Five years have passed since summer 2007, when the US subprime mortgage crisis arrested European banking markets. Economic growth has remained weak and unemployment high in both the United States and Europe.
The financial systems of the United States and Europe have yet to regain confidence in their resilience. A sizable amount of bad assets remain on the balance sheets of financial institutions although large provisions have been made. The Japanese experience of the banking crisis tells us that as long as bad assets sit on banks' balance sheets, there is a significant degree of uncertainty over both the cash-flows and profitability of banks, and as a consequence, banks tend to be cautious about extending credit.
While deleveraging is underway in the banking sector, monetary policy has only an uncertain degree of power in stimulating the economy because the credit channel - the traditional mechanism of monetary policy transmission -- is clogged.
Fiscal policy has a role to play in preventing a great depression, but it is also limited in terms of its ability to stimulate the economy. The Japanese experience of repeated fiscal stimuli in the 1990s demonstrates that the stimuli supported economic growth when applied to the economy, but the sad reality is that the effects quickly dissipated once the stimuli were discontinued. In these circumstances, there was virtually no multiplier effect stemming from either fiscal expenditures or a tax reduction. This is not surprising. When the economy has a lot of bad assets to work out, fiscal policy can ease the pains of adjustment but is unlikely to reverse the downsizing trend. Particularly when the banking system is deleveraging, banks are quite naturally reluctant to expand their balance sheets, which limits the pump-priming effect of fiscal stimuli.
There is historical precedent for this in the Great Depression of the 1930s. I examined the US and Japanese fiscal policies during this period as head of economic research at the Bank of Japan in the mid-1990s, reaching the following conclusions.
First, the US New Deal failed to engineer a sustainable economic growth although government debts increased from 20 to 40 percent of GDP between 1930 and 1939. As is well known, there was a renewed recession in 1936 and 1937. The unemployment rate remained stubbornly high at 17 percent even in 1939. Second, Japan's fiscal expansion under the leadership of Finance Minister Takahashi successfully brought about economic expansion from 1932 onward. Industrial production increased at an annual rate of 11 percent between 1932 and 1936, while real GDP increased annually by 6 percent. Economic growth continued uninterruptedly after 1937, when Mr. Takahashi was assassinated in an attempted military coup. Debts-to-GDP had gone up from 40 to 55 percent before he assumed his office, which was then sustained at that level until his death. From that point on, no one seems to have been able to reign in the subsequent military expansion in terms of budget or policy.
The success of Mr. Takahashi's fiscal policy has been attributed to his well-targeted strategy. Under his leadership, the annual budget size increased from 1.5 billion to 2.2 billion yen (1932-36 average). The-600-million yen increase was accounted for by public construction in the rural areas, expense related to the Manchurian incident, and armament. Both Manchuria-related expenses and weapons procurement/development invited growth in business investment as well as employment since it was obvious that these outlays would continue for some time.
I am by no means recommending a military build-up in the present context. The point I am making is that as long as the private sector has significant doubts about prospects for sustainable growth, fiscal policy can hardly exert a lasting effect on the economy. In fact, in the 1990s the Japanese government increased budget items for public construction, under which many roads were paved in places with no car running, while many ports were built in places with no ships to harbor. These expenditures were done not only because of bureaucratic ineptitude and pork-barrel politics but also because money could be spent quickly. In Japan and perhaps in Europe, too, paving a road in a congested area - which means paving a productive road - requires persuading residents to sell their land and move out. You know Japan is not as efficient as China in this regard. Little confidence in the fiscal sustainability means that fiscal stimulus supports economic growth only when it is applied to the economy. The key is confidence in sustainability.
Success in any policy comes down to restoring confidence in the system. The American presidential election campaign demonstrates that even an apparently popular leader cannot restore confidence in the system if the economy fails to improve. So what can we do? Insufficiency of effectiveness on the part of individual political leaders may point to internationally coordinated actions for projects which are credibly sustainable.