Satyajit Das: The World Turns Japanese
A review of the similarities -- and differences -- between the collapse of Japan's bubble economy and the post-global financial crisis economies of developed nations.
Japan's two decades of stagnation and Prime Minister Shinzo Abe's recent initiatives to revive the moribund economy may provide important insights into the world's current economic problems.
Since the collapse of the bubble in 1990, policymakers have implemented a variety of economic stimulus programs. Japan's public finances have deteriorated as the government has run large deficits, leading to an increase in government debt, which is now around 240% of GDP. Monetary policy has been highly accommodative, including zero interest rates and multiple rounds of quantitative easing since 2001.
Despite these measures, Japan remains trapped in a period of economic stagnation.
Policies designed to alleviate the slowdown have created anomalies and delayed essential structural changes, compounding fundamental problems.
Investments have increasingly been misallocated into expanding manufacturing capacity and excessive infrastructure spending, reducing returns and Japan's potential growth rates.
The excessive manufacturing capacity and low domestic demand has exacerbated reliance on exports and a high trade surplus to balance production with demand. This puts upward pressure on the yen, reducing Japan's ability to be competitive as an exporter. Much of the government-financed infrastructure investment is not productive. After the initial boost to activity, this investment – bridges, roads, and tunnels -- requires perpetual maintenance expenditure, absorbing scarce government resources.
Low interest rates allow debt levels to remain high. They reduce income for savers, decreasing consumption and encouraging additional saving for retirement.
Low rates have allowed weak businesses to survive in a zombie-like state, where they are free to continue to pay interest on loans. Banks avoided writing off loan assets, tying up capital and reduced lending to productive enterprises, especially small and medium enterprises (SMEs), which account for a large portion of economic activity and employment. The creative destruction necessary to restore the economy did not occur.
Correspondence and Divergence
There are similarities and differences between the collapse of Japan's bubble economy and the post-global financial crisis economies of developed nations.
In both cases, low interest rates and excessive debt build-ups financed investment booms intended to drive recovery from recessions. Both ultimately collapsed. Both were characterized by overvaluation of financial assets and banking system weaknesses. Policy responses to the crisis have also been similar.
At the onset of the crisis, Japan had low levels of government debt, high domestic savings, and an abnormal degree of home bias in investment. This allowed the government to finance its spending domestically, assisted by an accommodating central bank. Currently, around 90% of Japanese government bonds are held by compliant domestic investors. The absence of market discipline, especially from foreign investors, allowed Japan to incur high levels of indebtedness. Many of the current problem economies have low domestic savings and are reliant on foreign capital.
Japan's problems occurred against a background of strong economic growth in the global economy. Strong exports and a current account surplus partially offset the lack of domestic demand, buffering the effects of the slowdown in economic activity. The global nature of current problems means that individual countries will find it more difficult to rely on the external account to support their economies.
While its aging population has increasingly compounded problems, Japan's demographics at the commencement of the crisis were helpful. Its older population had considerable wealth. Low population growth meant that less new entrants had to be accommodated in the workforce during a period of slow growth, alleviating problems of rising unemployment.
Reflecting a homogenous society and a stoicism shaped by its history, Japan's citizens were accommodating of the sacrifices and transfer of wealth necessitated by the economic problems. But the demographic and social structure of other troubled economies may not accommodate the measures required to manage the crisis without significant breakdowns in social order.
In reality, Japan highlights the difficulty of engineering recovery from the effects of major deleveraging following the collapse of a debt-fuelled asset bubble. It reveals the constraints of traditional policy options – fiscal stimulus, low interest rates, and debt monetization.
What's Putonghua for "Turning Japanese"?
Despite a history of conflict and competition, China and Japan share a contiguous geography and development models. China may also share Japan's economic fate.
Japan's post-war economic recovery and China's more recent growth was based on an export-driven model, using low-cost labor to drive manufacturing. Both countries used undervalued currencies to provide exporters with a competitive advantage. Exports were promoted at the expense of household income and consumption. Both encouraged high domestic savings rates, which were used to finance investment. Both countries generated large trade surpluses, which were invested overseas, primarily in US government securities, to avoid upward pressure on their currencies and to help finance purchases of their exports. Both also used high levels of investment financed domestically to drive economic growth.
The Plaza Accord, signed on September 22, 1985, forced Japan to revalue its currency due to the appreciation of the yen, reducing Japanese exports and economic growth. In order to restore growth, policymakers engineered a credit-driven investment boom to offset the effects of a stronger yen, driving a bubble in asset prices that collapsed. Government spending and low interest rates have been used to avoid a collapse in activity exacerbating imbalances. This has resulted in large budget deficits, very high levels of government debt, and enlargement of the central bank balance sheet, in part to finance the government and support financial asset prices.
China's resistance to a sudden, sharp revaluation of the Renminbi is based on avoiding the Japanese experience. China's response to the global financial crisis, which triggered a large fall in Chinese exports and a slowdown in economic activity, is similar to that of Japan following the Plaza Accord. Recent Chinese growth has been driven by a rapid expansion of credit that has driven an investment boom.
Becoming Poor Before Getting Rich
As with the global economy, there are many points of correlation and divergence between the positions of Japan in the early 1990s and China today.
Investment levels are high, in similar areas like real estate and infrastructure. Chinese fixed investment at around 50% of gross domestic product (GDP) is higher than Japan's peak by around 10% and well above that for most developed countries of around 20%.
Like Japan before it, China's banking system is vulnerable. Rather than budget deficits, China has used directed bank lending to specially targeted projects to maintain high levels of growth.
The reliance on overvalued assets as collateral, and infrastructure projects with insufficient cash flows to service the debt, means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a significant portion of China's large pool of savings and income, reducing the economy's growth potential.
At the onset of its crisis, Japan was a much richer country than China, providing it with a significant advantage in dealing with the slowdown. Japan also possessed a reputable education system, strong innovation, technology, and a stoic work ethic that helped with adjustment. Japan's world-class manufacturing skills and significant intellectual property in electronics and heavy industry made it less reliant on cheap labor, allowing the nation to defer but not entirely avoid the problems.
In contrast, China relies on cheap labor to assemble or manufacture products for export using imported materials. The shortage in availability of labor and rising wages are increasingly reducing competitiveness. China's attempts at innovation and high technology manufacturing are still nascent.
Chinese authorities admit that the credit-driven investment strategy in response to the global financial crisis increased domestic imbalances and resulted in misallocation of capital, unproductive investments, and loan losses at government-owned banks. China faces significant challenges in shifting away from its investment-led growth model. Growth based on endless subsidized expansion of capacity is increasingly not viable. Attempts to continue the present strategy or a failure to adjust may cause an economic slowdown, greater than forecast with consequences for China's social and political stability.
In recent years, popular awe at the achievements of China has increased. But it is entirely possible that China's spectacular success could end in surprising failure if the country fails to make the needed economic transition. The question now: Can China avoid "turning Japanese?"
Until 1990, Japan was highly successful, growing strongly with only brief interruptions. Since 1990, after the bubble economy burst, Japan has been mired in almost two decades of uninterrupted stagnation.
The Japanese experience suggests that the state can provide palliative care to an economy in crisis but may have limited ability to restore economic health. The real lesson from Japan is that the only safe option to prevent a prolonged period of stagnation is to avoid a debt-fuelled bubble and subsequent build-up of public debt in the first place. But then again... it is too late for that!
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