The Economic Advisor

The Next Great Mistake

Mounting unemployment and layoffs are leading to greater and greater angst. When will this economic slump end? Doubts about the unprecedented monetary and fiscal stimulus have Americans suspecting we are in for a long struggle like the historic Great Depression or the more recent Japanese asset bubble. In both crises, a troubled financial system set off a decade long downward spiral of deflation, wealth destruction, and escalating unemployment as government appeared ineffective at restoring growth. But what tends to go unnoticed is that after the initial and painful recessions of both crises, each economy was apt to recover and respond to monetary and fiscal stimulus. However, specific miscalculations by the U.S. in 1937 and Japan in 1996 thwarted the recoveries and prolonged the downturns.

At the root of their miscalculations, policy makers maintained a bias to err on the side of holding inflation in check when the real public enemy was deflation. In the midst of zero interest rates and fragile growth, policy makers put the brakes on expansive monetary policy at the first signs of an upturn in inflation. This reignited deflation and threw each economy back into a steep downturn. These great mistakes are the reason both crises lasted over a decade.

In 1937, the U.S. was in its fourth year of recovery after the Great Depression. During that time, unemployment eased from 24.9% to 14.3%, the industrial production index more than doubled and the Dow Jones rebounded from 51 to 185. The deflation from 1930 to 1932 had not resurfaced. The U.S. was clearly on the road to recovery when the Federal Reserve, misguided by fears of looming inflation, raised the required reserve ratios for member banks. This limited the lending capacity of banks and led to a shrinking money supply, pushing the U.S. back into a severe 13 month recession. Contrary to the Federal Reserve’s expectations, inflation came in at a modest 2.86% in 1937. With the U.S. economy back in recession, deflation set in again. In 1938, the U.S. CPI shrank 2.78%, unemployment climbed to 19%, the industrial production index sank to 6.31, and the Dow Jones crashed to 99. Falling back into recession damaged confidence so much, the Dow Jones did not see 180 again until 1945.

Similar to the Great Depression, in the 1990’s Japan suffered from a collapse in stock market and real estate bubbles. In 1992 the Japanese economy began to decelerate significantly. Unemployment jumped up from 2.2% to 3.3% by 1996 and the Nikkei 225 index crashed from 38,275 to 22,531. Japanese inflation had slowed from over 3% to zero. To stem the tide of stumbling growth, the Bank of Japan slashed its target interest rate to below .5%. Unfortunately, this was not enough to restore growth or prevent deflation. But when inflation turned up in 1996, the Bank of Japan stopped cutting interest rates. By merely not cutting interest rates further, the Bank of Japan successfully subdued the temporary inflation. Yet the measures proved disastrous, by 1998 Japan’s inflation hit zero again and the economy fell back into a slump. From 1996 to 2002, Japan’s unemployment surged to 5.1%. The Japanese industrial production index fell 12% and the Nikkei 225 index crashed to 13,224. In 1999, deflation set in again and lasted through 2005. Japan has yet to sustain a lasting recovery. Its GDP shrank 14.1% in the fourth quarter of 2008 and the Nikkei 225 index has fallen to 7,054 in 2009.

So far current policy makers have taken great measures to apply lessons learned. They have increased the money supply, injected additional liquidity to the financial system, and enacted expansionary monetary and fiscal policies for stimulus. However, as the events of the past show us, we are by no means out of the woods. The next test will come when the monetary and fiscal stimulus appear to simultaneously pull us out of recession and ignite inflation fears. The faster commodities rise, the greater the pressure on the Federal Reserve to raise rates to contain inflation. Will policy makers throw us back into recession? Any recovery in a low interest rate environment, such as in 1937 and 1996, may be weak and any upturn in inflation may only be temporary. Ill perceived inflation risks while deflationary pressures continue to lurk could easily undermine any recovery and push the U.S. (and perhaps the global economy) back into a downturn. Considering the previous bias by the Federal Reserve to keep inflation low, a repeat of these mistakes could happen all too easily.

Kris Allen