After Japan's property bubble burst at the start of the 90s, the country fell into a deflationary trap. For the next decade its economy refused to recover. Could we be in for the same fate?
Prof Posen argues that Japan's continuing malaise was caused by policy mistakes. At several points the economy did pick up only to fall flat due to mistakes by policymakers. Economic growth did not flat-line; it saw-toothed. The key mistakes were withdrawing stimulus too soon and not forcing the banks to recognise bad loans and clean up their balance sheets. It was also too slow to try unconventional monetary policy once interest rates had reached zero.
In Britain and in Europe we have avoided that last mistake; but I worry about the other two. Have we done enough to fix the banks? Certainly across Europe more needs to be done - the Spanish Cajas and the German Lanesbanken need to face up to the loans they made which will never be repaid. Banks also need to take a realistic view of the sovereign debt they hold, and raise their capital accordingly. Will Greek bonds really be repaid at 100 centimes to the Euro?
On stimulus, I've already had my say - reduce the deficit over the medium term but not yet.
Deflation is too little understood concludes the good professor as he calls for more research. Inflation is a danger we know and can deal with, deflation is still mysterious. If we have to balance risk then risking inflation is the better choice.
