Is Japan’s past our future?
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com
The decision by the Bank of Japan Friday to raise the Overnight Call Rate from zero to 0.25% marks the definitive end of Japanese recession, which has lasted more than 16 years. Its onset was caused by excessive monetary expansion, and a consequent tsunami of speculation in stock and real estate markets. Here in the United States, we’ve had the monetary expansion and the speculation, so are we due to rot in near-recession until 2022?
We now have a pretty good handle on what caused the Japanese economy to under-perform for 16 years. The Bank of Japan expanded money supply too rapidly in the late 1980s, causing stock and real estate bubbles that reached peaks higher than had ever been seen in a major market. When the stock market index is selling at 100 times earnings, and the Emperor’s palace is worth more than the state of California, the overvaluation is not debatable, only the extent and timing of the crash to come..
In the early 1990s, stock prices approximately halved, and real estate prices began to decline. The Bank of Japan dropped interest rates, and the Japanese government expanded the public sector, indulging in Keynesian deficit spending as had become the accepted cure for a deflationary recession. As a result, the Japanese economy did not sink into deep recession, as might have been expected by those looking at the 1930s, but simply underwent mild deflation combined with low growth. As the 1990s proceeded, the economy’s refusal to recover properly became increasingly worrisome and the stock market, which had stabilized for several years at about 50-60% of its peak level, began to decline further.
In 2000, the apparent beginnings of recovery caused the Bank of Japan to attempt to raise the Overnight Call Rate above zero, but the move backfired. The banking system was now overburdened with bad loans, and the continuing recession was undermining the strength of borrowers previously thought invulnerable. A further burst of public spending (primarily on infrastructure in rural districts with important Liberal Democrat party Diet members) caused Japan’s public debt to rise above 130% of Gross Domestic Product and the state budget deficit to soar above 7% of GDP, but economic growth stubbornly refused to reappear.
That was the position when Junichiro Koizumi became prime minister in April 2001. He correctly diagnosed the main problem: the inevitable deflationary effect of declining stock and real estate prices had been exacerbated by the increases in public spending. If as in most countries the private sector is more productive than the public sector, continually increasing the public sector’s share of output produces a major drag on growth. This is common sense; it can also be demonstrated by regressions which show that in advanced OECD economies the growth rate is inversely correlated to the size of the public sector and its growth as a percentage of the economy. Thus in 2001 the public sector needed to be reined back while monetary policy remained loose to allow asset values to stabilize and begin to recover, which in turn would prevent the further erosion of the banking system.
That was the policy Koizumi followed, and after a delay of about two years, it worked. Public sector infrastructure spending had reached 8% of Japan’s GDP, the highest in the OECD and more than twice the level of the OECD’s next heaviest spender on public infrastructure, France. By cutting it back, resources were redeployed to the private sector, which at last had room to grow. Corporate profits began to recover as, after a delay did stock prices and asset prices. The Tokyo Stock Exchange bottomed out at about 20% of its peak value, and then doubled over the next 3 years.
Since the beginning of 2006, the Bank of Japan has decided that the economy is strong enough to bear a normal monetary policy, and the excessive easing of the previous few years is thus gradually being removed. With Japanese economic growth per capita as rapid as in the United States and inflation positive there is little reason to fear a return to recession.
Since the long Japanese recession began in a period of over-extended asset prices and monetary easing, we need to ask to what extent the Japanese experience might be repeated in the United States or the world as a whole, and what steps can be taken to avoid it. That’s not to assume that Japanese policy was uniquely incompetent, far from it. The last U.S. episode of such an overvaluation terminated in the Great Depression. Even if in retrospect a tighter Japanese fiscal policy, combined with its loose monetary policy, could have made its economic downturn shorter than it became, avoiding the Great Depression is itself an achievement worth celebrating.
Start by exploding a myth. The United States has not been enjoying a period of exceptional productivity growth, such as would justify sky-high valuations and allow them to remain elevated. Nor has Japan been a uniquely sluggish economy, such as would explain its 16 years of malaise and allow the U.S. to feel comfortably superior. In the 14 years following the Japanese market peak in 1990, according to OECD statistics, Japanese labor productivity grew by 2.1% per annum while U.S. labor productivity grew by 2.0% per annum. Remember: in the United States that period included a decade of cheap money, bullish markets and huge capital investment, while in Japan it included 14 years of recession and very little of the subsequent recovery.
