As the United States enters a recession amid growing signs of excess capacity after a surge of investment spending, inevitable comparisons arise with Japan’s 1989–1990 collapse and the disastrous decade that followed for its economy. While the American recession will be painful (like all recessions), it need not be followed by a decade or more of serious economic underperformance like that still suffered by Japan. One of the keys to a normal U.S. recovery is to avoid Japan’s serious policy errors of the 1990s.

The most reassuring conclusion to emerge from an examination of government policies, especially monetary and fiscal policies, that followed this century’s major equity market bubbles (including Japan’s in 1989 and America’s in 1929) is their extraordinary ineptness. Such mistakes should be easy to avoid, yet a need for caution arises from the fact that such mistakes were made by Japan even with the benefit of lessons provided by John Maynard Keynes’s monumental General Theory of Employment, Interest, and Money, published in 1936, and Milton Friedman and Anna Schwartz’s Monetary History of the United States, published in 1963. These important works provide a comprehensive guide to avoiding postbubble mistakes in monetary policy. While America’s grave monetary policy errors in the early 1930s were made without benefit of the lessons articulated by Keynes and Friedman, Japan chose to ignore these lessons, compounding its economic pain with major errors of fiscal policy in the 1990s. Given that Japan’s experience is both more recent and more disconcerting, because known tenets of monetary policy were ignored, the focus here will be upon lessons for U.S. policymakers from Japan. It is important to avoid the possibility, however remote, that American policymakers might fail to learn from the past just as Japan’s policymakers have done.

Lessons of Monetary Policy

Three basic lessons of monetary policy follow from Japan’s recent experience and from the analyses of monetary policy by Keynes and Friedman. These are: maintain stable monetary base growth; avoid targeting nominal, or market, interest rates--especially while inflation rates are falling or negative; and do not let deflation, a falling price level, take hold.

The need to maintain stable growth of the money base is clearly illustrated by problems resulting from the high degree of volatility exhibited by Japan’s money base growth in the 1980s and 1990s. The Bank of Japan allowed money base growth to rise rapidly from about a 6 percent annual rate in 1987 to more than 12 percent at the end of 1989. The Bank’s staff and leadership have, since then, been unrelievedly mortified by the realization that a rapid surge in money growth fed Japan’s late 1980s equity market bubble. It came when confidence in Japan and its economic future was as high as it would be ten years later in the United States, especially in late 1998 and 1999. Indeed, it is probably true that the rapid acceleration in money base growth supplied by the Federal Reserve--first, after the Long-Term Capital Management market crisis of October 1998 and, second, during the lead-up to the end of 1999 and its Y2K concerns--contributed to the extraordinary surge in U.S. equity prices that began in the fall of 1999.

A change of leadership and remorse over allowing the equity market bubble to develop led the Bank of Japan to slam on the monetary brakes in 1990, dropping the growth rate of the monetary base from 12 percent to below 2 percent during most of 1991, 1992, and 1993. This acute monetary contraction caused the equity market in Japan to collapse. The Nikkei index dropped first from close to 40,000 to around 24,000 during 1991 and then dropped further to about 16,000 in 1992. Japan’s equity bubble burst rather than deflated. Consequently, a sharp rise in the cost of capital caused private investment growth to collapse and subtract between 1 and 2 percentage points from overall growth during the three years following the early part of 1991.

The Bank of Japan was misled about the intensity of monetary tightening by a rapid fall in Japanese interest rates, which created an impression of easy monetary policy--an illustration of the danger of gauging the stance of monetary policy solely from the behavior of nominal interest rates. Actually, the drop in interest rates was a reflection of falling inflation expectations and falling real interest rates that accompanied the collapse in Japanese
investment spending.

The Bank of Japan has also tended to look with satisfaction upon a strengthening yen and a rising current account surplus as signs of a sound economy. Actually, the rising current account surplus mirrored a collapse in domestic investment spending coupled with a sustained high level of domestic savings. Japan ran out of investment opportunities at home while its households continued a high level of saving. For a time, consumption spending held up reasonably well while the high level of domestic saving made it easy for the Japanese government to begin a series of public works spending packages financed by the sale of government bonds to Japanese savers.

