Japan's Continuing Economic Crisis

One day or another Japan unfortunately is going to burst. Left on its present course, like the proverbial nineteenth century steamship with the boiler overheating, one day one too many of the bolts will sheer off, a boiler plate will give and then the devil take the hindmost. Of course one of the few debateable points remaining is whether or not there is really anything left to be done. Common sense says there is, and sheer humanity says that there ought to be. Recognising this is the easy part. The tricky bit is what to do. Ten years of sustained problems, various recessions, and the outbreak of what may be regarded as the developed world's first serious bout of sustained deflation have left little doubt about the depth and seriousness of what is taking place.................

In general terms, one of the problems with the whole Japan debate is that much of the available material fails to tackle the problem head-on. For instance the well-publicized Federal Reserve research report "Preventing Deflation: Lessons From Japan's Experience in the 1990s" rather surprisingly fails even to consider one of the most important factors which may be driving the Japanese deflation: DEMOGRAPHICS. This lacuna is not an isolated case. Even where the problem is mentioned, it is normally not explored.


So all of this is a bit like Hamlet without the prince. Little of the more fashionable analysis really helps us understand why Japan government debt is growing out of control - after all with deflation abounding, even government supplied services should get cheaper, and why raising interest rates at any point in the foreseeable future is going to be difficult. This is because many of the arguments rest on the assumption that eventually Japan will solve the slow growth problem and start to recover. Well, I'm afraid I wouldn't be too sureabout that. And if the problem is a faulty diagnosis, then how the hell do you expect the medicine to work............

As Robert Lucas among others has indicated, classical economists like Malthus and Ricardo saw the need to account for the dynamics of pre-modern societies, and in particular for the fact that in these societies per capita incomes normally did not increase, but rather tended to return to roughly constant levels despite technological improvement, as one of the central problems facing economic theory. Differences in ability to produce had the knock-on effect of leading to differences in population level, and not to differences in living standards. This static situation constituted what has become known as the Malthusian trap. With the coming of industrial society something new happened, we broke out of the trap. Population increased, but at the same time per capita incomes also continued to increase, systematically, and as never before in history. This 'modern era' has now lasted for around 200 years.


However, the signs are there that things are changing. We still continue to increase living standards in an unprecedented way, but planetary population is getting older, and soon, in some 33 developed countries according to the recent UN population revision, smaller. It seems we are once more in danger of falling into a population trap, one where population and economic growth again become ensnared, but this time in a downward spiral. Economic theory to date has notably and monumentally failed to come to terms with the implications of this change, and herein lies the significance of Japan.
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Japan a Lost Decade


A number of hypotheses have been presented to explain Japan's continuing economic failure since the beginning of the ninetees: inadequate fiscal policy, the liquidity trap, depressed investment due to over-investment during the "bubble" period of the late 1980s and early 1990s, a broken banking system due to a combination of the former, outdated labour market and work practices, growing competition from China, and (my own strong hypothesis, of course) demographic processes. While we have many hypotheses, we have, as yet, no coherent and compelling account. The Hayashi and Prescott paper examines the history of the "lost decade" using a standard neoclassical growth model. It identifies finds two developments which seem to be important for understanding the Japanese economy in the 1990s. First and most important: there was a fall in the growth rate of total factor productivity (TFP). This, argue the authors, had the consequence of reducing the slope of the steady-state growth path and increasing the steady-state capital-output ratio. Their most important finding: that the drop in the rate of productivity growth alone cannot account for the near-zero output growth in the 1990s.

Abstract
Japan a Lost Decade: Fumio Hayashi and Edward Prescott

This paper examines the Japanese economy in the 1990s, a decade of economic stagnation. We find that the problem is not a breakdown of the financial system, as corporations large and small were able to find financing for investments. There is no evidence of profitable investment opportunities not being exploited due to lack of access to capital markets. The problem then and still today, is a low productivity growth rate. Growth theory, treating TFP as exogenous, accounts well for the Japanese lost decade of growth. We think that research effort should be focused on what policy change will allow productivity to again grow rapidly.
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Japanese Saving Moves Towards Negative Territory


I'm really not sure what importance to put on this, but it does seem in line with the idea that demographics, and the life cycle model, have something to say about what is happening in Japan. It seems to fit my picture nicely, which is why I'm cautious. There isn't going to be anything to cheer about here.

