A bursting real estate bubble set off the Japanese recession of the 1990s, which deepened as ailing banks languished. It took Japan’s economy more than a decade to resume steady, noticeable growth.
Will this happen to the US? Probably not, but we may face a protracted process of recovery, stretching longer than the two or so years usually required to climb out of recession.
Behind every financial crisis there is usually a crisis in the real economy, based on some underlying structural deficiency. Even if the financial crisis is bottoming out, sooner or later the real crisis must be faced.
The fundamental problem in the US economy is that, for years, people treated rising asset prices as a substitute for personal savings. The thinking went something like this: As long as your home’s value rose every year, you didn’t have to set aside so much from your paycheck. If your stocks went up, too, so much the better; don’t forget that the Dow Jones industrial average stood in the 800 range in 1982 and seemed to rise almost nonstop for many years.
Of course, asset prices haven’t been rising much lately, so many people will need more savings for their retirement or for possible emergencies.
The need to save more sharpens a number of interrelated secondary problems. First, the US is aging. More people than ever are entering the years when they stop saving and start spending their nest eggs. That means that the transition to higher-than-expected savings may be drawn out and painful.
The second problem is that the US economy is enduring a credit crisis, with many banks trying to raise more capital and make fewer loans. Savings are good for the economy when they lead to investment, but there is no guarantee that financial institutions will be allocating capital efficiently.
The third problem is that lower consumer spending will require the US economy to make some shifts. That may mean fewer Starbucks and fewer new homes but more tractor production for export to foreign markets. In the long run, shifting some consumption to investment is probably beneficial to the economy; in the short run, it means job losses and costly readjustments.
In addition, there are still excess homes on the market, and housing prices need to fall further. Of course, such price declines can make banks less solvent and thus worsen the credit crisis. And politicians would like to moderate this fall in prices, again prolonging the adjustment process.
On top of all that is the largely separate matter of energy prices. High prices will encourage conservation and cleaner energy alternatives, but voters want low gasoline prices and winter heating bills. Politicians see lower energy prices as a way to help the economy in the short run — and as a way to win votes.
The evolution of energy prices may not follow any kind of desirable logic. There’s also the danger that the Fed will view high energy prices as a sign of permanent inflation and tighten money supply growth prematurely.
What should policymakers do? One path that is likely to prove counterproductive is further fiscal stimulus in the form of tax rebates. Such a stimulus can raise consumer spending and bolster the economy in the short run, but it works — if it works at all — only by pushing consumers to spend rather than to save. It merely postpones needed adjustments by providing a grab bag of goodies at exactly the wrong time.
Excessive bank regulation is another danger. To be sure, the regulatory structure for financial institutions failed in the current crisis, and change is in order. But we shouldn’t reform in a way that will discourage bank lending and weaken the tie between savings and investment. Banks are already allergic to very risky mortgages — probably excessively so — and we shouldn’t overreact by punishing them for past mistakes.
In other words, regulatory reform needs to be forward-looking rather than focused on penance. Given that politics often revolves around assigning blame, it’s not obvious that we will succeed in this task.
Emerging from the current slowdown isn’t just a matter of political will or smart central banking. If the recipe for success requires smooth adjustment into new growth sectors, more savings from disposable income, cleaning up the housing mess, well-functioning energy markets, and more effective financial intermediation— all in the right combinations and in the right sequences — neither the government nor the Federal Reserve can control this process. The Fed can add regulatory and monetary clarity, but there isn’t any magic bullet. Beware of anyone who tells you there is.
The Japanese failed to break out of their recession quickly because they didn’t promptly close down or clean up their problem banks. So far, the Fed and other regulators show no signs of making this mistake; they have been vigilant in resolving crises as they occur. But that’s not enough to guarantee a successful transition. The US economy will be tested for its deftness — and the test will be difficult precisely because there isn’t a single enemy on which to focus.
Have you ever tried to undo a bunch of tangled wires or cords? If you don’t pull on the right wires in the right order, the mess becomes worse. If you pull too hard, the whole thing can break. But if your first pulls are good ones, the untangling becomes easier with each move.
That’s like our economy’s situation today. If we expect too much too quickly, we’ll make matters worse. But there is a way out of the mess, and it lies in our hands.
Be careful, and start pulling.
Tyler Cowen is a professor of economics at George Mason University in Virginia.
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