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On Japan: The Confusing Economy

A Japanese-language version of this article appeared in the May 10, 2000 issue of Newsweek Japan.

Is the Japanese economy finally recovering, as the government wants people to believe? In early June, the government will publish GDP statistics for the first quarter of the year, just a couple weeks before the likely election date. Be suspicious of those numbers. The first quarter GDP growth is certain to be positive, and could even be very high. But the first quarter of 2000 has an extra day because of leap year. Since the Japanese government does not adjust for leap year, that one extra day is enough to push first-quarter growth up as much as a full percentage point (over four percent at an annualized rate). The Liberal Democratic Party thinks a solid growth figure will generate votes for its candidates, though one hopes voters will see through the ploy.

Even if the government puts out misleading statistics in June, what about the broader question of recovery? Is the government really wrong? Never have I seen so much disagreement among economic forecasters. Some economists are predicting that fiscal 2000 will be negative, others expect a positive growth rate of over two percent. Variation among forecasters is common, since each uses a different model or makes different assumptions about key variables. But this range of disagreement—from renewed recession to clear recovery—is highly unusual. What is going on?

The answer depends on the interplay of four critical factors: downward adjustment of labor and capital stock by the private sector, government macroeconomic policy, exports, and future growth of the information technology sector. Optimists argue that the fiscal stimulus and the zero-interest-rate policy of the past two years, coupled with corporate restructuring, is pushing the economy toward real recovery. In 1997, the government made a major mistake by raising taxes and cutting spending before the fragile recovery of 1996 was self-sustaining. But in 1998, the government cut taxes and increased spending again, expanding the government deficit from three percent of GDP to eight percent within two years. Meanwhile, the zero-interest-rate policy has helped the corporate sector reduce its debt costs and has encouraged purchases of houses.

Simultaneously, Japanese corporations have been restructuring for the past two years, eliminating excess labor and capital and reducing their costs. With the stimulus provided by government’s fiscal policy and the low level of interest rates added to the effect of restructuring, corporate profits should recover this year. If this happens, a self-sustaining recovery should get underway as the normal cyclical upturn begins.

Supporting this optimistic scenario are two further developments. The rest of Asia is recovering quickly from the 1997 financial crisis. As these countries return to high economic growth, they pull in more imports from Japan. After two years of decline, therefore, Japan’s global exports could rise this year.

In addition, the so-called “new economy” based on the Internet and other telecommunications services is growing rapidly in Japan. Employment growth in this sector is rising at over a 20 percent rate. This bright spot of economic expansion could pull the rest of the economy out of recession.

All of this sounds very straightforward. But the pessimists make some believable arguments as well.

Restructuring in the corporate sector may not be over. Japanese firms were very slow to face the reality of excess labor and capital in the 1990s. Adjustment that should have been occurring back in 1993 and 1994 did not take place until 1998, and the delay made the necessary adjustment larger than necessary, since firms kept on hiring and building factories when they should have been cutting back. Pessimists believe that the downward adjustment of both labor and capital may take as much as another year.

At the same time, macroeconomic stimulus has had less impact on the economy than expected. Because the Japanese government relied more heavily on expanded public-works spending than on tax cuts, part of the favorable impact of this stimulus has been lost. Economists usually argue that what really matters for fiscal stimulus is the size of the government deficit rather than the choice between tax cuts or spending. However, tax cuts would have increased income levels and spending broadly across the economy, whereas the public-works spending pumped demand mainly into one sector—construction. This choice has pushed construction activity well beyond long-term sustainable levels. As soon as the government begins to cut public-works spending, the construction sector will shrink, undercutting any private-sector recovery. With the deficit now at a very high level, many economists worry the government will begin cutting expenditures starting this fall.

Monetary policy is also a concern. The zero-interest-rate policy may not have had a large positive impact over the past two years, since other factors decreased loan demand despite the low interest rates. But raising interest rates this year, as the Bank of Japan has hinted might happen, could easily choke off new capital expenditures just as the private sector is ready to recover. It is imperative that very low interest rates continue.

It is also possible that the increase in exports may not materialize. The Asian economy is recovering, but what will happen to the other major export market—the United States? With inflation beginning to rise and interest rates also heading up, American economic growth will diminish. With luck, this will result in a “soft landing” rather than recession, but slower growth will have a negative impact on imports from Japan and other countries. In addition, ending the zero-interest-rate policy would cause the yen to rise against the dollar (as more Japanese investment money stays at home rather than flowing to countries where interest rates are higher), and the stronger yen would slow down exports. An export-led recovery would then be in doubt.

Finally, while the rapid growth of the “new economy” is encouraging, the pessimists believe that this sector is still too small to have much overall impact on economic recovery. In several years, this sector may grow large enough to be a real factor, but not now.

So which side is right? Nobody knows for sure because the signs in the monthly economic data are still very much mixed—up one month and down the next. The government has an obvious political motive in pushing an unrealistic optimistic forecast. But the disagreement among private-sector economists is produced by the confusing zigzag nature of much of the microeconomic data as well as differences in interpretation or prediction of future behavior of key players like the government or households. Nonetheless, the economy should begin recovering soon, so long as the government does not make further policy mistakes. Corporate restructuring has been substantial, and these cost reduction efforts should yield rising profits this year. And on the export side, the slowdown in the U.S. economy will probably be mild and may not occur until next year. But the government must maintain its current fiscal and monetary policy stance for a while longer until the recovery is clearly underway. That’s the good news—even if the story is less certain or less positive than the one the government wants to sell to the public prior to the election. The bad news is that the economy still faces serious long-term structural problems, but that’s a topic to discuss another time.

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