What we can learn from Japan’s decades of trouble
By Martin Wolf
Twenty years ago, the conventional wisdom was clear: Japan was the world’s most successful high-income country. Few guessed what the next two decades held in store. Today, the notion that Japan is on a long slide is conventional wisdom. So what went wrong? What should the new Japanese government do? What should we learn from its experience?
We must put this in context. The quality of the train system and the food make a visitor from the UK realise he comes from an utterly backward country. If this is decline, then most people would welcome it.
What has gone wrong? Richard Koo of Nomura Research points to “balance sheet deflation”. According to Mr Koo, an economy in which the overindebted devote their efforts to paying down debt has the following three characteristics: the supply of credit and bank money stops growing, not because banks do not wish to lend, but because companies and households do not want to borrow; conventional monetary policy is largely ineffective; and the desire of the private sector to improve balance sheets makes the government emerge as borrower of last resort. As a result, all efforts at “normalising” monetary and fiscal policy fails, until the private sector’s balance-sheet adjustment is over.
The sectoral balances between savings and investment (income and spending) in the Japanese economy show what has been happening (see chart). In 1990, all the sectors were close to balance. Then came the crisis. The long-lasting impact was to open up a massive surplus in Japan’s private sector. Since household savings have been declining, the principal explanation for this is the persistently high share of corporate gross savings in GDP and the declining rate of investment, once the economy went “ex growth”. The huge private surplus has, in turn, been absorbed in capital outflows and ongoing fiscal deficits.
Mr Koo argues that those who criticise the fiscal deficits miss the point. Without them, the country would have fallen into a depression, instead of a prolonged period of weak demand. The alternative would have been to run a bigger current account surplus. But that would have required a weaker exchange rate. Japan would have had to follow China’s exchange rate policies. The US would surely have gone berserk.
Yet Mr Koo’s argument has a weakness. It explains neither why the huge debt overhangs emerged in the first place, nor why Japan has proved so vulnerable to the global shock, now that the corporate sector’s balance-sheet adjustment is at last largely completed (see chart).
My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over. As Andrew Smithers of London-based Smithers & Co notes, Japan’s private non-residential fixed investment was 20 per cent of GDP in 1990, close to double the US share. This has fallen to 13 per cent after a modest resurgence in the 2000s. But no comparable decline has occurred in corporate retained earnings. In the 1980s, the challenge of absorbing these savings was met by monetary policy, which drove the cost of borrowing to zero and sustained wasteful investment. In the 2000s, the challenge was met by an export and investment boom, driven largely by trade with China (see chart).
Then came the current global economic crisis, which savaged exports and investment and generated a huge recession. With a peak-to-trough contraction of GDP of 8.6 per cent, Japan suffered the biggest recession in the Group of Seven high-income countries. In 2009, according to the Organisation for Economic Co-operation and Development, the decline in net exports would have shrunk the economy by 1.8 per cent on its own.
Japan’s aim now must be to achieve domestically driven growth. The most important requirement is a big reduction in corporate saving. Mr Smithers argues that this will happen naturally, since savings are largely capital consumption, itself the product of the history of excessive investment. I would add that if ever an economy needed a market in corporate control, to shift cash out of the hands of sleepy managements, Japan is it. Not being beholden to Japan’s corporate establishment, the new government should adopt policies that would change corporate behaviour, at last.
It is also time to stop the deflation. To achieve this result, the Bank of Japan must co-operate with the government to avoid an excessive strengthening of the exchange rate. The recent strength of the yen should have led to far more aggressive monetary policies. Once Japan has significant inflation at last – 2 per cent is a bare minimum – the country would have the negative real interest rates it still needs.
Meanwhile, the rest of the world has to wonder whether it is learning the lessons from Japan’s fall from economic grace. Japan’s experience strongly suggests that even sustained fiscal deficits, zero interest rates and quantitative easing will not lead to soaring inflation in post-bubble economies suffering from excess capacity and a balance-sheet overhang, such as the US. It also suggests that unwinding from such excesses is a long-term process.
Yet Japan’s experience also has a lesson for quite a different economy. It indicates that when very fast growth begins to slow in a catch-up economy with very high corporate savings and comparably high fixed investment, demand may well prove extremely difficult to manage. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. And who needs to learn this vital lesson now? The answer is: China.
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