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[From NYT] Hangovers and Hang-Ups

Posted March. 13, 2001 10:01,   


On Thursday Japan`s finance minister made the startling declaration that, after a decade of deficit spending to prop up the economy, his government`s finances were close to a "catastrophic situation." What Kiichi Miyazawa said was true — but men in his position are not supposed to tell the truth, at least not that bluntly. So the next day he apologized.

Recent data confirm that Japan is caught in a fiscal and economic trap. There are still policy options that might allow the country to escape from that trap; but Japanese officials have resolutely refused to try those options. In particular, though economic logic suggests that the Bank of Japan can and should help Mr. Miyazawa with aggressive monetary expansion, the B.O.J. has devoted considerable effort to devising creative reasons why it can`t and shouldn`t.

Indeed, Japan`s central bank actually tightened the screws on the economy last summer, abandoning its previous policy of zero short-term interest rates. Thereafter, as evidence of falling prices in the face of a weak economy mounted, bank officials proclaimed that the country was experiencing "good deflation" driven by technological progress. Now that it has become clear that goodness had nothing to do with it, the B.O.J. argues that since the interest rate is still close to zero, it can`t do much to promote recovery.

In fact, there`s a lot that the B.O.J. could do. It could commit to a long- term policy of printing more money, so as to replace expectations of deflation, which depress spending, with expectations of moderate inflation, which should encourage spending. It could also try to push down long-term interest rates by buying long-term bonds, and try to stimulate exports by weakening the yen. Not everyone agrees that these policies would work, though I think they would. (Full disclosure: I was one of the first to advocate a positive inflation target for Japan, and I remain public enemy No. 1 in the eyes of that proposal`s opponents.) But the real mystery is why the central bank of a chronically depressed economy refuses even to try.

Part of the explanation, I believe, is that Masaru Hayami, head of the central bank, has gotten hung up on a misguided economic doctrine — a doctrine that, unfortunately, has adherents here as well. I call it the "hangover theory"; it is the view that a recession is inevitable, even desirable, after a period of economic excess. In the case of Japan, it translates into the view that the economy cannot recover until it has been properly punished for the bubble years of the 1980`s.

The hangover theory has a strong emotional appeal. It turns the prosaic realities of the business cycle into a morality play of sin, punishment and redemption. But it doesn`t actually make any sense. During a financial bubble many bad investments get made. So what? The nation should write those investments off and move on. There are other productive investments to be made, other good uses for the economy`s resources. And if people are hesitant about spending enough money to keep those resources employed, well, the central bank should just cut interest rates until spending money is an opportunity too good to refuse.

But when policy makers take the hangover theory seriously, they refuse to move on. Hangover theorists tend to adopt the Naderite view that things can get better only if they first get worse. And central bankers, in particular, redefine their job: instead of trying to help the economy recover, they see themselves as disciplinarians, using interest rates to force flabby private companies to shape up. That`s exactly what happened last summer: Mr. Hayami argued that he needed to raise interest rates because the zero-rate policy made life too easy for corporations.

The United States is not in anything like Japan`s situation. Still, we are already starting to hear from hangover theorists — sometimes even on this Op-Ed page. Not only can`t we avoid a recession, they argue, we shouldn`t; we need hard times to purify our economic souls.

So let`s nip this fallacy in the bud. By all means let bad investments be written off. But if the bursting of a bubble turns into an overall recession, the fault will lie not in ourselves, but in our central bankers, who acted too little, too late. And it will be the Federal Reserve`s responsibility to get us out again.