Executive Summary: We Are Screwed

“Never make predictions, especially about the future,” baseball legend Casey Stengel once observed. Despite his admonition we make our guesses anyway, extrapolating our current moods and worldviews as far into the unknowable future as can be tolerated with straight faces by polite company. As such, optimists of America’s 21st century often see a rosy future of bunny rabbits and rainbows, where energy is unlimited, money is unnecessary, the world’s population is smaller, well-fed, educated, civilized and healthy, and future generations enjoy long lives of ease, comfort and wealth thanks to the extraordinary beneficent progress of science, medicine, technology and government.

Modern-day pessimists, on the other hand, foresee a future far more dismal than the crumbling present reality, teetering on the brink of anarchy and collapse and fraught with the vicious animal spirits arising from our reptilian brain stems as bipedal inhabitants of an over-populated planet violently compete for ever-scarcer resources and future generations are imperiled thanks to the extraordinary destructive progress of science, medicine, technology and government. Since pessimists merely are optimists with better information, and inasmuch as there is none so zealous as a convert, one can be forgiven the newfound realist zest of a former optimist whose eyes have opened to view the precipice at which we, as a nation and a species, now stand. Predicting major changes to a complex system, however, much less its collapse, is an exercise fraught with indescribable futility, subject as they are to sightings of Black Swans, that elusive species whose arrivals are unknowable and unpredictable, unlike the buzzards which still return every March 15th to Hinckley, Ohio.

For Black Swans are the harbingers of both good and evil, and, as such, are apt to make one’s future view of the world both amusingly irrelevant and dangerously outdated mere moments after their sighting. Undaunted, and with full foreknowledge of the hilarity with which some of these prognostications will be viewed after 2012, herewith I submit my forecast for the future.

Executive Summary

We are screwed.

Rationale

We have ruined our endgame. Our children are screwed. Their children and the posterity of humankind are screwed. Humans, as a species, have screwed up a really good gig on this planet and, at some point, some miserable centuries hence, likely will be evolutionarily selected, as were dinosaurs, to cease to exist. Other species will survive and thrive, however, if only bacteria dwelling far undersea or underground, and perhaps, in the four or five billion years before the eventual decomposition of our solar system’s star into a red giant engulfs the orbit of this planet, another form of conscious, self-aware, communicating, tool-using life will escape the evolutionary chains in which it now is entrapped. All of which will occur well-after 2012, but in the meantime, here’s what to expect between now and then:

Black Swan Alert

December 21, 2012, as every student of apocalypse knows is reset day of the current Mayan 5,125.36-year “long count” calendar, as well as culmination of a fifth long-count great cycle and beginning of a new great-great cycle of 25,626.8 years which roughly coincides with the earth’s axis-wobbling precession of equinoxes cycle. It also represents a point at which the sun will cross the elliptic plane of the galaxy at the same time all its planets are aligned behind it away from the galactic center and the day on which Thomas Friedman will realize, belatedly, everything he ever thought or said was wrong and dogs and cats will be living together and…

Well-before 12/21/12, however, an unknowable, unpredictable black swan – the tipping-point event – will occur, setting into motion a cascading chain of unstoppable events which leave humanity forever changed and slipping, eventually, into evolutionary obscurity, just one of many accidents of DNA which didn’t quite work out. These forecasts, these dark musings, focus more on the immediate aftermath of the tipping point event (TPE), and the longer-term repercussions for the United States and the world. As another commenter recently observed, two of the four horsemen of the apocalypse already appear to have been untethered: Demand Collapse, in the form of sharply reduced consumer spending, reduced debt levels and increased savings, and Systemic Failure, via the collapse of AIG.

In 2009, however, a strong case can be made that these seals only partially have been broken, as consumer demand is falling, but has not completely collapsed, and the systemic failure of AIG has been tempered by the unlimited amount of borrowed government/taxpayer funds which have been shoved into the gaping maw of the AIG transfer conduit, only to be parceled out among some of the nation’s, and world’s, largest unindicted co-conspirator institutions, whose own day of reckoning looms near. In the nearer term, clearly the current policy of the United States government, regardless which persons or political party officially are wielding power (or the oligarchs behind them), is to insure the grand game continues unmolested, that no financial bubble ever is popped and no economic reset button ever is pushed. The Treasury Department and the Federal Reserve, therefore, in coordinated fashion, have become, and will continue to be, the financial backstop and lenders of only resort, setting up the scenario which will culminate in the actual “financial Armageddon” of which we were warned, boy-who-cried-wolf-like last September, but in orders of magnitude far beyond the worst nightmares of even the most pessimistic among us.

