What Japan Gained and Lost

Abstract

The Japanese economy was not jump-started even after the bad loans were resolved. While Japan succeeded in averting the trade war escalating into a full diplomatic showdown and the banking crisis propagating into a systemic meltdown, its economic size and per capita income came to be overshadowed by its peers, particularly those in Asia. Japan tried to transform itself when its growth model reached an impasse in the mid-1980s, but the efforts resulted in bubbles, and the ensuing long clean-up process may have distracted the country from the critical task of developing a new growth model.

As shown in Fig. 7.1, the Japanese private non-financial corporate sector borrowed massively during the bubble years. During the in-between years, it did not borrow much in net but did not repay much either. Only after the crisis and following the three rounds of intensive bank inspections, the non-financial corporate sector started big repayments. Finally, the sector had shed off excess debts and stopped repaying in FY 2005 and 2006, but, in net, it did not start new investments either. Then there came the Global Financial Crisis in 2008 and the Great Eastern Earthquake and its tsunami and subsequent nuclear crisis in 2011, making the corporate Japan even more cautious. It continued to repay debts, and those companies which got no more debts to repay accumulated cash at hand. The Japanese corporate sector became a major net saver.

Fig. 7.1

(Source Bank of Japan, Flow of funds statistics)

Financial surplus/deficit of private non-financial corporates

After main banks demonstrated that they may not necessarily be reliable in times of stress, borrowers resorted to self-insurance. As shown in Fig. 7.2, the corporate Japan rapidly reduced debts payable to banks after the 1998 banking crisis and piled on cash at hand after the Global Financial Crisis. The net bank debt (i.e., bank debt minus cash) shrank to only 7% of the total asset at the end of FY 2018. On the other hand, the equity to asset ratio, which long stayed below 20%, started to jump up after the banking crisis and reached 42% at the end of FY 2018. Private non-financial corporations transformed their balance sheets during the last two decades so that they rely less on banks and more on their own cash and capital.

Fig. 7.2

(Note Corporations of all size and all non-financial industries. Equity to asset ratio represents shareholders’ equity [net worth] as percent of total assets. Bank debts represent loans payable to financial institutions. Cash represents cash and bank deposits held by corporations. Source Ministry of Finance, Financial Statements Statistics of Corporations, FY2018)

Balance sheet composition of private non-financial corporations

The corporate Japan’s much-enhanced risk-taking capacity, however, did not result in increased investments. The contribution of increase in capital stock to the potential growth rate fluctuated between negative 0.7% and positive 0.6% (Fig. 7.3). The capital stock was not revamped to take advantage of the information and mobile technologies and became obsolete year by year. The contribution of the total factor productivity growth to the potential growth rate was well above 1% in early years of the 2000s but became almost nil toward the end of 2010s. It was expected in the early 2000s that, once the Japanese economy broke away from the yoke of the bad loans and excess debts, it could make a jump start. This expectation did not materialize. The potential growth rate never rose above the level experienced during the first lost decade.

Fig. 7.3

(Source Bank of Japan, Output Gap and Potential Growth Rate, April 2020)

Factor contributions to the potential growth rate

The relative economic clout of Japan, as measured by the GDP expressed in the current exchange rate, which in 1995 reached 71% of the United States, came down to one quarter in 2018 (Fig. 7.4, Panel A). It was ten times bigger than the Chinese economy in 1993 but was only 36% in 2018. The average living standard of a Japanese, as measured by the GDP per capita expressed in the purchasing power parity rate, was only 13% less than an average American’s in 1991 but is 30% less now (Panel B). The Taiwanese overtook the Japanese already in 2009 and the Koreans have become almost as well off as the Japanese.