The Bank of Japan’s failure to maintain adequate monetary growth after the bursting of the equity bubble naturally led to its third major mistake: allowing deflationary psychology to develop. After allowing a modest run-up in money base growth rates from 2 percent during the 1992–1993 period to 6 percent in the middle of 1994, the Bank of Japan again began to restrict growth of the money base--dropping growth abruptly to below 4 percent by early 1995. The result was the closest thing to a deflationary crisis witnessed by any major industrial country in the postwar period. By the spring of 1995, Japan’s equity market was plunging--dropping from above 20,000 in 1994 to below 15,000 by May 1995. Private consumption began to contract rapidly while simultaneously the yen appreciated sharply, briefly reaching a high of just 79 yen per dollar in the spring of 1995. The combination of a falling stock market, collapsing consumption, and a strengthening currency is a dangerous one, indicative of a rapidly emerging deflationary psychology. Rising expectations of deflation shrink profit prospects, and equity prices fall. As consumers expect prices to continue falling, they hold off on spending and accumulate cash. The desire to add to liquid balances that appreciate at the rate of deflation also reduces capital outflows and causes the currency to appreciate. The currency appreciation is itself a deflationary event and thereby reinforces the trend toward further deflation.

Finally, confronted with what amounted to a deflationary crisis, the Bank of Japan relented and accelerated money base growth from about 3 percent to more than 10 percent in late 1995 and early 1996.

The reacceleration of money growth coupled with continuing fiscal stimulus from higher public works spending combined to produce a sharp recovery in Japanese growth in late 1995 and 1996. The move toward deflation was stopped, and the yen weakened back to more than 100 yen per dollar. Ominously, land prices in Japan continued to fall; by 1996 they had sunk to about half their level at the peak of the bubble.

While the Bank of Japan’s insensitivity to gyrations in the growth rate of the monetary base may seem hard to explain, the reason lies clearly in its tendency to focus on the level of interest rates as a guide to monetary policy. The danger of doing this in an environment of disinflation, deflation, and weak investment spending was clearly articulated in the Friedman-Schwartz Monetary History, which focused on the U.S. experience during the 1930s. Market interest rates reflect underlying real returns on investment and market inflationary expectations. After an equity market collapse accompanied by sharply lower investment spending, real interest rates drop, signaling economic weakness, not easier monetary policy. As an economy slows and prices fall, lower inflationary expectations also contribute to lower market interest rates. This too signals more economic weakness than it does ease of monetary policy.

The important impact of interest rates on the real economy flows from real (inflation-adjusted) interest rates, not nominal market interest rates. With Japan’s ten-year yields now at 1.6 percent and deflation close to 2 percent, real interest rates in Japan at 3.6 percent are well above the long-run average of about 3 percent. In short, monetary policy in 2001 is still tight, as evidenced by the continuing tendency toward a falling price level and the weak stock market. The shift toward a weaker yen that began in December probably reflects more outflows from Japan as foreign investors flee the sinking equity market. Meanwhile, the Bank of Japan insists in 2001 that with its policy interest rate at 25 basis points, there is little additional room for easier monetary policy despite the remarkably low growth rate of the monetary base, accelerating deflation, weakening consumption, and a falling stock market.

Lessons for Fiscal Policy

After 1993, the Japanese government pursued a series of fiscal stimulus packages that, by 1999, reached a cumulative total of over $1 trillion. The budget deficit approached 10 percent of GDP--the equivalent of a trillion-dollar deficit in the United States. Government debt has risen to 130 percent of GDP, the highest in the G7.

The additional spending was largely directed toward public works projects, shoring up a weak financial system, and subsidies to the weakest of Japan’s businesses, which, in retrospect, ought to have been allowed to fail. In short, Japan followed a decade of overinvestment in the private sector in the 1980s with a decade of overinvestment in the public sector in the 1990s. While the direct stimulus of government works projects and subsidies to weak businesses kept the economy from falling back into negative growth for a time, the weakness resumed once the direct stimulative effects of the spending packages wore off. This is hardly surprising in view of the fact that the large stimulus packages went to finance wasteful public works projects and simultaneously abetted the serious misallocation of resources by supporting weak industries rather than strong ones.

As soon as the Japanese economy began to recover, in the wake of powerful monetary and fiscal stimulus after the deflationary crisis of 1995, the Japanese government moved rapidly to raise the tax rate applied to consumption in Japan. This flirtation with fiscal orthodoxy (an attempt to reduce budget deficits by taxing household consumption in a deflationary environment) proved disastrous and threw the Japanese economy back into a sharp recession in 1997. Subsequently, private investment and consumption weakened, and another large program of fiscal stimulus was initiated in 1998 and again temporarily boosted the economy. But the recession resumed in 1999--resulting in yet another stimulus package. That stimulus package boosted the economy, once again temporarily, until Japan’s growth rate turned negative during the second half of 2000.

