hanging around. The securitization markets aren’t functioning (and what little growth there has been is dependent on the government). And bad business models and pay structures were left intact by the bailout process. These problems are likely to manifest in a big way in 2010 as the reality of the faux-recovery sets in.
4. There are still significant problems in the housing industry. Foreclosure rates are continuing to rise. Mortgage default rates will like not peak until the end of 2010. And while the decline in sales from the housing bubble pop seemed to have bottomed out this year, housing sales out West appear to be headed back down, signaling the potential for a nationwide re-decline, (beyond the season adjustment we’re going to encounter over the next few months). Thus, housing troubles are likely to plague the economy for the next 6 to 12 months at least, damping hope for banks to rapidly stabilize their balance sheets, leaving the economy weak.
5. We have still yet to see viable plans for exiting fiscal and monetary policies that are propping up the economy.

We can’t have real recovery without the government out of the way. We need to clear the decks and get all the toxicity (of mortgages and otherwise) out of the system. This is what the market tries to do with recessions, but we haven’t let it yet.

And thus we are starting to look like Japan. Our best bet is to move towards the monetary and fiscal exits and understand what a recovery process means. For more, check out my study on “Avoiding an American Lost Decade” and the corresponding article in Reason magazine, “Turning Japanese.”