For the past dozen years observers— both Japanese and foreign— have had difficulties figuring out the Japanese economy. Has it been in serious trouble? Could a crisis occur? Will these problems gradually go away? I do not claim to have the definitive answers to these questions, but I would like to offer some thoughts on what has been happening and how economists have viewed them. As many readers will know, there has been a debate between those who have viewed the problems as relatively minor versus those who see a potential crisis, as well as between those who believe the problems are structural and those who have viewed them as a macroeconomic phenomenon. My own conclusion is that the problems are quite serious (but hardly a crisis so far), that a future crisis is at least conceivable, and that the causes have been both macroeconomic and structural.
Japan is experiencing an unusual combination of problems unprecedented among industrial economic nations over the past half century. None of these problems alone represents a crisis for the economy, which is one of the reasons that many people have not viewed the situation as serious. But the combination of all these factors is what leaves economists rather worried. In addition, at least some aspects of economic performance are now moving outside the observed range of experience of industrial countries in the past half century— an unsettling development.
Once the stock market bubble burst at the end of 1989, economic growth remained high for two more years (until the real estate bubble peaked in 1991), but has been very low since 1992. Average annual real GDP growth since 1992 has averaged only 1.1 percent. Coming after a five-year period (1987 to 1991) during which economic growth had averaged almost five percent a year, this virtual stagnation has been a shock to the Japanese. The decade (1992-2002) has also been punctuated by four separate recessions (when real GDP has declined for two or more quarters).
Nevertheless, it is equally important to recognize that on average, growth in the past decade has been positive, even if low. The frequent description in the press of Japan experiencing a decade-long recession is not true. Those who wish to emphasize that the situation is not so bad can legitimately point out, for example, that households have higher wages and salaries today than they did a decade ago, although the increase is small.
This low but positive growth explains why American visitors to Tokyo often return puzzled by the lack of easily visible evidence of economic problems. Those casual observations also illustrate the difficulty in seeing what is happening. For example, a considerable burst of real estate development is now occurring in Tokyo, with construction cranes dotting the skyline, giving the impression of vigorous economic recovery. The data show that the square meters of new construction begun in 2000 in Tokyo was up 18 percent from 1995 (when the post-bubble economic downturn had caused construction to slow down). That gives the appearance of recovery. However, nationwide, square meters of new construction starts were down 12 percent in 2000 from the 1995 level, not up. In Saitama the drop was 11 percent, and in Hokkaido the decline was 25 percent.1 This suggests that casual observations about Japan based on the physical appearance of Tokyo are as dangerous as observations about the United States based on Manhattan.
Low growth has led to rising unemployment— up from 2.2 percent in 1992 to 5.4 percent in May 2003. The current level of unemployment appears mild in international comparison, and this mild outcome is consistent with the fact that the economy grew slowly rather than contracting. However, it is worth keeping in mind that there is at least some pain revealed in these statistics. Unemployment among 20-to-24 year-olds, for example, is currently 10 percent (and 12 percent among men) and for those 60 to 64, 8 percent (11 percent for men)--sufficiently high levels to become the subject of extensive media coverage in Japan. Perhaps more telling is what has happened to employment; through 2002, total employment in the economy had shrunk 3.5 percent from a peak in 1997 (a net job loss of 2.3 million). Furthermore, a rising proportion of those employed have only part-time jobs. By May 2003, 22 percent of the entire labor force was part-timers. Clearly the low growth of the past decade is having a negative impact on employment conditions, even though the damage is not at crisis levels.2
Overall price levels in Japan have been falling since 1998, whether measured by the consumer price index, wholesale prices, or the GDP deflator. In historical perspective, this deflation has been mild. Since the peak in 1998, consumer prices fell by about 3 percent through 2002, while the GDP deflator fell 6.4 percent.3 In contrast, consumer prices in the United States from 1929 to 1932 fell 25 percent.4 While mild, the Japanese decline has been broadly distributed; the prices of virtually all goods and services reported in the governments detailed data have been negative since 1998 (except petroleum products, publications, and imputed rent).5 The technical procedures used by the government to collect price data may be somewhat flawed, but if they are, the bias would be in the direction of underestimating deflation (because of slowness in shifting product price sampling to include more discount stores).
In Japan, blame for deflation is often placed on cheap imports from China. However, those imports are only 10 percent of total imports, and total imports are only 10 of GDP. Therefore, imports into Japan represent no more than one percent of GDP. The decline in prices is much too widespread to be accounted for by the impact of rising imports from China.
