Avoiding Japan’s Fate by Repeating Italy’s Mistakes
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According to last week’s GDP Report from the Commerce Department, the nation’s economy grew by 4.2% during the third quarter of 2010 in nominal terms and by 2% on a real, or inflation-adjusted, basis. This means that inflation was about 2.2% for the quarter, which was slightly higher than the 2% inflation recorded in the second quarter of 2010 (all figures annualized). Overall, inflation trends have been positive, as measured by the GDP deflator, since the end of 2009. Yet deflation apparently remains enough of a concern to members of the Federal Reserve’s Open Market Committee that it has decided to print $600 billion of new money to finance large scale purchases of Treasury Securities.
Much of the Fed’s motivation for further “quantitative easing” is “to make sure the U.S. stays off the path trod by Japan.” Rather than being empirically motivated, the Fed’s policy path seems based on analogizing the current U.S. experience to that of Japan -- no matter how different the situations may be. As explained in a previous article, the analogy to Japan first breaks down when one compares the state of U.S. non-financial businesses to those of Japan in the aftermath of its bubble: unlike insolvent Japanese businesses, U.S. non-financial corporations are profitable, have healthy levels of debt, and are cash rich – even sitting on a “cash hoard” according to Bloomberg.
Second the U.S. continues to run large current account deficits (the trade deficit plus investment income and transfers) whereas Japan ran equally large surpluses. This means that U.S. domestic savings – including the idle corporate cash balances – is insufficient to finance the borrowing of the government and U.S. households. By contrast, Japan ran large current account surpluses, as its corporate and household savings far exceeded borrowing needs even as the government was accumulating the largest public debt burden of any developed economy in history. Therefore, Japan showed clear evidence of excess savings, whereas U.S. savings continues to fall more than 3% of GDP short of what’s required for balance.
Rather than focus obsessively on the inapt comparison to Japan, the Fed should be more concerned about the growing similarities between the U.S. and 1970s Italy. Italy experienced financial crises in 1974 and 1976 spurred by large current account deficits, excessive public spending, and a central bank that acquired Italian government debt by printing money. These crises required external financial assistance, led to abrupt and disorderly swings in public finances, and bred political instability. The country moved from economic stimulus, to severe fiscal and monetary contractions, back to expansionary policy. Balance of payments difficulties were persistently addressed through currency depreciation to gain competitive advantage. From June 1972 to August 1977, the Italian lira fell from 579.71 versus the dollar to 884.76 – a depreciation of more than 34%.
The chart below compares recent U.S. public financial data to that of Italy in the 1970s. Relative to 1970s Italy, the U.S. has run larger current account deficits and generated slower economic growth. The U.S. investment rate has barely exceeded Italy’s anemic 13.5% average, and the dollar’s depreciation against gold has been only somewhat less steep than the lira’s fall in the 1970s. The U.S. budget deficit is much larger, although this comparison is difficult to make because official Italian budget deficits tended to understate the government’s true financing needs, which exceeded 12% of GDP in 1977.
Between 1974 and 1976, the Italian central bank printed lira in mass quantities to buy Italian government debt. This “large scale asset purchase” program led to a more than 100% increase in the monetary base. This was actually a much smaller increase in the monetary base than that engineered by the Fed’s money printing operations. From February 2008 to February 2010, the U.S. monetary base increased by more than 150% – from $822.54 billion to $2.11 trillion. The Italian central bank accelerated its money printing in conjunction with a “large fiscal reflation” package adopted in August 1975, much as the Fed’s quantitative easing began roughly the same time as the fiscal stimulus.
Although the stimulus and money printing succeeded in generating positive growth in 1976, it also precipitated a crisis in the lira. Mario Monti, later competition commissioner of the European Union, predicted the crisis in late 1975 based purely on observed growth in base money. Foreign creditors – responsible for financing 7.2% of GDP in domestic Italian borrowing during 1973-76 – fled Italian securities causing the value of the lira to fall by 35% in less than five months. Less than two years after the last crisis, the Italian financial system was again embroiled in a panic as printing money to accommodate spending in excess of income at both the government and national levels widened current account deficits and triggered a foreign investor revolt.
Just as Italy went from one financial crisis in 1974 to another in 1976, is the U.S. poised to follow its 2008 financial crisis with another in 2011 or 2012? Maybe. Just as Italian easy monetary policy boosted domestic demand, which could not be satisfied by domestic production even as it reduced the value of the lira, the Fed’s policy has stimulated domestic consumption and reduced the trade-weighted value of the dollar without materially closing the current account since 2008.
It seems that close observers of Fed policy can barely go a day without being reminded of the FOMC’s desire to avoid the mistakes of Japan. Why does no Fed policymaker speak on background to Wall Street Journal reporters about his or her concern that the U.S. is repeating the mistakes of Italy? While circumstances are far from identical, the Italian experience suggests that there are rather severe risks to a central bank strategy of printing money to generate growth and compensate for fiscal and regulatory policy failures. This lesson should have as much relevance to Fed policymakers as the Japanese experience. At the very least, rather than worrying about repeating the mistakes of 2003-2004, analysts should be concerned about an outcome far, far worse.