The Japanese Bubble Economy

by Mark Thornton



Business cycles and bubbles differ from one another, but the technical similarities between the Japanese and U.S. bubbles are striking. The Japanese bubble began in the early 1970s, the U.S. bubble started in the early 1980s. Both stock markets grew rapidly for thirteen years and then went parabolic to form bubbles, which peaked in Japan at the end of 1989, and in the U.S. during early 2000. Both stock markets lost about a third of their value eighteen months after their peaks. The Nikkei Stock Index has since lost as much as three quarters of its peak value, while the Dow Jones Industrial Average has been down forty percent and the NASDAQ Index seventy five percent of its peak value. The real estate bubble continued in Japan for some time after the stock market began its meltdown and, likewise, real estate – particularly housing – has remained in a bubble since the initial breakdown of the U.S. stock market in 2000.

The surprising thing is that in the U.S. the lessons of the Japanese bubble seem to have gone almost unnoticed. Japan has experienced fourteen years of economic stagnation since its bubble popped. The U.S. is now in the fourth year of economic malaise. Most troubling, the U.S. not only failed to heed the warnings of the Japanese bubble, they have thus far mimicked Japan’s failed attempts to stimulate its economy with extremely low interest rates and large government budget deficits. Both countries have opted for a slow, agonizing “recovery,” rather than a sharp correction of past errors that would quickly reallocate resources. Experts tell us that the Japanese and their economy are very different from the U.S., and that their bubble and policy response to its crash were likewise different, but while there certainly are many important differences between the U.S. and Japan, the technical features and new-age thinking are strikingly similar in both bubbles.

For example, there is no doubt that technology and new-era thinking played a major role in the Japanese bubble. During the bubble, Japan took over leadership of high technology in the areas of consumer electronics, the automobile industry, manufacturing, and even robotics, and was perceived as a major threat to dominate all technological development around the globe – just as the U.S. is today. The threat posed by Japan’s growing technological prowess can be seen in the titles of books published during the bubble era: Japan’s High Technology Industries (1986), The Technopolis strategy: Japan, high technology, and the control of the twenty-first century (1986), A High Technology Gap?: Europe, America, and Japan (1987), The Science and Technology Resources of Japan: a Comparison with the United States (1988), United States-Japan Economic Dilemma: a Look Into Automobile Industry (1989), Created in Japan: From Imitators to World-Class Innovators (1990), Japan as a Scientific and Technological Superpower (1990), Japanese Technology Policy: What's the Secret? (1991), Japan’s Growing Technological Capability: Implications for the U.S. Economy (1992).

Writing near the pinnacle of the bubble in the stock market, Kodama explained that the Japanese takeover of technological progress was a result of a new Japanese paradigm that was ushering in a new era:

Japan is becoming one of the frontrunners in industrial technology, which means that prominent science and technology policy researchers all over the world now pay more attention to Japan. Considering this change more deeply, one can understand the reason for the researcher’s academic interest: the paradigm of technological innovation is shifting. [1]

He found that in Japan the innovation of high technology “seems to be different from that for conventional technologies” and therefore that studies focused on Europe and the U.S. would not lead to a “new scientific framework for analyzing innovation of high technologies.” He suggested that we break away from the inadequate linear model of the past to the more unlimited model experienced under the unique “social and cultural context” of Japan. [2] He even ended his book with the suggestion that it was the Japanese cassette tape recorder, VCR, and fax machine that made the Iranian revolution, Philippine revolution and the Tiananmen uprising possible. [3] This is classic new-era-bubble thinking.

Another component of modern new-era thinking is the belief that the so-called scientific management of the economy creates perpetual prosperity. Here the Japanese experience epitomizes this phenomenon because the Japanese economy was said to represent a new “third way” positioned between the free-market economy and that of the centrally planned economy. In Japan, government and corporations are said to act cooperatively to achieve both their self-interest and the general interest of the nation. Bureaucracies help plan and coordinate the economy. They provide incentives, such as financing and tax breaks, in order to channel investment in profitable directions. Corporations, in turn, participate in joint research programs with their competitors, but share the results among participating firms, with each choosing what technological advances to employ in their firms. Production planning is facilitated by an overlap of ownership between final good producers and their input suppliers. Japanese management, especially during the bubble, was said to spur innovation, enhance product quality and reliability, and to create large market shares in export markets for Japanese industries. Alas, none of this could prevent a meltdown of the Japanese stock market and well more than a decade of stagnation in the Japanese economy.

