Making2008 - March 2008 Japans Lost Decade Lessons for the...

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Economic Outlook Japan experienced a disastrous decade of economic stagnation and deflation from 1991 to 2001 after bubbles in its stock market and land market col- lapsed. While some economic pain was unavoidable— given a 60 percent plunge in equity prices between late 1989 and August 1992, accompanied by the onset of what ultimately became a 70 percent drop in land values by 2001—the “lost decade” was not an inevitable outcome. It required a series of persis- tently wrong economic policy decisions that ignored the lessons learned in America’s Great Depression of the 1930s and the subsequent research on the causes of that painful period. Japan’s experience in its lost decade and, indeed, during the new millennium carries with it lessons for U.S. policymakers today after the collapse of America’s highly leveraged housing bubble that has already seen prices drop by more than 10 percent from their 2006 peak, with indications of another 10 to 15 percent fall. America’s stock market is about 15 percent below its October 2007 peak, suggesting that investors are currently expecting a mild U.S. recession. More ominously, however, credit markets have largely ceased to function, save for the highest quality loans, suggesting that a sharp reduction in the quantity of credit available at market-clearing interest rates is threatening to curtail real economic activity by more than the seemingly benign level of market interest rates would suggest. U.S. Credit Crunch The United States is experiencing an intensifying lack of credit availability that is causing a sharp economic slowdown—until recently unforeseen by most economists, including those at the Federal Reserve. This is understandable—though not comforting—because most economic models capture the link between financial markets and the real economy with movements in the level of interest rates. A credit crunch in which interest rates do not move much but credit becomes severely restricted is difficult, if not impossible, to model accurately. 1 The result: weaker-than- expected growth during a period of rapid Fed easing. The federal funds rate was cut by 225 basis points—from 5.25 percent to 3 percent between August 17, 2007, and January 30, 2008. Fourth- quarter growth, at an annual rate of 0.6 percent, was sharply lower than the 4.9 percent third-quarter growth rate. First-quarter 2008 growth will prob- ably be negative. Many sectors of U.S. credit markets are frozen because transactions at market-clearing prices and interest rates would imply asset prices substan- tially below levels being assumed in financial reports prepared by banks, investment banks, insurance companies, and other financial institu- tions. A fear of solvency problems is constraining liquidity. Beyond that, accounting convention calls for valuation of real estate–related assets based on current real estate prices, not expected (lower) future prices. This convention amounted to a conservative assumption when prices were rising, but it is unrealistic when prices are falling.
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