In the 1990s, Japan suffered a lost economic decade of highly disappointing economic growth and price deflation. It did so in the aftermath of the bursting of its massive equity and property market bubble. One has to wonder whether the U.S. might now be setting itself up for a decade of poor economic performance by allowing unusually large bubbles to once again form in its asset and credit markets and by throwing caution to the wind in the management of its public finances.
Even before the onset of the COVID-19 pandemic, the U.S. economy displayed troubling signs of Japanification. Following the 2008 bursting of its housing and credit market bubble, the United States experienced its slowest economic recovery on record while inflation remained consistently below the Federal Reserve’s 2 percent inflation target.
Meanwhile, its highly leveraged companies borrowed heavily at very low interest rate spreads, and the country seemed to have lost any constituency for budget discipline on both sides of the political aisle. Republican administrations proved to be very keen to cut taxes but were loath to cut public spending. Meanwhile, Democratic administrations proved eager to raise public spending but were hesitant to raise taxes. The net result was that the country now finds itself saddled with a record budget deficit and on an unsustainable public debt path.
The excessively expansive U.S. monetary and fiscal policy response to last year’s once-in-a-century health crisis makes it all too likely that in the years immediately ahead the Japanification of the U.S. economy will pick up pace.
By increasing the size of its balance sheet in less than a year by more than $4 trillion through its aggressive bond-buying program and by keeping interest rates at ultra-low levels, the Federal Reserve has created a troubling “everything” bubble in the U.S. equity, housing and debt markets. U.S. equity valuations are now more than double their long-term average and at lofty levels experienced only once before in the last 100 years.
Meanwhile, housing prices now well exceed their 2006 peak level and continue to increase by around 15 percent, while high-yield debt interest rate spreads are now close to their all-time lows.
By providing budget stimulus of as much as 12 percent of GDP in 2021 at a time that the Fed has its monetary policy pedal to the metal and that the Congressional Budget Office estimates that the country’s output gap is only some 3 percent, the Biden administration has increased the risk of economic overheating and persistently high inflation by year end. At the same time, far from thinking about long-term budget consolidation to restore public debt sustainability, Biden is rushing through Congress an improperly funded $1 trillion infrastructure spending bill and a $3.5 trillion anti-poverty and climate control package. This has to heighten the risk of high budget deficits and an unsustainable debt path for as far as the eye can see.
With inflation already picking up to a level not experienced in the past 30 years and to a level that is more than twice the Fed’s inflation target, it has to be only a matter of time before the Fed is forced to slam on the monetary policy brakes to meet its inflation objective. The Fed will do so first by tapering its bond-buying program and then by raising interest rates. That in turn is more than likely to burst the “everything” asset and credit market bubble, which has been premised on the assumption that ultra-low interest rates will last forever. It is also likely to worsen the country’s public finances as tax revenue receipts are bound to be adversely impacted by another leg down in the economy that the bursting of today’s asset and credit market bubbles will entail.
In much the same way as the bursting of its property and equity bubble in the early 1990s cost Japan a lost economic decade, the bursting of the U.S. “everything” bubble must be expected to usher in a prolonged period of disappointing economic growth, low inflation, unusually large budget deficits, the proliferation of zombie companies and yet another round of Fed quantitative easing. That is bound to increase the Japanification of the U.S. economy that already seems to be well underway.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.