New-era thinking about the scientific management of the economy was never more prominent and bold than during the Japanese bubble of the 1980s. It was often said that the Japanese system would lead to economic dominance and threaten the preeminence of the U.S. economy. Laura D’Andrea Tyson, who would later become Chairman of President Clinton’s Council of Economic Advisors, outlined (at the apex of the bubble) the “threat” of Japan’s technological superiority:

Certainly Japan continues to obtain technology wherever it is available and to translate it into commercial advance, as the United States itself did for so long. However, now talk has begun of a new, “technoeconomic” paradigm emerging in Japan, a new trajectory of technological development. That trajectory emerged from a pattern of industrial catch-up shaped by policies of import substitution and export promotion. As Japan reaches industrial maturity in a broad range of industries, its government is exerting substantial efforts to build a Japanese position in advancing technologies. Agencies such as the Ministry of Trade and Industries (MITI), which have become familiar names in policy discussions in the United States, are involved. [4]

In Japan, the government channeled research and development efforts, directed financing, and protected markets for business. This new third way of government management of the economy was thought to be Japan’s source of economic strength and would inevitably place it in a position of economic preeminence. As Tyson confidently asserted:

A generation from now, Japan will almost certainly have created its own mechanism for advancing the technological frontiers in a range of domains. Now the continuing pace of productivity increase suggests that Japan may indeed be on a growth trajectory different from that of the United States. As Japan ascends, America frets about its decline. [5]

Tyson and her coauthors questioned the validity of traditional economic thought, as all new-era thinkers must. They justified Japan’s “often flagrant and self-aware violations of the nostrums of traditional economic thinking” because when “technological change is a key determinant of market outcomes, standard economic models that treat such change as exogenous are a poor guide to understanding the dynamics of market competition and the effects of policy on such competition.” They argued that the “nostrum” of economic efficiency should be abandoned in favor of the less constraining and poorly defined notions of growth efficiency and technological efficiency. [6]

Leaving the anchor of economic efficiency and traditional economic thinking behind, Tyson was able to justify a variety of non-economic policies such as “beggar thy neighbor” protectionism. She heralded the concept of growth efficiency, which is essentially a Keynesian idea that rests on the assumption “that there are always unutilized resources that can be mobilized to meet growing demand…It is exactly this kind of thinking that led the Japanese to target industries whose products were perceived to have high income elasticities as a foundation for rapid economic growth.” [7] Ignoring the economic condition of scarcity and grasping the concept of an economy of perpetual unutilized resources is a precondition for new-era thinking, as well as a quintessential mistake of freshman college students taking their first course in economics. If resources are perpetually available then an unlimited amount of all goods and services can be produced and there are no economic problems to solve. This would seem the most basic of economic errors and a particularly grievous one to make in analyzing resource-poor and land-poor Japan.

Naturally she must also offer a rationale for why markets do not work, and she concluded that entrepreneurs will pass up more profitable long-run investments in order to pursue short-run profits under certain conditions. She even admitted that her argument was simply a variation of the long-discredited infant-industry argument for protectionism:

Under conditions of nondecreasing returns there is simply no way that markets can relate the varying future growth efficiencies of various industries to relative profitability signals facing individual producers. Basically, this argument is a variant of the infant-industry argument. Because of increasing returns, current market signals can be misleading indicators of future profitability. Consequently, government policies to promote a domestic industry with high future growth potential can improve economic welfare in the long run. [8]

From this perspective, modern-day entrepreneurs might invest in the production of jute, mechanical typewriters, and black and white television sets without the prodding and oversight of government bureaucrats.

