There is a major underlying fear among US policymakers: that the US will suffer the same longtime stagnation that Japan has suffered since the bubble burst in the early 1990s. This useful op-ed by Larry Summers in the Washington Post is a prime example of this concern.
In fact, many of the current crop of senior officials spent a decade loudly advising the (unreceptive) Japanese on the necessity to stimulate their economy, and telling themselves that the US would never make the same policy errors. Hubris has been followed by dismay.
In fact, there are three major historic analogies that often play in policy minds. Japan is one. Another is 1937, when the Fed arguably prolonged the depression by prematurely raising interest rates. And another is the experience of the 1970s, when the Fed likely overestimated slack in the economy, leading to the Great Inflation.
Athanasios Orphanides, at the time a Fed researcher (and later Governor of the Bank of Cyprus) wrote a series of papers on the later argument. He argues that the Fed (and others like CBO) suffered from very serious misperception of the output gap and natural rate of unemployment at the time.
Consistent with the natural rate hypothesis, maintaining the unemployment rate slightly above the perceived “natural” rate was meant to be the optimal approach for restoring price stability. The “optimum feasible path”, of course, became the Great Inflation. Accepting that this activist policy was optimal, the policy disaster of the 1970s cup deb attributed to bad luck – an adverse shift in the “natural” rate of unemployment that could not have reasonably been expected to be correctly assessed for some time. But a more fundamental flow can be readily identified – concentrating policy efforts towards targeting the economy’s elusive full employment potential.
If that also eerily sounds like recent Fed talk about optimal policy and the need to pay close attention to employment potential… it is.
So what do we make of this? First, many current Fed officials would argue that if they had their choice of bad outcome, inflation is likely preferable to endless stagnation or depression. At least the Fed can raise interest rates to head off inflation. But it also suggests that there is usually a balance to be struck between, and trusting completely in one particular analogy can produce huge policy errors. People have a remarkable tendency to “fight the last war”, or repeat the mistakes of the past. We naturally reason in terms of historic analogies, and naturally commit patterns of errors as a result. We have to be careful about which “last” analogy we evoke – Japan in the 1990s, or the US in the 1970s or 1930s.
The other point is that people also tend to cherry-pick analogies to fit with their preconceived policy views, and usually fail to explore similarities and differences in historic situations in any depth. For foreign policy hawks, every foreign crisis is Chamberlain at Munich all over again. For doves, it is Dr Strangelove and the Vietnam War.
So Larry Summer’s piece is an excellent analogy by a Democratic economist to Japan. But it is always worth asking what is left unsaid or overlooked in policy analogies. Japan has also engaged in massive fiscal stimulus for twenty years, so much so its debt/GDP ratio is almost 230% of GDP. And stagnation endured.
The most relevant differences are more likely the structural flexibility of the two economies.