Aftershock therapy

5 Mar 12
Japan’s economy was in deep trouble well before the recent natural disasters struck. As it struggles to pick up the pieces, what lessons are there to be learnt from the country’s ‘lost decades’?

By Dan Corry | 1 July 2011

Japan’s economy was in deep trouble well before the recent natural disasters struck. As it struggles to pick up the pieces, what lessons are there to be learnt from the country’s ‘lost decades’?

The March 11 earthquake and tsunami in Japan unsurprisingly clobbered its economy. Gross domestic product contracted sharply as transport and supplies were disrupted and factories had to shut.

But this natural disaster has exacerbated an already dire situation – Japan’s economy has been a bit of a busted flush for many years now. In the decade from 1994, Japan grew less than any of the other Group of Seven industrialised countries. From 1990 to 2006, its annual average growth was 1.3%, trailing behind 2.7% for the UK and other members of the Organisation for Economic Co-operation & ­Development and 1.9% in the euro area. 

That is of cursory interest, one might say. Hard luck to the Japanese but what’s it got to do with me? Well, everything, according to finance experts such as the influential Richard Koo, chief economist of Tokyo’s Nomura Research Institute. They believe that what happened to Japan could now happen to the UK. Koo will no doubt be making this argument when he speaks at ­CIPFA’s annual ­conference in ­Birmingham.

So what happened in Japan? First, there was the postwar ‘economic ­miracle’. Coming after a horrendous defeat and the two atom bombs on Hiroshima and Nagasaki, the Japanese rebuilt their economy. All looked good.

In fact, things were so good domestically that they started to invest overseas. Japanese inward investment became a familiar sight all over the world and rescued car production in the UK in places such as Sunderland. Productivity was high, incomes rose, the infrastructure was envied by the world.

But something else had happened too. Growth led to a massive property and speculation boom. Credit was easily available from banks and borrowing soared. Then, in 1990, interest rates were raised sharply. This led to a huge stock market crash the following year and to a debt crisis, when much of the debt turned out to be bad.

The Japanese banking system took a major hit and the authorities had to bail them out. While it is not surprising that this affected economic activity, it did come as a surprise that the economy did not recover. Instead, there has been a long period of deflation with poor growth and steadily falling prices for much of what is often referred to as the ‘lost decades’.

Deflation can cause lasting damage because it increases the real-terms value of large debts such as mortgages, and discourages consumers and businesses from spending due to the anticipation of falling prices. In Japan, it led to an ‘investment strike’ as companies responded to subdued domestic demand by paying down debt and building up financial surpluses.

The Japanese government did not just take all this lying down. In the first place, it tried to keep the banks going and lending to business. Indeed, the strategy was to focus on saving the banks, thinking that the rest of the economy would then take care of itself. The problem was that this avoided the necessary restructuring of the banks – which started to be known as ‘zombies’. A wave of bank consolidation followed and credit then became hard to obtain.

A second response was that interest rates were cut and kept low for many years. But this did not have much effect, as firms opted to pay down their debts from their own earnings rather than borrow to invest.

The third response was through fiscal policy. The Japanese government issued bonds and spent the excess savings of the private sector to sustain gross domestic product. This led to a budget surplus in 1991 turning into a deficit of 10% by 1998, with gross debt approaching 200% of annual economic output.

Japan managed to get away with such high figures partly because 90% of the outstanding stock of debt was held by local investors, risk-averse small savers, pension funds and institutions that were content to hold Japanese government bonds. But it is also one of the reasons why unemployment did not rise as much as the sluggish GDP record would suggest. Indeed, a powerful argument is made by some economists that Japan made a mistake in withdrawing its fiscal stimulus policy too early in 1996, at the first signs of growth returning, since in reality most of that growth was made possible by government ­support in the form of fiscal stimulus.

Once that support was removed in 1997, the Japanese economy fell off a cliff and experienced five consecutive quarters of negative growth. In the recent recession, Japan was hit hard again in GDP terms with a fall of 8.4% in the year up to the first quarter of 2009, substantially greater than the 5.8% OECD average decline.

Some take comfort that growth in Japan has not really been so bad – and that some of it just reflects a shrinking population of working age. But Koo and other economists believe it is a tale of incorrect policy moves and they see ­parallels with the UK and the US.

In both cases, we had a balance sheet recession that emerged after the bursting of a debt-financed asset price bubble that left many private sector balance sheets with more liabilities than assets. Firms then started paying off debts and not investing – despite loose monetary policy. This meant lower aggregate demand and therefore no self-sustaining growth – of the type UK Chancellor George Osborne hopes for.

Koo says that what is needed is a focus on mending private sector balance sheets, and it is wrong to think that saving the banks is sufficient to fix the economy. That is why the City and Wall Street are ­thriving again while the High Street and Main Street are still struggling.

And fiscal consolidation should not start until it is clear that if the government stops borrowing to keep demand and activity going, the private sector will take up the slack. Koo therefore believes the UK (and the euro zone) is making a great mistake by forcing austerity during a balance sheet recession. And while he believes the US is doing better than Europe, he is increasingly concerned about the deficit reduction rhetoric coming out of Washington.

So is Koo right? It really is too early to say. Some of the causes and responses are clearly similar, but some are not.

Policy responses in the UK were much more active than in Japan. The then prime minister, Gordon Brown, grasped the nettle early on by restructuring and recapitalising the banks and not just propping them up. The Bank of England not only kept interest rates low – and avoided all but a short period of negative inflation – but launched ambitious ‘quantitative easing’ programmes, pumping money into the economy.

The UK is not suffering from other factors such as a declining working age population and we have had a falling exchange rate that has helped support recovery, where Japan had a strong yen.

But the similarity is clear: the severe cuts in spending to reduce the budget ­deficit echo what happened in Japan.  A UK economy that was starting to recover under a broadly Keynesian approach to the deficit has come to a virtual halt in the past few quarters – and there are few signs of accelerating growth to make up for the lost output. Three years on from the start of the recession and we are still around four percentage points below where things were before the crisis – and somewhere around ten points below where the 2008 Budget thought we would be by now.

So we might be turning Japanese after all.


Dan Corry is a director of FTI Consulting and a former senior adviser on the economy to Gordon Brown when he was prime minister. Richard Koo, chief economist of Tokyo’s Nomura Research Institute, is speaking at CIPFA’s annual conference in Birmingham on July 5–7

This feature first appeared in the July edition of Public Finance

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