Deflation makes fixed debt harder to repay out of shrinking revenue or income. The corporate sector entered this period of deflation with excess capacity, low profit rates, and high debt levels, implying that even modest deflation could put them in trouble.
Some individuals in Japan express satisfaction with deflation, since they have seen falling prices for goods and services while their own incomes have held up. That is undoubtedly the case for some— especially academics and government officials with secure jobs and no pay cuts— the kind of people JPRI readers are likely to know best. However, overall statistics show household income falling as well. The household income and expenditure survey shows the income of worker households falling by 10 percent from a peak in 1997 through 2002.6 The broader national income data also show a decline in household income, stemming mostly from a drop in interest income and family business income. Wage and salary income for all households has dropped only two percent since 1998 according to the national income data, while total household income has slipped five percent.7 In either case, Japanese households on average have less income today than five years ago. The drop in household income, therefore, more than negates the positive effect on households from the three percent decline in the consumer price index. The drop also means that some households will feel the same pinch as do corporations from servicing debt (mostly housing mortgages) out of a shrinking income.
The collapse of the real estate and stock markets from the speculative bubble of the late 1980s left banks with huge portfolios of non-performing loans. Overall economic stagnation has subsequently generated further bad loans, and the deflation discussed above is contributing more. The official government estimate (for the end of September 2002) put the total at ¥40 trillion (or about $330 billion). When the results for March 2003 are announced later this year, stricter rules for evaluating loans will probably yield an increase in the official number. These represent non-performing loans that banks have not written off. Over the past decade, banks have written off an additional ¥83 trillion (about $700 billion)--a very large amount.
Many in the private sector believe that the real amount is considerably higher. Although reporting rules have been tightened in the past several years, private sector analysts believe that banks are still declaring some loans to be safe when they are not. What a more realistic amount for nonperforming loans might be is a matter of speculation, but estimates put it at double or triple what the government has reported.
Even the large amount of loans that has already been written off does not necessarily represent loans that have been resolved. In many cases, the banks have simply set aside reserves equal to the amount of the loan while taking no action against the borrower to recover the collateral, leaving zombie borrowers— effectively bankrupt but still in business. Failure to close down nonperforming borrowers contributes to the continuation of excess capacity in the economy, a situation that feeds deflation (as too many firms chase customers with lower prices in a desperate effort to increase sales volume as their banks stand by indulgently).
High Government Deficits and Debt
Over the past decade, the government turned to active fiscal stimulus as a primary policy tool to get the economy out of its stagnation. For the past several years, the annual fiscal deficit has been on the order of seven-to-eight percent of GDP, now the highest annual deficit among OECD-member countries.
The consequence of sustained annual deficits is a rising government debt level. Gross government debt will reach a ratio of 150 percent to GDP by the end of this year. While in other nations moderate inflation erodes the ratio of existing debt to GDP, in Japan deflation is now contributing to the rise in the debt ratio. Government debt is not currently a problem, since the government can issue its bonds at record low interest rates of one percent. Moreover, economists point out that the government has considerable assets (mainly the cumulative surplus in the social security account, as is the case in the United States) so that net government debt is not so high. Net debt was only 67 percent of GDP in 2002, but with social security reserves now declining, net debt is also rising rapidly (with the OECD expecting it to reach 84 percent in just the two years to 2004).8
Nevertheless, the ratio of debt to GDP cannot rise indefinitely, which leaves economists wondering when and how the government can reduce its annual deficits. Doing so is dependent on recovery in the economy, which has yet to materialize. Economic recovery would also include a return of low but positive inflation rates, which will help erode the ratio of debt to GDP.
Exhausted Conventional Monetary Policy
The other policy response of the Japanese government in the past decade has been to lower interest rates. This, too, is a normal government reaction to the problems the economy faced, just like the lowering of interest rates in the United States since 2000. However, in the case of Japan, most interest rates are now at extremely low levels. The overnight interbank rate (similar to the Federal Funds rate in the United States) is pegged at zero percent, leading to the term zero interest rate policy. Deposit rates for savings accounts at commercial banks are now one-tenth of one percent, and the prime lending rate to corporate borrowers is 1.4 percent. No industrial nation has had nominal interest rates this low since the 1930s (and long-term Japanese government bond rates are lower than they were in the United States at any point during the Depression).
Since nominal interest rates cannot be forced much lower, conventional monetary policy (meaning policy focused on manipulation of interest rates) has reached its limit. This has led to a consideration of unconventional monetary policy, which I shall take up below.