In their justification of Japan’s new-era thinking, Tyson et al. view technology from the historical rather than economic perspective. In an age of information and communication technology, their “path-dependent” and “sticky” processes of technological development seem odd and not entirely appropriate for new-age thinkers who often view technology as “spontaneous,” perfectly flexible, and ever-present. Nevertheless, they clearly are new-era philosophers of the Japanese bubble and its new technological paradigm:

The expression technological paradigm…involves a new set of best practice rules and customs, new approaches to how to relate technology to market problems, new solutions to established problems. The notion of a major industrial transition, of a second industrial divide, of a shift from “Fordist to flexible” manufacturing that has become a fad in some debates points to just such a shift in technological paradigm. [9]

In retrospect, the new-era thinkers of the Japanese bubble economy seem conceited and hopelessly naïve, but that is the power of bubbles to deceive. One of the few observers to correctly identify and characterize the bubble was Christopher Wood, who wrote that Japan “became so arrogant in the late 1980s because it really believed it was immune from the natural laws of the marketplace. This really was one of the most astonishing acts of mass delusion ever, and future historians…will marvel at it.” [10] The Japanese people might be particularly susceptible to the delusions of a stock market bubble because their culture has so long emphasized honesty and respect for authority, and the government has carefully maintained the isolation of its people, all of which could contribute to herd-like behavior and makes them ripe for what Charles Mackay famously called the “madness of crowds.” The Japanese also have characteristics in their social psychology as well as their well-known emphasis on precision and details, which might make them more impervious to new-era delusions. The truth is that all these psychological characteristics are unimportant in terms of the cause of bubbles.

In the wake of the bubble and bust, Japan experienced a long series of corruption scandals, a procession of failed prime ministers, the ousting of financial ministers, the conviction of bureaucrats for corruption, and the breakup of their one-party system. However, the Japanese have failed to truly recognize the cause of their bubble and to liquidate their economic mistakes. Instead they embarked on a post-bubble course of easy credit, public works, and deficit spending that has only served to condemn the Japanese economy to continuing economic doldrums.

[1] Kodama (1991, pp. 171)
[2] Kodama (1991, pp. 172)
[3] Kodama (1991, pp. 173–4).
[4] Tyson and Zysman, p. xiv.
[5] Tyson and Zysman, p. xiv.
[6] Dosi, Tyson and Zysman, pp. 4–5.
[7] Dosi, Tyson and Zysman, pp. 14–15.
[8] Dosi, Tyson and Zysman, p. 17.
[9] Dosi, Tyson and Zysman, p. 31.
[10] Wood, p. 255.

May 23, 2004

Mark Thornton [send him mail] is an economist who lives in Auburn, Alabama. He is author of The Economics of Prohibition, is a senior fellow with the Ludwig von Mises Institute, and is the Book Review Editor for the Quarterly Journal of Austrian Economics. He is co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War.

Copyright © 2004

Mark Thornton Archives


See Also

And a very good gateway page:


Understanding the Post-Bubble Economy
Friday, April 29, 2005


"Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."

-- John Maynard Keynes, Tract on Monetary Reform


- Economists and fundamental analysts often miss cycle turns.
- There's always another recession -- and expansion -- coming (eventually).
- Learn to separate hand-wringing permabears from credible commentators.

If you have been listening to the financial press recently, you might be shocked (shocked!) to learn that inflation has been increasing and the economy is slowing.

You don't say?

Of course, readers aren't just now discovering that this economy has been suffering from inflationary pressures for more than two years, as a chart of the CRB shows.

It's the same with GDP. Follow the numbers: The third-quarter 2003 number was 7.8% (originally reported as almost 9%), the next quarter's was 4.2% (originally 6%+) and 2004's quarterly data came in at 4.5%, 3.3%, 4.0% and 3.8%.

This week, we learned the first quarter of 2005's number of 3.1% was way below consensus expectations. While some will tell you that 3%+ GDP growth is pretty decent, it's the trend of waning momentum that is the issue. An early mentor of mine used to admonish traders to not look at the photo, but to watch the full movie instead.

So much for the idea of kinda-sorta-eventually-efficient markets hypothesis.

Slowing GDP and rising inflation have been discussed on this site for over a year now. The investing issue with macroeconomic concerns is not the actual data, but how -- and when -- that data affects psychology. It's a question of timing. The commentators who are first now discovering weak GDP and inflationary pressures are not much help to you once the ocean is flat again.

That's why I use macroeconomics to frame my longer term perspective, and then mate that with trend analysis and technical analysis. This allows me to see both long- and short-term actionable possibilities, and even hold contradictory perspectives (in different time frames).

That's how I can get long when I'm bearish or short when I am bullish. It depends upon the market conditions. It's also why I frequently mention Ned Davis' book, Being Right or Making Money.

