Britain and Japan: A Tale of Two Comebacks

In the last few months there have been many accounts touting the economic turnaround in Britain, claiming that its recent growth vindicates the policy of austerity pursued by the government over the last three years. The basis for this celebration was growth in the first three quarters of 2013. During this period, Britain’s economy grew at 2.8 percent. The International Monetary Fund now projects 2.4 percent growth for 2014.

Celebrants of the success of austerity may want to look at the numbers a bit more closely before the victory party. In the three years since the Conservative Party put in place its austerity plan, cumulative growth has been 3.6 percent, an average of 1.2 percent. This has not been sufficient to even regain the ground the economy lost during the downturn. On a per capita basis, Britain will still be 4.0 percent poorer in 2014 than it was in 2007, assuming that its growth is in line with IMF projections. If that is a successful policy, it is scary to imagine what failure looks like.

Furthermore, this picture may seriously overstate the health of Britain’s economy. It appears that one of the main driving forces in the current recovery is the return of the country’s housing bubble. Real house prices are not quite back to their 2007 peaks, but they have been rising rapidly in recent months. This increase is partly driven by deliberate government policy, which now provides a large subsidy for new home buyers.

Inflation-adjusted house prices are now more double what they were in the middle of the 1990s. The median house costs about 50 percent more than in the United States, even though its per capita income is around 20 percent less. Those who believe that this striking difference is due to the fact that Britain is a small island whereas the United States is a huge continental country, must explain why this distinction suddenly started having such a large effect on house prices. House prices in the United States were higher than in Britain in the 1990s.

As everyone should know by now, the story of bubbles is not a pretty one. They burst and ruin dreams and lives. Heavily leveraged homeowners will see their equity vanish and find themselves owing more than the value of their home. The demand that was driven by illusory bubble-generated equity will disappear with the bubble. This will leave Britain with yet another recession, possibly accompanied by a new financial crisis, as lenders are hit with another flood of bad mortgages.

That’s a pretty awful story, but politicians desperate for re-election might be willing to take the gamble that they can keep the bubble expanding at least until polling day. And, they can probably count on a compliant business media to downplay evidence and warnings of the bubble, instead touting the virtues of the government’s economic policy.

If the story of the recovery in Britain is not likely to have a happy ending, at least for the people living there, the picture is very different in Japan. The country’s new prime minister, Shinzo Abe, decided to go in the opposite direction after he took office at the end of 2012. He decided that he would deliberately run larger budget deficits in the hope of stimulating the economy. He also managed to get the Bank of Japan to commit itself to a policy of deliberately trying to raise the inflation rate. The BoJ announced that it would take steps to increase the rate of inflation to 2.0 percent, reversing a period of stagnant prices or modest deflation.

The results thus far from pursing this policy have been overwhelmingly positive. Japan’s economy grew at a 3.2 percent annual rate in the first three quarters of 2013. The IMF projects that its economy will grow 1.7 percent in 2014, a number that would be higher if the government did not plan to partially reverse its stimulus policy with a big tax increase in April. These numbers are actually somewhat better than they may first appear in comparison to Britain. While the latter’s population is growing at a 0.6 percent annual rate, Japan’s population is falling slightly. On a per capita basis, Japan was already more than 2.0 percent above its 2007 level by the end of 2013.

Japan’s effort to achieve a higher rate of inflation also appears to be working with the core inflation rate reported as 1.2 percent for 2013. This is the highest inflation rate the country has seen in five years. The idea that this would cause a flight from Japanese debt has proven unfounded; the interest rate on long-term bonds is just 0.6 percent. This means that the effort to lower the real interest rate, by keeping nominal interest rates low, while raising the inflation rate, has been successful thus far. In fact, investment has been one of the main forces driving growth last year, although the extent to which lower real interest rates are responsible can be questioned.

In any case, Japan’s experiment with stimulus, and explicitly boosting inflation, looks about as promising as could have been hoped. On the other hand, it is difficult to treat the three years of near stagnation in Britain as a success story. If the track record of these countries were laid before the public side by side it is difficult to believe many would choose the austerity and bubble route. Unfortunately, the promoters of austerity have much more access the media than proponents of stimulus. Therefore we can look forward to many glowing accounts of Britain amazing turnaround in the years ahead.

*Read the original op-ed here.

**The author is the co-director of the Center for Economic and Policy Research in Washington. The opinion expressed are his own.

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