Simple analysis of the Japanese economy suggests simple causal relationships. Export success, excess domestic savings, low inflation and anemic growth are frequently linked in the media and commentary. But any review of Japan’s economic performance must be considered in three domestic contexts: the current recovery from its deepest postwar recession; the continuation since 1990 of subpar growth; and the 40 immediate postwar years of extraordinarily rapid, catch-up growth.
It is a mistake to refer to the recent period as the ‘two lost decades’. Despite subpar growth, major institutional, social, and political changes have taken place. Japan’s economic recovery from 2002 to the end of 2007 of about 2 per cent annual GDP growth was good but not great, and was incomplete. Even before the recession hit, a substantial output gap remained, full employment was not achieved, and deflation persisted.
Thus far, Japan has successfully exported its way out of recession. Exports increased considerably more rapidly than anticipated, particularly to China and the other East Asian economies. Some 90 per cent of the increase in Japan’s aggregate demand over the past year has been from net exports. Domestic demand declined during 2009 until the last quarter, as business investment dropped sharply, consumption only increased slightly, and government spending slowed after the one-shot stimulus package. However growth has slowed significantly from the second quarter of 2010. Thus far, the recovery has only gone about half way to the previous GDP peak in 2007.
One of Japan’s most worrying macroeconomic problems is the return of mild but seemingly persistent deflation, interrupted temporarily in 2008 by the world commodity prices boom. Japan’s core CPI dropped by 1.6 per cent in fiscal 2009, and was a negative 1.1 per cent in July 2010. Even with its extraordinarily easy monetary policy, the Bank of Japan (BOJ) has not achieved price stability.
Persistent deflation has pernicious macroeconomic effects. It increases real interest rates, deters business investment and household consumption, reduces tax revenues, increases the fiscal deficit, renders traditional monetary policy ineffective, and generates adverse expectations about the future.
The most comprehensive measure of prices is the GDP deflator, which converts nominal GDP to real GDP. History suggests, as do current policy discussions in Japan, that the GDP deflator should be modestly positive. However, Japan’s GDP deflator has been negative since 1998, and indeed worsened to -2.3 per cent in the first half of 2010. If Japan’s GDP deflator had been slightly positive or even zero over the past decade, tax revenues would have been significantly higher and government debt smaller.
Japan’s financial system has weathered the recession well, largely because from the late 1990s it went through five years of its own crisis, reform, and consolidation. Corporate recovery has been internally financed, so bank loans have been decreasing. Banks continue to invest heavily in Japanese government bonds (JGBs) despite the very low yields. Japan remains over-banked; banks have huge deposits, market interest spreads are narrow, and profitability remains significantly below that of foreign counterparts.
While profits declined by a third and many companies recorded losses, the Japanese corporate sector held up quite well during the recession. Bankruptcies, in number and amount, did not increase significantly. Businesses reduced new fixed investment by 24 per cent from the peak first quarter of 2008 through the third quarter of 2009, before flattening out and beginning to pick up slightly in the first half of 2010. Profits have risen dramatically; profits of listed companies this fiscal year are projected to increase by 70 per cent. Companies have used cash flow not only to finance investment but to pay off debt. Almost half of listed companies are now essentially debt-free.
Forecasting growth for 2011 and following years is subject to significantly greater uncertainty than usual. The government and the BOJ are likely soon to reduce their optimistic estimates of a few months ago that the economy would grow at about 2 percent in fiscal 2011. Much will depend on the degree to which business investment picks up. Consumption is constrained by the slow growth of household income and the low share of wages in GDP.
The slowdown in export growth continuing into 2011 is mainly because the rapid-recovery phase of world growth is over. A further determinant of Japanese exports is the exchange rate, which averaged about 92 yen/dollar in 2009. Since May 2010 the yen has surged some 9 per cent relative to the dollar, a 15 year high. Not surprisingly, Japanese exporters and policymakers have voiced concerns, but it remains to be seen whether the government and BOJ policy steps in favour of a weakened yen will be effective. When adjusting for sustained difference in US and Japan inflation rates, the yen is not high, and the real effective exchange rate is at its long-run average.
Like the US and EU, Japan faces the conundrum of how to stimulate domestic demand and how to reduce the government budget deficit. This requires sensible policies of sequencing and timing. The big difference is that Japan is unique in having modest but persistent deflation. That must be overcome in order to implement successful growth and budget deficit strategies.
I am not optimistic about Japan’s near-to-medium term economic performance. Recovery will continue, but at a modest pace. Japan has a large overhang of labour even aside from recorded unemployment, notably those employed but underutilized and those who have withdrawn from the labour force. I am concerned whether Japan will overcome the persistent output gap and return to the full employment and stable growth path with price stability that for two decades it has not been able to accomplish. My sense is that it will take annual growth greater than 2 per cent for at least five years to achieve full employment.
Japan’s ‘two lost decades’ saw significant cultural, structural and technological development. With big short-term challenges remaining, particularly in terms of maintaining net-positive growth rates, forecasting future Japanese economic performance is not easy. With slow consumption growth, the focus of policy makers and analysts will sensibly be on the corporations and their competitiveness in international markets.
http://www.eastasiaforum.org/2010/11/20/the-japanese-economys-recovery/
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