What Does It Portend?
The statistics I have so far recounted indicate a troubling but far from crisis situation. Japan has not experienced a decade-long recession; deflation has been mild; and banks have written off a huge amount of non-performing loans. Nevertheless, the economy is not doing well. Economic growth in the past decade was well below the probable level of potential economic growth over the past decade of 2.0 to 2.5 percent. Deflation, even if mild, is proving stubbornly persistent, and has exacerbated the ability of debtors to repay their debts. Households initially liked the idea of falling prices, but they are experiencing falling incomes that offset the gains. Banks still have huge non-performing loans, and more loans continue to go sour. The government fiscal debt is not a problem now, but it is rapidly moving to levels never before seen in advanced industrial nations.
Meanwhile, the policies followed by the Japanese government over the past decade to rectify these problems have not inspired much confidence among economists. The government, for example, has moved forward with policies to deal with non-performing loans, beginning with the jusen crisis in 1995, but the piecemeal process has not been very aggressive given the large amount of non-performing loans still on the books as well as the incomplete resolution of many of the loans listed as written off. As a result, many economists believe that a financial crisis is a real possibility— in the form of a rash of uncontrolled bank and/or insurance company failures. Some economists believe that most Japanese banks are technically bankrupt (with liabilities larger than assets). In any economy, firms that are technically bankrupt can continue to exist as long as they generate a positive cash flow. That is, a firm is not really forced to close until it cannot meet its weekly payroll. Nonetheless, being technically bankrupt is a very dangerous position to be in, and one that creditors and shareholders abhor. The probability of massive failures of Japanese financial institutions may be low, but certainly higher than zero. So far, the government has responded to the financial sector problems sufficiently well to avert a major crisis— much like the o-mikoshi in shrine festivals lurching from side to side of the road but never quite crashing into the crowd. Everything we know about the relatively practical responses of the Japanese government when faced with severe economic problems suggests that it will continue narrowly to avert crisis, but there is no guarantee that this will be the case.
In the longer run, a fiscal crisis is also possible, when bond markets finally balk at absorbing large volumes of new issues of bonds at low interest rates. The high level of private sector savings has enabled the financing of bond issues so far, but a fiscal crisis is conceivable in another decade. Since the government can print money, there is no risk of outright default on government debt. However, investors may start worrying that the very high level of debt will lead to inflation, at which point they will stop purchasing more bonds unless interest rates are higher. If that were to happen, then the government would be forced to monetize its debt, bringing about the inflation that the market feared. As was the case in the late 1940s, the level of inflation could be very high, with all the detrimental economic consequences that entails (such as wiping out the value of savings accounts).
How did this array of problems come to afflict Japan? Debate over the past decade has involved two basic explanations: structural and macro-cyclical. As a typical two-handed economist, I support the view that a combination of both is important for understanding the situation.
The Macro-cyclical Interpretation
The immediate cause of Japans problems over the past decade was the speculative bubble in real estate and stock market prices in the second half of the 1980s. Macroeconomists point out that such bubbles can (and have) occurred in many countries; Japan has no monopoly on foolish investor behavior. Once the bubble burst, the situation was exacerbated by poor government decisions. The government failed to move quickly to deal with non-performing loans (even though the previous experience of the United States and several European nations with similar banking problems in the 1980s and early 1990s provided a template to follow).
Meanwhile, a heavier and more consistent dose of fiscal stimulus in the early post-bubble years would have provided a better growth environment during which non-performing loans could have been written off. Instead, the government waited until 1994 to begin serious stimulus and then unadvisedly raised taxes by a substantial amount in 1997, throwing the economy into recession.
Finally, monetary policy bears some blame as well. The government raised interest rates too far and kept them high too long when trying to prick the speculative bubble. Eventually interest rates were lowered to a very low level, but by this point deflation was already setting in, undermining the effectiveness of policy.
Macroeconomists see the solution to this situation in a combination of three policies: aggressive action to deal with existing non-performing loans, continued fiscal stimulus while this process is occurring, and unconventional monetary policy (such as targeted inflation) to end deflation. Once the existing non-performing loans are removed, the economy should return to a healthy growth path.