Fig. 7.4

(Source World Bank, World Development Indicators database [for Panel A] and International Monetary Fund, World Economic Outlook Database [for Panel B])

Changes in the economic clout of countries and the living standard of nationals

Abiad et al. (2014), five economists at the International Monetary Fund, look at medium-term output dynamics after 88 banking crisis episodes. With charts showing changes in real GDP per capita for the ten years leading to the crisis and seven years following the crisis, they persuasively categorized the postcrisis growth path into three types. The first group of crises, such as those in Japan in 1997 and Thailand in 1997, resulted in growth at persistently slower rate than before, and in addition to immediate output losses, ever wider deviation from the pre-crisis trends. The second group, such as Korea in 1997 and Sweden in 1991, resulted in return to the pre-crisis growth rate, but the initial output losses are not recovered. The third group, such as Turkey in 2000 and Mexico in 1994, resulted in growth outperforming the pre-crisis trends.

Though Abiad et al. (2014) do not argue for this, one may tempted to infer from these cases that quick hard-landing reforms prescribed by the IMF (such as Korea in 1997 and Mexico in 1994) and quick and aggressive self-reforms (such as Sweden in 1991) can preserve or even improve medium-term growth, while the Japanese style soft-landing can leave lasting damages. Could Japan have belonged to the second or third group had the IMF imposed ruthless reforms?

But the growth paths look quite different if we include period before and after the 18 years examined by Abiad et al. (2014). In Japan (Fig. 7.5, Panel A), it was the burst of bubbles in 1990 which kinked the growth trend. The banking crisis in 1997–1998 did not result in a change in the growth trend and may be considered rather as an example of the second group characteristics. In Thailand (Panel B), the pre-crisis decade of sharp growth acceleration was rather a deviation from the long-term trend and the post-crisis period could be considered as a return to normalcy. Not shown in Fig. 7.5, but Indonesia shows a pattern similar to Thailand.

Fig. 7.5

(Note The vertical axis is with logarithmic scale. Korea, whose growth during the period is by far the biggest, is shown with different scale. Source World Bank, World Development Indicators database)

Changes in real GDP per capita (The level in 2018 = 100)

Looking at a short time horizon, Abiad et al. (2014) maintain that the crisis in Korea in 1997 resulted only in initial output loss and did not lower the growth trend. Despite the structural reforms done in the wake of the crisis, however, the growth gradually decelerated from around 2000 (Panel C) and the case may be considered as an example of the first group. Sweden in 1991 (Panel D) looks like an example of the third group rather than the second.

In short, the cases of Sweden in 1991, Turkey in 2000, and Mexico in 1994 may imply a merit of a painful big quick surgery, but the cases of Thailand, Indonesia, and Korea in 1997 may suggest that is not always the case.

The economic growth in the post-war Japan (Panel A) is characterized by three steady periods with two kinks. The post-war miracle growth kinked around the time of the hyperinflation ensuing the October 1973 oil crisis. The economy transited to a more moderate growth, and then kinked again at the burst of bubbles in the early 1990s. Since then, the Japanese economy maintained a slower but steady growth. The banking crisis in 1998 and the corporate and banking restructuring in 2001–2002 left scars much less noticeable than the one left by the Global Financial Crisis in 2008.

This structure of three steady periods and two kinks contrasts sharply with the US growth path (Panel G), which shows fluctuation around the steady trend only, as introductory economics textbook presupposes, until the Global Financial Crisis caused a modest downward change in the growth trend. Though not shown, the UK growth path is similar to the US one.

The steadiness of the Japanese growth since the second kink, in spite of all the dramas described in this report, may make one suspect that the bubbles and the busts may have been part of the adjustment process resulting from transition from one growth model to another. The transition might have been necessitated by factors such as demographic changes (Japan transited from the period with demographic bonus to that with demographic onus in the early 1990s) and the size of the Japanese economy becoming excessive to be sustained by the export-led growth strategy.

In Chapter 1, we called Japan’s rapid modernization in the late nineteenth and early twentieth centuries as its first miracle and the post-WWII growth as the second. Japan sustained the second miracle by transforming its growth engine from reconstruction to export, from cheap and abundant labor to capital-intensive plants then to advanced technologies, and from energy dependent production processes to energy efficient ones of the post-oil shock era.