This next year-to-three-plus-years represents the final “blow-off” stage of our financial evolution, from our meager origins on the slime-lined shores of metal coins to the sophisticated velocity of electronic money, mere electrons, circling the globe at the speed of light. And it will be to those ancient metal coins and a much larger, rounder, colder world (sorry, Tom Friedman), at some point in our bleaker future, to which we will return. Whether good-intentioned or ill – it’s immaterial - the U.S. government/Federal Reserve will be enabled to become the final Ponzi-finance bubble of humanity’s electronic era, and in doing so will again replicate the oft-repeated outcome of all paper (fiat) currencies.

The last giant bubble shall burst on that day – not in 2009, but within four years – when:

· We will have bailed out, rescued, backstopped, guaranteed and thrown money at every major business, corporation, industry, state, city, bank, insurance company, automaker, retailer, airline, factory, shopping mall, commercial real estate company, pension fund, mutual fund, money market fund and a good portion of the population, ballooning our national debt to incredible, historic, bubblicious proportions, mostly via funds borrowed from international creditors.

· Under this illusion, we will have returned to some semblance of pre-2007 “life as we knew it,” albeit with new, improved price-deflated consumer goods, but also a renewal of free-flowing credit for consumers and businesses and cities and states and a restored, growing (if illusionary) economy.

· Just when things are looking up and Obama is running for re-election, with a prevalent, growing perception of hope and a “big bullet” dodged, the TPE occurs (unexpectedly, of course), say, yet another derivatives bomb (hey, there’s a quadrillion of ‘em…) which threatens the extinction of yet another too-big-too-fail financial institution. This time, however, the “financial Armageddon” cry-wolf ploy fails to engage our international patrons, as they previously have read about John Law and know the movie’s ending (like “Titanic:” it sinks every time).

· America, belatedly, will realize we have gone “a bailout too far,” which will end as badly for the Allies as did the movie “A Bridge Too Far.” (Note: by definition, the Black Swan TPE will NOT be a derivatives eruption, because that is already a “known unknown.” The Black Swan TPE will be a Monty-Python-esque “And Now For Something Completely Different” occurrence, which may, in fact, detonate a derivatives bomb. As such, it shall be henceforth, for the purposes of this commentary, be referred to as “the Black Swan TPE Which Cannot Be Named,” or BSTPEWCBN.)

· America’s international creditors, including “friendlies” like Japan, Britain, Canada, Brazil, and others, immediately and en masse, become unwilling to lend the United States, at any rate of return or rate of interest, save the pledging of U.S. gold reserves and/or deeding over of real, physical assets. The “Full Faith and Credit of the United States” overnight becomes regarded as some sort of ironic joke.

· Our international suppliers of energy, on which we foolishly still are dependent for two-thirds of our minimum daily requirement, no longer will accept our paper IOUs, again only gold or the deeds to other real, physical assets.

· The U.S. dollar no longer is accepted for any form of payment outside the country, much less is deemed the world’s reserve currency. In its place, a hastily arranged basket of other currencies is created to isolate the financial damage to the U.S.

· U.S. dollar-denominated global trade and commerce grind to an abrupt halt, ships at sea stop, divert or return to ports of embarkation (if headed to the U.S.), pending delivery of goods to alternate buyers or arrangement of payment in forms which are not the U.S. dollar.

· Resolutions are introduced to the United Nations to require the United States to stand down its military everywhere in the world, in recognition of our new status as a banana republic with nuclear arms. The U.S. naturally vetoes this resolution in Security Council. U.N. member representatives approve a measure to immediately relocate U.N. headquarters to Switzerland.

· After the failed U.N. resolution, our overseas armed forces are ordered by host countries to immediately vacate their garrisons or face forcible ejection, including troops based in active theaters of conflict.

