Frog in the pot: Germany's path to the Japan syndrome

National Interest, The, Spring, 2003 by Adam S. Posen

JAPAN'S DECADE of decline is the worst fate suffered by an advanced economy since the Great Depression. Contraction in Japan, however, is not only Japan's problem-it is also a drag on the global economy. Japan's withdrawal of capital from Asia and a weakening yen contributed heavily to the Asian financial crisis of 1997-98. Since then, Japan's continuing slump has limited export earnings for emerging market countries, thus strengthening the backlash in Asia and Latin America against globalization and the "Washington Consensus." It is also exacerbating rather than offsetting the current global slowdown.

Japan seems unable to halt its decline, even though its problems are obvious, and effective, albeit painful, remedies are available. But Japan's very wealth and stability seem to be the sources of its inaction. In other words, when enough wealth remains to allow most Japanese citizens to travel the world and purchase luxury goods, to buy off with government programs those who are directly harmed by the recession, and the costs of this and other borrowing can be put off into the future, little political pressure for change can coalesce. Small wonder, then, that financial observers have wondered whether such a fate might befall other advanced economies. When stock market bubbles have burst and deflation appears in prospect, the question "Who will be the next Japan?" has taken on urgency for policymakers and markets.

But it takes more than a bubble to become Japan. Bubble economies can build up overhangs of investment and industrial capacity in formerly overvalued sectors (like telecoms and IT), and then work these off in periods of slower growth-as current U.S. economic difficulties demonstrate. Mature economies can also reach the limits of technological catch-up, or find themselves confronting difficult choices about generous social welfare commitments made during times of faster growth and greater export opportunities-as the UK did in the 1980s, and the Netherlands and Sweden did in the 1990s. And practically every economy has suffered disruptions to financial markets and growth from corrupt or undercapitalized banking systems that misallocate credit- from the U.S. savings and loan debacle to France's Credit Lyonnais affair to the Nordic countries' widespread banking crises. In other words, it is possible to have a bad time of it, but still not fall into Japanese-style stagnation.

As it happens, there are four determinants of Japan's negative economic model: incomplete financial liberalization; macroeconomic policy division and deflationary bias; financially and politically passive households; and a lack of openness to trade or capital flows or foreign ideas. Of all the OECD countries, Germany increasingly shares Japan's political-economic profile. It already evidences the first three parts of the Japanese model, and the recent approach to EU enlargement taken by Germany and other EU members--elevating the power and interests of the incumbent nation-states vis-a-vis Brussels and the accession countries--threatens to provide the fourth.

All of this is happening gradually, however, so much so that, as in Japan, there is little significant pressure for painful and politically difficult changes. Germany, like Japan, is coming to resemble the proverbial frog slowly heating in the pot, and is in danger of a fatal consequence if it doesn't soon recognize its predicament. In a world economy in which sole reliance on the U.S. economy as the engine of growth since 1995 has created major imbalances-and where transatlantic relations are already under stress-the world can ill-afford a Germany following Japan down the path to economic perdition. (1)

A deepening of Germany's current economic weakness would not just compound the drag from a declining Japan; it would also deprive the United States of a critical partner in the promotion of economic liberalization and in the integration of developing democracies into the global economic system--a role Japan never played. It would also render even more improbable a significant increase in defense spending by the second-largest member of NATO.

The Japanese Model

WHAT A difference a decade makes. Over the last ten years, Japanese public debt and unemployment levels have doubled, and average economic growth has fallen by nearly three-quarters--to about 0.9 percent per year, the lowest of any industrialized economy. Bad debts in the Japanese banking system total an unprecedented $1 trillion and are still rising. On current trends, Japan will be unable to roll over its public or private debts and will fail to meet its internal pension and social security obligations within just five years at most. Japan has gone from being a soft power punching above its weight in international relations to being an aging society of declining significance even within Asia.

Worse, Japan seems unable to free itself from the tightening vise of fiscal erosion and debt-deflation in which its economy is caught. With each passing year of stagnation, tax revenues fall while public demands rise, limiting further the Japanese government's scope for constructive fiscal policy. Debt-deflation, meanwhile, is a vicious self-reinforcing cycle, last seen during the 1930s, where companies and individuals hit by falling prices and incomes are unable to service their outstanding debt obligations and so default or sell their marketable assets. These defaults and fire sales drive prices down further and dry up bank credit, leading to another round of failures. In Japan--with a bank-dominated financial system that offers little corporate access to stock and bond markets--the resulting credit crunch has starved the entire economy of new investment. It has also given aging savers little or no return on their assets, thereby sapping consumption as well.