When the existing growth model reached an impasse in the mid-1980s, Japan did try to transform itself again, from the world’s factory to the world’s headquarters, investor, and financial center, from a country of workaholic to an attractive land with new lifestyles, and from a selfish beneficiary of the world order to a contributor to global commons, as we saw in Chapter 2. But the new visions and dreams that were quickly fabricated in the latter half of the 1980s largely turned out to be papier-mâché and resulted in an inefficient allocation of resources. Massive costs were incurred to banks, corporations, and the government, and burdens were imposed on the labor force, as Chapters 3–6 described.

But perhaps more significant were the lost opportunities. Japan already confronted with the need to design a new system which can support a new growth model in the mid-1980s, as well recognized by the Mayekawa report, but spend the 1990s mainly to prevent the collapse of the old system. The crisis in 1998 made the failure of the old system evident, and immediately after that, the Economic Planning Agency (1999), in its report approved by the Cabinet, clearly defined the task as follows:

The system which supported the growth of the Japanese economy till the 1980s relied on banks’ corporate governance functions under the main-bank system and other established practices. The approach was effective during the catch-up period, as the key success factors in the period were piecemeal improvements in production efficiency and in products. Japan, however, completed the catch-up processes which can be attained by piecemeal improvements and is now being caught-up by emerging competitors. Now, the key success factors are the abilities to innovate and propose new lifestyles for an affluent society and excavate new demands, but the existing system do not support activities to foster such success factors well.

As the Japanese economy needs to proactively face new challenges, it should take greater amount of risks. The key task here is designing a new system which can support economic agents to face forward-looking challenges without scaring the households. So far, the Japanese household sector has been protected from risks, but this is just because banks absorbed enormous risks backed by the growing value of the real estate collaterals and large latent gains on the equities held, not because of the excellence in risk diversification system embedded in the Japanese economy.

We should design a new system where i) risks can be assumed in a well-diversified manner and are compensated by proper returns, ii) economic agents proactively face new challenges to innovate technologies and life styles, and iii) returns on financial investments are improved.

The task was defined clearly in 1999, but Japan spent the first half of the 2000s to clean up the mess created by the old system.

A new system would require many new components which are complementary to each other: A governance framework that can effectively allocate risk, return, and monitoring function within the society; a growth model that can create values by solving the problems the global community confronts with; a social norm that can foster entrepreneurship and innovation while preserving social fabric; properly designed safety nets; and vibrant investments. The transformation requires enormous efforts, courage, resources, and ingenuities of business leaders, policymakers, and all other members of the society. The 1986–2004 financial cycle distracted the country from this critical task to transform itself.

The slow GDP growth does not necessarily mean that Japan lagged in all aspects of public welfare. Jones and Klenow (2016), who propose a summary statistics for economic well-being of people in a country, argue that, despite its “lost decades” after 1990, Japan moves sharply up in the growth rankings when considering welfare instead of income. According to them, both Japan and the United States had average annual income growth just over 2.0% between 1980 and 2007, a period which includes the Japanese crisis but not the Global Financial Crisis. But Japan’s annual welfare growth nearly doubled to 4.0% when rising life expectancy, rising consumption relative to GDP, and rising leisure are incorporated, almost one percentage point above the US welfare growth rate of 3.1%.

The rising leisure is expressed as the constant negative contribution of work hours to the potential growth rate in Fig. 7.3. Figure 7.6 shows male and female longevity in Japan, which ever improves without any kinks and outperforms Germany and the United States by wide margins.

Fig. 7.6

(Source World Bank, World Development Indicators Database)

Male and female life expectancy at birth in Germany, Japan, and the United States

Japan may not have used the 1986–2004 financial cycle most efficiently to find and establish a new growth model. But Japan evaded a full-fledged trade war in the 1980s and, despite the burst of bubbles two to three times bigger than those in the United States in the 2000s, averted a meltdown of its banking system in the 1990s and 2000s. Through a painful process, it acquired a toolbox to deal with distress in the banking and corporate sectors.

In Japan today, streets are clean, trains operate punctually, and people are largely polite and diligent. Populist overtone is reasonably contained. Shared norms often work more effectively than coercion. The country may be assessed to have maintained its basic social fabric, which should constitute the foundation of any third miracle to come.