The most basic lesson about fiscal stimulus to be learned from the Japanese experience is to avoid wasteful government spending. Rather, it is better to reduce tax rates in order to encourage private demand as well as private work effort and investment. Japan’s wasteful demand stimulus created nothing but temporary relief from a chronically depressed economy resulting from underlying deflation and monetary policy that was too tight. The spending in support of public works projects, such as tunnels under Tokyo Bay and railroad lines to underpopulated parts of Japan, would never have been undertaken by the private sector. In effect, the Japanese government used Japan’s huge flow of trapped savings, pushed into government bonds by high levels of economic uncertainty and fear of investing abroad, to finance immensely wasteful expenditures. Had Japan instead reduced tax rates in 1992 to encourage investment and additional work effort, the economy would very likely have begun to recover, provided that the Bank of Japan did not keep monetary policy too tight. In fact, Japan’s only forays into tax policy raised consumption taxes in 1997 while increasing payroll taxes to finance health insurance programs. Both measures reinforced the deflationary pressures from tight monetary policy.

Japan’s tendency to use stimulative fiscal policy in conjunction with the Bank of Japan’s invariably tight monetary policy pushed up real interest rates and thereby caused the currency to strengthen, which reinforced the deflationary tendency already present. Curiously, the Japanese government was never able to recognize the dangers inherent in this deflationary policy mix. Furthermore, advice from the American Treasury Department reinforced this misguided policy.

Will the United States Repeat Japan’s Mistakes?

It seems highly unlikely that American policymakers will repeat the postbubble mistakes of Japanese policymakers. But difficult problems still face the designers of both monetary and fiscal policy in the United States.

In monetary policy, the most fundamental challenge will be to modulate the slowdown in the real economy without creating another bubble in the U.S. equity market--particularly in the dot-com and information technology sectors. The very stimulative monetary policies pursued by the Federal Reserve in late 1998 and late 1999 probably did contribute to the late 1999 bubble in parts of America’s equity market. One of the big problems with such a bubble that goes unrecognized for a time is the fact that it creates too much investment because rapidly rising stock prices make it tempting for managers to expand capacity too rapidly. Simultaneously, resources are misallocated by the sectoral nature of the bubble. The surge in dot-com and information technology (IT) stocks meant that adequate funding was unavailable to expand oil-drilling capacity, or electricity-generating capacity. Who wants to invest in oil well drilling when the price of oil is low and the cost of capital is high?

Now that America’s sectoral equity market bubble has burst, there is too much capacity in some areas and too little in others. Resources need to move out of the IT and dot-com sector and back into the basic industry sector. Government policies should not interfere. In particular, if the tax code is opened up this year to reduce marginal tax rates, pleas for special support for "needy" industries should be avoided. The pleas from dot-coms and IT companies may be especially loud in view of the excess capacity problems and the rapid deterioration in conditions in those industries. The Japanese government yielded to the siren call to help weak industries at the expense of sound industries, thereby accentuating resource misallocation rather than gradually eliminating it.

The Federal Reserve probably understands well the need to guard against deflationary tendencies like those that have emerged in Japan. The basic lesson arising from Japan’s experience is to avoid a situation in which a falling stock market and weakening consumption are accompanied by a stronger currency, as happened in Japan in 1995. The fact that the dollar has remained stable while the U.S. economy has slowed rapidly over the past several months is not a bad sign in view of the negative implications of a U.S. slowdown for global growth.

The biggest lessons for the U.S. flowing from Japan are in the area of fiscal policy. The Bush administration proposal to reduce tax rates will help to stimulate both demand and supply, with the latter being helped by the encouragement of more work effort and investment in basic industries. Lower and more uniform marginal tax rates will allow the U.S. government to collect taxes with less distortion of the private sector. Fiscal stimulus through lower tax rates also helps to stabilize the dollar by strengthening both supply and demand in the private sector.

America in 2001 is remarkably well supplied with policy options to contain recession. With the federal funds rate, the policy interest rate of the Federal Reserve, just half of a percentage point below its recent 6.5 percent high, ample room remains to cut rates another 3 percentage points if necessary. Tax rates are clearly too high with government revenues at over 21 percent of GDP (a postwar record) and a surplus of over 2 percent of GDP, or about $250 billion annually. Lower tax rates make eminently good sense even without a recession. With one, they become a necessity. The notion of paying down America’s debt (the lowest in the G7) instead of lowering tax rates as we enter recession is absurd, akin to Japan’s disastrous flirtation with fiscal orthodoxy when it raised tax rates in 1997 and precipitated a sharp recession.

Finally, the Federal Reserve must take care not to cling too hard to a fear of inflation. Should the end of America’s investment boom precipitate a sharp recession, inflation rates will fall faster than interest rates. Real interest rates will rise and monetary policy will be tightening even as market interest rates fall. Should this happen, the Fed will have to be very aggressive in pushing down market interest rates, using faster money growth to signal its desire to achieve stable, not falling, prices. The lesson that stable prices are best but falling prices are highly dangerous is the most important lesson American policymakers can learn from Japan’s sad experience since 1990.

John H. Makin is a resident scholar at AEI.