The Lesson of Japan

If like me you've heard our present situation compared to Japan's "Lost Decade" without really understanding what that means, this is a pretty good explainer:

Richard Koo, chief economist at the Nomura Research Institute, says the Japanese government implemented "one of the most successful economic policies in history."

Koo notes that when the real estate bubble of the 1980s burst, property values plummeted 87 percent from the peak nationwide. Counting the value of real estate and stocks, Japan lost wealth equivalent to three years' worth of gross domestic product. It was "just about the largest loss of wealth in human history in peacetime," Koo says.

Still, Japan wasn't in recession. While growth slowed, GDP never fell below the peak of the bubble. And unemployment never went above 5.5 percent — lower than the current rate in the United States.

The Japanese government tried to spur growth by reducing interest rates — from 8 percent to zero. But despite that drastic action, Koo says, "absolutely nothing happened — no increase in asset prices, no increase in economic activity."

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Like Japan in the 1990s, the U.S. is suffering what Koo calls a "balance sheet recession." When asset prices collapse, the people who bought those assets with borrowed money are left with balance sheets underwater, and all they want to do is pay down debt.

"People are no longer maximizing profits the way it's assumed in economics. They're minimizing debt. The invisible hand of [economist and philosopher] Adam Smith works in the opposite direction," he says.

With private borrowing and spending frozen, the Japanese government stepped in, spending on highways, bridges and other infrastructure, and running up big deficits. Where the Japanese government erred, Koo says, was in worrying about those deficits. It cut back prematurely on the stimulus. The economy faltered, and the government had to resume spending.