Recent economic data suggest that an improvement is occurring in the economy, and the stock market has reacted strongly to this information over the past several months. The end of the initial phase of the war in Iraq and the fading of SARS have helped, as has structural change in the private sector of the economy, with companies cutting costs and increasing profits. I am pleased to see some improvement in the Japanese economy. However, I do not share the enthusiasm that I hear from many contacts in Tokyo for five important reasons.
First, the evidence so far is for a very modest upturn. Given the weak performance of the past several years, the economy has considerable slack. When economies in that situation begin a cyclical upturn, they usually grow at rather high rates for at least several quarters. At the present time, a robust recovery in Japan ought to produce a year or two of growth in the range of three to four percent. There was a recovery like this in 1996 that lasted until the government snuffed it out in the spring of 1997 by raising taxes. Even though economists are now upgrading their forecasts for this year and next year, those forecasts are still in the range of one percent. This implies that Japan is not really entering into the kind of cyclical upturn that I would like to see occurring.
Second, the recovery in economic growth may not last very long. One of the surprising developments in the past year has been the willingness of households to reduce their savings rate in order to keep up their consumption levels as incomes have fallen. As many readers of this column know from personal experience, wages and salaries are falling on average, and investment income from savings accounts or stock investments has fallen sharply. Nevertheless, consumer spending has continued to rise slowly, as people have chosen to save a smaller proportion of their income. For the past several decades, Japanese households have saved a much higher share of their income than have Americans, but that may not be true this year as the Japanese savings rate has declined sharply. This shift in behavior has been good for the sake of propping up economic growth, but I wonder how long it can continue. In all societies, people choose to put aside part of their income to finance their future needs, so I expect that the drop in the savings rate has reached its limit. As deflation continues to erode income, therefore, consumer spending will begin to fall soon.
Third, a short, modest economic upturn implies that the fundamental problems in the economy will not be affected very much. I doubt that the small increase in the economic growth rate will do much to reduce the continuing problem of non-performing loans or deflation. Higher growth certainly helps to prevent emergence of new non-performing loans and to push prices back up. However, the current recovery will not be strong enough or last long enough to help very much. These problems need stronger direct policy action. For example, the FSAs action on Resona Bank was a step forward, but Resona is only one of many banks that need serious repair.
Fourth, I worry that the upturn in economic growth will cause Prime Minister Koizumi and his government to become complacent about further action on non-performing loans and deflation, especially after the LDP presidency election and the probable Lower House election later this year. I do not believe Prime Minister Koizumi was ever as enthusiastic about economic reform as he led the public to believe, and the modest economic improvement will provide an easy excuse to do less. This would be very unfortunate, given the conclusion that the upturn will be insufficient to improve the non-performing loan or deflation situation.
Finally, I worry that the Bush administration will also relax. At the moment, the administration has adopted an extremely generous attitude toward Japan. Because Japan has been so supportive of the war against Iraq (in words if not deeds), the Bush administration has chosen to remain silent on economic issues. The upturn in the economy will lead them to think that this policy silence is acceptable. This is unfortunate because serious economic problems remain, and what the American President and other high-level officials say does factor into policy debates in Japan. Silence sends a false signal since many in Washington remain quite worried about Japanese economic problems and the possibility that the situation could become worse.
Economic data is always changing, and perhaps stronger signs of economic recovery will appear in coming months. At the moment, however, I remain skeptical that the improvement will be strong or long-lasting
Edward J. Lincoln, Senior Fellow, The Council on Foreign Relations