The US Economy and Japan's Lost Decade - An Eerie Similarity

Nobel prize winner and economist, Paul Krugman, in his book "Depression Economics" describes how the current US economy bears a disturbing resemblance to Japan's lost decade from 1991 to 2000.

In the 1980's, during Japan's period of economic miracle, Japan experienced incredible levels of growth in GDP. This was fueled by low interest rates, and crony capitalism - similar to sub prime mortgage, only in this case, corporations with bad credit could also easily borrow from the banks. The abundant supply of cheap credit tripled Japanese asset prices and the stock market soared, leading to a giant asset bubble. Realizing that such astronomical asset prices were unsustainable, the Japanese central bank, suddenly began raising interest rates in 1990. The market responded quickly resulting in a steep market crash. The stock market went down 60% and asset prices took a nose dive. Japan went from a 2.4% budget surplus in 1991 to a 10% deficit in 1998.

In response to the impending recession, Japan's central bank lowered interest rate and increased the supply of money. Big banks were bailed out several times. Through quantitative easing (printing money and buying government and bank bonds to supply banks with cash to encourage lending and in turn hope that "deposit multiplication" leads to creation of more money) the government hoped for a market recovery. Despite several stimulus injections the economy did not respond favorably. Instead of borrowing money from the government, Japanese corporations decided to save more and pay down their massive debts. Corporations tightened their belts and unemployment went up and so did inflation resulting in a decade long period of flat GDP known as the lost decade of Japan.

The US economy seems to be following a pattern of asset bubble burst and liquidity trap similar to Japan. The question is whether the Fed's expansionary monetary policies (low interest rates, increase in money supply) and government's fiscal policy (taxation and expenditure) will have any positive sustainable effect on the GDP and unemployment rate or will the US economy slip into a period of stagflation. Stagflation is generally preceded by a supply shock event such as a steep rise in oil price (the gulf of Mexico spill could be a catalyst). If the US experiences a stagflation, it will be very difficult to counter it with measures suggested by Keynesian theory (since inflation and unemployment are supposedly mutually exclusive). Irrespective of the market response, the Fed and government should initiate policies to fix the economy. Inaction (mainly due to political disagreement)or policies such as "quantitative neutrality" will only make matters worse.