· Post-Katrina-New-Orleans-like, widespread hoarding of cash, food, water, medicines, alcohol, batteries, candles, fuel, arms and ammunition occurs within hours of the BSTPEWCBN, rapidly escalating into regional episodes of violent theft, robbery, burglary and looting which overwhelms local law enforcement.

· Our remaining domestic armed forces and national guard units are ordered into U.S. streets, with authorized use of deadly force, to support local and state law enforcement in quelling protest, looting and violence, to enforce 24-hour curfews and, for the third time in our nation’s history, to enforce martial law. Armed forces and local law enforcement conduct house-to-house weapons sweeps, under the auspices of local force majeure ordinances (in violation of the Second Amendment and Fourth Amendments), and based on NCIS gun-purchase records and state concealed-carry permits, as applicable.

· In short, we transform ourselves from unilateral superpower to international pariah in a matter of a few weeks. Martial law, curfews and restricted movement and travel remains in place for months as essential services and commerce are allowed to recommence under strict rules and regulations.

Then what? The process begins anew under an entirely different reality, an entirely different set of criteria, but the process remains the same: Denial, Anger, Bargaining, Depression, Acceptance.
Denial will evaporate rapidly at a pace which coincides with full establishment of the new world order, and Anger, having flourished briefly and violently on our streets and in our neighborhoods, will be severely, perhaps painfully, curtailed in a previously unimagined militarized manner. There will be no Bargaining, for there is nothing left to bargain for, or to bargain with. What was, was, and what now is, is, and for the first time in the post-WWII era, possibly longer, the United States of America no longer will call the shots in the assemblage of nations. Depression, arising from a lifestyle lost, and Acceptance, of a new, much lower, standard of living, will be the most difficult segments to live through.

But muddle through we must. As always, younger children will adapt most easily and most quickly to our reduced means and living arrangements. They will , however, grow weary of the endless stories of how wonderful and amazing American life used to be, as told to them by their aging Baby Boomer, Generation X and Generation Y elders.

Now my head hurts…time for some scotch, which I will sorely miss, someday.

Despite Fed Efforts, Deflation on the Horizon

Despite the heroic efforts of Ben Bernanke's Federal Reserve to combat the forces of deflation, not seen en masse since The Great Depression, March wholesale and retail inflation data now confirm sightings of the forward elements of falling prices, the Fed's (and bankers') worst-case economic scenario. Under Bernanke's leadership, the Fed has more than doubled its balance sheet in the last year to more than $2.3 trillion as it undertook an unfamiliar role as U.S. lender of only resort and deflation eradicator, and it has pledged to nearly double its footings again to an unprecedented $4 trillion in its so-far unsuccessful battle against the deflationary effects of individual and business balance sheet deleveraging.

But March and April inflation data from the Producer Price Index (PPI) and the Consumer Price Index (CPI) confirm the potential beginnings of with what Ben Bernanke's nightmares must be filled: downward spirals of asset prices and incomes insufficient to service fixed amounts of debt in an unfamiliar environment of a shrinking money supply as new money created by Fed fails to keep up with wealth being destroyed. April Producer Prices for Finished Goods ticked up 0.3 percent but fell 1.2 percent in March, and have fallen six of the last nine months. Intermediate Goods declined 0.5 percent in April following a drop of 1.5 percent in March, falling nine months straight, but Crude Goods, the most volatile measure, jumped 3.0 percent on higher energy prices after falling eighth consecutive months, previously down 0.3 percent in March.

May 15th's Consumer Price Index for April reflects falling prices at the retail end as well, where prices also have declined in six of the last eight months, but more importantly, now are showing the first back-to-back monthly and year-over-year declines (-0.7 percent) in more than a half-century. No, not since 1955, when President Ike was improving his golf game and laying groundwork for the nation's interstate highway system, have consumer prices declined in a twelve-month span.

Admittedly, some of the overall decline in prices at all levels, wholesale and retail, can be attributed to a dramatic plunge in energy prices compared with a year ago, but crude oil at $60 in early May against $100 a year ago cannot explain away all of this new evidence of price deflation. As we suggested above, deflation technically is a shrinking money supply which manifests itself in the form of lower prices - literally fewer dollars available to purchase a finite quantity of goods and services.