Moreover, this is labor productivity not total factor productivity; to the extent the United States threw capital at the economy, as it did in dot-coms in 1997-2000 and housing in 2003-05, it got a “free ride” of labor productivity improvement as the economy became more capital intensive.
Like the United States since 1995, Japan in the 1980s enjoyed low inflation – an average of 1.9% per annum in 1981-1991. The Bank of Japan was thus able to reduce interest rates from 6% to 0.5% in 1990-95 without worrying overmuch about inflation. By reducing interest rates, the BOJ was able to cushion the decline in stock and asset prices, without reigniting the 1985-90 bubble.
It’s fairly clear that the U.S. stock market in 2000 was suffering from an overvaluation similar in kind although maybe less excessive in degree to Japan’s in 1990. On the other hand, the U.S. housing market was not particularly overvalued in 2000, since it was still recovering from the tight money recession of the early 1990s.
The Fed reduced interest rates much more aggressively in 2001-02 than had the BOJ in the early 1990s. This cushioned the decline in the stock market, at the cost of inflating a housing bubble, and causing U.S. savings rates to swing negative (this had not been a problem in Japan; savings rates declined from their previously high levels but never became negative.) Public spending increased moderately, less than in Japan, and taxes were cut, which they weren’t in Japan. Thus after 2003 the U.S. economy recovered more robustly than had the Japanese economy in the early 1990s. U.S. stock prices once again approached their bubble levels but on broad based indices did not reach them. Cheap money and tax cuts also caused a rise in corporate profits, although over-flexible accounting played a role in this.
We are now in the equivalent position of Japan not in 1990 but in 1995, with some differences. The stock market and the economy in general have been propped up by loose money and stimulative fiscal policy, so that the decline in stock prices from the peak has been only moderate and house prices are higher than in 2000.
On OECD figures, for comparability, the Japanese budget was in surplus by 2.0% of GDP in 1990; in 1995 it ran a deficit of 4.7% of GDP. The U.S. Federal budget ran a surplus of 1.7% of GDP in 2000 and a deficit of 4.8% of GDP by 2004. A pretty close correlation there between the post-peak fiscal stimulus in the two countries, though in the United States the fiscal gap was widened by tax cuts as well as spending increases.
In the U.S. today, unlike in 1995 Japan, housing prices are considerably higher than they were at the top of the boom, inflation appears to be making a comeback and the trade deficit is enormous.
We know what happened in Japan in 1995-2000 – the bottom fell out. The stock market index halved again from its reduced 1995 level, the budget deficit and public debt spiraled out of control, the economy remained mired in recession and bank bad debts endangered the entire financial system. If the Fed puts up interest rates far enough to beat inflation (a Fed Funds rate of around 8% is about what it would take at present) the U.S. will probably follow a similar trajectory.
If as is more likely the Fed sees recession arriving and therefore wimps out on inflation, the stock and asset price declines will be somewhat less, but the economy will lapse into 1970s style stagflation, with inflation spiraling upwards towards 10% per annum.
The federal budget deficit in either case will increase rapidly, probably to the $750-800 billion level at which it becomes difficult to finance. If as in Japan in 1995-2001 the George W. Bush administration then attempts to cure the stagflation by increasing public spending further, it will choke off capital availability to the private sector, because the federal deficit will take up too much of the financing pool. If that happens, the United States is due for a long and punishing recession, similar to the 1930s and worse than that in Japan because of the lack of domestic savings and the dangerous trade deficit.
If fiscal discipline is maintained, a 4-5 year recession, accompanied by a substantial decline in the dollar to correct the trade balance (which will itself be inflationary) is probably what we can look forward to -- an unpleasant future, like Japan in 1990-2003, but not a wholly disastrous one, and ending considerably sooner than Japan’s 16 year trauma.
That’s not too bad – IF we can rely on the Administration and Congress to maintain fiscal discipline. Otherwise, better not start your new business before 2022!