How We Got Here

We are at a peculiar point in the business cycle where prior assessments are increasingly coming under scrutiny, expectations are getting dashed and estimates are being revised. Yet at the same time, corporate profits are strong, balance sheets are in terrific shape and future earnings estimates remain robust.

All the while, Mr. Market is suffering from a malaise.

How did we arrive at this juncture at which economists are not only late in recognizing shifts but have been quite frequently wrong (and often wildly so)?

To figure out where you are going, it helps to know where you have been, and this is definitely one of those times.

The last bull market began in 1982 and ran almost uninterrupted for 18 years. During the last three of those years, an enormous bubble inflated. While it was concentrated in the dot-com/tech/telecom arena, the zest for stocks spilled over into other names. We saw more than enough enthusiasm to go around.

Alas, like all manias, this one had to unwind. That began in March 2000, as the preannouncement season revealed a quarter to forget. It has long been my suspicion that Y2K played a significant role -- the massive upgrade cycle prior to the calendar flipping sated buyers of tech. No one really needed much more of anything tech-related in the first quarter of 2000. The first quarter was a disaster waiting to happen. With stocks at such lofty levels, the preannouncement season was the straw that broke the camel's back. The bubble popped in ugly fashion.

At the time, few were willing to believe it. The bulls failed to recognize the shift and pounded the table all the way from Nasdaq 5100 down to 1100. That disbelief is not atypical behavior. What is surprising is that some of the same incorrigible characters from that sad era are coming out of the woodwork. A few recognized (and detested) faces are once again on TV, peddling their snake oil. Their advice has been completely irresponsible, and it's a crying shame they have been allowed back into the television studios where they can perform more mischief and do additional financial damage.

And as bad as the postbubble economic environment was, the economic weakness was further exacerbated by a modest recession and then by the 9/11 attacks. But in my opinion, the most significant negative factor was and remains the great 1990s bubble, and its repercussions. I believe that we will be wrestling with that bubble's economic aftermath for the rest of the decade.

As is typically the case, the consequences of the popped bubble were extensive. Huge excess capacity was created at the same time that fantastic productivity gains were being made. Hiring was frozen and capital expenditures ground to a halt. The economy had a hangover proportionate to the huge frat party that was the 1990s tech and telecom fest. Indeed, the vast majority of the economic woes we presently faced -- anemic growth, poor nonfarm payroll job creation, declining personal income -- are a direct result of being in a bubble.

Market crashes are typically followed by a "refractory period" -- a substantial length of time in which the prior excesses get wrung from the economy. Japan is at the tail end of a decade-plus-long growth respite. This process sets up the next healthy expansion. In an ideal world, the powers that be would recognize this and allow market forces to work off this hangover on its own. Alas, most elected and appointed officials lack the discipline and the will to get out of the way.

In our case, the postcrash era saw massive government stimulus: Personal income taxes were cut, deficit spending soared, interest rates were dropped to half-century lows, money supply increased dramatically, not one but two wars were prosecuted, corporate dividend taxes were slashed, capital gains taxes were cut and capital expenditures were granted a special accelerated depreciation. Uncle Sam's unprecedented and enormous stimulus package included "everything but the kitchen sink."

I suspect this will only make matters worse. We keep taking a "hair of the dog that bit us" -- easy money -- to postpone the hangover for as long as possible. But there is no free lunch, and I fear that this will only make the ultimate misery that much worse when the bill finally comes due.

On cue, that stimulus is now fading. The most vibrant sector of the economy -- the real estate complex -- is slowing. The Fed has painted itself into a corner, with inflation on the one hand and a fear of crimping what's working best (real estate) on the other. Increased energy costs are a drag on the global economy. Interest rates and taxes have been going higher. Earnings momentum, as measured on a year-over-year basis, has been slowing for five consecutive quarters. Hiring remains anemic, capital-expenditure rates are unimpressive, leading economic indicators softening, GDP is fading.

The market has begun recognizing that the first postbubble expansion was premature. Like an injured runner who pushes himself before he is fully healed, the stimulus-driven economy is at risk. It has failed to develop organic momentum of its own, without further stimulus. I expect this recovery cycle will run out of steam sometime over the next two to four quarters.

It's No Different This Time

One of the ironic twists of this postrecession recovery has been the awful performance of the dismal scientists.

