Theoretically, there are four possible scenarios that can unfold when a bubble has burst and the subsequent, inevitable crisis and recession have hit. First, the economic and monetary authorities might insist on continuing to inject money in a never-ending flight forward which tends to prevent the arrival of the recession. Eventually, hyperinflation results, as we have seen at certain times in the past: for instance, following World War I, hyperinflation in Germany nearly destroyed the German monetary system and helped bring Hitler to power. This first scenario is possible, and it has unfolded on various occasions in the past, but it has not unfolded in the last cycle, nor in the case of Japan.
The second scenario is exactly the opposite. It consists of an absolute and total collapse of the banking and financial system. When the monetary system disappears, it must evolve again from scratch and new money must be chosen to replace the destroyed and defunct fiduciary money. This is another possible, catastrophic scenario which has not unfolded in the last cycle (nor in previous cycles, since central banks were created precisely to support private banks as much as necessary to keep them from suspending payments one after the other, in a chain reaction).
The third scenario is usually the most common. With great difficulty, and in spite of monetary manipulations that can be more or less timid or isolated, rhetorical or actual, the real economy ends up being restructured and adjusting to the new situation. In other words, productive factors are removed on a massive scale from unsustainable lines of investment and, in an environment of relative free enterprise, entrepreneurs eventually recover their confidence and start to detect new, sustainable lines of business and investment projects, and in this way, the recovery gradually begins. It is true that human beings do not learn, and once a sustained recovery has occurred, political and institutional incentives will sooner or later lead to new artificial credit expansion which will plant the seeds for the next cycle, and so on.
This third scenario is the one that has usually unfolded in the western world following the different financial crises and recessions that have devastated it. For instance, this scenario has played out in the United States following the most recent US economic cycle. We must remember that the bubble originated in the US economy, and after the crisis, the Federal Reserve injected a huge quantity of money (and in fact, the Federal Reserve led and directed the quantitative easing with Japan). However, the American economy is one of the most flexible in the world. In fact, in
relative terms, if something characterizes the American economy, it is its great flexibility, its remarkable capacity to quickly remove productive factors and reallocate them to other, sustainable investments uncovered by an entrepreneurship that is quite free, restless, and creative. Therefore, despite all of the monetary aggression and growing interventionism in the American economy, again and again it ends up restructuring and starting down a path toward sustainable recovery. It is true that sometimes recovery begins sluggishly, and in fact even today, the American economy has not yet been fully restructured, nor has monetary policy been normalized. As we know, central bankers find it extremely hard to raise interest rates, and they are constantly looking for the smallest excuse
to lower them. In this context, long-term interest rates were raised to 3 percent (which is insufficient, since interest rates should be around 4 or 5 percent when expected inflation is 2 percent). And more recently, in response to political pressures and on the pretext of an increase in uncertainty, not only has monetary normalization been paralyzed, but a step backward has been taken, and interest rates have been lowered a quarter of a point… But in any case, the American economy is highly flexible, and thus it provides the typical example of a recovery that sooner or later becomes a reality.
Finally, a fourth scenario also exists and arises when the economic environment, in sharp contrast with that in the United States, is very rigid and fraught with taxes, interventionism, and regulations. In this highly rigid context, when monetary authorities insist on injecting a large quantity of money, the syndrome I have called the “Japanese economic illness” or “economic Japanization” inevitably occurs. And this cocktail of great institutional rigidity, heavy taxes, highly regulated labor markets, together with growing state intervention in the economy at all levels, intense manipulation, and unbridled injections of money, is precisely what characterizes the economy of Japan and threatens to spread to other economic areas in the world, starting with the European Union.
Indeed, Japanese authorities responded to the bursting of their bubble with an overly lax monetary policy, in which it was also decided that there would be a continual rollover of loans. In other words, companies unable to repay their loans were offered new loans with which to pay off the old ones, and so on, and the Japanese central bank backed and promoted the whole thing. In Japan, it is culturally unacceptable for a company to fail; it is culturally unacceptable for workers to be let go. Each company is like the mother of a large family, and she must keep all the members safe and employed. Though officially, the unemployment figures may be very low, and everyone may seem to have a job, we must remember the photographs of those big departments in many Japanese companies, where employees are seen sleeping or doing nothing. Officially, they are working, but obviously, the hidden unemployment is massive, and the drop in productivity and the ongoing loss of relative competitiveness are very high (especially with respect to China, South Korea, and the other emerging Asian economies). Moreover, interest rates were slashed almost to zero, and on top of that, the government added an aggressive fiscal policy which pushed public spending through the roof.
Well, this whole mix of economic policy measures is responsible for generating the fourth scenario, which we have called “Japanization,” and to which I am devoting my lecture today. In an environment of great institutional and economic rigidity, as in Japan, massive monetary manipulation and the unbridled increase of public spending block any possible incentive to spontaneously restructuring the economy. As a result, productive factors are not transferred from the projects where they were erroneously invested toward alternative, sustainable lines of investment, which entrepreneurs could discover only in an environment of liberty, economic flexibility, and confidence. This is how Japan entered an indefinite period of recession and economic lethargy that has already lasted several decades and from which it has not yet managed to emerge.