Lessons from Japan's Economic Malaise

Japan's economy has been in a state of malaise--slow growth alternating with recession--for over a decade, with intense debate meeting policy vacillation. Some, for instance, prescribe budget deficits to stimulate the economy; others, remembering the Clinton Administration's claim that fiscal consolidation underpinned the US recovery in 1993, argue for deficit reduction. Similarly, some argue that the country needs a mild dose of inflation, while Japan's central bank continues to resist the very idea that inflation could ameliorate any economic problem.

Confusion about what cure to prescribe is caused in part by the fact that different medicines are suited for different problems, whereas much of the policy debate fails to distinguish among them adequately. As one of President Clinton's economic advisers during the critical period of America's economic recovery, I feel obligated to point out that circumstances in the US in the early 1990's were unique.

Normally, deficit reduction in an economic downturn makes a downturn worse--just as the British economist John Maynard Keynes demonstrated 70 years ago. Indeed, thanks to the IMF, we have had ample opportunity to see what happens, both in East Asia and Latin America, when an economy in a downturn tries to balance its budget.

The reason deficit reduction worked in the US in 1993 was that America's banks, whose balance sheets were weak, had large holdings of long-term bonds, the value of which increased as long-term interest rates fell. The fall in interest rates, which spurred business investment, was in part due to the long-term deficit reduction strategy.