How We Can Avoid Becoming Like Japan
These days, it is said, the industrialized world economy is like a beauty pageant for the unattractive in which the victor will be the contestant deemed the least ugly. And so, as disappointingly as the U.S. economy has performed over the past four years, America could still end up a winner. That helps explain why U.S. Treasury bonds continue to be the safe haven for the world’s capital. But is being the “least ugly” good enough for a country experiencing rising social disruption stemming from high unemployment and declining personal income?
Twice a year, the world’s central bankers, finance ministers, and bankers gather for meetings of the IMF and the World Bank. In the evenings, policymakers and the masters of the universe hobnob over cocktails and canapés at various hotel receptions. During the latest such gathering in late September, I conducted an informal poll. In any cocktail conversation with a central bank or finance ministry official, I would utter this statement: “So the Eurozone and the United States are both becoming Japan.” To my surprise, virtually no one disagreed. That would not have been the case six months earlier.
“Becoming Japan” would mean that the economic situation in Europe and the United States would come to resemble Japan’s two lost decades of dismal economic performance since the early 1990s. The weight of crushing public debt and a traumatized banking system led to the creation of a zombie economy. Because of the government’s massive spending programs on infrastructure, which barely kept the economy from collapsing, the debt eventually ballooned to twice the economy’s size. The Japanese people fell victim to an economic slow-bleed condition.
Like Japan, both the Eurozone and the United States have accumulated massive public debt as a result of bailouts, fiscal stimulus, underperforming economies, and declining tax receipts. Like Japan, both have powerful banking sectors with balance sheets still holding toxic assets at unrealistically high valuations. And like Japan, both are beginning to resemble economies that have lost their daring.
Today Eurozone policymakers are in the fight of their lives trying to save their monetary union. Their banks are loaded with questionable Greek, Portuguese, Irish, Spanish, Italian, and French sovereign debt. One minute, policymakers achieve a “historic breakthrough” in solving the problem. Stock markets soar. The next minute, markets collapse. And why? Because of the simple math. The Eurozone economic-crisis managers have $380 billion in hand to resolve a $7.2 trillion problem. The total sovereign debt and external bank debt of the five most troubled Eurozone countries (Greece, Ireland, Italy, Portugal, and Spain) is $7.2 trillion. Yet the Eurozone’s new rescue bailout fund has only $620 billion in cash, and a third of that is already committed to previous bailouts. Policymakers are holding a BB gun in the face of a charging bull elephant.
If, as expected, the German taxpayer backstops the rescue operation, the spending—including government guarantees—will be enormous. Germany’s debt-to-GDP ratio could exceed 200 or even 240 percent (compared with 80 percent today), according to some experts. That’s higher than Japan’s debt-to-GDP ratio. Doing nothing would be a huge risk, to be sure. But a colossal expansion in the Eurozone’s core country public debt risks a downgrade by the international credit-rating agencies. Eurozone interest rates would rise. Eurozone banks would come under further duress. Lending and economic growth would decline, dealing a severe blow to an already fragile economic system. In short, for a while at least, the Eurozone could risk an extended period of mediocre economic performance.
This would be a horrible outcome for the rest of the world, including the United States. Today, as a result of bailouts, fiscal stimulus plans, and low growth, the world’s public and private debt has already reached an incredible 300 percent of GDP. Since January 2008, global growth has averaged only 1.2 percent, so tax receipts have plummeted. Analysts say not to worry, this is a necessary period of public and private deleveraging, and once it’s over, growth will resume.
If only things were that simple. Since January 2008, the world’s public and private debt has actually increased by 17 percent. This figure will swell once the full bill for the Eurozone bailout comes due. As a result, the entire world is at risk of undergoing a brutal revaluation of asset prices that will instantly make it a poorer place. Central banks across the globe will resort to various artifices to pretend it isn’t happening. Financial markets will simply respond by taking down the stock prices of the banking sector, risking a credit crunch.
Japan and the Eurozone both have debts twice the size of their economies, with zombie banking systems and increasingly pessimistic societies. Can the United States avoid joining this ignominious club? After all, America’s public debt is now approaching 100 percent of GDP. How do we keep ourselves from becoming Japan?
American economists are facing a crisis of confidence. The $860-billion Obama stimulus, which was intended to raise levels of demand dramatically, failed miserably to live up to its expectations. Conservative economists have little reason to be smug about this failure, as the policies many of them championed during George W. Bush’s administration didn’t work very well either. If you toss out the effects of home-equity loans, refinancings, and other byproducts of the bubble, the economy grew by less than 2 percent during Bush’s tenure. Over the last decade, productivity growth, higher than 2.5 percent, was greater than the productivity growth of the 1970s, 1980s, and even the 1990s. Yet for the first time since the Great Depression, this productivity performance failed to produce new jobs. Economic theory said it wouldn’t happen that way, and yet it did.