But I think I've finally figured out what ails them. It's in the cliche "It's no different this time." The problem lies in which "time" you choose to use as your basis for your comparison. While typical econometric models use a postwar period as a frame of reference, they might be better served only working with a subgroup. The 1929, 1972 and 2000 markets in the U.S., and the 1989 Japan market, are far better comparisons than the typical postrecession recovery.

That is not a particularly happy vision for the macroeconomic environment, or for equities over the next few years. At this point, I am much less concerned with inflation than I am with the softening demand for industrial metals. That's an early warning sign of a slowdown in industrial production and the global economy. The same goes for the slowdown in oil. While the Fed is busy eyeing inflation, it may wish to instead start watching the warning signs that the macro picture is further deteriorating. They risk falling behind the curve -- once again.


Understanding the Post-Bubble Economy
Barry Ritholtz, 4/29/2005 3:30 PM EDT


Seeking the simple life in post-bubble Japan

Shoichi Nasu

The Yomiuri Shimbun


Seventeen years have passed since the collapse of the bubble economy in Japan. Recently, I saw a morning TV talk program in which some interviewees were looking back to their bubble days.

One man told the interviewer he had once spent 3 million yen on a one-night binge. "All in all I spent 30 million yen that week," he said. He wasn't boasting. He was just looking back to the days of the peak of the bubble.

A housewife in her 40s told the interviewer she once flew to Sapporo from Tokyo just to eat a bowl of ramen.

"I even went to South Korea to have yakiniku grilled meat," she said. "All the costs were paid by men around me. It was such a time." No boasting here, either. She was surely just reminiscing about her best days as an OL [office lady], I mean, an office worker.

At one point, the woman told the interviewer that if she had put aside the money spent on her during the bubble years, it would have amounted to at least 100 million yen. Wow!

I recently saw a movie on the very same theme that just happened to be playing, and I really enjoyed it. Some parts of the film were quite staggering.

In one scene, lavishly dressed young men and women had gathered for a party, and during a bingo game the heroine of the movie won a prize--2 million yen in cash.

In another scene, people try to hail a passing taxi on a busy night when there seem to be far more customers than available cabs. So how did one man secure a taxi in this competitive situation? By waving a 10,000 yen bill or two at the taxis.

It is generally agreed that Japan was in the economic bubble for about four years from the end of 1986 to early 1991. I was in Africa for three of those years, so I had no idea of the things that were happening in Japan. I might have benefited from the trickle-down effect caused by the bubble economy, but I can swear that I never had an experience like those mentioned above.

I returned from Africa in March 1990. A year later, Japan entered what we call ushinawareta junen, a failed or "lost" decade in which people lost assets and jobs following the bursting of the economic bubble.

We may be still experiencing its aftereffects.

When I asked a barber in Fukuoka, where I frequently go despite a scarcity of hair, if he had benefited from the bubble, he said he certainly had.

"You know, human hair grows at the same rate, irrespective of the economy," he said. "But the frequency of visits to the barbers is certainly affected by how much money people have in their pockets. So we were busier in those years."

The opposite to life during the bubble economy is a steady and simple life. Nowadays, we sometimes come across the acronym LOHAS (lifestyles of health and sustainability). LOHAS might not lead one to a simple life. However, if we have a simple life, I guess it's pretty close to LOHAS.

Long before we had heard of this new term, we led such a life all over Japan. Early to bed and early to rise. Always starting the day with a solid breakfast, with miso soup. Eating whatever came from our region. Wearing clothes handed down from our older brothers and sisters.

When the bubble economy visited us, we forgot those days. It may sound like a TV commercial, but simple is best and simple is beautiful--and the simple life is what I would like to achieve some day.


Nasu, a senior writer at The Yomiuri Shimbun, Seibu, was editor of The Daily Yomiuri between March 2004 and September 2006. Prior to that, he was a correspondent in Africa and Europe. This weekly article is based on a translation of his column "Eigo de Saruku," which is published in The Yomiuri Shimbun's Kyushu edition and also can be read on The Yomiuri Shimbun's Web site for the Kyushu region.
(Mar. 16, 2007)



Japan Economy 2007/2008, The Moment Of Truth?

by Edward Hugh: Barcelona

Wednesday, December 19, 2007


Well the Japan Cabinet Office have just published their monthly economic report together with their their revised forecasts for fiscal year 2008. As could be expected, downward revisions are to be seen everywhere, except in the plans for government spending, which commentators expect may well be up (details of the 2008 budget are due to be released tomorrow), but even this last detail seems pretty ominous in the light of the fiscal problems which Japan faces, and the steadily rising cost of supporting Japan's growing elderly dependent population.