But won't all this Fed balance sheet expansion create big-time inflation some day? After all, $4 trillion is a lot of pump priming – it's 30 percent of GDP. The answer, categorically, is “maybe.” Or, “someday,” but not today, because so far – halftime, perhaps – it is estimated nearly $14 trillion of wealth (money) has been dispatched to money heaven since the end of 2006 in the form of stock market values, real estate values and credit write-downs and charge-offs.
The Fed's heavy lifting to-date has created far less money than already has been destroyed by the financial and real estate markets so no inflation worries now, though, mate, it's DEflation ahead. Which is why, no doubt, the Federal Reserve now must be practically desperate to ramp the speed of the printing presses in the basement of its grand edifice at 20th and Constitution in Washington, D.C. Well not really. The Fed actually doesn't print currency in its basement – that messy chore is performed by the Treasury Department's Bureau of Engraving and Printing a few blocks away at 14th and C Street.

But the Fed does create money from thin air in a number of ways, most often by buying government bonds and paying the seller via an accounting entry on its books (the thin air). As you remember from Macro Econ 101, the Fed adds the bonds to its assets and credits a financial institution's account on its liability side (which, in turn, credits the bond seller if other than the bank). In theory, the Fed can do this almost endlessly, to the extent of the total amount of publicly held government bonds ($6.8 trillion not counting about $3 trillion of Agency bonds), and, if necessary, other bonds such as the $5 trillion of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac.

In fact, this is exactly what the Fed has begun doing in earnest since reaching monetary DEFCON 1, Zero Interest Rate Policy (ZIRP), the "zero bound" for interest rates in mid-December. But there are many other ways the Fed can will money into existence, most of which were neatly outlined more than six years ago by then-Fed-Governor Bernanke in his now famous November 2002 speech, "Deflation: Making Sure 'It' Doesn't Happen Here." (Because as we all know, "it" happens.)

In hindsight, since August 2007 the Fed has been following Dr. Bernanke's 2002 playbook “Reviving an Ailing Economy by Prevention and Treatment of Deflation,” page by page, and these are the step-by-step “in case of deflation” instructions Ben outlined to re-flate a deleveraging economy:

· First, cut interest rates: Check – all the way to an effective fed funds rate of zero-ish (officially 0.00 percent to 0.25 percent), down from 5.25 percent in mid-2007.

· Next, increase paper currency in circulation: Check – Federal Reserve Notes outstanding have increased to more than $900 billion, up $80 billion since August 2008, with a more-than-usual amount likely now lurking under mattresses notwithstanding the recent increase to $250,000 in FDIC coverage for deposit accounts.

· Then, fling open the Discount Window: Check – The Fed has lent $467 billion to depository institutions, up from nothing a year and a half ago, through its Term Auction Facility (TAF).

· Still no pulse? Create lending facilities for non-banks under Fed's “other duties as assigned” bylaws: Check – Resulting in an acronym-rich variety of cheap loans for commercial paper issuers (CPFF), primary dealers (PDCF and TSLF), securitized asset issuers (TALF), money market funds (MMIFF) and money market funds owned by depository institutions and bank holding companies (AMLF). Total credit extended now exceeds $300 billion under these facilities, none of which existed 18 months ago.

· Next, backstop selected “SITBTF” institutions (Systemically Important Too Big To Fail): Check and check – Bear Stearns and the AIG Money Conduit now account for $108 billion of newly created loan facilities which didn't exist at the end of 2007.

· Then, start buying bonds in size: Check – The Fed has begun purchasing agency mortgage securities ($431 billion) and selected Treasury debt ($50 billion) as a means to reduce longer-term interest rates, and, hence, mortgage rates. The Fed has announced its intention to purchase up to $1 trillion of bonds, including sovereign debt of other nations.

· Finally, make loans to foreign central banks: Check – the Fed now has $247 billion outstanding in Central Bank Liquidity Swaps, in which it has lent foreign central banks dollars in exchange for their local currencies which the Fed holds as an asset on its balance sheet.

