Japan’s Shrinking Economy

February 12, 2010

In the 1990s, the Japanese economy suffered a prolonged recession that followed the collapse of the fabled economic bubble of the 1980s. This stretch of economic stagnation, the “lost decade,” finally ended in 2002; it had taken more than 10 years, punctuated with occasional “false dawns,” to pull up the economy. Some abrupt economic crises outside Japan – including the Asian currency crisis in 1997 and the Mexican default in 1994 – and too-early exit strategies from revitalization efforts by the government and Bank of Japan attributed some to the stagnation especially in the late 1990s, but these factors do not tell the whole story. The conventional wisdom is that two factors prevented the Japanese economy from getting out of the deep hole created by the bursting bubble.

The lost decade

First, the recession was accompanied by a financial crisis. After the markets collapsed, financial institutions faced serious downturns in profits in the wake of falling real estate prices kept as collateral, plummeting stock prices and increasing bad loans. The debacle of Yamaichi Securities, the Long-Term Credit Bank of Japan, and the Hokkaido Takushoku Bank was a symbol of how big the impact was; after first struggling to keep these firms afloat, the Japanese government finally let them go bankrupt. In addition, capital adequacy requirements were introduced by the Bank for International Settlements (BIS) in the early 1990s to regulate excessive loans. The two phenomena made banks reluctant to lend money, caused them to forcibly withdraw money from borrowers, and undermined real businesses. Like today’s recession, a downward spiral combining the real economy and the financial market broke out, thus intensifying and prolonging the economic stagnation.

Second, the business sector was plagued by “three excesses”: excess equipment, excess employment, and excess debt. These excesses indicated that the Japanese business model had reached a dead end. Until the burst of the bubble, Japanese companies had emphasized expanding market share, diversifying their business, and maintaining employment rather than profitability. The inefficiencies in this business model were magnified and accelerated by the bubble economy in the late 1980s, which finally made adjustment inevitable. It then took more than 10 years for businesses to adjust their over-leveraged balance sheets. They were fighting against deflation at the same time, which lifted interest rates and increased businesses’ exposure to debt in real terms.

Digging out

The balance sheet adjustment was finally completed in 2002, and for 69 months between February 2002 and October 2007 the Japanese economy marked its longest postwar expansion until today’s economic crisis. Yet, there was something different from past expansions. The economy expanded in the midst of nagging deflation and increasing fiscal deficits, conditions which would have been expected to be resolved or improved during a period of expansion. The Consumer Price Index fell steadily on an average of 0.2 percent from 2002 through 2007, and the ratio of government debt to GDP climbed from 152.3 percent in 2002 to 167.1 percent in 2007. The chronic concerns of the Japanese economy – deflation and fiscal deficit – still remained desperately intractable.

However, uneasy about cash flows and balance sheets, companies abated risk assets and cut back on nonessential expenditures and employment costs just as they had during the lost decade. Even after they wiped out the three excesses and restored their balance sheets, businesses didn’t loosen their reins on spending. The number of part-time workers increased, debt-equity ratios declined, and the corporate sector developed a savings-to-investment surplus: these trends, which were dramatic, all indicated that the corporate sector remained reluctant to expand its activities.

Continuing negative trends

Despite Japan’s well-known system of “life-time employment,” the corporate sector is becoming more and more dependent on part-time workers. The percentage of part-time workers compared to all employment has climbed from 20 percent in the early 1990s up to its highest level, more than 30 percent in 2009. This ratio has gradually risen since the 1980s, but the pace has escalated since the late 1990s. Next, the debt-to-equity ratio of the corporate sector has dropped from 4 in the 1990s to as low as 2 in 2008, indicating that they are in a negative position for borrowing; the decline did not stop during the 2002-2007 economic expansion. Finally, the ratio of the business sector’s saving-investment balance to GDP has shown a surplus since the late 1990s, which means that businesses have invested with their own cash without raising funds from financial markets.

Increasing part-time workers signals that businesses seek to cut employment costs to a minimum. Both declining debt-to-equity ratio and the surplus saving-investment balance are caused by the declining investments. The problem was that businesses’ conservative stance went a little overboard. Ultimately, the corporate sector retains the huge surplus and it is absorbed in capital outflows especially toward the purchase of U.S. treasury bonds and servicing fiscal deficits. Corporate savings are going to the enormous debt of the U.S. and the Japanese government, instead of being used for investments in the future.

