The Outlook for the U.S. Economy: Echoes of Japan’s Lost Decade

September 14, 2009

The panic is over. The outlook for the U.S. economy has brightened as large financial institutions which had previously recorded huge losses ended in the black in the latest quarter and interbank market rates eased. Though some risk and uncertainty remains, the worst period for financial institutions is passing.

However, the lesson from Japan’s “lost decade” is that it is not so easy to completely break out from financial and economic crisis because full-fledged recovery of financial institutions must be accompanied by bullish economic momentum; the complete recovery of the financial sector requires resurgent demand in the real economy. Likewise, unless the real economy regains momentum the present financial improvement will soon lose its vigor or energy and this burst will be only temporary. A quick examination of Japan’s recovery from its “lost decade” and a survey of the situation currently faced by the U.S. economy indicate that true economic and financial recovery may be some time off.

In the case of Japan, exports were the driving force to pull up the economy after the stagnation of the lost decade, although it took more than 10 years after the economic bubble burst in the early 1990s for the correct combination of conditions to develop and enable exports to resuscitate the economy. In the 1990s Japan was faced with asset deflation and shrinking economic activity, and during that long stagnant period there were several “false dawns.” There was no driving force in the Japanese economy, and financial crises in Asia and other parts of the world conspired with a strong yen to hamper exports. The banking and corporate sectors spent a lot of time and energy to readjust their balance sheets through support measures such as a large-scale stimulus plan and loosened monetary policy. Until the early 2000s, financial institutions went under on a regular basis. The household sector was also unable to expand because unemployment did not stop rising until 2002. At that time, exports to the U.S. and emerging Asian countries finally drove up the domestic economy and helped remedy the degraded balance sheets of Japanese financial institutions.

Figure 1 presents the movement of Japanese exports and of indices of business conditions (coincident index), measures for aggregate economic activity. It suggests that these two statistics are correlated and that exports have influenced the overall economic ups and downs since the early 2000s. Until the current crisis began in late 2008, exports rose strongly since 2002; this increase was consistent with the movement of the entire economy. As the graph indicates, Japan’s recovery from the lost decade was not V-shaped but more W-shaped, including several “false dawns.” Real economic recovery must include a wellspring for sustained growth. For Japan it was exports which finally improved the financial institutions’ balance sheets.

Figure 1: Japanese Real Exports and Business Conditions (Coincident Index)


The U.S. economy may be bottoming out now but like Japan its recovery is not expected to be V-shaped. Rather, its direction will be irregular and its pace will be very moderate because domestic demand is still weak. It is usual for the corporate sector to enthusiastically raise funds to acquire more industrial capacity during economic expansion because companies need to respond to increasing demand. But recently their willingness to find money and invest has declined; corporations have become too conservative to drive economic activity. During the last period of economic expansion, the saving-to-investment balance of the corporate sector showed a surplus. This means that the corporate sector possessed excess savings, which is an unprecedented occurrence in the U.S. Even when the economy was strong corporations were reluctant to expand capacity so it is no wonder that now, during a recession, they are even more reluctant to expand their activity. Uneasy about cash flows, companies are abating risk assets and cutting back on nonessential expenditures. Furthermore, data from the Federal Reserve Board suggests that facility utilization has not yet returned to levels sufficient to encourage expansion.

Over the last six months businesses have worked off excess inventories, and production will begin to step up somewhat. But the investment environment is still far from alluring. Now saddled with excess capacity, the business sector is expected to go about restructuring both staff and facilities. This kind of survival strategy on the part of individual companies has given rise to a fallacy of composition in the national economy: the appearance of “green shoots” here and there, including in the financial sector, does not necessarily indicate that the economy as a whole is ready to rebound.

The household sector is also in the process of curbing its excess consumption and readjusting its deteriorated balance sheets. During the last period of economic expansion the U.S. economy was driven by household consumption, rather than by the business sector as it had been in the past. Until 2007 people consumed more and saved less, supported in part by the wealth effect of increasing housing prices. The saving rate dropped to an all-time low and the share of consumption-to-GDP climbed to its highest level. Now, the dramatically rising saving rate is a sign of modification of household behavior which is needed just to go back to a more normal and sustainable level of consumption. This process will take more time to complete because the unemployment rate remains historically high and the debt-to-income ratio hasn’t reached a sustainable level. In fact, despite less consumption and more saving, the debt-to-income ratio has changed little since the recession began; it is now 124 percent compared to 130 percent in early 2008. Historically, until the early 2000s, it had been well below 100 percent. The ratio remains high because income is not increasing, which prevents the ratio from improving. Household balance sheets need more time for adjustment.

In such a severe economic situation, what tool can the U.S. economy utilize to dig itself out of this deep hole? Exports are the popular response, and the U.S. economy must be more export-oriented, as President Obama’s chief economic adviser Larry Summers has said. In Japan the share of exports-to-GDP was about 15 percent in 2007, compared to only 8 percent in the U.S. – the lowest ratio among advanced countries. It would be difficult to address such an imbalance even under normal circumstances, but now it will be difficult for the U.S. to find strong customers as Japan did in 2002.

Even China, which may be the world economy’s best hope for recovery, can’t serve as a strong engine because China accounts for only 5 percent of total U.S. exports. In addition, today’s worldwide economic crisis has shown the limitations of decoupling theory which argues that other economies, including developing ones, are no longer dependent on U.S. economy. Now almost all countries have been more or less damaged by the crisis which began in the U.S.

So, exports are not a dependable catalyst for the U.S. economy; the corporate sector is restructuring and will not expand until household demand recovers; and household demand itself is depressed by unemployment, slow wage increases, and its own restructuring. Comprehensive economic recovery will take some time as these interrelated sectors regain profits and confidence. There is no wellspring of economic growth yet. While the financial panic is over, financial hardships are not over yet.