The end result of which has been a more-than-doubled Fed balance sheet to $2.3 trillion as of May 14, 2009, on its way to $4 trillion by the Fed's own estimate, and $927 billion of Fed member-bank deposits (excess reserves currently available for lending) earning somewhere between 0.00 percent and 0.25 percent. Back to the “should-we-be-worried-about-future-inflation” question, for a moment: those $927 billion of excess reserves, in theory, could create more than $9 trillion of new money once the economy recovers and bank lending resumes under more normal economic conditions.

“The large volume of reserve balances outstanding must be monitored carefully,” Dr. Bernanke observed in an April 3rd speech about the Fed's balance sheet,1 “as – if not carefully managed – they could complicate the Fed's task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher.” (Emphasis added.)

But for now, falling real- and financial-asset values, wholesale and retail price declines, collapsing industrial production and capacity utilization, plunging retail sales and automobile sales, and, probably, for the first time ever, declining consumer credit (both mortgage debt and revolving credit lines) are conspiring to produce a bout of domestic deflation not seen in several generations.

So when it comes to future inflation, Ben Bernanke, Scarlett-O'Hara-like,2 “can't think about that right now” and thus will worry about inflation “tomorrow,” opting instead to fret more now about deflation and hope against hope that when tomorrow arrives his Fed (or his successor's?) will, one, be able to recognize it, and, two, constructively rein in the powerful forces of money creation which will have been unleashed.

Note that not everyone is as convinced as Dr. Bernanke that, when the time comes to be more worried about inflation, the Fed will be able to return the evil spirits of huge, inflationary money supply increases to Pandora's box of moderate economic growth, currency stability and full employment as we quickly are becoming addicted, at all levels of our economy it is said, to the crack cocaine of record-low financing rates. The obvious fly in the ointment is the impact on all debtors – business, individual and, especially, the federal government – of a return to a “normal” interest rate environment. That impact, of course, is a significant jump in the cost of debt service as interest rates rise, which clearly could impede any nascent economic recovery.

On that day, sometime in the misty future but perhaps as early as the end of this year (you heard it here first), the Fed's Open Market Committee will decide inflation poses a greater risk to the economy than any other risk and will vote to increase its target fed funds rate. That may signal the beginning of a long march upward, especially rates on the long end of the yield curve, and the process of breaking our low-interest-rate addiction may be painful indeed, fraught, as it will be, with heated political discord and ample amounts of second-guessing ahead of the 2010 mid-term elections.

And the Fed's usual method of draining such reserves – selling its Treasury holdings into the marketplace – may not be as effective as it has been in the past based on the portfolio the Fed then will be holding: long-maturity Treasury and Agency obligations, mortgage-backed securities and foreign government debt, all of which could be trading at significant discounts to par when long-term interest rates surge from the constraints of this artificially induced short-end zero-bound. Who would want to buy the Fed's long-term bond portfolio, even at substantial discounts (big losses to the Fed since the Fed will have been collecting most of these bonds at par or “near-maturity” prices), if the likely direction of long-term interest rates is upward and buyers could get stuck with even bigger (you know, mark-to-market) losses?

Like the card games “Spades” or “Old Maid,” no financial institution with rational investment managers will be willing to pick up game-ending long-term-bond “cards” from a selling Fed in a rising interest rate environment. What then would be the Fed's options to quench the fires of inflationary expectations? When he delivered his better-to-prevent-than-to-cure "Deflation..." speech nearly seven years ago, at the time Dr. B was referring to the unpleasant effects of deflation on Japan's economy, which had been bumping along for a "lost decade" in the 1990s, due primarily, as Bernanke noted, to "political constraints" inhibiting the necessary and painful measures required to appropriately deal with that country's deep economic malaise.3, 4

As is generally agreed by economists in polite company, that malaise stemmed much from Japan's seeming inability to effectively solve the crisis in its banking sector, which, in turn, arose from deflating asset values lurking at par on the banks' balance sheets. Those mis-valued assets, it was thought, masked the true solvency picture of those lenders, giving rise to the derogatory term “zombie banks,” those Japanese financial institutions rumored to be dead but still walking.
At this moment, in the "history-may-not-repeat-but-sometimes-it-rhymes" department, one should be wondering if Japan's immediate past is not America's possible prologue: "Political constraints" preventing effective monetary and fiscal policy? Keep reading...

