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Why did Japan stop growing?
Saturday, 12 May 2012 03:17

Japan's very strong economic growth from the 1950s through to the 1980s was a virtual miracle.  Its stagnation for the past two decades seems a mystery.  How did it all happen?

In the period up to the 1980s, Japan went through a process of economic catchup.  This was no mean feat because, although all less developed countries have catchup potential, very few manage to succeed.

In Japan's case, there were several special factors that underpinned its catchup, but which could not support a subsequent necessary transition to domestic-demand- and innovation-driven growth.

From the mid-1950s to the mid-1970s, Japan enjoyed average economic growth of around 10% a year, just like China has over the past three decades.  A key driver of this growth was substantial capital investment, often fueled through close connections between government, business and banks.  Industrial upgrading was facilitated by imitating and importing foreign technologies.  True, Japan was often able to make improvements, but most technologies came from overseas.  Protection against imports gave Japanese industry the breathing space to upgrade.  Thus, Japan was able to transform itself from a nation of transistor radio producers to a leader in motor vehicles and electronics.

Japan's growth was also export-oriented which meant that product standards had to be raised to international market standards.  Japan benefited from open markets in the US and elsewhere.  Again, like China, a fixed and under-valued exchange rate helped gave Japan a competitive edge.  But financial globalization and the collapse of the fixed exchange rate regime meant that by the end of the 1970s Japan could no longer rely on an undervalued exchange rate.  Japan also benefited from a very low share of elderly people during this time -- in other words, most people were working rather than being on a pension.

Already, by the 1980s, Japan's economic growth began slowing down -- Japan's annual economic growth was 3.8% from 1974 to 1990, compared with 9.2% from 1956 to 1973. This is natural as countries progress further in the catchup process. But Japan's slowdown was also a sign that there was something awry in Japan's model.  It slowed more than countries like the US, UK and Canada did at a similar level of development.

Let's explore some of the reasons why Japan stopped growing.  Allocating finance through relationships between government, banks and industry can facilitate economic catchup.  But as a country matures, market mechanisms are necessary to ensure that finance is allocated to the most efficient uses.  While protecting local industry can help support export-oriented growth, it can also lead to weakness in the domestic economy, notably services, where there is no discipline from international competition.

And when a country is small compared with the rest of the world, it can depend on exports.  But as the economy grows larger and more competitive, it can provoke trade frictions and protectionism.  Thus, in 1985 Japan was ultimately pressured to raise the value of the yen. This led to a hollowing out of much of its manufacturing sector.  For example, motor vehicle producers shifted production to export markets, including in the US and EU.  And labor-intensive electronics and other industries were offshored to East Asia, setting up the now very familiar production networks and supply chains.

Lastly, Japan has been undergoing the most rapid aging of its population of any advanced country.  This means that a progressively smaller share of the national population is working to support retired workers.  By 2022, 30% of all Japanese citizens will be aged 65 or older, nearly twice the percentage in the US.  

Real problems showed up when Japan developed a monumental real estate and stock market bubble which exploded from 1990.  Policy errors were behind the bubble, as the government stimulated the economy excessively in response to the deflationary effects of the yen appreciation.  And there was a lot of imprudent lending due to lax and misguided oversight of the banking system.

Policy errors would continue.  The burst bubble left the banking sector with large non-performing loans in the corporate sector. Instead of recognizing them and raising new capital, with the encouragement of the government, most banks denied the problems and rolled over loans in the hope that things would get better.  Weak banks operated for too long by misallocating credit to obscure their problems.    

By rolling over loans to zombie firms, the banks distorted competition, keeping the zombies in business and reducing the rewards to strong firms from expanding their business.  Over time this stifled the process of creative destruction that is essential for innovation and productivity growth in a mature economy.  The government would take a decade before forcing banks to get rid of non-performing loans.

Unnecessarily tight monetary policy prolonged deflation, and entrenched deflationary expectations.  Economic weakness was exacerbated by premature tightening of monetary policy on several occasions.  
Government expenditure to stimulate the economy allocated large amounts of money to ineffective spending programs, often more to the benefit of construction companies than to the country's productive potential.  90% of public spending between 1993 and 2002 was on the types of projects which were already unproductive by the start of the 1990s -- notably: roads, harbors, and airports; agricultural-related public capital and fishing ports; flood control and forest conservation.  

Japan went from having the best debt position among advanced countries to the worst.  If the government maintains its current spending and taxation, it will ultimately have to renege on future promised transfers (through the national pension system) or pursue very high inflation (that would reduce the real value of debt) or to engage in an outright default on its debt.  

The failure to deregulate the services sector, a potential growth sector for a mature economy, has also held the economy back.  Japan has heavy government regulation in some sectors, and on average regulatory barriers in the service sector actually started to rise from the late 1990s.  Service sector productivity has been flat since the early 1990s.   

Japan enjoyed a long period of modest growth in the first decade of the new millennium, buoyed by some reforms by the Koizumi government, and fast growth in China.  Koizumi's major contribution was cleaning up the long-running problems in Japan's banking sector.  The major banks reduced the amount of their non-performing loans by more than half in two years.   

But Japan was knocked off its perch again when the global financial crisis struck, as demand for its exports was badly affected.  The government has since continued to dope up the economy with budget stimulus, with the result that gross public debt now represents over 200% of GDP.  Then came the triple whammy of earthquake, tsunami and nuclear crisis which knocked the country over again.  By 2010, Japan's nominal GDP was lower that that of 1994.

The current Democratic Party of Japan government has launched a "New Growth Strategy".  Regrettably, this strategy does not contain much hope for boosting growth as it is mainly a combination of old industrial policy, and proposals that rely on external demand.

What is the Japan problem, and why has it failed to reform?  Despite crises and a clear deterioration in performance, Japan has been a rich country, with little pressure for reform.  The status quo has been mostly satisfactory.  

In contrast to Korea, it has long had a current account surplus and large external assets, which have protected it from the ire of international financial markets.  With the government and society having no clear vision for the country's great potential, it has not been possible to mobilize the country on a reform track.

In more recent years, Japan's confidence has been sapped by the sense of never-ending economic crisis, lack of political leadership, the dramatic rise and feisty behavior of China, confusion regarding the US/Japan Alliance, and the 2011 triple crisis.  This means that vested interests can always raise their ugly head to block reform.

"When you're in a hole, you should stop digging" is an old saying that applies very well to the case of Japan.  All countries have crises at some point in time.  But with more competent and decisive governance, Japan could have got out of its funk a long time ago.  


Why did Japan stop growing?  Takeo Hoshi and Anil Kashyap.



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