Stagnation Not Depression

The most commonly cited parallels for today's financial crisis are the debt crunches that hit America in the 1930s and Japan in the 1990s. Both comparisons are apt, but one is more so. Policymakers are under strong pressure to avoid either of these dire outcomes. But as psychologist Carl Jung put it: "You meet your destiny on the road you take to avoid it." Neither scenario exaggerates the scale of the challenge. There have been only two other instances in history when a major country's credit expansion began to follow a vertical trend line, taking total debt as a share of the economy close to 300 percent—the United States in the 1920s and Japan in the 1980s. Today the U.S. economy is even worse off, with total credit as a share of GDP at a record 350 percent. A debt supercycle has once again hit an iceberg.

There is a finite limit to how much debt a country can absorb, but it is hard to identify that point in advance. This supercycle goes back 30 years and has appeared on the verge of collapse many times. In fact, every time the economy suffered any setback, from the 1987 stock-market crash to the mild recession in 2001, the perma-bears sounded the bugle. However, policymakers successfully managed to repeatedly restart the economy by cutting interest rates—creating the impression that downturns are indeed getting shorter and expansions longer. The goal of policymaking shifted from just cushioning the pain in a downturn toward creating a new expansion cycle. Economic growth and increased debt came to be two sides of the same coin. The fundamental basis of a debt cycle is increased appetite for borrowing, usually on the back of expanding faith that new factors—like technological innovations spurring productivity growth—are raising the potential of the economy. Eventually, all such storylines get disconnected from reality.

The failure of the U.S. economy to respond to the Federal Reserve's aggressive interest-rate cuts since August 2007 is about as clear a signal as any that the fashionable solution—easy money—is no longer working. The debt burden is already too large to bear, yet the ironic nature of any policy solution to kick-start growth involves pushing the system into taking on even more debt. This was last attempted in 2001-02, when interest rates were cut sharply to keep the expansion on track after the tech bubble burst. The result was a $20 trillion pileup in the stock of domestic debt between 2001 and 2007, with much of it in the housing sector. The stage was set for the staggering debt-deflation process currently underway.

There is a certain inevitability about what follows a debt binge. After having borrowed growth from the future, the U.S. economy will have to sacrifice growth for a long time to come. History shows two possible outcomes: a debilitating depression that sharply shrinks the economy in the short term, but leaves it stronger and more productive in the long term, or a long period of stagnation that saps productivity and never really ends.

The U.S. today is probably going down the path taken by Japan, where economic pain was amortized over time, but where meaningful economic growth has yet to return.

The common perception is that the Depression and Japan's stagnation were the fault of authorities who acted too slowly to bail out the economy. Indeed, in the early 1930s U.S. President Herbert Hoover took no steps to halt a deflationary spiral, following Treasury Secretary Andrew Mellon's advice to "liquidate" the unprofitable portions of the economy, including farmers, workers and stockbrokers. Legendary economists such as Friedrich Hayek and Joseph Schumpeter influenced such thinking, saying it was the private sector's task to carry out any readjustment following a boom; after all, allowing boom-bust cycles to play out naturally served the U.S. economy well in the 19th century, when it emerged stronger after each downturn with no government intervention.

However, they carried that faith in the purging power of the market too far, leaving the policy mix of tight money and high taxes in place well after the excess had been wrung from the system. The result was an unprecedented period of economic decline in the 1930s. Ever since, governments and central banks have played an active role in managing every wiggle in the business cycle.

Still, the Japanese policymakers' response to the deflating real-estate bubble of the late 1980s is viewed as a failure to remember the lessons of the 1930s. During the Depression, John Maynard Keynes had argued the government must spend as much money as it takes to revive the economy. The Keynesian view is that the Japanese government in the early 1990s was too obsessed with its responsibility for inflating the bubble and so offered little policy stimulus even as deflation was setting in. Such inaction is widely blamed for the stagnation that followed. But any parallel with Depression-era America ends there.

Far from attempting to "liquidate" the weak, Japan did everything it could to save them. In the first half of the 1990s, Japan tried to shove the debt mess under the carpet, by employing creative accounting techniques and allowing banks not to recognize losses in their underlying assets. Poor-quality creditors were kept on life support with concessionary interest rates. Japan also started to ease monetary policy swiftly from late 1991 onward and announced many fiscal stimulus plans to pump-prime the economy. When the banks couldn't bear the rising burden of the toxic debt on their books anymore and began failing in 1997, policymakers finally took more-direct steps to deal with the crisis—from equity purchases in financial institutions to buying nonperforming loans with public funds.

The crisis eventually abated, but its effects linger. Japan still has a debt-to-GDP ratio of more than 300 percent; the only change is in the composition of debt, with government debt now totaling 175 percent of GDP compared with 75 percent in 1989 and the private sector's debt burden falling from 225 percent in the early 1990s to 150 percent now. The various bailout packages over the years have totaled nearly 25 percent of GDP, and the government's increased share in the economy has naturally led to a major decline in productivity. It is hardly surprising then that Japan's overall growth has settled at a much slower pace. The economy today is only 25 percent larger than it was in 1989.

The United States, in contrast, went through a Darwinian flush in the 1930s. Its debt-to-GDP ratio fell below 150 percent by the 1940s and huge productivity gains helped the economy nearly double in size two decades after peaking in 1929. Of course, it would be "extraordinary imbecility," as Keynes would have put it, to suggest that the United States should follow the 1930s policy script. The damage wreaked on the economy and society was huge before the renaissance. From 1929 through 1933, the U.S. economy halved, and prices declined by a third while unemployment reached 25 percent and stayed above 15 percent for all of the 1930s. No rich, modern society would tolerate such pain.

Today, the United States looks like Japan in 1998. Both have seen crises of solvency leading to a credit freeze and the failure of large financial institutions. Only the United States has been forced to move quickly to the bailout phase following the financial-market panic of this year, rather than waiting nearly 10 years as Japan had the luxury of doing during its near-denial phase from 1990 to '98. The U.S. economy will also avoid a depression: the low point for Japan was 1998, when the economy contracted by 2.1 percent. Productivity is bound to fall, too, as government takes a larger role in the financial sector and corporations worried about the future cut back on capital spending. Even after Japan's bank crisis abated, growth remained weak, averaging only 1 percent over the last decade, and the U.S. economy may do no better for the foreseeable future.

Similarly, the U.S. stock market need not fall any further after having already suffered one of its worst bear markets in history. Like the Nikkei in the late 1990s, prices are no longer excessive. The U.S. stock market currently trades at a PE ratio of 12 compared with its historical average of 15.

The lesson of Japan is that U.S. policymakers can prevent a depression but can't engineer a new growth cycle. This is not so much about a crisis in capitalism or the demise of the Anglo-Saxon model, but just that the American consumer—long regarded as the buyer of last resort—is binged out just as Japanese corporations were by 1989. It's the beginning of an era that may come to be known as the Great Stagnation 2.0.