What is still the world's second-largest economy is now expected to grow by 1.3 percent in the fiscal year ending March 31, slower than a previous forecast of 2.1 percent. At this point in time it is very difficult to assess the viability or otherwise of this forceast, since it is obviously very sensitive to small changes of environment in key sectors as we move forward. However one or two observations are in order. The first of these is that we are likely to get a very strange reading on Q4 GDP. The reason for this is that GDP growth in Q4 2006 was very high indeed (1.3% quarter on quarter - see chart below - and indeed the strength of this growth threw Claus and I considerably when it happened - and the same was true of what happened in Germany - since we hadn't really forseen the spurt in the global growth rate - who had - and how this would influence the key export dependent economies. Everything is now, however, coming back into line, and I doubt we will see big surprises on the upside across 2008).


It is thus very probable that we will see negative year on year growth in Q4 2007 (the high base effect), even if the quarter on quarter Q4 2007 growth rate does not itself plunge into the red (a possibility which is not at all excluded at this point).

Looking more generally at the government revision other things stand out. First this:

”With the global economy recovering in fiscal 2008/09, the corporate sector will remain firm and households will show improvement gradually”

and then this:

”A private-demand-led economic recovery is expected through joint efforts by the government and the Bank of Japan.”

This strikes me as incredibly optimistic. On the global economy front things are really bound to get worse before they get better. Some economies - Thailand, India, Turkey, Chile, Brazil, India - may well be able to sustain momentum, but Eastern Europe is very likely to suffer a correction (in all probability quite a strong one), while both Russia and China will be struggling with their growing inflation problems. In particular in the Chinese case, some sort of slowdown or other is now almost bound to come - and it can be sharper or softer according to when it starts - since the inflation problem is really about to get out of hand if something is not done soon on this front.

The developed economies, on the other hand, will, if they are internal consumption dependent (Spain, the US, Australia, the UK etc) be wrestling for some time to come with the effects of the unwinding of the financial component of the construction boom, while those who are to some degree export dependent (Germany, Austria, Italy, Finland, Sweden - the rapid-ager group) will simply notice any slowdown in the rate of growth in world trade.

As for the above-mentioned support from the government and the Bank of Japan, this can only mean more fiscal support and the absence of any further rate increases from the BoJ (Fukui will have to retire without fulfilling his dream, and the big question now is rather when will the BoJ start to talk about coming down again).

On the fiscal front slower growth will probably place a squeeze on tax revenue, making it harder for the government to narrow the budget deficit and reduce its 777 trillion yen ($6.9 trillion) debt, which is the world's largest. The 2008 budget outline is due to be released tomorrow, and will probably incorporate an increase in government spending according to a leaked preview which appeared in Nikkei newspaper today. The primary deficit, the excess of spending over revenue excluding bond sales and interest payments, is projected to widen for the first time in five years, according to the article, suggesting that government spending may well rise to something in the order opf 83 trillion yen as the continuous and relentless ageing of the population swellshealth and social welfare costs. Such an increase would constitute a 0.4 percent increase from this year's projected level.

Economic and Fiscal Policy Minister Hiroko Ota has already confirmed that the government anticipate that revenue from taxes will start falling, although Finance Minister Fukushiro Nukaga insisted when he spoke to reporters that the government still intends to try to balance the budget by year-ending March 2012. If they go down the road I think they are going to go down, and if this "slowdown" is a drawn out affair - as I think it is very possible that it will be - then it is hard to see this committment being fulfilled.

All of this reveals, and very clearly, just how fragile Japan's situation actually is at this point, despite all the bravado, and despite every attempt to put the best face possible on things that you can find in the government reports and the financial press at the moment. Structurally Japan is in a very tight fixt. The central bank has been unable, even during the longest expansion since the late 1980s, to raise interest rates above 0.5%, and the government has only been able to start thinking about reducing the massive outstanding debt precisely when it looks like we may be heading back to recession again, and thus they can't. You don't need to be a genius to see that there is a substantial underlying problem here, and that, in the mid term, none of this is sustainable.

