Economic anorexia: Japan's real demand problem - International Solutions

Challenge, March-April, 1999 by Richard Katz

The author argues that stimulating demand in Japan is not enough. Large-scale reform is necessary to get the economy out of its rut.

Japan, the country that once defined growth, has forgotten how to grow. Most recessions last two or three quarters. But Japan is about to become the only major industrialized country in the postwar era to suffer falling gross domestic product (GDP) for three consecutive years. After a decline of 0.4 percent in fiscal 1997 (April 1997-March 1998), GDP is projected to have tumbled 2.5 percent in fiscal 1998 (April 1998-March 1999). In fiscal 1999 (April 1999-March 2000), GDP is widely expected to fall a further 0.5 to 1.5 percent.

Worse yet, no one can predict with confidence when the economy will turn around. In a stunning reversal of past optimism, the prestigious Japan Center for Economic Research (JCER) now predicts a fourth year of downturn (-1.4 percent) in the year 2000 and then a fifth decline in 2001. The World Bank, on the other hand, is projecting a recovery to positive growth of 1.4 percent in 2000. Yet this recovery forecast presumes that Japan will stabilize its banking crisis and enjoy a hefty boost in exports. Otherwise, says the World Bank, GDP could actually plunge 4 percent in 1999 followed by another 2 percent drop in the year 2000.

One reason the economic slump has continued for so long is that policymakers in Tokyo have misdiagnosed the malady. Tokyo believes that Japan is suffering nothing worse than the type of recession that typically follows the bursting of a financial bubble. Hence, it believes that it can eventually ignite a self-sustaining recovery by using the standard tools of fiscal and monetary stimulus, coupled with a government buyout of the banks' bad assets. At best, such measures can only create a temporary spurt of GDP growth.

The cure has failed because the diagnosis is wrong. It has been almost a decade since the stock market crash of 1990 ended the late 1980s' bubble. Japan is not suffering a short-term recession but long-term stagnation. For three long years - 1992, 1993, and 1994 - Japan eked out an average growth of only 0.5 percent. Massive fiscal and monetary stimulus led to a mere two years of illusory recovery in 1995-96. Once the fiscal props were reduced, the economy crumpled again. Today, even with interest rates close to zero, a budget deficit nearing an astronomical 10 percent of GDP, and a rebounding trade surplus, Japan still has not recovered. In 1999 there may be a few positive quarters, but afterward the current stimulus packages run out. Some economists already predict that, without still more stimulus, GDP will drop 2 percent in the year 2000. Whether or not Tokyo avoids recession in 2000, "stop-go" low growth and sky-high deficits are Japan's future for years to come [ILLUSTRATION FOR FIGURE 1 OMITTED].

Japan's intractable shortages of demand are rooted in the same structural flaws that cause Japan's supply-side inefficiencies. Hence, no amount of macroeconomic tinkering can permanently revive demand. Only structural reform can do the job. Ever since the mid-1970s, Japan has suffered from "economic anorexia," that is, a chronic inability of private demand to consume all that Japan produces. In the late 1970s and 1980s, the shortfall (i.e., the private savings-investment gap) averaged about 4 to 5 percent of GDP a year. Today, it totals 7 percent. In the past, Japan could make up for anorexia with artificial stimulants: huge budget deficits, mushrooming trade surpluses, and, during the late 1980s' bubble, monetary steroids. Today; those nostrums have run out of steam.

Saying Japan needs fiscal and monetary stimulus is like saying a car needs tires without noticing it could also use an engine. The prescription of recovery first and reform later has been tried and found wanting. Macroeconomic stimulus is not an alternative to reform. It is a necessary tool to make the patient strong enough for surgery.

Mainframe Economics in a PC World

Japan is a case of "arrested development," a country still gripped by the patterns of the 1950s and 1960s. The so-called Japanese economic model transformed a poor country with more farmers than factory workers into an industrial powerhouse in record time. But it left a legacy of institutions that turned obsolescent once Japan matured in the early 1970s. Chief among these are pervasive (albeit illegal) corporate cartels, structural impediments to imports, a financial system unable to judge creditworthiness, and a regulatory structure designed to protect the inefficient. Yet, like IBM veterans still seeking to push out mainframe computers in a PC world, Japan held onto obsolete patterns just because they used to work.

Continuing in this obsolescent mode has created obstacles to growth on both the supply side and the demand side.

The supply-side problem is dwindling productivity growth. This is caused by Japan's unique "dual economy;" a hybrid of superstrong exporting industries and superweak domestic sectors.