Thursday, March 14, 2013

Joseph Stiglitz: lessons from Japan's malaise

In his Project Syndicate column, Professor Joseph Stiglitz looks at the lessons we can learn from Japan's economic malaise.  He finds

  1. Before proposing an economic cure it is important to understand what the real problem facing the economy is.
  2. It is import to select an economic cure that actually addresses the real problem facing the economy.
While these seem like obvious lessons, economists have not adhered to them in making policy recommendations or implementing policies for either Japan's or the current global financial crisis.
Confusion about what cure to prescribe is caused in part by the fact that different medicines are suited for different problems, whereas much of the policy debate fails to distinguish among them adequately.... 
Today, Japan faces a problem of deflation, not inflation. During the Great Depression, the great American economist Irving Fisher focused on the adverse effects of falling prices.... 
Fisher's criticism, however, was even more devastating--and more relevant to Japan's current circumstances: as prices fall, debtors, whose obligations are fixed in nominal terms (that is, in terms of yen) find it increasingly difficult to repay what they owe. 
In real terms, they are forced to pay back more and more to their creditors.
Some debtors default--the debtor problems then become the banks' problem--while others are forced to cut back their expenditures, deepening the downturn....
Professor Stiglitz has succinctly summarized the problem faced by Japan and, since the current financial crisis began, the EU, UK and US.  The problem is debtors have more debt than they can pay.

The concern about deflation is a red herring that distracts from the real issue.

The real issue is that the debtors cannot service their loans.  In this circumstance, it is to be expected that prices will drop (deflation is a symptom of the problem) as debtors default and the underlying collateral is sold.  The price decline is the market's way of clearing.

However, in Japan, the EU, the UK and the US, policymakers and financial regulators have stepped in to block the recognition of losses on the excess debt and the related price decline.  They have done so to protect bank book capital levels and banker bonuses.  In reality, a modern banking system is designed so that banks can absorb the losses and continue to operate with low or negative book capital levels.

[Banks can do this because of the combination of deposit insurance and access to central bank funding.  Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.]

Preventing the banks from recognizing losses sets up a very interesting situation.  Everyone in the market knows that the losses have not been realized and that there should be downward pressure on prices.  This gives an incentive to hold off and lowers demand.

At the same time, the real economy is being asked to bear the burden of servicing the excess debt.  This diverts capital that is needed for growth and reinvestment.  This too leads to a decrease in demand.

To try to offset the decrease in demand and reduce the burden of the excess debt, central banks pursue zero interest rate policies.  These policies in turn crush demand as savers, both individuals and companies through pension funds, postpone current demand to offset the lack of return on their retirement savings.

This is why Professor Stiglitz cited lesson one is to understand what is the true underlying economic problem.
How can Japan's deflation be reversed?
This is where Professor Stiglitz second lesson comes in.  The choice of economic policy must actually fix the real problem.

Regular readers know that the only economic policy that does this is requiring the banks to recognize the losses on all the excess public and private debt.

Yes, the banks will have negative book capital levels, but this doesn't matter (actually, it matters to banker cash bonuses, but that is a different issue).

What matters is that the burden of the excess debt will be removed from the real economy and capital will no longer be diverted from growth and reinvestment.

What matters is that the zero interest rate policies can be ended and with it demand will return as savers can once again earn a return.

What matters is that prices will make a large adjustment down to clear the market and there will be no more overhang of bad debt to keep prices from rising in the future.

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