Greenspan and Lessons from Japan

The former Fed chief is on the defensive and one of the biggest charges against him, WSJ's Greg Ip tells us, "is his decision to slash interest rates to 1% in 2003 and wait to raise them until 2004, and then only slowly."

Greenspan explains that policy makers were motivated by the specter of Japanese-style deflation which descended upon that country in the 1990's after booms in its stock and real estate markets the previous decade:

"He justified the policy by noting that at the time, inflation was falling persistently and the risk of deflation -- though small -- seemed real, despite his prior assumptions that it was impossible with a dollar unlinked to gold.
To prevent deflation, the Fed spurred growth by keeping interest rates low. At the time, he notes, the only dissenting votes on the Fed policy committee were those who wanted to set rates even lower."

In retrospect, this now seems to have been a grand miscalculation, charge his critics -- especially those who in 2002 said the U.S. was not like Japan. Unlike the Asian nation, U.S. companies had much stronger balance sheets, there was no real estate bubble, and interest rates still had plenty of room to fall.

The irony of course is that in keeping interest rates low after the tech-stock boom of the late-90's, Greenspan (implicitly or explicitly depending on who you want to listen to) encouraged both the consumer spending binge and the real estate bubble. While these developments kept the economy humming at a healthy clip through parts of this decade, they had the unfortunate side-effect of encouraging unsound behavior, particularly in the subprime lending market. The fallout from this is expected to last at least another three years: According to the Case-Shiller index of housing prices, traders think real estate values will deflate by close to 30 percent through 2011.

In hindsight, it appears that in trying to maneuver around an outcome similar to Japan's "lost decade," Greenspan and his compatriots only succeeded in delaying it.

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