Adam Posen and Takatoshi Ito are representative of this group of macroeconomic analysts. Some bureaucrats and politicians believe only one of the above three actions would be sufficient. BOJ governor Masaharu Hayami (and his articulate academic economist on the Policy Board, Kazuo Ueda) argued that non-performing loans and structural reform, and not monetary policy should be the primary focus of policy (because further loosening of monetary policy simply would not work). The Ministry of Finance and Financial Services Agency, on the other hand, have argued for a primary emphasis on monetary ease to stop deflation and the emergence of new non-performing loans. And some LDP politicians appeared content with fiscal stimulus as the primary action, especially if it meant more construction projects for their supporters.
Others have argued that what happened in the 1990s was primarily a structural problem: the economy harbored institutional flaws that made the bubble and the failure to deal with its aftermath quite understandable. The main features that have proved problematical are: the heavy reliance on banks to mediate between savers and borrowers; the weakness of the rules for financial disclosure; and the strong but informal role of the government in the economy.
When the economy was growing quickly, these features of economic structure were not a problem. The government played its role well in informally directing the allocation of capital resources; in a high-growth environment few companies failed, therefore banks did not need to worry much about credit risk; and with most corporations experiencing high profits, disclosure rules were unimportant. However, in a low growth environment (the inevitable result of success in catching up with the worlds industrial leaders), these features came to be problematic.
Bankers proved to have few analytical skills in evaluating borrowers other than their gut reactions based on close personal interaction (and perhaps were increasingly mesmerized by the trappings of the entertainment syndrome rather than the hard-nosed understanding of borrowers that was supposed to stem from these rounds of eating, drinking, golfing, and whoring). Weak disclosure means that bankers and capital market investors lacked believable financial data to carry out such analysis in any case. A new generation of government officials also seemed to lack good sense when applying administrative guidance. It was MOF officials who advised the banks to shift toward real estate lending and presided over establishment of the jusen. Furthermore, bureaucrats seemed to become more concerned with generating amakudari positions than pursuing policies intended for the good of the economy.
In the new slow growth environment, weakness in identifying poorly performing companies hurts the process of reallocating productive resources from losers to winners. With high growth, this was less of a problem because few sectors of the economy were losers. No modern economy manages this process perfectly, but Japans economic system harbors strong barriers to carrying out this function well (as do a number of European economies).
The structural interpretation offers some insight to the events of the past two decades. Administrative guidance encouraged the banks aggressively to pursue real estate loans in the 1980s. Bankers operated on the belief that they need not worry about the risk of lending when government implicitly stood behind them. Even if government did not provide guidance, the banks lacked the analytical skills to fend off borrowers who were lousy credit risks. Once the bubble broke, the system lacked the rules or market pressures to bring disclosure of non-performing loans and bankruptcy of the borrowers. No banks or borrowers wanted publicly to admit their mistakes, and they could easily manipulate the rules to avoid doing so. Again, no society has perfect disclosure rules, but the situation in Japan was particularly lax.
The solution in this interpretation lies in extensive reform aimed at better financial disclosure, improved corporate governance (lessening the independence of career managers and increasing the power of shareholders and bondholders), and deregulation or, more broadly, reduction in the informal role of the government in guiding the economy. In this interpretation, the fundamentally structural nature of the problems explains why a decade of traditional fiscal and monetary stimulus has failed to put the economy back on a better growth path. And in this interpretation, the government might want to raise interest rates rather than lower them, because extremely low interest rates make it easier for bankrupt companies to remain marginally alive, delaying the needed shakeout of non-performing borrowers. Adherents of this view include Richard Katz, Yukio Noguchi, Iwao Nakatani, Haruo Shimada, and former BOJ governor Hayami.
Both schools of thought have some merit, and some problems. The macro approach is right on the big picture— problems came from the collapse of the bubble and were prolonged by mistaken macroeconomic policies and the failure aggressively to clean up non-performing loans. But this interpretation begs the question of why this happened. To be sure, all societies and governments can make mistakes, but why these particular mistakes in this particular society at this particular time? Only the structural approach can supply those answers. Furthermore, macroeconomists tend to be far too sanguine in assuming that a government will follow their prescriptions even though they involve actions outside the scope of what any industrial nation has carried out in the past half century. After all, aggressive action is politically frightening when the magnitude of the Japanese problem dwarfs that of the S&L crisis in the United States in the 1980s. Asking for even larger deficits when total government debt is so high and rising rapidly beyond the level that other nations have experienced is a hard sell. And the unconventional monetary policy being recommended to Japan has never been used elsewhere and implies an unheard of high growth rate for the monetary base.
