The Economy -- A Different Story

The U.S. economy is not 'going Japanese.'

After the Federal Open Market Committee cut the federal funds rate to 2% in November, it all but announced that would not be the last reduction. Based on these comments, a decline in the Fed funds rate to 1% sometime in 2002 now seems likely. This development has raised the question of whether the U.S. is about to head down the road to stagnation taken by the Japanese in the 1990s, a course that will continue at least through 2002. Claims that "it can't happen here," are met by reminders that 10 years ago, no one thought it could happen in Japan either. The similarities, it is said, include near-zero interest rates and possible deflation in both countries, plus a 75% collapse in the stock market: In Japan it was the Nikkei, in the U.S. it has been the Nasdaq. In my view, though, the differences dwarf the similarities. First, Japan had a thoroughly corrupt financial system, with the banks engaging in the Japanese version of a giant Ponzi scheme whereby large corporations that were losing money kept borrowing from the banks so they could lose even more money-but investors were not alerted to this. That couldn't happen here. Second, the yen was far more overvalued than is currently the case for the dollar. In an open economy, an overvalued currency has both pluses and minuses. On the minus side, of course, exports stagnate. But on the plus side, consumers usually benefit from lower prices of imports, and the inflow of more foreign funds boosts investment and productivity. In Japan, however, the system was short-circuited: Consumers did not benefit from lower prices because of the archaic distribution systems in that country, and in many cases, foreign investment was not encouraged. Japan got all of the disadvantages but none of the advantages from an overvalued currency. Third, the U.S. economy has benefited from government deregulation over the past 20 years far more than has been the case in Japan. Even if the reported gains in productivity in the late 1990s were somewhat overstated, there is no doubt that the technological revolution gave a major boost to the U.S. economy; once the current glut of excess capacity has been worked down, it will continue to boost real growth and productivity this decade. By comparison, productivity growth in Japan stagnated in the 1990s. So there is virtually no risk of a Japan-style stagnation in the United States. Even if that is indeed the case, it still raises the questions of why stimulative monetary and fiscal policies have not yet had any positive effect, how deep the current recession will be and how long it will last, and whether the eventual recovery will be vigorous or sluggish. Fed rate cuts earlier this year did not stimulate the economy because they were more than offset by the unexpectedly large decline in stock prices. Although the stock market remains well below its peak levels, it has recovered substantially from the lows following the terrorist attacks. That is not exactly wonderful news, but it does mean that the combination of lower interest rates and flat stock prices will permit monetary policy to have some stimulative impact on the economy next year. While the percentage decline in corporate profits has been unprecedented since World War II, firms are fighting back, and earnings will begin to recover next year. Even before the terrorist attacks, operating earnings had fallen 15%, from $895 billion to $760 billion. A further drop to $650 billion is expected before the carnage is complete. That would be a 27% drop, larger than any other in the post World War II period. Yet in spite of this relatively gruesome news, profits will rebound next year. Once again, this is not Japan: Our accounting records are reasonably transparent, and banks do not have trillions of dollars of bad loans to write off that are still being disguised. Furthermore, there were signs the economy was gradually starting to improve during the third quarter. However, the terrorist attacks generated a new round of cutbacks in employment, capital spending and discretionary business purchases. It will take the usual two to three quarters for these effects to work their way through the economy, with bad news still ahead on the employment front. Without further setbacks by terrorists, stimulative monetary policy should get the economy moving forward again by midyear. While another round of terrorist attacks could always delay the recovery indefinitely, in the absence of these events, the economy will pick up substantially in the second half-and the U.S. economy will diverge from the path of stagnation taken in Japan. Michael K. Evans is chief economist for American Economics Group, Washington, and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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