The Fed and Fear of Becoming Japan

I just got around to reading the Aug. 23 The Economists with its Economics Focus article on "The Lost Decade" (more than that now), comparing the US and Japanese housing bubbles. Turns out our bubble has been a lot worse than theirs. Between 1985 and 1991, housing prices nationally in Japan rose only 50%, whereas in the US between 2000 and 2006 they rose 90%. Furthermore, even after the recent declines in the US market, national housing prices are still above the peak level reached in early 1991 in Japan in terms of percent above the starting point, which does not bode well for the future. While housing prices stabilized in major Japanese cities a few years ago, they continue to gradually decline nationally, as they have since 1991, providing a major downward drag on the Japanese economy.

So, the Fed is afraid of this, and Bernanke has encouraged the Fannie/Freddie bailout, partly with "advice" from both the Chinese and Japanese, who just happen to hold a lot of paper from those Agencies. But, in fact, this fear has been influencing the Fed for quite some time. In the period of 2002-2004 the stimulative policies of the Fed, which cynics might say were designed to help Bush get reelected, were justified on the basis of avoiding getting into a Japanese style deflation, which fear was what triggered Bernanke to make his famous public remarks about dropping money out of helicopters (an image taken originally from Milton Friedman, who did not approve of such an approach). Indeed, Alan Greenspan noted the problem of the threat of a possible deflation in his discussion of monetary policy during that period in his AER paper (Alan Greenspan, "Risk and Uncertainty in Monetary Policy," American Economic Review, Papers and Proceedings, May 2004, pp. 33-40). Of course the ultimate irony here is that this stimulative policy almost certainly further goosed the US housing bubble, whose unraveling is now causing such havoc in the financial markets, so that a policy to avoid a crisis has brought about a crisis.