This column by Roger Arnold originally appeared on RealMoney on Aug. 16. For a free trial to RealMoney, follow this link.
NEW YORK (RealMoney) -- Since 2000, the U.S. has been undergoing a version of Japan's experiences from 1990 to the current day. Economic activity and equity and bond market performance, as well as monetary and fiscal policy actions, are very similar. And the U.S. is clearly still on that path.
This is not accidental or coincidental. It is the result of repeating the same failed policy responses. Japan is in this situation because of the monetary and fiscal policy decisions it made after being advised by U.S. policymakers.
During the latter half of the 1990s, Robert Rubin was the Treasury secretary, and Alan Greenspan was the chairman of the Federal Reserve. They were the primary advisers to their counterparts in Japan, and they advised the Japanese to make the decisions they did on both monetary and fiscal policy.
The advice from the U.S. was based on the long-held belief that deflation was impossible because it could be counteracted with monetary and fiscal stimulus -- printing and spending. This is what the Japanese did. And it didn't work. The conventional rationale for its failure has become not that the prescription was wrong but that the application of it by the Japanese was inadequate.
In other words, the Japanese economy continued to deflate, and is still doing so 17 years later, because the Japanese did not print and spend fast enough or large enough. If they had done so, the policy prescription would have worked to offset deflation and stimulate inflation.
This has been a convenient way to explain why the policies failed in Japan. But it was also perceived to be necessary. I will address this momentarily.
If we simply blame the Japanese policy makers for improperly applying fiscal and monetary stimulus and thwarting it with counterproductive tax policies, the status quo remains unchanged.
Academics did not have to review Keynesian fiscal policy prescriptions or Friedmanite monetary assumptions. Nobody in the public or private sector had to question the concept of the impossibility of deflation. And as a result, the capital markets could pretend that the emergency prescriptions of print-and-spend, if they were ever needed again, could still correct any imbalance that occurred.
To believe in this remedy, you would have to believe that no other policy prescriptions were available. Since the early 1960s, the corrective fiscal and monetary response to a financial crisis or nascent deflation was to print-and-spend and to repeat until the policy was successful or the country was broke.
Politicians, academics and bankers began to believe that if they admitted that there was a problem with the financial emergency response system, and that there was no safety net underneath the capital markets and that wealth could be destroyed, the fear would become self-validating, and investors would move away from risk.
Which brings me to current events in the U.S.
Moral hazard mandated that if the capital markets were to function under the premise that there was a safety net underneath the markets that could correct a market contraction, offset deflation and prevent real loss of wealth, then market participants would eventually push the markets to the point where corrective measures would be required.
And that is indeed what happened. This was the underlying driver of the subprime crisis and the other debacles that led to the collapse of Lehman Brothers.
And just as the policy prescriptions failed in Japan, they've been failing in the U.S. The difference is that the Japanese had no other countries' experiences to look back on and therefore had very little reason to believe those policies wouldn't work there. The U.S., however, does have the Japanese experience to look back on. And that means that the potential for crisis of confidence among the investor class in the U.S. is far greater than it ever was in Japan.
It also means that it is less likely that the U.S. markets and economy will continue to follow the pattern of the past 10 years -- a path that mirrors the one Japan took 10 years earlier. At some point investors will conclude that the Japanese trajectory is unavoidable as policy responses are unworkable; a crisis of confidence.
The seminal question for investors to consider is, are policy makers attempting to prevent this from occurring, or are they preparing to respond to the aftermath?
-- Written by Roger Arnold
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