For lessons in austerity, look to the Japanese
Does Ben Bernanke suffer nightmares? Does Jean-Claude Trichet have sleepless nights? Does Mervyn King wake up in a cold sweat, his pyjamas soaking wet?
I wouldn't blame them if they did because after the biggest policy stimulus known to man, Western economies appear to have hit a brick wall.
Last week, the Federal Reserve revised down its projections for US economic growth in 2010, a response to an unexpected “soft spot” in the American economic recovery. European policymakers, meanwhile, worry about the impact of the sovereign debt crisis on the eurozone's recovery. And Mr King has, to date, managed only to pump up the volume of inflation: the underlying real economy remains very soggy.
The hoped-for recovery has not materialised. Instead, Western economies are languishing at the bottom of a cliff. Having fallen a long way, the renewed ascent is proving to be remarkably taxing.
Not all have suffered the same fate. Although there are plenty of worries about the ongoing pace of China's economic expansion, Asian economies have rebounded with considerable ease over the past year or so. The same is broadly true of other emerging nations. How have they managed to pull off a trick which the magicians of Western policy making are still attempting to master? What sleight of hand have policymakers in the emerging world achieved? And why can't the same ploy be replicated in the West?
Back in 2002, Federal Reserve economists wrote a paper arguing that Japan's economic stagnation in the 1990s and beyond, was largely the result of a failure to loosen monetary policy sufficiently. Japan's problems ultimately stemmed from the excesses of the 1980s. Japan was a nation living beyond its means. A simple steak sandwich at Tokyo's Palace Hotel cost the equivalent of £35, a totally silly price, which those participating in the late 1980s boom were mad enough to pay. Japan's economy had taken leave of its senses, helped by a stock market and real estate bubble which allowed access to more debt.
When the bubble burst and reality slowly dawned on a nation of fantasists, the great deleveraging began. Austerity wasn't forced on the Japanese. Instead, they chose austerity, recognising that the era of ever-rising wealth was over.
As a mechanism to avoid a Japan-style deflation, sterling's earlier decline has, therefore, been rather too successful. But unless sterling carries on falling or, instead, the public's price expectations become dislodged, it's doubtful that higher inflation will be around for very long. As the UK's new Government delivers austerity, the great deleveraging will affect the UK as much as everyone else, leaving us ultimately with too little, not too much, inflation. Western economies are all in the same boat full of debt-induced holes. Maybe that's the real reason why Mervyn King's pyjamas are soaking wet.