Debt-fuelled Growth: Can the West Avoid a Japanese Future?

Scientists study distant galaxies to gain a better understanding of our own planet. In the same way, Japan’s experience provides important insights into current global economic problems. Unfortunately, the lessons from Japan are largely being ignored. As John Kenneth Galbraith wryly observed: “There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Getting There…
Japan’s post-war growth was originally driven by low-cost manufacturing and an undervalued yen. The artificially low currency emphasised growth in exports at the expense of household income and consumption. It also helped increase domestic savings rates.  

On September 22, 1985, France, West Germany, Japan, the United States, and the United Kingdom agreed to the Plaza Accord, designed to devalue the yen by intervening in currency markets. Between 1985 and 1987, the yen appreciated by 51 percent against the dollar, moving Japan from an era of En’yasu, an inexpensive yen, to a period of Endaka Fukyo, an expensive yen.

Japanese exports and economic growth fell sharply, from 4.4 percent in 1985 to 2.9 percent in 1986.

Desperate to restore growth and offset the stronger yen, the Japanese authorities eased monetary policy with the Bank of Japan (BoJ) cutting interest rates from 5 percent to 2.5 percent between January 1986 and February 1987. The lower rates set off a debt-funded investment boom, driving real estate and stock prices higher. At the height of the “bubble” economy, the 3.41 sq km area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California.

Following the collapse of the bubble, policymakers have implemented a variety of economic stimulus programmes. Despite these measures, Japan has been trapped in a period of economic stagnation, known initially as Ushinawareta Jūnen (the Lost Decade). As the economy failed to recover and the problems extended beyond 2000, it came to be referred to as Ushinawareta Nijūnen (the Lost 20 Years).

Despite differences, the sequence of events, including the response to the crisis, resonates strongly with the present state of the global economy.

Getting Out…
Japan highlights the difficulty of engineering recovery from the effects of major deleveraging following the collapse of a debt-fuelled asset bubble. It reveals the limitations of traditional policy options—fiscal stimulus, low interest rates and debt monetisation.

Since the collapse of the Japanese debt bubble in 1989-1990, Japanese growth has been sluggish, averaging around 0.8 percent per annum. In contrast, Japan enjoyed decades of strong economic growth—around 9.5 percent per annum between 1955 and 1970 and around 3.8 percent per annum between 1971 and 1990.

Nominal gross domestic product (GDP) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) around 5-7 percent.

Japan’s public finances have deteriorated. At the time of collapse of the bubble economy, Japan’s budget was in surplus and government gross debt was around 20 percent of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending created substantial budget deficits, leading to an increase in government debt. Japanese government gross debt is now around 240 percent of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135 percent.

Monetary policy is ineffective with limited demand for credit. The BoJ’s attempts to increase inflation to reduce debt have been unsuccessful, with Japanese inflation averaging minus 0.2 percent in the 2000s, a decline from levels of 2.5 percent in the 1980s and 1.2 percent in the 1990s.

Morbidity…
Policies designed to alleviate the slowdown have created anomalies and delayed essential structural changes, compounding fundamental problems.

Investment has increasingly been misallocated into expanding manufacturing capacity and excessive infrastructure spending, reducing returns on investment and Japan’s potential growth rates.

The excessive manufacturing capacity and low domestic demand has exacerbated reliance on exports and a high trade surplus to balance production with demand. Government-financed infrastructure investment has allowed politicians to channel funds to favoured projects. But much of the investment is not productive.

Low interest rates have allowed debt levels to remain high. They have also reduced income for savers, reducing consumption and encouraging additional saving for retirement.

Banks have avoided writing off loan assets, tying up capital and reduced lending to productive enterprises, especially small and medium enterprises (SMEs) which account for a large portion of economic activity and employment. Low rates have allowed weak businesses to survive in a zombie-like state, where they survive to continue to pay interest on loans which banks do not want to acknowledge can never be repaid. Structural reforms necessary to boost growth have not been implemented.

It is unlikely that Prime Minister Shinzo Abe’s initiatives can reverse the decline. Most of the policy prescriptions, designed to create growth and inflation, have been tried before with limited success. With fiscal policy limited by the size of Japanese government debt and monetary policy also reaching into unknown territory, Japan’s choices are increasingly constrained. While the efforts may buoy stock and real estate prices, at least temporarily, its effects on the real economy are likely to disappoint.

The Japanese experience suggests that the state can provide palliative care to an economy in crisis. Its ability to restore economic health is more limited.

Echoes and Dissonance…
There are notable similarities and differences between the collapse of Japan’s bubble economy and the Global Financial Crisis (GFC).

In both cases, low interest rates and excessive debt build-ups financed investment booms to drive recovery from recessions. Both ultimately collapsed. Both instances were characterised by overvaluation of financial assets and banking system weaknesses. The curative policies pursued in both cases—government spending to support economic activity, debt monetisation and zero interest rates—are also similar.

At the onset of the crisis, Japan had low levels of government debt, high domestic savings and an abnormal degree of home bias in investment. This allowed the government to finance its spending domestically, assisted by an accommodating central bank. Currently, around 90 percent of Japanese government bonds are held by compliant domestic investors. The absence of market discipline allowed Japan to incur high levels of indebtedness. Many of the current problem economies have low domestic savings and are reliant on foreign capital.

Japan’s problems occurred against a background of generally strong economic growth in the global economy. Strong exports and a current account surplus partially offset the lack of domestic demand, buffering the effects of the slowdown in economic activity. The global nature of the problems means that individual countries will find it more difficult to rely on the external account to support their economies.

While its aging population has increasingly compounded problems, Japanese demographics at the commencement of the crisis were helpful. Its older population had considerable wealth and low population growth meant that less new entrants had to be accommodated in the workforce during a period of slow growth, alleviating problems of rising unemployment.

Japan is an insular, homogenous society, where citizens have a strong national consciousness and stoicism shaped by the experiences of World War II and the post-war period. Citizens were accommodating of the sacrifices necessitated by the economic problems. Savers have accepted the net transfer of wealth through low interest rates to borrowers. The social structure of many troubled economies may not accommodate the measures required to manage the crisis, without significant breakdowns in social order.

These differences will greatly complicate dealing with current global economic problems.

Ignorance is Bliss…
Low growth, disinflation or outright deflation, weak banking systems and the ineffectiveness of policy actions all point to the increasing likelihood of the many nations, particularly developed economies, turning Japanese. But most policymakers resist the similarity, railing against the “dying of the light”.

Intoxicated on the massive liquidity infusions from central banks, financial markets, in particular, seem to be oblivious of the risks of turning Japanese.

The Japanese stock market is around 70-80 percent below its highs at the end of 1989. Japanese real estate prices are at the same levels as in 1981. Short-term interest rates have been around zero for more than a decade. Ten-year Japanese government bonds yield around 1 percent per annum.

The lesson from Japan’s experience is that the only safe option to a prolonged period of stagnation is to avoid a debt-fuelled bubble and a subsequent build-up of public debt in the first place. As Johann Wolfgang von Goethe knew: “Precaution is better than cure.”

Satyajit Das is a former banker and author of Extreme Money and Traders, Guns & Money