The Legacy of Japan's Heisei Malaise

In 1990, Japan’s economy was the envy of the developed nations, with a high savings rate, high investment, a balance of payments and a fiscal surplus—but this apparent health masked one of the biggest bubbles in modern economic history. By 2009 and after a debilitating Heisei Malaise, Japan’s economy is but a mere shadow of what it was in 1990. The popular view is that Japan’s experience now serves as a lesson to central bankers and government policy makers of what not to do after the bursting of a historically large bubble.

Contrary to this popular view, Nomura Research Institute economist Richard Koo in his book The Holy Grail of Macro Economics argues with his concept of a balance sheet recession that Japan’s LDP-led government should actually be praised and considered heroes for being able to a) avoid a depression and b) sustain Japan’s GDP above prior bubble peak levels for the past 18 years (to 2008) in spite of massive debt de-leveraging from a JPY1,500 trillion asset value wealth implosion of stock market and property values between 1990 and 2005 that was equal to the current entire stock of personal financial assets. Between 1990 and 2003, over 20% of corporate demand was lost due to debt de-leveraging in what Mr. Koo has coined “a balance sheet recession.”

During this period, the Bank of Japan’s monetary policy was effectively useless, as aggregate demand shrunk by an amount equal to the sum of net household savings plus debt repayment by firms, and because Japanese companies shifted from seeking profit maximization to reducing debt. In other words, Japanese monetary policy had fallen into a liquidity trap, where the BOJ was effectively trying to push a string. Upwards of JPY25 trillion of reserves, or five times what the banking system required, that were pumped into the financial system between March 2001 and March 2006 in what was termed “quantitative easing”, and a zero interest rate policy (ZIRP) had virtually no beneficial impact on corporate fund demand or the economy. Our explanation at the time was that Japanese banks had ceased to function as money multipliers for monetary policy, i.e., instead of multiplying the money that the BOJ was pumping into the system through keeping only as much money in the vault as was required by the BOJ’s bank reserve requirements and lending out the rest, banks literally could not give money away because there was effectively no loan demand.

Balance Sheet Recession Theory Would Have the Government Keep Throwing Fiscal Resources At the Problem, No Matter What the Cost: Sound Familiar?

Under the balance sheet recession theory, Japan was ostensibly able to avoid depression through “good” fiscal deficits totaling JPY315 trillion between 1990 and 2005. This fiscal stimulus, it is argued, prevented cumulative losses to Japan’s GDP of JPY2,000 trillion, assuming Japan had fallen into depression and GDP dropped back to 1985 levels (JPY330 trillion) and stayed there for 15 years. Ostensibly, Japan’s mistake was not wasteful fiscal stimulus, but insufficient “stop-and-go” fiscal stimulus that ended up costing JPY115 trillion more than otherwise needed to overcome Japan’s balance sheet recession. Without this stimulus, it is argued that would have seen a Great Depression like the US experienced in the 1930s, i.e., a nearly 50% implosion in GDP, 25% nationwide unemployment rising to 50% in large cities, a 33% shrinkage in the money supply, and loss of national wealth worth one year of 1929 GDP. We also believe that Japan’s LDP and BOJ have generally gotten a bad rap for effectively saving Japan from depression.

(Sources: Cabinet Office, Nikkei)

But while Japan’s balance sheet recession ostensibly ended in 2005 when net debt repayment in the corporate sector finally reversed and corporate borrowing demand returned, what did Japan lose in the process? Japan’s economy should have seen dramatic growth in tax revenues as the economy pulled out of this balance sheet recession, whereas the apparent surge in tax revenues of 7.6% in 2005 versus anemic GDP growth of 1.0% was in the main due to the reversion to companies paying more normal taxes after the expiration of the bulk of five-year tax carry-forwards, meaning that real (adjusted for this distortion) growth was more in line with GDP growth, according to Mr. Koo’s analysis. Even though companies finishing paying off debt, they remained debt adverse as they tried to restore financial assets to “normal” levels, keeping interest rates lower than historical averages. Conversely, companies were supposed to adopt a more positive attitude toward fund raising as their aversion to debt dissipated, resulting in a period of relatively high GDP growth while interest rates remained uncharacteristically low. It does not appear that Japanese companies ever made this conversion, judging from the trend in government tax revenues.

What if the Economy Never Recovers Enough to Begin Paying Down Debt?