Other factors have contributed to the continued sluggish business activity since 2002. Globalization, combined with conservative business practices, is one. Similar conservative stances in the corporate sector can be seen more or less in parallel elsewhere around the globe. That being said, in Japan economic developments are more conservative than other high-income countries because in Japan this trend has been under way over the last two decades. The bursting of the bubble had deep and wide-ranging effects, including the basic mind-set for business: “no more excess” appears to be a mantra for the Japanese business sector. Though it sounds healthy, this mantra has made the Japanese economy a weaker domestic-demand economy than it was before which, combined with globalization, leaves it susceptible to shocks from abroad.

As suggested in my previous report, “The Outlook for the U.S. Economy: Echoes of Japan’s Lost Decade,” the Japanese economy has recently been driven by exports ups and downs. The Japanese economy has become despairingly vulnerable to external shocks, as Japan has nothing to cling to but the other countries’ demand for its economic growth. The ongoing economic crisis underscores the vulnerability of the export-led economy when external demands almost evaporate. At the beginning of the current economic crisis, many economists believed the Japanese economy would be less damaged than the U.S. economy because Japan did not suffer from a housing bubble, financial institutions did not hold huge amounts of toxic financial assets like the U.S., and, most of all, the corporate sector took conservative strategies. But, actually the Japanese economy was more damaged than the U.S. economy, the epicenter of the crisis. For example, the peak-to-trough fall of industrial production was as high as 38 percent in Japan, compared with 17 percent in the U.S. In the wake of this economic decline, the Japanese corporate sector is rectifying its deteriorated balance sheets, again. Japanese businesses appear to be stuck in a pool of quicksand that keeps growing around them.

More problems ahead

Going forward, whether businesses stick to their conservative stance or act more aggressively, the Japanese economy is likely to shrink because of the nation’s changing demographic structure. Over the next decades Japan will continue to grow older and will have fewer and fewer families. From an economic point of view, this situation will lead to a smaller labor forces and less saving. In January 2010, the Japan Center for Economic Research (JCER), one of most distinguished think tanks in Japan, released a report titled “Japan’s Economic Outlook 2009-2020” which predicts that the saving rate of the household sector will go negative in the late 2010s, and that the labor force will shrink by 0.5 percent every year on average over the 2010s. Japanese households at one time saved almost one-quarter of their disposable income, but the ratio is already down to about three percent, less than the current saving rate in the U.S. The labor force has been on a downward trend since the beginning of the 2000s and according to the latest figures it dropped by 0.3 percent in FY2008 from the previous year. An older and smaller society isn’t unique to Japan, but the shift in Japan is much larger and faster than in other countries.

Economic growth arises from changes in the quantity and quality of the labor force and capital stock. But Japan’s demographic change and the increase in part-time workers lower both the quality and quantity of the nation’s labor force, and the conservative investment stance does the same for the capital stock. Productivity growth is required to compensate for the decline of labor forces and slower increase in capital stock, but the corporate sector’s seemingly innate conservative approach physical and human investment seems to defy this hope.

A strategy for growth

Hence, a structural reform is necessary in order to revive the Japanese economy. There was public euphoria and widespread hope that something may change in the wake of the DPJ’s (the Democratic Party of Japan) historic electoral victory in August 2009. But the Hatoyama administration so far appears focused on micro-economic policies like the introduction of a screening process for budgetary planning or bureaucratic meddling in politics, and it lacks macro-policies like growth strategies or a long-term vision to deal with the inflating fiscal deficit. Most economists doubt that the DPJ’s economic policies can reverse the declining economic trend. The Hatoyama government, the first apparently sustainable non-LDP government in the postwar era, appears reluctant to take major steps to confront the economic challenges facing Japan, perhaps fearing that there is little hope for success.

For example, the anticipated 0.5 percent annual decrease in the size of the labor force over the next decade is equivalent to an economic contraction of 0.5 percent every year assuming unchanged productivity. But, at the same time, more resources will have to be devoted to the elderly and the ever-growing government deficit in the future as slower economic growth will be likely to generate fewer resources than needed. There is no evidence that Japan will acquire a magic wand by which it can improve productivity to make up for the declining demographic trend.

Allowing more immigrants into Japan is one possible solution for shoring up the declining work force, but there has been no serious discussion on that in Japan, even though most other advanced countries already have immigrant worker programs. Proactive reforms are required, but an immigration policy seems to be a taboo subject to Japanese society. An influx of immigrants might carry a risk of side effects, but given the economic risk of not acting, it is worth discussion.

The Japanese economy is bottoming out from the current recession. It is time for the government to design and launch long-term economic growth strategies. Without effective policies, the Japanese economy definitely will continue to shrink. If the government can offer brighter prospects, the corporate sector’s conservative stance will show signs of improvement; especially with increased immigration the domestic market may expand and economic growth will be boosted.