A nation's economic activity begins to slow after its ratio of total public and private debt exceeds 250 to 300% of gross domestic product (GDP), according to a range of academic studies surveyed by internationally known economist Dr. Lacy H. Hunt. The bad news is that the United States, China, the Eurozone and Japan already passed the 300% total debt-to-GDP level by 2016. Leading the debt race is Japan, a country mired in decades of low growth despite near-constant stimulus efforts. This represents a crisis in mainstream macroeconomic theory, which advocates monetary easing and government deficits to revive struggling economies. Prices are not rising fast enough for macroeconomists, who tend to fear deflation above all else. Worse yet, the problems of Japan look like a precursor for the United States.
Macroeconomic Policies Have a Poor Track Record
Macroeconomics has been considered a separate and distinct science from microeconomics for less than 100 years, and the performance of macro-influenced policy is spotty at best. Macroeconomic forecasts are less accurate still, regardless of whether they are made in government bureaus or private-sector forecasts.
However, Japan's macroeconomic malaise is troubling because the Bank of Japan (BOJ) got there by following New Keynesian theory. Virtually every government and major central bank in the world adheres to New Keynesian fiscal and monetary policy, including the Federal Reserve and European Central Bank (ECB). If Japan fails because of faulty assumptions, it follows that Europe and the United States are also in trouble.
New Keynesian Theory and Japan
New Keynesian theory followed Keynesianism, which was based on the work of British economist John Maynard Keynes. The Keynesian model abandoned classical theory and Say's Law, asserting that prices and wages do not adjust efficiently. Neoclassical and monetarist economists successfully challenged many Keynesian assumptions in the 1970s and 1980s.
In response, Keynes' remaining acolytes adjusted their models and emerged as New Keynesians. Governments and central banks were quick to adopt this model, partially because those proposals often called for more government spending and central bank authority.
New Keynesian theory arrived as Japan entered its Lost Decade, which refers to the prolonged slowdown of the Japanese economy between 1991 and 2000. Japan had averaged 4.7% annual growth during the 1980s, but annual growth fell to 1.2% during the 1990s. The turning point was the bursting of a massive asset bubble in 1989, ending a period in which the Nikkei stock price index climbed 200% in less than four years, and briefly grew larger than the U.S. stock market.
The Lost Decade Is Almost 30 Years Old
According to prevailing macroeconomic theory, the BOJ needed to cut interest rates and Japan's government needed to engage in deficit spending to boost aggregate demand. This is precisely what happened. The BOJ cut its discount rate from 6 to 0.25% in the 1990s, and the government tried nine fiscal stimulus packages during the decade totaling 140.7 trillion in 2016 yen, or about $1.3 trillion.
The national debt-to-GDP ratio in Japan was 67% in 1990, but this grew to 143.8% in 2000. With the exception of a small reduction between 2005 and 2007, the nation's public debt kept skyrocketing year after year. Interest rates stayed near the zero bound to help the government afford its debt burden. By December 2015, the debt-to-GDP ratio was 229.2%, but total public and private debt to GDP was 615%.
No country in the history of the world has engaged in monetary and fiscal stimulus as long as Japan between 1989 and 2016. Nevertheless, Japan's economy was smaller in 2014 than in 1995, according to the most recently published World Bank data. The net effect of New Keynesian policies has been more than 25 years of no growth and the world's most debt-leveraged country.
Similarities Between Japan and the United States
New Keynesian macroeconomists reviewed the Japanese experience and, oddly, concluded that Japan has not stimulated enough. If you read policy papers by the International Monetary Fund (IMF) or columns from Nobel winner Paul Krugman, then you have heard that Japan needed to be more drastic. This sort of "heads I win, tails you lose" logic is commonplace in macroeconomics. Nobody can run real experiments to identify causality.
Similar rationalizations are underway in the United States. Following the Great Recession, the U.S. government ran the largest fiscal deficits in world history, more than $1.1 trillion each year between 2009 and 2012. The Federal Reserve set its discount rate at 0% for seven consecutive years between 2008 and 2015. Subsequently, the U.S. economy experienced its slowest recovery ever. Still, many macroeconomists demand more easing and more spending.
Fortunately, Americans are younger and more entrepreneurial on average than the Japanese. Entering 2016, the United States had a far lower debt-to-GDP ratio, as well as a much larger economy, than Japan. Unfortunately, economic growth was weak in 2015, and Americans piled on almost $2 trillion in nonfinancial debt. Without a change in policy and theory to challenge the borrow, print and spend model, the United States seems to be following Japan's example.