Viewpoint

What Chairman Bernanke Could Learn from Professor Bernanke


This just in from the National Bureau of Economic Research: The Great Recession officially ended in June 2009. Despite the formal end of the recession, a meaningful economic recovery has yet to begin.

Even with massive Keynesian pump-priming, economic growth has been far weaker than the typical postslump rebound. While some private-sector jobs have been created over the last few months, there is no momentum propelling the job market, and unemployment may well continue at current levels for some time to come. The U.S. has actually shed more jobs than it has created since June 2009, when the recovery officially began.

Real estate also continues to be a drag on the economy. Even though home prices are well below their 2007 levels and mortgage rates are at historic lows, the residential real estate market has fallen into another slump since the expiration of the first-time home-buyer tax credit on Apr. 30. Fears of further erosion of real estate values may be keeping buyers on the sidelines.

Quick Recovery Eludes U.S.

Since World War II, the resilient U.S. economy has emerged relatively quickly from each and every recession. Over the last several decades, the deeper the recession, the more powerful the recovery. A recovery with the strength to create a substantial number of private-sector jobs has just not happened this time around.

Following the 1973 recession, one of the deepest postwar downturns, triggered by OPEC's rapid and significant increases in oil prices, the U.S. economy took seven quarters from the start of the recession to grow back to prerecession levels of gross domestic product. We are now at 10 quarters and counting since the start of the Great Recession, and prerecession economic levels are but a distant dream.

Clearly the Great Recession was different. Most recent slumps have been the consequence of tight monetary policy. In such a recession, you could spark demand by loosening monetary policy. Not this time. The financial crisis and the subprime mortgage crash were the catalysts for the Great Recession, and changes to monetary policy alone will not get us out of it.

Despite trillions in U.S. government spending and a ballooning national debt, inflation has remained eerily tame. Low inflation and slow growth are worrisome and may indicate that "the economy is just one modest contraction away from dipping into a Japan-like deflation," according to Steven Ricchiuto, chief economist at Mizuho Securities.

Lessons from Japan's "Lost Decade"

The so-called "lost decade" in Japan could be a perfect analogy for America's current economic woes. In the same way that the financial crisis in the U.S. was caused by the bursting of the residential real estate bubble in 2007, the Japanese economic malaise was sparked by the bursting of their real estate-driven asset bubble in the late 1980s.

The Japanese government and central bank attempted to deal with the symptoms, rather than the cause, of the crisis. While Japan's response to their bursting real estate bubble allowed the Japanese economy to grow throughout the 1990s, its rate of growth of real GDP was painfully low—essentially 1 percent per year—and resulted in economic stagnation. By not acting boldly and dealing with the underlying causes of the problem, slow growth and low inflation were assured. But was that the right prescription for Japan's ills?

Bernanke, a respected expert on the Great Depression, published a paper in late 1999 while he was chairman of the Economics Dept. at Princeton University, focusing on the Japanese economy in the 1990s. The paper's title itself—"Japanese Monetary Policy: A Case of Self-Induced Paralysis?"—gives some insight into what he saw as the cause and effect of Japan's economic woes.

A decade of subpar growth can have an enormous cumulative impact. In Professor Bernanke's critique of the Japanese economy during the 1990s, he calculates that had Japan had a rate of inflation-adjusted, or real, GDP growth of 2.5 percent from 1991-99, rather than the 0.9 percent pace actually achieved, the nation's GDP "in 1999 would have been 13.6 percent higher" than it actually was. Given the size of the Japanese economy, then the world's second-largest, this would have had an enormous positive impact inside and outside of Japan. As I am sure Professor Bernanke would be quick to stipulate, calculating the impact of higher growth is far easier than taking the necessary steps to create it.

The Inflation Prescription

So, if the U.S. economy today is in a state similar to Japan's a decade ago, what would the professor recommend? Inflation! In his scholarly view, the Bernanke of 1999 concluded that the Bank of Japan should have announced "a target in the 3-4 percent range for inflation, to be maintained for a number of years."

The normal reaction to inflation is that it should be kept contained, held to a low level. The destructive effects of a sustained rise in prices are well-documented. But is it possible that higher inflation would actually strengthen the economy? Inflation increases the nominal dollar value of assets while the nominal dollar value of debt remains the same. As wages and prices increase, the debt burden is effectively eased. Clearly the holders of that debt are losing out as rising prices erode the "real" value of their holdings—but that might be preferable to a long-term economic malaise. Individuals and companies would be reluctant to sit on their cash during a period of sustained inflation. Instead, they would spend or invest it. Igniting inflation is risky business and it is understandable that few central bankers would have the resolve to promote such an approach.

A decade after Professor Bernanke delivered his paper, Bank of Japan Governor Masaaki Shirakawa, speaking in New York in April 2009, acknowledged the striking similarities between Japan in the 1990s and the U.S. since 2007. Shirakawa warned that "the U.S. might be entering its own version of the 'lost … not necessarily decade but something else.' " With the benefit of hindsight, Governor Shirakawa acknowledged that his BOJ predecessors had not acted as quickly and decisively as was required to avoid the economic stagnation that comes with low growth and deflation.

In Professor Bernanke's 1999 paper he rebuts the argument made by the Bank of Japan at the time that simply maintaining low interest rates for an extended period represented monetary policy necessary to provide economic growth. As he noted then, "low nominal interest rates may just as well be a sign of expected deflation and monetary tightness as of monetary ease."

Sage advice from Professor Bernanke to Chairman Bernanke.

"Rooseveltian Resolve"

The role of an academic is far different than that of a central banker. While an academic can propose policies based on theories, a central banker must take actions that could have enormous consequences, sometimes very negative consequences. Professor Bernanke clearly understood that challenge and urged Japan to have "Rooseveltian Resolve" in dealing with its stagnating economy. Although Professor Bernanke accepted that many of Franklin D. Roosevelt's programs did not work as expected, he praised FDR's resolve and willingness "to do whatever was necessary to get the country moving again."

Governor Shirakawa challenged Americans, and possibly Chairman Bernanke, to remember "that 'bold actions' are [not always] judged to be bold afterward." Hopefully Chairman Bernanke will take the advice of both Governor Shirakawa and Professor Bernanke. It is clear that we need a moment of "Rooseveltian Resolve" in order to re­ignite the U.S. economy.

Frank_aquila
Aquila is a partner in the Mergers & Acquisitions Group of Sullivan & Cromwell LLP.

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