The structural interpretation yields the right analysis on why the problems of the past decade have occurred, but its solutions tend to be long term and some of its advocates ignore the need to deal with existing nonperforming loans and the safety net of fiscal and monetary stimulus needed to cushion the economy while bankrupt borrowers are forced out of business. Also, this interpretation often overestimates the ability or the desire of the society to adopt the reforms that economists believe are necessary. Do the Japanese really want to recast their economic system in a manner similar to that of the United States?
The solution therefore appears to lie in a synthesis of the two views, and economists have been drifting in that direction. Real resolution of Japans problems requires a package of:
- A relatively aggressive cleanup of non-performing loans, including closure of many non-performing borrowers and seizure/sale of the real estate collateral underlying the loans.
- Continued loose fiscal policy for the duration of non-performing loan cleanup. Larger deficits might be too much to expect, but deficits should not be reduced until the non-performing loan situation is under control in another three to four years.
- Monetary policy might flirt with some forms of unconventional policy. The structural recommendation of raising interest rates could be overkill— "zombie" companies exist now at very low interest rates; bringing them down requires political will not higher interest rates.
- Continued reform. Better disclosure helps reveal bankrupt borrowers and lowers the possibility of a repeat of the non-performing loan crisis in the future, while deregulation helps create new jobs in new sectors to absorb workers forced out of failing companies. Japan need not be a clone of the American system, but it needs to find some new configuration with which society is comfortable that includes an improvement in disclosure and corporate governance.
This package approach is also presumptuous. Since each of these proposals requires strong political will, it is difficult to imagine the political system embracing all of them together in a thorough way. The most likely outcome is some action on all these fronts that economists will find insufficient but that bureaucrats and politicians will consider to be bold steps. After all, the policy process has worked in a reasonably practical manner over most of the past century, so that these actions will probably manage to keep the economy from facing a serious financial sector crisis. The downside is likely to be another decade of economic growth that is below the potential growth rate (now down to about 1.0 to 1.5 percent because the working-age population is falling). A system that reacts to the possibility of crisis does not necessarily mean that it will be able react in a thorough manner to clean-up all the problems, especially since the array of vested interests and other obstacles to reform appears to be greater than it has been at other times of stress (such as the oil-shock years of the 1970s). Whether muddling through would at least end deflation and enable the government to reduce its annual fiscal deficit is unclear. If not, then the economy might be facing the prospect of a fiscal crisis in another decade.
EDWARD J. LINCOLN is a senior fellow in the Council on Foreign Relations, Washington DC, and the author of numerous books on the Japanese economy and Japanese economic policy. His latest book is East Asian Economic Regionalism forthcoming from the Brookings Institution in late 2003.
1. Data are from Management and Coordination Agency, Japan Statistical Yearbook, http://www.stat.go.jp/english/data/nenkan/zuhyou/b0806000.xls, plus the printed version for 1996 and 1998, p. 337. More recent data would be helpful given the recent burst of construction in Tokyo, but the Ministry of Land, Infrastructure, and Transport does not provide prefecture-level data on its web site. Construction begun in 2000 probably reasonably reflects buildings being completed in 2003.
2. Ministry of Health, Labor and Welfare, Final Report of Monthly Labor Survey— May 2003, http://www.mhlw.go.jp/english/database/db1/15/1505fr/mk1505re.html (July 17, 2003); http://jin.jcic.or.jp/stat/stats/09LAB33.html (March 18, 2003); Japan Statistical Yearbook 2003, http://www.stat.go.jp/english/data/nenkan/zuhyou/b0301000.xls (July 25, 2003).
3. http://www.esri.cao.go.jp/jp/sna/qe031-2/rdef-cy0312.csv (July 24, 2003); http://www.stat.go.jp/english/data/geppou/zuhyou/m07.xls (July 24, 2003).
4. Bureau of Economic Analysis, U.S. Department of Commerce, Long-Term Economic Growth 1860-1970 (Washington, DC, 1973), pp. 222-223.
5. Management and Coordination Agency, Monthly Statistics of Japan, http://www.stat.go.jp/english/data/geppou/zuhyou/m08.xls (July 25, 2003).
6. http://www.stat.go.jp/english/data/geppou/zuhyou/n01.xls (July 24, 2003).
5house/90i5.xls (July 1, 2003).
8. OECD, OECD Outlook, June 2003, http://www.oecd.org/document/61/
0,2340,en_2649_201185_2483901_1_1_1_1,00.html, Annex Table 26. General Government Total Outlays (July 24, 2003).