This is because, four years after the so-called end of the Heisei Malaise balance sheet recession, Japan’s economy is but a shadow of what it was in 1990. While the Japanese government declared an end to deflation in the summer of 2006, Japanese prices excluding raw foodstuffs and energy have effectively been declining since September 1998. The supply-demand gap deteriorated to about 5% of GDP in 2001 and gradually recovered to 1%~2% of GDP in 2007, only to plunge to around 8% in the current crisis. Japan’s potential GDP growth coming out of the Heisei Malaise never recovered above 1%.

Basically, while Japan’s authorities may have avoided a depression, they have been unable to achieve sustainable growth since. Average GDP growth between 1992 and 2003 was 0.5%, but growth swung from 2.5% to -2.4%, with the positive phases only reflecting the impact of additional stimulus packages. Government tax revenues peaked in 1990 at JPY60.11 trillion and declined to JPY43.8 trillion by FY2002. Tax and stamp revenues recovered to JPY51.0 trillion by FY2007, but then fell again to JPY44.3 trillion as Japan’s economy again entered recession. Meanwhile, gross debt as measured by the IMF soared from JPY383 trillion in FY 1990 (59% of GDP in terms of central and local government debt only) to JPY1,044 trillion (150.7% of GDP in terms of central and local government debt) by FY2009, with only one year, FY2007, seeing flat growth.

(Source: Ministry of Finance)

(Source: Ministry of Finance)

Further, Japan was not able to avoid massive consolidation in many business sectors, most noticeably in the financial sector, despite arranging “shotgun” marriages, hiding the losses under historical cost and other accounting changes to ease the pain, as well as massive capital infusions for “too big to fail banks”. Twenty years ago, there were 23 major banks. Japanese regulators had compartmentalized Japan’s financial services industry into a) city banks, b) trust banks, c) long-term credit banks, d) regional banks and c) broker/dealers--and totally ignored consumer finance, which fell under the purvey of the Ministry of Trade and Industry. Today, these 23 banks have been consolidated into five “megabanks” that are still not globally competitive and still have insufficient core capital. Consequently, the consolidation of Japan’s financial sector continues. Further, this consolidation in our view merely made them “too big to (efficiently) manage” while making them “too big to fail”.

(Sources: JapanInvestor.com, Nikkei)

Neither Monetary or Fiscal Policy is of Much Use In Combating Globalization

In the 1960s and 1970s, Japanese competition almost wiped out industry after industry in Europe and the US. The US consumer electronics industry, semiconductor memory and automobile industries were wiped out by Japanese competition. Now, Japanese industries like steel, chemicals, and even electronics are under siege by Asia rivals, are increasingly being forced to focus on specialty applications to survive an onslaught of competition, and to funnel their new investments in newly emerging markets, not in domestic factories or for that matter in the US or Europe.

As Japan’s balance sheet recession lingered, Japanese industries and its economy were increasingly under siege from globalization. Under globalization pressure, fiscal stimulus is little more than a painkiller, and monetary policy has no role to play except to keep rates low for as long as possible. Even Mr. Koo admits is it likely to take a great deal of time and effort—measured in decades—to overcome the effect of globalization on Japan’s economy. Thus Japan’s economy was never able to meet the conditions for a policy shift to full-fledged deficit (and government debt) reduction—i.e., a recovery in private sector loan demand and tax revenues returning to “normalized” levels. Further, debt on the government’s balance sheet continues to swell, and recently at an alarmingly faster rate as the Japanese government struggles to deal with the current crisis and a still-large JPY40 trillion dearth of demand.

The extraordinary fiscal stimulus and central bank policies of the Heisei Malaise did not solve Japan’s debt problem, but merely shifted it to the government, like shuffling the deck chairs on the Titanic. While massive and unprecedented fiscal stimulus and monetary policy most likely prevented those responsible for the balance sheet recession from experiencing maximum pain, Japan effectively mortgaged future revenues and savings, leaving its economy to sink into a state of languor, inactivity and impotence. Given this reality, the policies taken by the LDP-led government and BOJ during the Heisei Malaise were not the Holy Grail of Macroeconomics, they are more like a poison chalice, to be born by the new DPJ-led government and future generations. Japanese wages and GDP have not moved forward, they have moved backward, to 1992 levels, or 13 years before the so-called end of the balance sheet recession.