From Bernanke's "Deflation..." conclusion:

"As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve." (Emphasis added.)

Well, that's a relief. We're certainly glad the U.S. is grabbing those "large-cost" bulls by the horns and choosing not to follow in Japan's failed-policy footsteps, having learned what can go wrong in an environment of political deadlock from that country's now two decades of economic stagnation (an extended "L-shaped" economic reset). Irony alert: Clearly in the last 12 months, and painfully more apparent in the last six, we are trodding exactly in the footsteps of the world's second-largest economy as attention and scarce resources continue to be diverted to "systemically-important-too-big-to-fail" financial institutions while unemployment soars, GDP retracts, industrial production and capacity plummet and retail sales wither.

The U.S. is not alone teetering on the brink of general deflation. Japan deflates anew as its exports crumple, and we are being joined in short order by Iceland, Sweden, Switzerland, Ireland, Britain, Korea, Taiwan and Singapore. Many of those export-dominated countries in Asia and Europe and other floating-exchange-rate currency countries will be desperate to devalue those currencies against the U.S. dollar and the Euro as a means of halting their exports slide.

Exporting deflation via currency devaluation, however, could have some unpleasant side effects for us by choking off our better-priced export business, the recent gains in which have helped bring the U.S. trade deficit to a nine-year low of $26 billion in March from an all-time high in August 2006 of nearly $68 billion. And yet we depend on a number of foreign countries – China, Japan, Saudi Arabia, Brazil and Russia chief among them – to recycle their export remittances from us into freshly minted U.S. Treasury and Agency (Fannie Mae/Freddie Mac) debt.

A slump in their exports to us means less money to recycle into our debt instruments, and at a crucial time when, to combat the effects of our own recession, our government is generating unprecedented deficits which could top $2 trillion by the September end of FY2009. Oh, the inter-connectedness of it all. Our global economy has been likened to a big clump of traffic – say a couple hundred cars, buses and semis – at 75 mph with about 10 feet between each vehicle travelling at 3:00am entering a densely foggy stretch of road covered with black ice.

Now it's entirely possible the traffic clump will emerge unscathed, at least theoretically. But all it takes is one young deer to bolt across the road in front of the lead vehicles to bring the entire entourage screeching to a horrific, crumpled, deadly halt. And it's not good for the deer, either. The ensuing chain-reaction accident would leave many battered and bruised, and they would be the lucky ones. Such is the risk, however small, when a complex system requires perfection for a safe, suitable outcome.

And such was the global economy at year-end 2006, priced for, and requiring, perfection to emerge from an oncoming foggy stretch of black-ice-covered highway. It's now quite possible to observe, with the clarity of hindsight, that scrawny sub-prime deer that jumped in front of us on the global economic super-highway a couple of years ago.

The question which remains, as the resulting global economic pile-up still is in progress, is when the time comes to call for cease-fire and truce with the forces of deflation and muster anew against the armies of inflation, will Dr. Bernanke's (or his successor's) Fed be up to this unprecedented task. When that day arrives, it will be another one of those “theory meets reality” tests upon which, no doubt, countless Ph.D. dissertations will be based for decades to come.

* * * * * *
Note: All data updated as of May 15, 2009

Footnotes and References
1 “The Federal Reserve's Balance Sheet,” Dr. Benjamin S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, April 3, 2009.

2 “I can't think about that right now. If I do, I'll go crazy. I'll think about that tomorrow.” Scarlett O'Hara, Gone With the Wind, 1939.

3 “Deflation: Making Sure 'It' Doesn't Happen Here,” Dr. Benjamin S. Bernanke, Governor, Board of Governors of the Federal Reserve System, November 21, 2002.

4 “Deflation: Making Sure 'It' Doesn't Happen Here,” Dr. Benjamin S. Bernanke, Governor, Board of Governors of the Federal Reserve System, November 21, 2002, full text of comments on Japan:

“The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

“First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

“Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result,
politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

“In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.”