The European Union was supposed to be recovering from 2000, but the past year’s growth performance was once again lower, suggesting that the earlier growth impetus, such as it was, was not sufficient to raise the dynamism in the European economy. Both the IMF and the OECD estimates suggest a further deterioration in aggregate growth performance of the European Union in the coming year.

The Japanese economy is currently in the weakest position of all the major capitalist economies. Clearly this economy is in the grip of a classic deflation, with low output, falling prices and poor expectations leading to declining levels of investment. The Japanese government’s own forecasts show that the economy will not grow at all in the fiscal year starting in April, with unemployment continuing to rise, to nearly 6 per cent. In 2001, prices in Japan fell for the third year in a row, which is unprecedented for a major industrial economy since the 1930s. Furthermore, net export performance has also worsened. There was a 38 per cent fall in the Japanese trade surplus for 2001, the largest fall since 1970 and the third successive year of decline.

Accompanying all this has been a strange process of convergence of unemployment rates, as evident from Chart 3. While Japan had always been considered a low unemployment economy largely for structural reasons, it was argued that more ''flexible'' labour market combined with greater economic dynamism made rates of open unemployment much lower in the US than in Western Europe. But Chart 3 shows that over the recent past, while rates of unemployment have been declining in Europe (despite less impressive output growth) they have been rising in both the US and Japan.

What is the prognosis, given such a combination of forces in the major economies ? Most analysts have been pessimistic about the prospects of an early recovery, despite the Bush administration’s efforts to provide a fiscal stimulus through large tax cuts and increased spending, especially after September 11. The pessimism ranges from perceptions that the size of the fiscal stimulus is simply not enough to provide the kind of stimulus which is required, to the argument that it has been largely oriented towards tax cuts for large corporations and the wealthy along with increased military spending, neither of which have large multiplier effects.

Another view is expressed in a report issued in December 2001 by the Levy Economics Institute, written by economists Wynne Godley and Alex Izurieta. This argued that the current recession in the US is different from earlier recessions because of large structural imbalances in the US economy. According to them, ''the United States should now be prepared for one of the deepest and most intractable recessions of the post-World War II period, with no natural process of recovery in sight unless a large and complex orientation of policy occurs both here and in the rest of the world. The grounds for reaching this sombre conclusion are that very large structural imbalances, with unique characteristics, have been allowed to develop. These imbalances were always bound to unravel, and it now looks as though the unraveling is well under way.''

In Japan, deflation currently poses the greatest threat. Not only have prices been falling over the past three years, the rate of decline has been accelerating. Falling prices raise the real level of interest, which explains why the very loose monetary policy with historically low nominal interest rates has not implied falling real rates of interest, This is the classic ''liquidity trap'' situation. High real rates of interest in a depressed real economy increase the debt burden on both the private and public sectors to potentially unsustainable levels. Over the past decade, the ratio of gross public debt to GDP in Japan has increased from 61 percent to 131 percent, which is now the highest level for any OECD country. If debt levels keep rising in this manner, it is possible that this may lead to a collapse in public confidence in such debt, which in turn can even lead to an Argentina-like crisis with soaring interest rates, high inflation and outright default.

This means that the attempt to explain the Japanese economic conundrum in terms of a bloated and opaque banking sector completely misses the point, since it is the macroeconomic conditions which are creating the problems in individual banks as well. Certainly it is the case that in an economy that is already burdened with vast post-bubble debt and a heavy burden of non-performing loans held by the banking system, falling prices and consequently rising real interest rates could result in a spiral of mass bankruptcy, financial contraction and deepening recession.

So far the rest of the developed world has tried to ignore the magnitude of the Japanese economic quagmire, and certainly has not provided any meaningful assistance. But there can be significant international implications if the problems get worse, which they seem likely to do at present. Japanese capital has financed a large portion of the US international debt. So an implosion on the Tokyo financial markets, leading to the calling in of funds from the rest of the world, would have major consequences for the world economy. At the very least this would certainly prevent a rapid recovery in US financial markets, but it could have even more devastating financial effects.

Policy choices : The fiscal stance
One of the more destructive economic consequences of the downfall of Keynesianism in mainstream policy discussion has been the conscious rejection of the fiscal stance as a major means of changing levels of economic activity. One of the more blatant examples of this has been in the case of the European Union, in which the Growth and Stability Pact of the Maastricht Agreement explicitly restricted the ability of member states to use fiscal deficits to reduce levels of excess capacity and unemployment.

Nevertheless it is true that the conditions for using fiscal policy in this manner have changed significantly over the past decade, partly because of the cross-border mobility of finance, which can play havoc with domestic attempts to reflate economies, and partly because of certain other processes. In fact, what is remarkable about the period since the mid-1990s in particular, is the very different effects that fiscal policy have had on particular economies, often completely contrary to received wisdom.

Consider the evidence presented in Charts 4a to 4d. The first point to not is how the fiscal deficits have been declining quite rapidly as shares of GDP in all the advanced countries taken as a group, to very low levels. In fact, in terms of structural deficit (that is, accounting for the fact that fiscal deficits move with business cycles, increasing in slumps and declining in booms), the fiscal deficit in the major advanced economies was less than 2 per cent of GDP in the latter half of the 1990s and has been less than 1 per cent thereafter.

In the United States, the boom was originally led by large increases in government spending combined with tax cuts. In the mid-1990s, however, the US, despite being the country with the international reserve currency, chose to curtail its fiscal deficits initially. And when the US government was confronted with surpluses in the course of the boom triggered by private spending, it chose to hand over some part of those surpluses to the private sector in the form of tax cuts. As Chart 4b shows, since 1999 the US government budget has been in surplus (negative deficit indicates surplus).

Chart 4a >> Click to Enlarge

Chart 4b >> Click to Enlarge

Chart 4c >> Click to Enlarge

Chart 4d >> Click to Enlarge