Today, Washington is full of tax-reform schemes, ideas for small-business stimulus, proposals to bend the cost curve of entitlements, and ideas for smart infrastructure investment financed by new infrastructure banks. The Federal Reserve is toying with deploying a third round of monetary stimulus. Yet before policymakers act, they need to answer these questions: Why, after unprecedented amounts of fiscal and monetary stimulus, did the economy fail to perform? Is there something more fundamental at work holding back investors and consumers? Is the world experiencing a long-term period of overcapacity? Are U.S. workers not being hired because the negative effects of America’s mediocre public educational system have finally arrived?
The good news is that Washington policymakers are for once engaging in the kind of self-reflection their Japanese counterparts never managed. In one form or another, everyone agrees that virtually all the net new American jobs created in recent decades have come from small, young, start-up firms. There appears to be a begrudging realization that America is facing a start-ups crisis, with business start-ups having dropped by 27 percent from 2006 to 2009. New policies are needed.
There also seems to be a consensus that the U.S. jobs crisis is the direct result of the difficulties firms face in initiating initial public offerings (IPOs). Because the regulatory barriers have increased, the proportion of IPOs (those worth less than $50 million) over the past decade has plunged. That is a critical development because 9 out of 10 jobs created by venture-backed firms take place after the firms go public. So without improving the financial conditions for an explosion in IPOs, America’s jobless nightmare is likely to continue.
Another truth has been unearthed by the troubles of the last four years: Consumers are influenced far more by the prices of their homes than by the values of their stock portfolios or retirement funds. A year ago, when the Federal Reserve flooded the economy with money, the implicit goal was to create a stock market rally as a means of encouraging what economists call a “wealth effect.” It did. Today Republican presidential candidates criticize Chairman Ben Bernanke for having politicized the Fed by advancing this policy, which is nonsense; when traditional economic tools aren’t working, people like Bernanke have no choice but to experiment. But the huge boom in consumption never happened. That’s because for most people, the negative perception of the future value of their homes trumps all other factors.
America has never undergone a vigorous recovery without real estate leading the way. And that seems unlikely any time soon. Yale’s Robert Shiller, the nation’s expert on the matter, predicts U.S. home values will continue to drop. Recently, Republican candidate Mitt Romney spoke an uncomfortable truth—that for the U.S. economy to recover, the housing market must “clear.” This process will be grueling, but if the U.S. economy is to rebound, consumers need to feel in their bones that housing prices across the board have reached a bottom.
This idea was in common discussion in 2008 when the financial meltdown first occurred. And yet the policy to combat the crisis went in a different direction. If things go badly, when the history of this post-crisis period is written, the summary could well be as follows: After the U.S. bubble burst (and the European sovereign-debt bubble burst), elites marshaled their political power. They cajoled their governments and central banks to produce generous bailouts, subsidies, guarantees, fiscal stimuli, and monetary injections to try to prop up the assets on the balance sheets of big banks at value levels that were unsustainable. Such efforts were like trying to keep the tide from dropping. Eventually all the monetary and fiscal policy tricks either failed or, at best, kept the economy barely afloat.
That is why the big banks are at the center of today’s populist dramas. During the Clinton administration, James Carville offered the clever line that if he believed in reincarnation, he’d like to come back as the powerful bond market. He should have asked to come back as a Wall Street or European banker. That’s because we’ve learned that no matter how foolish your mistakes are, your government and central bank stand ready to help, no matter the cost to the rest of society in the form of unintended consequences. True, in the midst of a financial crisis in a democratic society, policymakers may have no choice but to “do something.” But these unintended consequences have been destabilizing.
The issue is not whether the big banks should have been bailed out. They had to be. The question is how they were bailed out. The original case for the TARP bailout in the fall of 2008 was to use $700 billion in funding to remove the toxic assets connected to bum real-estate loans from bank balance sheets. Putting the taxpayers at such risk would have no doubt necessitated a change in bank management and a restructuring of the too-big-to-fail Wall Street banking industry. But the idea made some sense. It was to avoid the 1990s Japanese mistake of leaving the toxic assets on the books, which led to two decades of diminished lending.
