Why the US won’t lose a decade

There have been many comparisons made between Japan’s “lost decade” and what’s currently happening in the US. Legal & General economist Tim Drayson has taken a rather bold stance in explaining why the US won’t spiral into a Japan-style slowdown.

There are fears the US is about to follow the Japanese experience. Both countries share similar characteristics prior to the initial downturn (Figure 1). Unemployment was low and inflation was under control, but just starting to rise. Confidence was high that the strength in productivity growth would be sustained. Credit growth was strong, underpinned by increasing use of leverage. Japanese domestic bank loan growth neared 10% in the late 1980s and US private sector debt has grown at a similar rate over the last few years (Figure 2). Fuelling the credit boom was a belief in both countries that house prices would never fall.

Those are the similarities. As Drayson rightly notes, there are also lots of differences.

After Japan’s first recession in the early 1990s, the country’s central bank, with no major event to trigger a quick response, did not cut interest rates fast enough. This eventually leadto a classic liquidity trap, Drayson says. (That was, incidentally, also the view of recent Nobel prize-winner Paul Krugman in 1998, who advocated potential inflationary monetary policy to get out of the trap).

In the US, however, there is the rapid seizing up of credit — providing the shock necessary to trigger big moves by the Fed.

Events have unfolded much more abruptly in the US than in Japan. While the US economy is not yet technically in recession, labour markets and the financial sector are adjusting rapidly. Unemployment has risen sharply and there have already been several high profile bank failures. House prices have fallen sufficiently quickly to restore affordability (figure 5) - though it’s hard to get a mortgage at present and new home building is now running below sales. It will take time to work off excess inventories, but this should allow house prices to stabilise much more quickly than in Japan which failed to address its glut of properties.

Most crucially, according to Drayson, the Fed has recognised the dangers that deflation poses in a highly indebted economy and has aggressively cut interest rates. Real interest rates are now negative, even using core CPI. If the Fed sees any sign that core inflation could fall much below 2 per cent it will likely cut interest rates again, Drayson says.

The US is heading into recession along with many other developed economies (Figure . Concerns that the US might repeat Japan’s experience are likely to intensify. But we believe that policymakers will cut interest rates aggressively to ward off this threat. Globally short-dated government bonds should perform well. If conventional efforts to reflate fail to gain traction, the US is likely to pursue more unorthodox policies. This should prevent a sustained bear-market in equities and housing, but also put a floor under long-term bond yields and could undermine the dollar.

Of course, Drayson’s argument is predicated on the market responding positively to the Fed’s measures (thereby avoiding a Japanese-style liquidity trap). If you’re of the Austrian school you might argue that the Fed’s aggressive interference will only prolong the pain of what is a necessary correction. In which case we may not be looking at a lost decade, but a lost decade or two. Or worse.