Recipe for a Lost Decade, or Two

By: Paul Kasriel | Tue, Jun 22, 2010
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There are legitimate concerns that the U.S. could catch the "Japanese" disease and endure a lost decade in terms of normal economic growth. What would be the recipe for such? Chart 1 shows the behavior of the 40-quarter (10-year) compound annual growth in Japanese nominal GDP and the 120-month (10-year) compound annual growth in the Japanese M-2 money supply. (The shaded areas are periods of economic recession in Japan.) Notice how the 10-year annualized growth in M-2 has been trending ever lower, especially between 1990 and 2000. Since September 2000, the 10-year annualized growth in Japanese M-2 has ranged only from about 3% to about 2%. Chart 2 shows that this downward trend in Japanese M-2 growth has been accompanied by an exceptionally low Bank of Japan policy interest rate.

Chart 1
Japan GDP 1980-2010

Chart 2
Japan Money Supply M2

Now, it is not as though Japanese real GDP did not grow in the past twenty years. It has, as shown in Chart 3. But, not surprisingly, similar to Japanese M-2 growth, trend Japanese real GDP growth has been slowing and has not been up to the 2% mark since 1997. Given a declining population and workforce, we should not expect a high rate of growth in aggregate Japanese real GDP. But as shown in Chart 4, trend real GDP growth in Japan has consistently been below the sum of trend growth in the Japanese labor force and the trend rate of growth in Japanese labor productivity since 1998. Thus, something else has been constraining Japanese economic growth.

Chart 3
Japan GDP

Chart 4
Japan labor Force Growth

I would argue that weak bank lending (see Chart 5), which is related to weak M-2 growth, bears a lot of the responsibility for the trend underperformance of the Japanese economy.

Chart 5
Japan Domestic Lending

Although the U.S. M-2 money supply growth on a trend basis is currently nowhere near as weak as that of Japan (see Chart 6). On a year-over-year basis, however, U.S. M-2 growth is very slow, just under 2% (see also Chart 6). The reason for the recent weak year-over-year growth in U.S. M-2 is the recent contraction in U.S. commercial bank credit (see Chart 7). And, as has been the case in Japan, weak U.S. money and bank credit growth is occurring in the context of very low monetary policy interest rates. Something is wrong with the transmission mechanism between the Fed and the economy. The private financial system is not transforming the inexpensive credit being offered it by the Fed into credit for the private nonfinancial sector of the U.S. economy. Until this transmission mechanism between the Fed and the economy gets mended, we are unlikely to experience potential economic growth.

Chart 6
Money Stock M2

Chart 7
Break-Adjusted Bank Credit



Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

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