Theechoes are eerie. Ben Bernanke’s gradual change of tone during the pastyear and this week’s massive cut in interest rates seems to parallelthat of Japanese officials back in 1992. At that time, an initialperiod of denial was replaced by the shocking realisation that thedamage caused by the bursting of the bubble could take years to repair.
Clearly there are differences between the Japanese and USbubbles, but the key cause of the economic downturns remains the same:the private sector has become more concerned with its financial healththan maximising profits. Companies and individuals have made thelogical decision to concentrate on repairing balance sheets. Theconsequences of those actions can cause the whole system to collapse.In the arcane world of economics it is known as a fallacy ofcomposition.
In Japan during the 1990s, it was corporations thatrushed to pay down debt after the commercial real estate they hadbought with borrowed funds lost 85 per cent of its value. Their need toeliminate the debt overhang meant there was nobody left to borrow fromthe banks, even though interest rates were effectively zero, creating asignificant shortfall in demand.
This time, in the US and partsof Europe, it is banks and households struggling to regain theirfinancial health. Although some top-tier banks have obtained funds fromsovereign wealth funds, thousands of ordinary banks that have no suchaccess will now be forced to slash lending and other activities to meetcapital adequacy requirements. We face a significant credit crunch thatwill not be solved by central banks’ monetary easing or liquidityinjection because the key constraint is lack of capital, not lack offunds.
If the Japanese experience is any guide, the housingmarket in these countries may not respond to the monetary easingeither. With the housing price futures market in Chicago indicatingthat prices will continue to fall well into 2011, there is littlereason for people to buy houses now, given the asset will be stillcheaper in the future. Valuations will need to fall to a level thatproperly reflects the discounted cash flows provided by rents.
Whenthe private sector is more concerned about regaining balance sheethealth than maximising profits, a great deal of conventional economicsbecomes irrelevant. In such a situation, only fiscal policy can liftthe economy. Japan managed to keep its GDP above the peak-bubble levelsthroughout the past 15 years in spite of an 85 per cent fall in realestate values. The government achieved this by borrowing and spending,which more than compensated for the damage wreaked by household andcorporate debt repayment. It also eliminated the credit crunch byinjecting capital into the banks in 1998 and 1999.
US andEurope, which could be facing similar economic downturns, would do wellto line up policies along the above lines. Even though there are talksof tax cuts in the US, there is a high probability that a significantportion of these will be saved or used to cut debt. In the currentsituation, therefore, increased spending will be far more effective.Capital injections are likely to meet resistance from those who arguethat bankers stupid enough to get involved in the subprime mess do notdeserve taxpayer’s help. But when the whole economy begins to implodeas a result of a credit squeeze, watching bankers struggle torecapitalise themselves might be satisfying, but it is economicallyunsound.
Lastly, by mobilising fiscal policy, Japan kept itsproblems within its borders. This in spite of numerous foreigneconomists, including Paul Krugman, urging the government to weaken theyen and harness foreign demand. This point is particularly importanttoday because if all the countries affected by the subprime crisistried to export their way out of recessions, there would be a globalfallacy of composition just like in the 1930s. In other words, while anexport-driven policy might make sense for each country, collectively,the outcome would be disastrous. In order to avoid that outcome,international bodies such as the G7 and the IMF should require individual countries affected by this crisis to mobilise fiscal policies so as to keep their problems inside their own borders.
The writer is chief economist at Nomura
