by Adam S. Posen, Peterson Institute for International Economics
Testimony submitted to the Subcommittee on Trade Committee on Ways and Means
United States House of Representatives
July 13, 1998
© Peterson Institute for International Economics
1. What is wrong with the Japanese economy?
The Japanese economy has been growing painfully slowly since the asset price bubble burst in 1992. Initially, it was just a standard downturn following a stock market decline. The Japanese government, however, continued on a stop-go course of fiscal policy throughout the 1990s, and let bad debts mount in the financial system due to poor supervision. When the government raised the national consumption tax by 2% in 1997, and contracted government spending, confidence took a huge blow. The economy has not recovered since. In fact, things have gotten worse with people saving more, but pulling their savings out of the Japanese private banking system, which contracts credit and then the economy further. Note—this is the result of a badly managed business cycle, not some sort of structural decline in the Japanese economy, so it should be remediable in the near-term.
2. Didn't they already try fiscal stimulus? Why didn't it work?
Fiscal policy works when it is tried. The problem is that the Japanese government and the Ministry of Finance have way overstated the amount of fiscal stimulus in which they actually engaged. In total, around 23 trillion yen (4.5% of a year's GDP) was injected into the economy from 1992-97, in contrast to claims of 65-75 trillion yen. The government actually took a total 2.0% out of the economy in tax rises and spending cuts over the same years, which meant that the total stimulus was really small compared to the growth shortfall. In September 1995, they did pass a package that was large (1.5% of GDP) and 60% of the size they claimed, and they did get strong growth in 1996.
3. What about their deficits and their aging society?
Japan did add the most to its debt in the 1990s, and has the most rapidly aging society, amongst the OECD economies. The relevance of these facts to the appropriate policy response at present, however, is questionable. On the deficits side, most of the accumulation came as a result of the downturn; the structural deficit (representing changes in government policy) only rose by 5% over the decade. There is no reason that this trend should not be reversible when growth returns. Besides, Japan has the best net debt position in the OECD, once their social security surpluses (like our trust fund) are counted. While the society is indeed aging, the demographic trends are so large that they can only be responded to with appropriate large measures—increasing the retirement age, the participation rate of women in the work force, or the rate of social security contribution. Saving one or even a few years' deficit spending will make no real difference to the long-run, but will sacrifice growth.
4. How bad is the problem with their banks?
The Japanese banking problem is analogous to the U.S. Savings and Loan crisis in several ways. Banks with deposit guarantees made a lot of risky loans when their net worth got near or below zero, but supervisors did not shut them down. Businesses and banks which took a hit on property, and in Japan stock, holdings found their debt burden rising as a proportion of their ability to pay. When loans went bad, and more companies had problems, banks contracted lending, which put more borrowers into liquidity problems. The differences are that the Japanese situation is about five or six times as large as a share of the economy, and the transparency of their financial bookkeeping is inferior to that in the US. While clean-up of the banking system is necessary, it will not be enough to restore growth on its own—lack of credit availability has only been pinching Japanese companies for about a year, and it is a broader lack of demand which is the problem. Moreover, growth will help revive the banks themselves by improving their own and their borrowers' balance sheets.
5. What does Japanese economic stagnation mean for the United States?
The primary effect on the United States is to rapidly increase our trade deficit, both bilateral with Japan and with East Asia as a whole. A contracting Japan imports far less, which has direct effects on the U.S., as well as driving more of the crisis countries in East Asia's exports in our direction (as well as Western Europe's). So long as savings outpaces investment in Japan, which it will keep doing while Japanese households and businesses are in a precautionary mindset and the financial system is fragile, Japan will run a trade surplus. This is not all bad for the American economy, because it is accompanied by a stronger dollar and capital flows to the U.S., both of which increase our buying power. It also represents the relative strength of the U.S. economy and the attactiveness of our investment opportunities at present, as opposed to the 1980s high trade deficits which were the results of our lack of competitiveness and shortfall of savings. The danger is if this trade imbalance goes on too long, because that would mean a lack of capital getting back to Japan and East Asia, prolonging if not worsening their slump. It also risks an eventual rapid decline in the dollar. Still, in the short run, the U.S. running such a trade deficit is the best of bad options given the fact that there has been a slump in Japan and Asia.
6. So are there any risks in the Japanese situation we should be concerned about?
Yes, there are some mounting downside risks which could affect the United States. If confidence in Japan suffers another blow—say when the to-be-chosen Prime Minister adheres to continued fiscal austerity—or the financial system is allowed to lope along without clarifying which banks are safe and which are not, Japanese savers could increase the rate at which they are pulling money out of their economy. This could lead to a sharp contraction in growth, imports, and in the viability of their remaining financial system. Because a likely outlet for such savings is dollar-denominated assets, this would also lead to a rapid decline in the yen versus the dollar. Such capital flight would put the Japanese government in a true dilemma: those policies which would fix the financial system (lower interest rates, government capital infusion, printing money) would be exactly those which would speed the yen's decline, and vice versa. Meanwhile, Japan's neighbors would come under pressure to devalue or depreciate their own currencies, and there would be an added risk of trade protection, either of which could spiral out of control. This would have strong negative effects on U.S. growth, on confidence in financial markets worldwide, and on our ability to keep emerging markets playing by market rules over the long-run.
7. What should the Japanese government do about this?
The Japanese government should engage in a three part program. They should engage in serious fiscal stimulus, sufficient to raise the growth rate in Japan above its potential level—only above potential growth starts to reemploy unemployed workers, so smaller packages will be unlikely to affect confidence and reverse excessive savings. Given a forecast contraction of 1%, and potential growth of 2-2.5% of GDP, the fiscal package should be on the order of 3.5%. It should consist of permanent tax cuts. The monetary authorities should announce a positive, finite, inflation target of 3% in order to stave off deflation, and print the amount of money necessary to achieve that target. Unanchored inflation or yen-depreciation by just turning on the printing presses will add to uncertainty and increase the risk of international backlash. The financial system should be cleaned up along the lines well-known, but not yet implemented—in particular, the sorting out of viable from insolvent banks should be speeded. This is all manageable, quick to implement, and likely very effective.
8. What can the U.S. government do?
Not much. If Japan's government does not recognize Japan's own self-interest in resurrecting its growth rate, there is little we can do besides attempt to persuade them. Unilaterally, there is even less the U.S. can do to make up for inappropriate Japanese policy, except keep our markets open to East Asian imports. It is important that the U.S. not engage in economic brinkmanship with Japan, say by publicly threatening lack of support for the yen if it tumbles quickly, or trade protection if Japan does not take in its fair share of imports. This is not because we should not be frustrated with Japan's unwillingness to change policy—frustration is justified—but because it would be self-defeating for U.S. interests. We would increase the risks of either yen decline or trade collapse getting out of control without affecting the Japanese economy sufficiently to change their behavior - we also would not credibly be able to reduce those risks if Japan acceded to our threats, so the Japanese would have no incentive to comply.
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