"Japan's endless travails since the collapse of its twin stock market and real estate bubbles in 1990 provide a lesson not to be ignored. The Japanese government did not act to repair the balance sheets of the private sector following the crash. Instead, it chose a policy of keeping bank rate near zero so as to reduce deposit rates and let the banks earn their way back into solvency. This proved ineffectual. A number of long-suffering banks failed in 1997—seven years after the crash!—prompting limited government recapitalisation of the system. Finally, late in 2002—twelve years after the crash!—the government took decisive steps to clean up the bad loans problem in the banking system. This took another three years. Eighteen years after its big crash Japan has still not completely emerged from its aftermath.
Japan did try the kind of fiscal policies that were considered conventional Keynesian economics some decades ago. Enormous amounts of money were spent on ‘bridges to nowhere’ and other, hopefully better motivated, projects until Japan's national debt grew to a size that discouraged any continuation of the policy. All to little apparent avail.
Why so? Recall that, in the Keynesian theory, public works spending is supposed to work and have a strong multiplier effect when unemployed labour is cash constrained and unable to exercise effective demand for consumer goods. That was not Japan's problem. The effective demand failure that plagued Japan rather was that business firms could not, and later would not, do the intertemporal trade of expected revenues from future output for the factor services in the present needed to produce that output, that is, they could not or would not borrow to finance investment. In the early post-crash years, the state of the banks was such that they would not lend. Even when the Japanese banks eventually got into healthier shape, many business firms still had balance sheets in such condition that they were loath to borrow ( Koo, 2003). So Japan was unable to resume the growth rates that it had achieved before the bubbles burst.
The other lesson to draw from the Japanese experience is that once the credit system had crashed a central bank policy of low interest rates could not counteract this intertemporal effective demand failure. Year after year after year, the Bank of Japan kept the bank base rate as close to zero as makes no difference and even then the economy was under steady deflationary pressure and healthy growth did not resume. The low interest policy served as a subsidy, which enabled the banks eventually to earn their way back into the black but this took a very long time.
Contrast this experience with that of Sweden or Finland in the wake of their real estate bubbles (and in Finland's case the loss of its Soviet Union export markets) in the early 1990s. Both the Nordic countries fell into depressions deeper than what they had experienced in the 1930s. Both had to devalue and Sweden in particular had to climb far down from its lofty perch in the world ranking of per capita real income. But, in contrast to the Japanese case, the governments intervened quickly and drastically to clean up the messes in their banking systems ( Jonung, 2008, 2009). Both Sweden and Finland took some three years to overcome the crisis but have shown what is, by European standards, strong growth ever since. The devaluations that aided their export industries were no doubt of great importance for this growth record but it is extremely unlikely that anything like it could have been achieved without the policy of ‘quarantining’ and then settling the credit problems resulting from the crash.
The Great Depression in the USA saw no consistent policy of deficit spending on adequate scale in the 1930s. War spending not only brought the economy back to full resource utilisation but also crowded out private consumption to a degree. However, the deficits run during the war meant, on the one hand, that at war's end the federal government's balance sheet showed a debt of a size never before seen but also, on the other, that the balance sheets of the private sector were finally back in good shape. At the time, a majority of forecasts predicted that the economy would slip back into depression once defence expenditures were terminated and the armed forces demobilised. The forecasts were wrong. This famous postwar ‘forecasting debacle’ demonstrated how simple income-expenditure reasoning, ignoring the state of balance sheets, can lead one completely astray.
The lesson to be drawn from these examples is that deficit spending will be absorbed into the financial sinkholes in private sector balance sheets and will not become effective until those holes have been filled. 9 If the sinkholes are large, this will take a long, long time. Today, they are enormous. Policy must address both the capital accounts and the income accounts ( Leijonhufvud, 2009B). Nationalisation of the crippling losses of the financial sector—whether or not the financial institutions are nationalised outright or just ‘bailed out’—is a precondition for old-fashioned ‘Keynesian’ stimulus to work." |