Of course, the government fall back on the hope eternal argument of that anticipated rise in domestic consumption, but this failed to materialise during the boom, and I see little reason why we should anticipate its arrival at this point, indeed there are strong ageing-population-related structural reasons for assuming that we won't.

Policy Driven Or Structural?

Now one of the big debates which is bound to arise is the one which relates to the extent that (yet one more time around) Japan's problems are policy related, and the extent to which they are now "normal" problems associated with the impact of a steadily ageing population which has passed the median age 42/43 milestone. Claus has already drawn attention to Morgan Stanley analyst Takehiro Sato's views in this regard here.

Takehiro Sato presents the policy-driven case, which I will quote extensively:

Errant government policies have started to hurt domestic demand. First, the availability of consumer financing has dried up and micro businesses as well as small and midsize enterprises (SMEs) are having financing difficulties because Credit Guarantee Corporations (CGCs) started a ‘responsibility-sharing arrangement’ in October. Second, the revised Building Standards Law (BSL) has led to a sharp decline in construction starts. Third, consumption and investment sentiment has been further harmed by the prospect of higher taxes and a return to the 1990s-style fiscal policy. Implementation of the Specified Commercial Transactions Law and the Financial Instruments and Exchange Law (FIEL) can probably be added to the mix too. The FIEL has hampered foreign investors and accelerated yen appreciation. Just to be clear, we do not think that the objectives of these policies are misguided, but hasty moves by bureaucrats to implement such laws, without regard for the economy, have had a considerable impact.

We think that such errant policies will result in a policy-induced slump (‘kansei fukyo’). First, the contraction in consumer credit and financing backed by CGCs has already put a tight squeeze on micro businesses and SMEs. With sharp increases in material and energy costs worsening the terms of trade and labor’s share of income still high, SMEs do not have much leeway to increase wages or capex. The tightening of credit may lead to an increase in bankruptcies among SMEs in Jan-Mar 2008, when cash flow tends to be tight.

Second, housing investment has fallen off sharply because of the revised BSL and is unlikely to recover in F3/09. The condominium market took a heavy hit, particularly since demand had already been weak amid a decline in what households can afford to purchase. Condo starts have slumped in 2007 and are unlikely to fully recover in 2008 because the bottlenecks that have resulted from government inadequacies are likely to take time to clear up. GDP-based housing investment will probably take longer to recover. We estimate the housing weakness alone shaves 0.3ppt from our F3/08 GDP growth forecast, and do not expect a rebound of the same extent in F3/09. If the situation continues until mid-2008, small and midsize builders are likely to go bankrupt and housing spending would be affected, and hence the problems would be more than just bottlenecks.

Third, the government’s discussion of taxes has chilled consumer and investor sentiment. The Cabinet Office’s Council on Economic and Fiscal Policy released an estimate that the consumption tax needs to be increased to double figures, and the government’s Tax Commission is considering raising tax rates and limiting deductibles against income. The need for such a major consumption tax increase is understandable, but we think that the way the idea was floated was not a smart one. More SMEs may go bankrupt, housing investment looks unlikely to recover, and already-cautious consumer sentiment may worsen further as a result of all the talk of tax increases. The prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence. The Specified Commercial Transactions Law and the FIEL, which are nominally designed to protect consumers and investors, actually appear to be dampening consumer spending and investments in financial products.


Well the list of policy "errors" is an impressive one, but let's think a little about some of them for a moment. Firstly the Specified Commercial Transactions Law and the FIEL. As Sato says, these are nominally designed to protect consumers and investors, so it is surprising that they are having such a negative effect. Since I am in no position to comment on the details of these measures, I will simply note that the danger of even well intended policy measures going wrong only increases as the fragility and vulnerability of an economy rises, and that is the phenomenon we seen to be observing in Japan right now. For anything to work for you in life you need a certain amount of good luck, and when your luck is down, and the level of adversity you face mounts, then the problems only seem to pile up. This perfectly describes Japan present problem set I think (I mean don't forget the famous pensions-records scandal, which seems to have been all but forgotten at the moment, except by the people who had their records lost, of course). If you really could live without a spanner showing up in the works, then it never fails to show up. That's what we mean by being "down on your luck". As Jefferson said, when I find myself being lucky I am normally sitting here, hard at work at my desk. That is, we make our own luck, using foresight and sound policy.

