SYNOPSIS: Paul Krugman explains why persistent slow growth can be just as bad or worse than a temporary slump -- excellent article

How much has Japan's economy shrunk since its bubble burst? It's a trick question; Japan's economy hasn't shrunk. It had only two down years over the past decade, and on average it grew 1 percent per year.

Yet Japan's is a genuinely depressed economy. Because growth has been so slow, an ever-increasing gap has opened up between what the economy could produce and what it actually produces. This "output gap" translates into rising unemployment and accelerating deflation. Slow growth can be almost as big a problem as actual output decline.

Now the non-trick question: What would a similar analysis say about the United States?

The U.S. economy's "potential output" — what it could produce at full employment — has lately been growing at about 3.5 percent per year, thanks to the productivity surge that began in the mid-1990's. But according to the revised figures released a couple of weeks ago, actual growth has fallen short of potential for seven of the last eight quarters.

The conventional view is that we had a brief, shallow recession last year, and that recovery has begun. But the output gap tells a different story: Two years ago we went into an economic funk, and it's not over. In a way the whole double-dip controversy is a red herring; the real question is when G.D.P. will start growing fast enough to narrow the output gap. And so far there's no sign of that happening.

There's no mystery about the causes of our funk: the bubble years left us with too much capacity, too much debt and a backlog of business scandal. We shouldn't have expected a quick and easy recovery, and we're not getting one.

Some readers have already guessed where I'm going with this. The U.S. stock bubble in the second half of the 1990's was just as big as Japan's bubble in the second half of the 1980's. Will our two-year funk turn into a five-year or ten-year funk, the way Japan's did?

A loud chorus is already shouting "We're not Japan!" Half the time, depending on what I had for breakfast (rice and pickles?), I'm part of that chorus. But let me share some disquieting thoughts.

Back when I first got professionally obsessed with Japan's problems, around four years ago, I made myself a mental checklist of reasons that Japan's decade of stagnation could not happen to the United States. It went like this:

1. The Fed has plenty of room to cut interest rates, which should be enough to deal with any eventuality.

2. The U.S. long-term budget position is very strong, so there's plenty of room for fiscal stimulus in the unlikely event interest rate cuts aren't enough.

3. We don't have to worry about an Asian-style loss of confidence in our business sector, because we have excellent corporate governance.

4. We may have a stock bubble, but we don't have a real estate bubble.

I've now had to strike the first three items off my list, and I'm getting worried about the fourth.

More and more people are using the B-word about the housing market. A recent analysis by Dean Baker, of the Center for Economic Policy Research, makes a particularly compelling case for a housing bubble. House prices have run well ahead of rents, suggesting that people are now buying houses for speculation rather than merely for shelter. And the explanations one hears for those high prices sound more and more like the rationalizations one heard for Nasdaq 5,000.

If we do have a housing bubble, and it bursts, we'll be looking a lot too Japanese for comfort.

A recent Federal Reserve analysis of Japan's experience declares that the key mistake Japan made in the early 1990's was "not that policy makers did not predict the oncoming deflationary slump — after all, neither did most forecasters — but that they did not take out sufficient insurance against downside risks through a precautionary further loosening of monetary policy." That's Fedspeak for "if you think deflation is even a possibility, throw money at the economy now and don't worry about overdoing it."

And yet the Fed chose not to cut rates on Tuesday. Why?

Last year some economists began privately referring to the Fed chairman as "Greenspan-san." The joke faded out as optimism about recovery became conventional wisdom. But maybe it's not a bad nickname after all.

Originally published in The New York Times, 8.16.02