The incredible shrinking economy

Apr 2nd 2009 TOKYO From The Economist print edition Japan is in danger of suffering not one but two lost decades Illustration by S. Kambayashi TO LOSE one decade may be regarded as a misfortune; to lose two looks like carelessness. Japan’s economy stagnated in the 1990s after its stockmarket and property bubbles burst, but its more recent economic performance looks even more troubling. Industrial production plunged by 38% in the year to February, to its lowest level since 1983. Real GDP fell at an annualised rate of 12% in the fourth quarter of 2008, and may have declined even faster in the first three months of this year. The OECD forecasts that Japan’s GDP will shrink by 6.6% in 2009 as a whole, wiping out all the gains from the previous five years of recovery. If that turns out to be true, Japan’s economy will have grown at an average of 0.6% a year since it first stumbled in 1991 (see top chart). Thanks to deflation as well, the value of GDP in nominal terms in the first quarter of this year probably fell back to where it was in 1993. For 16 years the economy has, in effect, gone nowhere. Was Japan’s seemingly strong recovery of 2003-07 an illusion? And why has the global crisis hit Japan much harder than other rich economies? Popular wisdom has it that Japan is overly dependent on exports, but the truth is a little more complicated. The share of exports in Japan’s GDP is much smaller than in Germany or China and until recently was on a par with that in America. During the ten years to 2001, net exports contributed nothing to Japan’s GDP growth. Then exports did surge, from 11% of GDP to 17% last year. If exporters’ capital spending is included, net exports accounted for almost half of Japan’s total GDP growth in the five years to 2007. Exports boomed on the back of a super-cheap yen and America’s consumer binge. Japan did not have housing or credit bubbles, but the undervalued yen encouraged a bubble of a different sort. Japanese exporters expanded capacity in the belief that the yen would stay low and global demand remain strong, resulting in a huge misallocation of resources. As foreign demand collapsed and the yen soared last year, Japan’s export “bubble” burst. Total exports have fallen by almost half in the past year. Japan’s high-value products, such as cars and consumer electronics, are the first things people stop buying when the economy sours. Richard Jerram, an economist at Macquarie Securities, argues that the worst may soon be over for industrial production. This year, output and exports have fallen by much more than the drop in demand, because firms have temporarily closed plants in order to slash excess stocks. For instance, Japan’s vehicle production in the first two months of 2009 was 50% lower than a year before, but global car sales fell by only 25%. Mr Jerram reckons that the inventory rundown is coming to an end, which will lead to a short-term bounce in output as factories reopen. If so, car output in June could be around 50% higher than in March (but still down by 25% on a year earlier). This means that GDP growth might turn positive in the second quarter even if foreign demand remains weak. Unfortunately, the economy is likely to totter again as the second-round effects of tumbling profits and rising unemployment squeeze investment and consumer spending. According to the latest Tankan survey of the Bank of Japan (BOJ), in March business sentiment among big manufacturing firms was the gloomiest since the poll began in 1974. Manufacturers say they plan to cut investment by 20% this year. They are also trimming jobs and wages. The seemingly modest unemployment rate of 4.4% in February understates the pain. The ratio of job offers to applicants has declined to only 0.59, from around one at the start of 2008, and average hours worked have also fallen sharply. Average wages (including bonuses and overtime pay) went down by 2.7% in the 12 months to February. Household spending fell by 3.5% in real terms over the same period; department store sales plunged by 11.5%. The weakening domestic economy has prompted the government to man the fiscal pumps. A stimulus of 1.4% of GDP is already in the pipeline for 2009, and a further boost of perhaps 2% of GDP is expected to be unveiled in mid-April. The package is likely to include measures to strengthen the safety net for the unemployed and so ease concerns about job security. There will also be new infrastructure spending. Much of the expenditure on public works in the 1990s is now considered wasteful, so this time the focus is meant to be on projects that boost productivity, such as an expansion of Tokyo’s Haneda airport. Better crafted stimulus measures which raise long-run growth are also less likely to spook bond markets concerned about the government’s vast debt. So long as the extra measures are not delayed by an early election (which must be called by September), Japan’s total fiscal stimulus in 2009 could be the largest among the G7 economies. But it would not be enough to prevent a sharp widening of the output gap (the difference between actual GDP and what the economy could produce at full capacity). This had already risen to 4% of GDP in the fourth quarter of 2008, and it is likely to approach 10% by the end of 2009, twice as much as in the 1990s downturn (see bottom chart, above). This gaping economic hole is again putting downward pressure on prices. By late summer consumer prices could be more than 2% lower than a year before—a faster decline than during Japan’s previous bout of deflation. The risk is that deflation will squeeze profits and hence jobs, thereby further depressing demand and prices. The BOJ cut interest rates to 0.1% in December and it has introduced several measures to keep credit flowing, such as buying commercial paper and corporate bonds, as well as shares held by banks, which boosts their capital ratios. In contrast to the 1990s, bank lending is still growing. The BOJ has also stepped up its purchases of government bonds, but after its experience in 2001-06, the bank remains sceptical that such “quantitative easing” can lift inflationary expectations and spur demand. One big difference is that the previous episode of quantitative easing coincided with stringent budget-tightening under Junichiro Koizumi, the then prime minister. The budget deficit was reduced from 8% of GDP in 2002 to 1.4% in 2006 (which partly explains why domestic demand was weak). The combination of fiscal expansion and government-bond purchases by the BOJ should work better. The OECD predicts that public-sector debt will approach 200% of GDP in 2010, so the scope for further fiscal stimulus will be limited. Nor can Japan rely on exports for future growth; to the extent that it had enjoyed an export bubble, foreign demand will not return to its previous level. Japan needs to spur domestic spending. One possible option, which the government is exploring, is to unlock the vast financial assets of the elderly. Japanese households’ stash of savings is equivalent to more than five times their disposable income, the highest of any G7 economy, and three-fifths of it is held by people over 60 years old. Gifts to children are taxed like ordinary income, but if this tax were reduced, increased transfers could boost consumption and housing investment since the young have a much higher propensity to consume. In theory, this could give a much bigger boost to the economy than any likely fiscal stimulus. Of course, one reason why the elderly are cautious about running down their assets is concern about the mismanaged pension system and future nursing care. Services for the elderly should be among Japan’s fastest growing industries and create lots of new jobs, but they are held back by regulations which restrict competition and supply. Deregulation of services would not only help to improve the living standards of an ageing population, but by helping to unlock savings might also drag the economy out of deep recession. Japan’s second lost decade holds worrying lessons for other rich economies. Its large fiscal stimulus succeeded in preventing a depression in the 1990s after its bubble burst—and others are surely correct to follow today. But Japan’s failure to spur a strong domestic recovery a decade later suggests that America and Europe may also have a long, hard journey ahead.