Yet in implementing the bailout, Washington blinked. Wall Street convinced the New York Fed’s Timothy Geithner and the man Geithner would succeed as treasury secretary, Henry Paulson, that removing their toxic asset–backed securities was too difficult, legally and technically. So TARP instead was used to support bank stock prices. The too-big-to-fail banks survived. And thrived.
Meanwhile, the Fed slashed short-term interest rates to near zero percent. This too provided a cash cow to the big banks. (They borrowed from the Fed’s Discount Window for next to nothing and bought much higher-yielding government-agency paper for lucrative profits, with no need to add to their reserves, which would be the case, say, if they issued a jumbo loan to the private sector.) But the unintended consequence was nightmarish. Average folk dependent on money market fund returns and retirees with fixed-income investments needed to supplement Social Security took a financial chop to the neck. Their returns dropped in some cases to below 1 percent.
And so this period may be remembered for having allowed the greatest transfer of middle-class and elderly wealth to elite financial interests in the history of mankind. And to make matters worse, this losing effort to prop up big-bank asset values has contributed to mind-boggling global debt-to-GDP ratios. We may be saving our banks, but we are losing our economy.
And even so, despite all that, despite being catered to by governments, global banking looks dismal. The Eurozone banks are hanging by a thread. The Chinese state-run banks are hiding a mountain of toxic debt that can never be repaid. The timid Japanese banking dinosaurs can barely get out of their own way.
Since the Second World War, the U.S. economy has benefitted from a many-tiered financial system that was the envy of the world precisely because of its ability to assess risk and target entrepreneurial initiative. As a result of the financial system’s ability to locate and finance innovation, the American economy became a turbocharged job-creating machine. This financial model has broken down.
Today, when policymakers talk about fixing the American economy, they mention reforming the corporate tax code, fixing bridges, eliminating harmful regulations, adjusting Social Security COLAs, and improving the educational system—all important goals. But the first order of business is to fix the financial system. The U.S. economy is unlikely to recover fully until the banking system is restructured. Banks need to be lean and agile, with skin in the game and a taste for prudent financial risk in America’s innovative future. They can’t be the electric company. And yet that is what America’s 20 largest financial institutions, now under a spate of regulations and dependent on political largesse and friendships, are becoming.
It is here, however, that the Republican Party, which seems to be arguing for an across-the-board “big bang” approach to regulatory reform, is playing a politically risky game. When Republicans talk of rolling back the Obama financial regulations, they need to distinguish between the Wall Street insiders and the hundreds of overregulated, middle-sized regional banks and thousands of small banks that are vital to job creation. These suffocated, overregulated smaller institutions are desperate for financial oxygen. Washington needs to change how the big Wall Street banks operate.
The GOP needs also to push more strenuously for a growth agenda that is not only domestic, but global. Given the connected nature of the world financial system, there ultimately are no winners in the “least ugly” beauty pageant, not even the United States. That’s because turmoil elsewhere will inevitably lead to massive capital flows into U.S. dollar assets for safety. Such a development would drive down long-term U.S. interest rates, dramatically narrowing the gap between short- and long-term rates (what economists call a flattening of the yield curve). This would kill bank profitability and lending, perhaps even forcing some regional banks out of business. When Japan’s long-term interest rate dropped to below 1 percent, bank lending screeched to a halt. Today U.S. long-term rates are hovering around 2 percent. Adding to this U.S. vulnerability, China and other emerging market economies continue to produce regardless of demand, contributing to worldwide overcapacity. A global growth agenda and new foreign exchange rules are therefore essential.
So can the U.S. economy avoid even a moderate version of the “Japan disease”? The answer ultimately depends on the degree to which Washington has the courage and will to adopt solutions that simultaneously reduce debt and increase economic growth. Accomplishing these twin goals will not be easy. The European bureaucrats demanded the Greeks reduce their debt without offering reforms to encourage growth. As a result of these austerity policies, Greece’s debt-to-GDP ratio, 120 percent before the crisis, jumped to 170 percent.
U.S. policymakers cannot make that mistake. This is no time for timidity, as the Japanese demonstrated early on in their crisis when they underestimated the threat. Solutions need to be bold. Success will depend on whether the banking system can be rebooted and a floor in housing prices found, on whether the cost curve of American entitlement spending can be bent downward, and on whether the financial resources can be unleashed to create a series of revolutions in American innovation. Ultimately, success will depend not on whether we can establish ourselves as the “least ugly” in the global beauty pageant, but on whether the traditional American hunger for risk-taking—what David Brooks has called a desire to “salivate for the future again”—can be reignited.