How To Survive a 'Zombie Economy'

Economists are urgently studying Japan’s experience in the 1990s to learn how to avoid a “lost decade.”

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Imagine if the U.S. economy grew just 1 percent per year over the next 20 years. The Dow Jones Industrial Average would plunge by 60 percent, to less than 4000. The average price of a home would fall by nearly 50 percent, from $184,000 to about $100,000. The economic carnage would make the Great Recession seem gentle, upending families, devastating communities, and transforming America for generations.

[See how to plan for a double-dip recession.]

That's the outer edge of a "Japanification" scenario painted by economists at Bank of America Merrill Lynch, meant to examine what would happen if the U.S. economy got stuck in a deep rut like the Japanese economy did in the 1990s. It's an unlikely outcome, yet a weakening U.S. recovery has sent economists back to their textbooks to study the world's most famous "zombie economy." And there are some unnerving similarities between Japan then and America now. Both countries experienced a real-estate bubble fueled by greedy speculators and complicit banks providing the funds. In each case, the bust came quickly, leaving banks, investors, and consumers with steep losses that would take years to absorb. And both wipeouts challenged policymakers hoping to jump-start the economy by pulling conventional levers.

Japan's zombie economy is generating new interest now because a recovery that looked like it was taking root in the first half of the year seems to be unraveling in the second half. After a couple of impressive quarters, GDP growth is sagging again, and it might even turn negative if not for the remnants of last year's big stimulus bill. With weak demand for goods and services, companies aren't hiring. Unemployment seems stuck at nearly 10 percent. The housing bust persists despite government subsidies. Investors are bailing out of stocks. Even at the normally staid Federal Reserve, policymakers are starting to bicker over what to do.

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This could all be part and parcel of a stutter-step recovery, with the economy shaking off the jitters and picking up steam later this year or next. But it could also be the early stage of a prolonged period of stagnation that bedevils policymakers, which is a growing concern at the Fed and on Wall Street. "The U.S. is closer to a Japanese-style outcome today than at any time in recent history," wrote James Bullard, president of the Federal Reserve Bank of St. Louis, in a recent study.

Japan's economy seemed to be on fire in the 1980s. Then its booming real estate market collapsed, sending the nation into a 10-year tailspin. From 1991 to 2000, Japan's economy grew a scant 0.5 percent per year, compared with healthy 2.6 percent annual growth in the United States. Deflation set in, which torpedoed spending and bank lending. Unemployment rose and stayed high. Living standards sank. Japan's rapid economic ascent stalled, and the erosion of confidence became self-perpetuating.

The lesson of Japan's "lost decade" is that chronic stagnation can be even more punishing than a sharp recession. But don't head for the ledge just yet—there are key differences between Japan in the 1990s and America in 2010, including the way the government reacted to the problem. In Japan, the real estate bust was even worse than it has been here, with bigger price drops. Japan's central bank waited until eight years after the peak of the bubble to cut interest rates, one antidote to a financial crisis. In the United States, the Federal Reserve cut rates just three years after the bubble's peak—and cut more deeply. And the American bank bailouts, as unpopular as they were, helped banks recover from deep losses and accelerated the healing in the financial sector. "One might say that the U.S. leap-frogged the first phase of Japan's decade of economic underperformance," says Alan Levenson, chief economist for investing firm T. Rowe Price.

[See 4 reasons to fear deflation.]

If that's true, then that leaves the next phase of Japanification, in which banks restrict credit while they work through a large pool of bad loans, and the nation as a whole pays down excessive debt. This seems to be precisely where the U.S. economy is right now—and might stay for awhile. U.S. banks, for example, probably have enough reserves to handle underwater mortgages and defaults on credit cards and other consumer loans. But it's not clear that those losses have peaked, and the longer unemployment stays high, the worse that problem will get.

All those non-performing loans represent the "toxic assets" that were such a concern at the start of the financial crisis—and many of them are still there. The banks have argued that those assets will regain some of their value as the economy recovers, and the Fed's policies are basically allowing time for that to happen. Meanwhile, however, banks are lending less, which constricts home and car purchases and other economic activity. Instead of galloping forward, the economy just stumbles along.

[See 5 reasons companies still aren't hiring.]

Many consumers don't want new loans anyway, since they're overwhelmed with debt and their assets have plunged in value. Americans, on average, have a debt-to-income ratio of about 122 percent, which means the average amount of individual debt equals nearly 15 months' worth of earnings. That's down from a peak of 133 percent in 2007, but historical averages are well below 100 percent. That means many Americans have no choice but to dedicate leftover income to paying off debt instead of buying stuff. So money once dedicated to tomorrow's purchases is now dedicated to yesterday's.

If you're wondering what a zombie economy looks like, in other words, you're probably looking at it.

If we're lucky, that quick action by the government sped things up, and we might be facing a lost half-decade, with some time already served, rather than a full lost decade like Japan. But the next few years could still be challenging. It's a good bet that interest rates will stay low, bedeviling savers. Inflation will be so low as to flirt with deflation, likely to keep incomes depressed and consumers on the sidelines. Companies will remain reluctant to hire, and stocks will zig-zag.

[See why the stimulus spending is over.]

But there are ways to ride the zombie, and Japan has shown us how. With interest rates painfully low and stocks volatile, investors should look for dividend-paying stocks and high-quality bonds. Consumers should keep paying down debt and resist any additional debt if possible. Tempting as it might be to replace an aging car or out-of-style appliance, it's okay to wait. Prices are unlikely to rise by much, and might even fall. Home prices in particular seem likely to keep falling, at least into 2011. And lenders might become more permissive over the next year or two, as they slowly improve their own financial health.

Job seekers should develop every new skill they can, since employers these days are looking for people with two or even three distinct skill sets. Even if the U.S. experience amounts to Japan Lite, the job market will stay tough. People need to go where the jobs are and prove why they're worth investing in during slack times. It doesn't hurt to have a secondary source of income, since raises are likely to be scarce.

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However long it lasts, our very own zombie economy will wake from its restless slumber as soon as the Fed raises interest rates again. And the Fed will do that when it feels confident that the economy can stand on its own. A year ago, some prognosticators thought the Fed would raise rates by mid-2010. Instead, the Fed expressed unusual concern this year as the recovery faltered, continually renewing its pledge to keep rates low for "an extended period." Economists now guess that could last until late 2011 or early 2012. If they're right, Japanification here will have lasted only half as long as it did over there. That will be long enough.