Japan Falls Into Recession: What Does This Mean?

One of the differences between economics and most of the physical sciences is that controlled experiments cannot be used to economic theories.  Natural experiments occur, however, that provide some insight into economic theory.  The economic experiment in Japan provides an opportunity to examine economic ideas more closely.  The government has used monetary and fiscal policies to stimulate an ailing economy with limited success. It seemed to work for awhile but the economy contracted by 1.6% in the last quarter. What went wrong?

The government has used an aggressive monetary policy that is similar to that used by the Fed in the US.  It was even more aggressive than US policy given the relative sizes of the two economies.  It was expected that pumping more money into the economy would arrest the price deflation that accompanies deep recessions.  The anticipated increase in price inflation has been less than expected.  This flies in the face of some economic theories which claim that price inflation is a consequence of an excess supply of money.  Inflation would only occur if the money were spent by consumers or by business.  That happened for awhile but consumer spending has unexpectedly declined.

Fiscal policy can be used to stimulate an economy but it is more difficult to use fiscal policy when the ratio between government debt and GDP is very high.  Japan has the highest debt ratio of any advanced economy.  That may have led the government do reduce spending and increase taxes.  Japan tried to increase tax revenue by raising the sales tax.  Consumers responded by reducing their spending and the economy has shrunk.

One interpretation of this experiment is that monetary policy and fiscal policy won't work to restore an economy in recession.  Conservatives, and many business executives,  argue that structural changes in the economy provide the best opportunity for restoring growth.  They generally recommend tax cuts for business and a reduction in government regulations which limit business opportunities.

Another interpretation is that monetary policy, which works well during modest recessions, does not work as well when interest rates have fallen to zero and cannot fall any further.  Deflation makes this worse because it increases the real interest rate which makes borrowing more expensive.  Inflation would lower the real interest rate but Japan and Europe have not been able to bring the inflation rate up to their 2% target.  Fiscal stimulus worked during the Great Depression, but it is politically difficult to use when it increases the government debt to GDP ratio.  Market forces can also limit the use of fiscal policy when investors in government debt demand a high premium to compensate for the risk of default.  Japan has been able to borrow at low interest rates because investors do not expect it to default on its debt.  It shares this advantage with other countries such as the US, England and many countries in the eurozone.  For these countries, the limit on fiscal stimulus is due to political and legal restrictions.  They have not taken advantage of historically low interest rates to invest in their economies.  The focus has been on cuts in government spending which have proven to be contractionary. 

Recession in Japan, along with an increasing risk of recession and deflation in the eurozone have increased concerns about the global economy.  China has been growing at more than 7% but this is much lower than it has grown during its decade of rapid growth.  Slow growth in China has had a profound effect on nations which provide raw materials and intermediate products to China.  The US has had decent growth which has been stimulated to some extent by a rise in military spending which is not resisted by the Republican Party.  This places the US in a familiar position as the "consumer of last resort"

While there has been much concern about the decline in global growth, there has been one bright spot in the economic picture.  Corporate profits in many parts of the world have been very good despite the decline in economic growth.  Stock prices and real estate prices have also increased despite the gloomy economic picture.  Consequently, some people have done well but many have not done as well.  This increases the risk of political uncertainty in many parts of the world.