Sunday, January 30, 2005

A Lesson from (1930s) Japan

How Strong is the Pressure to Keep Spending?

Suppose an economic policymaker decides that a policy of fiscal stimulus, easy money, and devaluation of the currency is necessary in order to keep demand afloat. If there is plenty of excess capacity in the economy, and wage pressure is light for one reason or another, this type of effort could be successful at reflating demand without generating too much inflation.

But how does the policymaker know when enough is enough? When does reflationary policy become inflationary? At present, the member of the Fed's open market committee seem to disagree about whether the economy is close to, at, or above potential, and hence the scope for continuation of loose policy without inflationary consequences.

From the December minutes:
A few participants also noted that uncertainty about the extent of resource slack in the economy was considerable and that it was quite possible that the economy could soon be operating close to potential, particularly if labor force participation rates did not turn up much while employment continued to register gains. The increase over the last few months in five-year measures of inflation compensation derived from Treasury nominal and inflation-indexed securities might be a warning sign that expectations were not as well anchored as they had been over the summer.
So the Fed seems like it believes the time has come to remove some stimulus and indeed is (timidly) doing so.

But, will the US treasury follow in its footsteps? There is a lesson from Japan in the 1930’s that shows just how difficult it is to get an economy off junk once politicians have noticed how effective stimulus is for staying popular. Japan’s policy during the great depression years was one of stimulus and devaluation. Japan was actually very successful at keeping unemployment low during those years, though of course at the cost of making its trading partners quite upset at the beggar-thy-neighbor policies. In short, though, the stimulative monetary and fiscal policies were effective at reactivating demand and production without inflationary consequences because the economy, like most of the world, had plenty of slack capacity (and commodity prices had plunged).

From W. Arthur Lewis’ account of the world economy during the inter-war years we learn what happened next:

By the beginning 1936 the Finance Minister responsible for this policy (Takahashi Korekiyo) had come to the conclusion that full employment had been reached, that further deficit expenditure would now start an inflation, and that expenditure should now be curtailed. But the militarists were now too firmly established to be denied. He was murdered. His successor continued the military expenditures, and wages and prices started to move swiftly upwards. Then, in 1937, came the attack on China, and the adoption of a full war economy.
The US is being quite successful with its reflationary policy, forcing the rest of the world to accommodate to its loose policy or suffer from exchange rate appreciation. Eventually (who knows how soon) full employment will be reached, and the stimulus will need to be taken away in order to avoid inflation. I wonder whether politicians will be eager to do so.


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