Despite a worsening income environment for employees, personal consumption has held up pretty well. Nominal employee compensation in calendar 2002 shrank by 2.4%, but nominal consumption was flat or up 1.5% in real terms. This has resulted in a notable decline in the rate of household savings. The household savings rate fell from the 14% range at the start of the 1990s to around 10% in the late 90s, and to 6.9% in 2001. Figures for 2002 are not yet available, but judging by the relevant data, we estimate that it slipped still further to about 4.3%. The savings rate based on sequential quarterly data (the 4-quarter moving average) has dropped even more startlingly. After dipping below 10% at the start of 1996, declines accelerated from 2001 to 4.7% in January-March 2002, the most recent period that can be calculated. Our estimate is that this figure was down to about 2.5% for October-December 2002, and that a negative savings rate is a possibility soon. This could happen within a few quarters, under our assumptions of an ongoing decline in disposable income and flat consumption.

Normally, the savings rate tends to rise during an economic recession, due to the tendency to suppress consumption amid rising uncertainty. Further, deflation is known to stimulate demand for bank notes and cause expenses to be put off. The classic business cycle theory suggests that the savings rate should now be rising. This makes the actual declining trend all the more alarming. We attribute this decline to (1) growth in the generation that is tapping into assets, a result of the aging of society and the increase in unemployment among older workers (the life cycle hypothesis); (2) reduced incentives to save and a growing preference for durables, due to extremely low interest rates; and (3) due to the difficulty in reining in spending after becoming accustomed to a certain level, spending is cut back, but not by enough to offset the decline in income (the habit-formation hypothesis).

Regarding (1) above, we assume the following age/life-cycle influenced consumption/saving pattern is in effect: consumers borrow when they are young and their incomes are low, save in preparation for old age in mid-life, and live off what they saved in their retirement years. The increase in unemployed older workers has played a substantial role in the decline in the savings rate in recent years. The savings rate for unemployed older workers stands at -26.0%, making it clear that savings are being drawn upon. On top of this, the decline in the savings rate resulting from the increase in unemployed older workers, in addition to being grounded in a long-term trend caused by the aging of the population, has been further exacerbated by earlier retirement age, early retirement programs and the dismissal of older workers. The percentage of households headed by unemployed aged 60 and over is conspicuously trending upward, having increased from around 12% in the early 1990s, to 19.1% in 2000 to 21.0% in 2001 and to 22.0% in 2002. Japan's population is expected to reach a peak in 2006 and then began to decline, but the fact that savings have begun to decline ahead of the population suggests greater urgency.


Regarding (2), the view that extremely low interest rates have destroyed the incentive to save is further supported by recent consumption patterns, which show that the consumption of durable goods has remained relatively strong. One incentive for holding financial assets is the function they provide as a store of value and wealth, but it is conceivable that low interest rates have diluted this "store of value" function of financial assets and thereby increased the preference for real assets. This increased preference for durables, which also function fairly well as a store of value, as opposed to regular consumer goods, could be considered further corroboration of this hypothesis. It is interesting to note that this massive shift of funds in 2002, which was sparked by both implementation of a deposit insurance cap and disappointment in investment trusts with net asset values below initial investment amounts, coincided with the period in which the consumption of durable goods was robust.
Source: Osamu Tanaka, Morgan Stanley Global Economic Forum
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Japanese Intevene Heavily to keep Yen from Rising


The Bank of Japan intervened heavily in March, spending the double of what it spent in February. The only remaining question: just what would have been the yen/dollar rate without this intervention?

The Bank of Japan stepped up its efforts to prevent the yen strengthening in March, according to official data that confirmed traders' suspicions that the authorities had covertly intervened in the market for a third successive month. The BoJ said on Monday it spent a total of Y1,131bn ($9.5bn) in March through its foreign exchange account, which generally indicates foreign exchange intervention. In January and February, the bank spent Y678bn and Y513bn respectively.But strategists noted the money spent, believed to be mostly buying dollars for yen, had had little impact on the yen's exchange rate this year. The dollar ended 2002 around Y118.6 against the yen - almost exactly the level at which it was trading when the BoJ released its data on Monday.
Source: Financial Times
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