The Great Recession: Lessons for Macroeconomic Policy from Japan

Stanley Fischer:

¹ This interesting paper by Kenneth Kuttner and Adam Posen presents persuasive evidence that the Japanese economy reacts in the textbook way to monetary and fiscal policy, and that the weakness of the Japanese financial system is a drag on economic performance and the effectiveness of policy. The message is "to trust what you learned in intermediate macroeconomics class"-a conclusion with which I am bound to agree.

Rather than focus on the details of the evidence, I want to take up the obvious question the paper raises: Why, if the answer is so simple, have policymakers allowed the Japanese economy to perform so poorly for almost a decade? One reason is that Japanese economic performance during the 1990s, although unimpressive, was not disastrous; policy would probably have been more decisive had Japan experienced a deep crisis rather than chronic underperformance. Kuttner and Posen are right to call this the Great Recession, rather than a great depression, for the economy grew, albeit very slowly and inconsistently, during the decade.

It is hard to know how far below potential the Japanese economy was operating at the end of the decade. The standard measures imply a gap of 3 to 4 percent of potential GDP, which is surprisingly small. By assuming that labor productivity grew during the 1990s at the previous decade's rate of 2.5 percent a year, the authors manage to raise the gap to 11 percent of potential GDP, which is more formidable, but less plausible.² It is tempting to conclude that the right measure is somewhere in between, but whatever the right measure, there is no doubt that the Japanese economy substantially underperformed during the last decade and shows no signs of strengthening at present.

Japanese policy during the 1990s becomes easier to understand by looking at growth year by year during the decade. Growth in 1990 was 5 percent, and in 1991 it was 4 percent-this being the end of the asset price bubble boom of the late 1980s. There was then a lengthy recession, lasting through 1995, during which growth averaged less than 1 percent a year. This could be explained, and was explained, as the price that had to be paid for the excesses of the previous decade. It is unlikely that Japanese policymakers were particularly concerned about long-run problems in the economy at the middle of the 1990s, although the strengthening of the yen exchange rate to 80 to the dollar in the spring of 1995 did give cause for concern and led to coordinated intervention that soon reversed the appreciation.

With growth at 3.6 percent in 1996, the recession seemed to be over, and the authorities decided it was time to clean up the budget. During the 1980s Japan had moved into budget surplus, and the 1996 deficit, which reached 4 percent of GDP, did not sit well with the Ministry of Finance, particularly with the aging of the population in prospect.

So it was decided to raise the value-added tax starting in July 1997; the total fiscal tightening was close to 2 percent of GDP. Predicting the impact of the tax change was complicated by the intertemporal substitution induced by the VAT increase, which caused spending to rise rapidly in the second quarter of 1997. Growth in that quarter was very high-and then the economy fell off the edge of the cliff. And all this just as the Asian crisis was beginning.

Why was the strong impact of the tax increase not foreseen? Partly because economists and policymakers were then paying a great deal of attention to the possibility of expansionary fiscal contractions-even though, as Kuttner and Posen remind us, the circumstances of the Japanese economy were not conducive to that outcome. Another factor was confidence that the growth momentum of 1996 was sufficiently strong to withstand a negative fiscal impulse, and another was that the strong intertemporal substitution caused by the VAT increase was not anticipated. Thus it was only in the second half of 1997 that it became clear that the economy might be suffering from a deep...