July 9, 2017 7:00 am JST
Thomas Mayer

'Japanese Disease' threatening global economies

Constant injection of liquidity reinforcing low growth, low inflation

Low growth and low inflation, or "Japanese Disease," was caused by avoiding structural adjustments after the bubble economy burst in the early 1990s. © Getty Images

Recently, I was again asked if the world was at risk of "Japanese Disease." When I was asked this during the Great Financial Crisis of 2007-08, I said no. Back then I expected the global policy response to the crisis to be different from the policy response of the Japanese authorities to the bursting of the "bubble economy" in the early 1990s.

Since then I have changed my mind. Yes, the world is suffering from Japanese Disease, because the policy response has been similar.

In my view, Japanese Disease -- low growth and low inflation -- was caused by avoiding structural adjustment after the bubble economy burst. Banks and companies in financial difficulties were propped up by loose monetary and fiscal policies, and private households were protected against adverse consequences. Hence, although land values plunged and the Nikkei Stock Index dropped 55 percent between the end of 1989 and 1993, the Japanese economy did not fall into recession.

At the same time, however, adjustment of unviable structures was impeded and resources locked into unproductive "zombie" companies and banks. Productivity growth fell from more than 3 percent per year on average in the 1980s to less than 1 percent in the 1990s. This induced a decline in wage growth as employers and employees wanted to minimize job losses. As a result, inflation fell. As adjustment was postponed to the indefinite future, low productivity growth and low inflation became entrenched. Easy monetary policy was not only a consequence of the conditions it helped to create, but it has also helped to perpetuate these conditions.

The global policy response to the Great Financial Crisis of 2007-08 broadly followed the Japanese pattern and has thus created a similar environment on a global scale. Emergency liquidity assistance by central banks in the wake of the collapse of Lehman Brothers averted a collapse of the financial system. The operation was similar to defilibration in case of cardiac arrest, and it was very successful.

Instead of suffering a Great Depression like in the early 1930s, the global economy only experienced a deep but short recession. However, the persistent injection of liquidity after the emergency was over -- undertaken with the intention to fortify economic recovery and push inflation to central banks' target rates -- has been harmful. It has prevented liquidation of unviable projects and locked the economies of the affected countries into a low growth-cum-low inflation state similar to that of Japan.

What is to be done? The answer seems to be clear: End a policy that has failed.

But this is easier said than done. In Europe and Japan, a highly indebted public and private sector has become dependent on readily available funding at ultra-low interest rates. Should financing conditions ever become tighter, bankruptcies on a large scale would be the result. Priming the liquidity pump therefore seems essential for survival in both Europe and Japan.

Liquidation of unviable activities undertaken during the expansion of the credit bubble was more forcefully pursued in the U.S. Hence, the US economy is now less dependent on ultra-low interest rates. But the supply of the world with massive amounts of liquidity by the European Central Bank and the Bank of Japan thwarts the efforts of the U.S. Federal Reserve to exit from its own policy of ultra-easy money. Money flows from Europe and Asia keep U.S. Treasury yields low even though the Fed raises its policy rate and is about to shrink its balance sheet.

How will it end? Central banks pursuing harmful policies will lose credibility in the event. When the loss of credibility is evident, confidence in our fiat-money system will wane. Whether people will then embrace "old money," such as gold, or "new money" in the form of privately issued crypto currencies, such as bitcoin, remains to be seen.

Thomas Mayer is the founding director of the Flossbach von Storch Research Institute in Cologne, Germany

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