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Mr Bernanke, Japan and the US debt problem

Today saw the start of a significant rally in the US stock market for the first time in several days, and a significant day for the UK stock market, where the yield on the equity market briefly rose above that of the 10-year bond yield, traditionally an early warning signal that equities will deliver good returns over the medium term. It still looks like being a long hot August, however, with the Eurozone crisis showing little immediate signs of easing.

It was naughty - but oh so pointed – of Albert Edwards, the very bearish  market strategist at Soc Gen, to point out what Ben Bernanke, the chairman of the Federal Reserve, had to say in the now infamous “helicopter Ben” speech nine years ago. That was the speech, made well before he succeeded Alan Greenspan in the top job at the Federal Reserve, in which he expressed absolute confidence that the US would never again be allowed to experience a deflationary recession.

The Fed, he said, quite unequivocally, had the tools, in the shape of the printing presses, with which it could be sure of preventing deflation (and boy, you might say, has he used them already!).  But then, he asked – rhetorically – in his speech:

The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I
will just make two brief, general points. First, as you know, Japan’s economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt.

Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan’s overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan’s long-run economic health.

But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among
policymakers is difficult to achieve.

In short, Japan’s deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.

Political gridlock and excessive debt? Does that not sound the United States in 2011? It certainly does. The reality is that the Fed is going to have its work cut out to pick a path through the current minefield of excessive sovereign debt – the legacy of the steps taken to resolve the credit crisis of 2008 – and the manifest failure of the political leadership to arrive at an agreed way forward. And that of course is just looking at the U.S. on its own. As I noted last year, ever since the crisis the markets have swung back and forth between fear of deflation and fear of inflation, and the last few weeks have seen the former in the ascendancy.

It is an ugly and precarious situation, even if the markets continue their rally, as they may well. Mr Bernanke of course is due to say something later today, and it will be interesting to see what he has to say. Just as the European Central Bank is being dragged kicking and screaming into bailing out the Eurozone against its better judgment (and some say, its constitutional capabilities), so too the Fed is once more being thrust centre stage as Washington fiddles and London burns.

Written by Jonathan Davis

August 9, 2011 at 4:17 PM