The recent central bankers' conference in Jackson Hole, Wyoming, highlighted yet again that there exist yawning transatlantic differences in perspective on the global economic challenge ahead and, more important, what to do about it.
This policy debate, with Europeans urging fiscal austerity and Americans promoting continued economic stimulus, has been a sore point for months. Now it is evident that leading European and American economists even disagree on their interpretation of history, with both sides using Japan's economic stagnation in the 1990s as evidence in support of their preferred course of action today.
This debate is not just about what Tokyo did or didn't do two decades ago. Transatlantic differences over Japan's experience are really about whether inflation, the European obsession, or deflation, the American concern, poses the greatest threat to the world economy today. These contrasting European and American perspectives reflect deep-seated economic scars on the European and American psyches, products of their own economic trauma in the early part of the 20th century.
Make no mistake about it. This is no academic debate best resolved by Japanologists. It is rooted in differences in transatlantic experience that may never be resolved and are of great consequence for the global economy.
"Some have suggested," said Jean-Claude Trichet, president of the European Central Bank, at Jackson Hole, "to ignore existing financial imbalances ‘for the time being' and focus only on the short term. Rather than pressing on with the deleveraging process, more spending could be encouraged to sustain growth in the short term."
"I believe," he continued, "that adopting this view would be very dangerous for our economies. There is a very clear example of the consequences of choosing to live with the debt: Japan in the 1990s [with its] ‘lost decade'."
American economists, such as Nobel-prize winner Paul Krugman, disagree. They argue that Japan's lost decade was a direct result of turning off the fiscal spigot too early. "The lesson from Japan," he told the Toronto Globe and Mail recently, "is that despite cutting interest rates, Japan has never had a real recovery. There was enough government spending to keep the economy from plunging, but never enough to generate a boom. And private market forces never kicked in."
How can Europeans and Americans read such different lessons from Japan's experience? It actually has little to do with Japan and much to do with contrasting transatlantic trauma before World War II.
Current European views, especially at the European Central Bank, are shaped by Germany's scarring experience of hyperinflation in the 1920s. When Trichet warns about debt, his real concern is to avoid the inevitable inflation that governments have often used to dig themselves out of debt traps, paying off their obligations in debased currency. When Krugman and members of the Obama administration advocate more government spending, it is to head off a repeat of the debilitating deflation America experienced in the 1930s' Depression.
In this debate by Japanese proxy, it is instructive to point out that students of Japan's lost decade tend to agree with Krugman, not Trichet. Richard Koo, chief economist for the Nomura Research Institute, argues that in Japan "fiscal stimuli were applied intermittently and almost always behind the curve, after the effect of the previous stimulus had expired and deflationary pressure had been allowed to again weaken the economy. This on-and-off approach ended up increasing the cumulative deficit and lengthened the recession unnecessarily." At the time, Japan suffered what Koo calls a "balance-sheet" recession in which "businesses and individuals were saddled with excess liabilities and were forced to pay down debts by curbing consumption and investment. The last thing they were interested in was increasing their borrowings."
Rather than maximizing profits, individuals and corporations became obsessed with reducing debt. In the face of such caution, monetary policy was ineffective in stimulating borrowing again, despite the Bank of Japan's cutting short-term interest rates close to zero.
In such a business climate, Koo says, "if everyone is deleveraging and the government does nothing, then the economy falls into deflation."
Washington and governments in Europe have moved much more rapidly than Tokyo did in the 1990s to turn on the fiscal spigots. But Koo wonders whether policy makers realize just how long the spigots may need to remain open, especially in the United States, where business and individual debt greatly exceeds government debt.
"Given the size of the problem," Koo warns, "there is absolutely no reason to believe that balance sheets will be repaired with just one pump-priming action by the government."
Trichet could undoubtedly cite his own Japan experts to counter Koo. But any further such "he said, she said" debate about Japan is a counterproductive distraction. Europeans and Americans need to stop talking about Japan. They need to acknowledge that their own historical experience may constrain their policy perspective today. And then they need to have a frank debate about current prospects of inflation or deflation.
It may well be that Europe and the United States face different threats going forward. And if Europe's challenge is rising prices and America's is falling prices, managing the global economy will be much, much more difficult in the months ahead.
