Fighting Deflation in the U.S. and Japan

As the U.S. boom turned to bust, the monetary policy pursued by the Federal Reserve was far more aggressive than that followed by its counterpart, the Bank of Japan, in the 1990s and its decisive response may have helped the U.S. economy recover more quickly.

During the late 1980s, Japan's economic system -- its innovative management methods, efficient manufacturing processes, and bold investments in new technologies -- was widely seen as a model to be emulated. Little more than a decade later, America again turned to Japan for a lesson in economics, but for a different reason: this time the issue was not how to replicate Japan's success, but how to avoid its failure.

In Lost Decade in Translation: Did the U.S. Learn from Japan's Post-Bubble Mistakes? (NBER Working Paper No. 10938), NBER researchers James Harrigan and Kenneth Kuttner identify what went wrong in Japan in the 1990s, and the lessons the United States could - and perhaps did - learn from Japan's experience. Focusing on the critical role of monetary policy, their analysis reveals how U.S. policymakers successfully avoided the monetary missteps that are partly to blame for Japan's "lost decade."

In 1991, after years as the economic envy of the world, Japan entered a period of stagnation from which it has yet to fully emerge. Ten years later, in 2001, America's own record expansion came to a halt. And some of the same problems that have caused so much pain in Japan -- chiefly, falling prices or "deflation" -- began to loom as threats to the U.S. recovery. Yet the United States avoided Japan's fate and may have Japan to thank.

Harrigan and Kuttner document a number of worrying parallels between the situations in Japan and the United States as the two countries fell into recession. Both economies' expansions were powered by extraordinary investment growth, and both countries experienced asset price bubbles. And the U.S. government's fiscal situation, like that of Japan's, deteriorated sharply as the economy collapsed. There were also some important differences, however: Japan's asset price bubble was significantly larger, and its financial system more fragile than that of the United States.

Harrigan and Kuttner note that the U.S. Federal Reserve and the Bank of Japan both responded to the recessions in their countries by cutting interest rates. But a more detailed analysis of monetary policy reveals that, as the U.S. "boom turned to bust," the monetary policy pursued by the Federal Reserve was "far more aggressive" than that followed by its counterpart, the Bank of Japan, in the 1990s and that "its decisive response may have helped the U.S. economy recover more quickly."

Harrigan and Kuttner suggest that, with Japan's sobering lesson in mind, Fed policymakers were sensitive to the threat of deflation, and acted accordingly. "Perhaps because it had learned from Japan's experience, the Fed was prepared to implement a vigorous anti-deflation policy...much more quickly than the Bank of Japan," they write. "Moreover, this intention was consistently backed up by statements and speeches by Fed officials emphasizing the seriousness of the deflation threat, however small, and pledging to do whatever was necessary to prevent it."

The impact of their action, if judged by the state of the economy, appears to have been positive. By the summer of 2004, three and a half years after the onset of recession in the U.S., its economic recovery had become self-sustaining, and deflation had receded as a threat. The contrast with Japan's experience is stark. At the same point in its own post-peak period, the Japanese economy remained stagnant, and deflation was emerging as a chronic problem.

While it's easy to understand why the Fed would want to do what it could to avoid with the corrosive effects of deflation, Harrigan and Kuttner said it has remained puzzling why Japanese responded "so slowly and so erratically in the face of deteriorating economic conditions." The insufficient response early in the crisis, they said, could be attributed to the simple fact that few anticipated how rapidly disinflation would assert itself. But even when it was apparent to all that it was well established, Japan's response remained weak.

In fact, in 2000, the Bank of Japan actually raised interest rates and a senior bank official publicly stated that deflation was beneficial. Harrigan and Kuttner note that some economists compare this decision to the Federal Reserve's move in 1937 to effectively restrict bank lending, which is widely blamed for extinguishing the incipient post-Depression recovery underway at the time.

Harrigan and Kuttner suggest that the reluctance to act consistently and forcefully against deflation could be partly attributable to bureaucratic turf wars between the Bank of Japan and the country's Ministry of Finance, with the lack of cooperation producing weak policy. They also note that others view the long-term effort by the Bank of Japan to seek independence from the Ministry of Finance, which was formalized in 1998, as producing what is known as an "independence trap." Bank leaders may have feared that if a bold initiative against deflation backfired, they might lose their new autonomy.

Harrigan and Kuttner also note that Japan's inaction may have been the result of a simple, rigid adherence to "certain economic doctrines," such as those that stress caution in doing anything that could cause inflation. These doctrines might work well in normal conditions, they observe, but can be obstacles to effective action in other times.

The authors offer one cautionary note in an otherwise favorable view of U.S. response to its post-boom period. One difference between the two countries that does not bode well for the United States is a comparatively high level of government debt, which stood at 43 percent of GDP prior to the recession, compared to 13 percent for Japan. There also is the even more troubling fact that U.S. foreign indebtedness has "soared in recent years" while Japan continues to run surpluses in this area. Harrigan and Kuttner view foreign indebtedness as a serious issue that remains unresolved, despite the recovery. "Such a large U.S. current account is not sustainable and adjustment is likely to be a substantial policy challenge in the coming decade," they conclude

-- Matthew Davis