From the December-January 2011 issue of Treasury & Risk magazine

Swift Steps Help Avert 'Lost Decade'

The National Bureau of Economic Research declared that the recession ended in June 2009, but the pace of recovery has been anemic, and restrained growth expectations are in order for 2011.

The 3% rebound in real GDP over the four quarters ending in June was less than half of what the post-World War II record suggests should occur after a recession in which GDP fell 4%. Moreover, the U.S. economy evinced lingering fragility this summer with the onset of the euro region's sovereign debt crisis.

No wonder doubts have persisted. Will the United States experience a double-dip recession? Does it face a "lost decade," such as Japan suffered in the 1990s, or the sustained deflation Japan has seen since the late 1990s?

We answer "No" to these questions, but do not reject out of hand the references to Japan. After all, both countries experienced a bursting real estate bubble and its consequences: deteriorating loan performance, banking crises, deep recession and a reduction in underlying growth potential.

Yet important differences suggest the United States will not suffer Japan's fate.

First, the three-pronged policy response--monetary easing, fiscal stimulus, and bank recapitalization and loss recognition--has been implemented more quickly and aggressively in the U.S. than it was in Japan. Broadly speaking, the 11-year period after the 1991 peak in Japanese real estate prices became a lost decade of economic stagnation by virtue of a generally delayed, weak and uncoordinated policy response, accompanied by a delayed restructuring of the private economy.

In the early 1990s, Japanese policy makers adopted an explicit policy of loan forbearance, which delayed the recognition of losses and impeded the creation of new, growth-supporting loans. Japan did not implement aggressive capital injections and loss recognition until the early 2000s, fully a decade after the peak in land prices. In contrast, U.S. policy makers performed stress tests on banks and injected capital where needed within three years of the house-price peak.

Similarly, the Bank of Japan cut rates too slowly in the immediate aftermath of the asset price bubble to achieve negative inflation-adjusted rates; it did not complete the transition to a zero-interest-rate, quantitative easing policy until the early 2000s. In contrast, the Fed achieved a negative real policy rate, cut the nominal policy rate to zero, and initiated a program of large-scale asset purchases within three years of the peak in house prices.

Second, private industry restructuring has been quicker, deeper and broader in the U.S. than in Japan. One example draws a stark contrast: While construction employment has fallen by 27% in the U.S. in the four years since house prices peaked, it continued to rise for six years (by 17%) in Japan after 1991. Swift capacity adjustments in the U.S. reduce the scope for a double dip in growth and also limit deflation risk by paring excess supply.

So just 3 1/2 years after house prices peaked early in 2006, the U.S. economy has been through its deep, banking crisis-induced, excess-purging recession, leapfrogging Japan's decade of economic underperformance. Moreover, the policies in place in the U.S. are comparable to those that finally underpinned Japan's sustained expansion in the 2000s. This supports our view that the U.S. recovery will gradually gain momentum.

Yet it is important to recognize that the diminished post-bubble expectations that descended upon Japan also apply in the United States. Growth during Japan's 2002?07 expansion, at an annual rate of just 2%, was less than half of that during the 1980s bubble years. Similarly, we anticipate U.S. growth of 2 3/4 % to 3% in 2011, a disappointment relative to the heady 3.5% pace in the 1990s.

In contrast to previous recoveries from deep recessions, residential construction will add only fractionally to growth, and consumer spending will grow no faster than income, as households maintain or increase saving rates. A sturdy expansion in business equipment purchases, fueled by strong profits and pent-up replacement demand, will be one of the few engines of growth.

Although the economy's growth potential has been impaired, the jobless rate will soon begin to move lower, approaching 8.5% by the end of 2011. Underlying inflation, as measured by CPI excluding food and energy, will stabilize in a 0.5% to 1% range and rise toward 1 1/4 % by the end of the year.


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