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A Tale of Two Recessions

Dan Tortorice

Two cities, Tokyo and New York City. Centers of the two largest economies in the world; both economies now mired in recession. Comparisons between the two economies and the recessions are all over the media. But these comparisons are faulty, for Japan’s recession is due to structural problems, while the United States’ recession is due to a temporary shortfall in demand.

The talk began on Tuesday when the Federal Reserve cut the fed funds rate to 2%. This is the rate at which banks loan to each other. The Federal Reserve requires banks to keep a certain fraction of their deposits in reserve. When a bank does not have enough reserves to meet its requirement, it borrows from other banks and does this at the fed funds rate. Now if the Federal Reserve wants to lower this rate, it buys bonds from banks and gives them money for the bonds. This increases the supply of reserves that banks have. Since they have more reserves, they are more willing to loan them to other banks, and so the interest rate (the monetary encouragement they need to agree to give the loan) falls.

But the important result is that there are more reserves. So banks will make more loans, pumping more money into the economy. How do we know they won’t hoard the reserves? This is simple. When they loan the money they make a profit. Since banks want to make as much money as possible -- is there any entity other than banks for which this is less true, other than maybe Microsoft? -- they’ll loan out the reserves. How do we know that people will be willing to take out the loans? That’s simple too. The increased supply causes the interest rate to fall, encouraging more people to borrow, until enough people are willing to take up the excess reserves.

So what does all this have to do with Japan? In Japan, this simulative policy is no longer available. Their interest rates are essentially zero. You can’t lower them any more. And now since U.S. rates are at 2%, people are afraid we’ve lowered them too much, that we’re going to get down to zero and no longer be able to stimulate the economy. That we’re going to end up like Japan, mired in a ten-year recession. But this fear is unfounded.

Let me explain why the story you hear from the media is wrong. Take this quote from a CNN article: “Japan’s big problem was that fiscal stimulus was not there,” said Robert Macintosh, chief economist at Eaton Vance Management. “They haven’t coordinated monetary policy with fiscal policy. That’s what we’re doing differently, and that’s why we won’t have the same problem.” Mr. Macintosh has his facts wrong. Japan had huge fiscal policies. In trying to stimulate the economy, the Japanese built bridges to unpolluted islands. If Mr. Macintosh wants us to think that Japan did not try to stimulate its economy with fiscal spending, how does he intend to explain Japan’s huge budget deficit? An arithmetic error?

It is possible that the United States will end up lowering its interest rates to zero. But this will not put us in the same boat as Japan. The U.S. recession has all the portents of a recession caused by a shortfall in demand: a sharp decline in investment and falling consumer confidence. The great thing about a recession caused by a shortfall in demand is that eventually it will go away. Demand always responds to prices. Eventually prices have to adjust to get people wanting to buy the production of the economy. Eventually supply needs to be equated with demand.

So why then hasn’t the Japanese recession gone away? Simply because it’s not a demand -based recession. Japan’s economy has seen essentially zero growth for ten years. It hasn’t been contracting, just stagnating. Part of economic growth is about finding out how to do more with less. Japan’s economy is restricted by structural facts; for example, it’s very difficult to fire someone there. Factors of production don’t move freely enough through the economy. As a result, it’s difficult to optimize resources to achieve productivity gains. It is these structural problems which afflict Japan’s economy, and monetary policy is unable to solve these problems.

So you’ll probably hear more “America is going to become like Japan” comparisons in the next few months as the Fed continues to lower interest rates. Don’t listen to them. America’s problems are temporary, and Japan’s are structural.