U.S. and Japan: Land of the falling price

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When some of the top economic policy makers in the U.S. meet on Tuesday in Washington, it's fair to say their minds will wander to a place thousands of kilometres to the east.

For 20 years, Japan has struggled to pull itself out of an economic funk, which began when a gigantic property bubble burst and later morphed into a financial crisis. That narrative, long a cautionary tale, is starting to sound uncomfortably familiar on the other side of the Pacific.

As the U.S. recovery loses steam, some investors and economists are arguing that slower growth is a prelude to a period of Japan-style economic malaise: recurrent recessions, lacklustre recoveries, and ominously, falling prices.

It's an outcome that investors - especially in the bond market - are giving more attention. Seeking safety, they're piled into government bonds in recent weeks, sending yields, which move in the opposite direction as prices, sharply lower.

Government bond yields across the developed world are flashing signals of slower growth ahead. In the U.S., the yield on 2-year government notes fell below 0.5 per cent Friday for the first time ever in the wake of disappointing data on job growth. In Japan, the yield on the 10-year government bond slipped below 1 per cent last week, a seven-year low.

Few central bankers have been more obsessed with the lessons of Japan than Fed Chairman Ben Bernanke, who devoted a speech to the topic back in 2003. Mr. Bernanke "is doing all the things he told the Bank of Japan to do" to pull the economy out of its slump, says Kenneth Kuttner, a former Fed economist. The test now is "whether that will be enough."

Some of the parallels are striking. Like the U.S., Japan experienced a spectacular boom in real estate. The bubble burst in the early 1990s and paralyzed the banking sector, which remained in a state of cardiac arrest for almost a decade. By the middle of the 1990s, broad measures of consumer prices began to fall, marking the start of the country's long battle with deflation, a struggle that continues today. Over the past 20 years, Japan has fallen into recession five times. Last year, its total economic output, adjusted for changes in price levels, was lower than it was in 2004.

"Probably we've done enough [to avoid that scenario in the U.S.] but I worry that we haven't," says George Evans, an economist at the University of Oregon. Mr. Evans has researched the precise dilemma the Fed now faces - stimulating the economy when interest rates are already at zero.

So far prices in the U.S. are still rising, albeit in an increasingly anemic way. In June, core inflation rose 0.9 per cent from a year earlier, among the lowest such increases in the past 40 years. As long as prices are at least stable, Mr. Evans says, the economy should be able to right itself. But if they start to fall, there is the potential for "unstable paths."

Deflation - much less common and more mysterious than widespread increases in prices - keeps economists up at night. What they fear is a volatile downward spiral, where a lack of demand sets off falling prices, spurring consumers and investors to hoard cash rather than spend it, which depresses economic activity and prices further.

Interestingly, in Japan, the curse of deflation has not followed that plot. Prices in Japan have fallen in a steady but very modest way, at the rate of about 1 per cent a year, more like a low-grade fever than the raging infection economists would have predicted. "There is no question that deflation has been a drag on growth," wrote Adam Posen, an economist who has studied Japan and is an official at the Bank of England, earlier this summer. "But it has not been a disaster."

Of course, the knowledge that the worst-case scenario hasn't emerged in Japan is little comfort. A wealthy country with high savings rates and unusual level of social cohesion, "Japan is not going to drop away into the ocean, but it's not exactly a jobs machine," says John Makin, an economist at the American Enterprise Institute, a think tank. "The reality of Japan is one that no American politician could present to the public."

If Mr. Bernanke has his way, no American politician will have to. In his speeches and writings, he has maintained that a central bank can create inflation if it tries hard enough. "Sufficient injections of money will ultimately always reverse a deflation," he famously declared back in 2002, citing "the logic of the printing press."

The U.S. has several advantages. Unlike in Japan, the policy response to the financial crisis was swift and overpowering, rather than belated and cautious. Although U.S. banks still shy away from lending, they have returned to a relative level of health fairly quickly, where their counterparts in Japan stayed in a zombie-like state for years.

It's not all good news, however. One major factor that has mitigated Japan's woes in recent years is strong demand from elsewhere in the world for its exports. The U.S. will have no such cushion. (Unlike Japan, "we don't have China growing like a weed right next door," mutters one bearish U.S. hedge fund manager.)

In the meantime, some investors are girding themselves for a situation that might be described as "Japan lite" - years where recessions are interspersed with weak growth and prices remain more or less flat.

"This is about a very long term build-up of debt which is going to take a very long time to unwind," says George Papamarkakis, who heads North Asset Management LLP, a London hedge-fund firm. "We are going to go through a lost decade."