So then there is the housing permits paperwork issue(another of those spanners, I guess). I am sure this has been a factor, but I am sure it is not the whole story. The building permits question was merely the trigger which fired off an already primed gun. Let's look at quarterly annual growth in residential construction.

What we can see here is that the drop in Q3 is large and significant, but that the downward trend was already present even before the permits problem hit, and the situation is probably now being fed more by the knock-on effects of the credit crunch and the sub-prime concerns than by the paperwork issue itself. As such we should not anticipate any early resolution of the problem, although the rate of downturn is obviously going to ease up.

Lastly we have the fiscal issue. Now as Sato again notes, the reasons why people have been talking about such a consumption tax increase are understandable, since government debt problems are important, but as we can see from what has happened in Germany with the 3% VAT hike in January, in a society with a high median age population where domestic consumption is fragile, loading up the consumption tax is definitely not a good idea. Other solutions need to be found, and many of these will now involve cuts in provision I fear. This is the price to be paid for having left the ageing issue unattended for so long. There is now a certain inevitability about things.

Which is why it is also worrying that Sato says this: "the prospect of a return to 1990s-style fiscal policy could also harm personal consumption and investment due to Ricardian equivalence."

Leaving aside the knotty problem of whether or not there is such a thing as Ricardian equivalence, I take this to mean that he anticipates a return to fiscal deficit stimulus support. This is a very dangerous road to go down for an economy in Japan's situation. Each recesssion now is not simply a repeat of the earlier one, since each time now the screw will turn another notch, and one day something or other will break. Japan needs to look for long term solutions to its problems, which mean facilitating substantial immigration in the short term, and a radical change in fertility policy to try to address the longer term issues. Will we see that happen? I am not optimistic, but then the longer you keep saying that fertility doesn't matter, the longer people continue to think that there is no important and pressing reason why they should have children. That is, the situation becomes self-perpetuating. This is the damage that is doen by denial.


Update: 20/12/07

Well, as forecast yesterday by Nikkei, the Japanese Ministry of Finance has today announced that Japanese spending will rise by 0.2 percent to 83.1 trillion yen ($735 billion) in the year starting April 1 2008. The government will sell 25.3 trillion of new debt, almost the same as this year, to help fund the deficit. This spending increase may not seem that significant, but it will mark the first time Japan's budget deficit has increased in five years and will inevitably call into question Prime Minister Yasuo Fukuda's resolve to cut the world's largest public debt, following the recent electoral trouncing of the LDP.

According to the Japan MoF's own figures debt of central and local governments combined will now reach 776 trillion yen by March 2009, equal to 147.2 percent of gross domestic product. That compares with 149.6 percent as of March 2008. The significance of the present decision is that this trend may now reverse, and this of course raises the issue of just when the trend can revert back to debt reduction, given the presssure of population ageing, the rising median age of voters, and the fact that Japan is actually ageing more rapidly than anticipated in earlier forecasts. Ageing population related welfare costs and interest payments on bonds now account for approximately half of total spending in the budget.

General expenditure, covering items ranging from defence and public works to social welfare and education, is projected to rise 0.7 per cent from the current fiscal year to 47.28 trillion yen, largely due to an increase in social security payments. Social welfare, which accounts for 46 per cent of general expenditure, will rise 3.0 per cent as Japan’s ageing population requires more spending on pensions and medical services.

The new budget sets aside 7.44 trillion yen for pension payments, up 5.8 per cent from the current fiscal year. The government is also planning to increase tax grants to municipal governments by 4.6 per cent to 15.61 trillion yen to respond to pressure from rural voters to increase spending in an attempt to reinvigorate regional economies.

Interestingly enough the MOF has managed to reduce new debt issuance by 0.3 per cent to the above mentioned 25.34 trillion yen, in large part by increasing non-tax revenues such as transfer of surplus funds in the foreign exchange special account to the general budget account. Oh, that trade surplus!

What all this means is that the so-called primary deficit - the excess of spending over revenue excluding bond sales and interest payments - is now set to grow to 5.2 trillion yen from this year's 4.4 trillion yen.

And remember, despite the fact that the government yesterday redced its growth forecast for the current fiscal year, it is still anticipating 1.3 percent annual growth in this fiscal, and 2 percent next year. Any slippage on this will mean an even greater tax shortfall and hence a higher budget deficit.
Posted by Edward Hugh at 3:00 AM