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Daily Archives: August 16, 2010

Tea with Nouriel Roubini

How different is the US from Japan?

A nice piece from WSJ compares how the current economic situation in the US is different from Japan during the same period after the big housing bubble burst:


Mr. Darda is the chief economist, chief market strategist and director of research for MKM Partners.

Despite record doses of monetary and fiscal support, the U.S. recovery appears to be stumbling. First-time claims for jobless benefits are on the rise and economic growth estimates for the April-June quarter have fallen to just over 1%. Many are now asking if we are on our way to a double-dip recession or even a Japanese-style "lost decade."

These concerns are not without merit. Although the Federal Reserve expanded its balance sheet massively in 2008-2009, most of the high-powered money (currency plus bank reserves) that it's provided has piled up as excess bank reserves on deposit at the Fed.

Growth in commercial bank credit and broad money (which consists of currency plus bank reserves plus deposits in the banking system) is decidedly weak. That's a reminder that interest-rate cuts and money printing don't have the same traction when households are debt- and savings-constrained, and financial institutions are uncertain about the value of the collateral underpinning their loans.

But there are key differences between where we are now and where Japan was 50 months after the 1990 peak in its real-estate market. These differences make it less likely that we'll succumb to a deflationary double-dip recession or a lost decade.

For example, industrial commodity prices are about 75% above comparable levels in Japan just over four years from the peak of its real-estate bubble, suggesting a lower risk of a deflationary slump here. Corporate profits in the U.S. are more than 50% above where earnings were at this point of the cycle in Japan, despite the fact that the S&P 500 is actually lower than the Nikkei 225 was at this point in Japan.

Although broad money is currently expanding slowly in the U.S., the level of the broad money stock is 20% higher here than it was in Japan 50 months from the peak in its real estate market. This gap owes to the more aggressive early efforts of the Fed as compared with the Bank of Japan.

Those concerned about a Japanese-style lost decade occurring here will point out that the Treasury yield-curve spread (the gap between long-term interest rates and short-term interest rates) is actually narrower in the U.S. now than it was in Japan 50 months from its real estate peak. This gap not only gives us a picture of monetary policy, it also tells us about the behavior of inflation expectations. The yield-curve spread actually widened after the Fed announced the planned purchases of $1.75 trillion in agency, mortgage and Treasury debt in early 2009, as deflation expectations were replaced with expectations for modest inflation.

But the yield-curve spread peaked in February 2010—the same month the level of the monetary base peaked—and has since narrowed sharply. Treasury Inflation Protected Security (TIPS) spreads have compressed during this period. These indicators suggest the need for the Fed to remain accommodative, as the Fed statement on Tuesday suggested would be the case.

The current economic situation looks like the first few years of economic recovery following the 1990-91 U.S. recession, which were also characterized by weak broad-money growth and a contraction in bank lending. The M2 money supply (a measure of broad money) expanded by only 1.4% per annum through 1994 from 1992, but the velocity of money (the frequency with which a unit of money circulates) turned higher, allowing real GDP growth to average 3.7% per year nonetheless.

Putting fiscal policy on a sustainable, pro-growth track may help reduce uncertainty and improve velocity now.

One problem that dogged Japan during its lost decade was a stop-and-go fiscal policy in which stimulus packages were administered in an "on again, off again" fashion and taxes were lowered and then raised. There is a risk that the U.S. could fall into this trap in an effort to strike a balance between short-term fiscal support and long-term budget integrity.

This strongly suggests that congressional leaders of both parties should embrace a pro-growth fiscal reform that would help to create long-run fiscal stability and foster certainty about future tax rates. With the 2001-2003 tax cuts set to expire at the end of 2010, the time is now to move ahead with broad-based reform.

A good starting point would be the bipartisan Wyden-Gregg tax reform bill. This bill is not incredibly bold, but is probably the best we could do in the current environment and is much better than the current tax code.

Wyden-Gregg would be revenue-neutral; it would simplify the tax code by reducing the number of personal income tax brackets to three from six and would do so without raising marginal income tax rates. The bill also would cut the top corporate tax rate to 24% from 35% in exchange for eliminating corporate tax loopholes.

This would surely be preferable to raising marginal tax rates at a time of high economic anxiety. Raising tax rates on capital, which will occur if the 2003 tax cuts expire at the end of this year, generally has not been an effective source of revenue for the Treasury and could do damage to the recent strong productivity trends the U.S. has enjoyed.

The most likely course for the U.S. economy from here is for a choppy recovery cycle to continue until households have increased their savings and reduced their financial obligations to sufficient levels and financial institutions have more confidence that loan losses have peaked.

Avoiding policy mistakes during this period will be critical. While the Fed is the ultimate source of liquidity and thus "demand," congressional leaders could help reduce uncertainty and increase confidence by embracing a bipartisan tax reform that focuses on broadening the tax base and preserving incentives for growth.