Governments Do Not Have an Unlimited Timescale to Deal With the Debt

In his book, Mr. Koo insists there is no particular reason to think a specific size of budget deficit is fatal to an economy. Ostensibly, a nation has plenty of time to right its fiscal ship before the next crisis like the Heisei Malaise occurs. But guess what? Japan is now yet again experiencing a “once in a century crisis” only some four years after the end of the Heisei Malaise balance sheet recession. This crisis has triggered one of the deepest recessions in Japan’s postwar history and has decimated corporate profits as well as employee wages, personal consumption, and domestic prices. The nation is again faced with a deep supply-demand gap. According to the balance sheet recession theory, the Japanese government should step in with virtually unlimited fiscal stimulus to “do whatever it takes” to plug the private sector demand hole. This is ostensibly what the Aso Administration did in passing a JPY40 trillion supplementary budget in April 2009, but the same old approach by the same old political leadership was rejected by voters last September.

To date, the threat of Japan’s government debt has been downplayed because it was “all in the family”, as the vast majority of this debt were domestic financial institutions with too much cash on their hands due to a dearth of corporate fund demand, and public pension plans that have traditionally held the bulk of their assets in “safe” government bonds. On the other hand, only around 6% of Japanese government bonds are held by foreign investors.

But there are disturbing signs that the new DPJ-led government can no longer take domestic JGB investors for granted. While the macro environment, i.e., a strong yen and deflation, are ostensibly supporting factors for government bond demand, recent surveys show that even Japanese voters are worried about the surging debt, while financial markets increasingly fear that a heavy calendar of new JGB issues could force up domestic interest rates. Japan’s population is aging rapidly, wages are under siege from globalization, and Japan’s workforce has been contracting since 2005. Consequently, potential GDP growth is a mere 1% and not about to improve dramatically soon. In other words, Japan’s ability to repay this ballooning debt has been seriously compromised.

Japan's GPIF (government investment pension fund-- the world’s largest--has become a (reluctant) net seller of government bonds this year as it must meet pay-out obligations from rapidly aging pensioners. Japan Post Bank was balking at further additions to its already substantial holdings of state debt, but since it is in the process of being re-nationalized with new government agency “old boy” management, it is likely to revert to being basically a government financing piggy bank. The take-up of JGBs by individual investors has also been below government expectations. On international markets, CDS (credit default swaps) on JGBs are beginning to develop a noticeable premium over comparable sovereign debt.

In terms of economic policy options, the DPJ has been handed a poison chalice of clearly unsustainable government debt. With the supply-demand gap still at some JPY40 trillion. The conventional (Keynesian) policy prognosis is more fiscal stimulus sufficient to offset the JPY40 trillion supply-demand gap.

But 20 years after the onset of the Heisei Malaise and four years after the end of the so-called balance sheet recession, we see no evidence that the first ten years of fiscal stimulus produced anything more than an enfeebled, heavily indebted economy that is basically unable to deal with external “shocks” such as the current crisis. By the IMF’s measure, Japan’s gross debt will reach a whopping JPY1,043.8 trillion in 2009, or 11 years worth of general budget expenditures, severely limiting the DPJ’s ability to “resolutely address” the problem with more fiscal largesse. The nation's corporate tax receipts in the first half of FY2009 (April to September 2009) actually fell into negative territory for the first time since 1961 as deficit companies were claiming tax refunds, and total tax receipts could fall below JPY40 trillion, versus a JPY46 trillion forecast a year ago.

The Sad Reality is Probably that Governments are Probably Doomed to Repeat the Same Mistakes

In our view, there is no free lunch when it comes to debt that is this massive. Merely taking this debt from the private sector and moving it over into the government’s corner and throwing a tarp over it doesn’t make it go away. This debt is a cancer that is relentlessly destroying the whole house. While hard work and sacrifice have long been considered a virtue in Japan, Japanese companies and their workers can no longer hope to survive on hard work alone. Despite this massive debt, Japan’s politicians, bureaucrats and “old economy” companies are vainly trying to pretend there is nothing wrong, despite the rapid emergence of China, India and the rest of of Asia forcing major adjustments in Japan’s already debt-enfeebled economy that Japan’s “old” economy and politicians/bureaucrats are powerless to resist with conventional policy tools and “more hard work”.

The sad fact of life is that Japanese politicians and the general public are not unique in seeking pain avoidance over "doing the right thing", which would be to suck it up, take your lumps, and pick up the pieces. Any elected government who attempted to do so would be committing political suicide. The IMF may be able to mandate such pain on an emerging economy (such as was done during the Asian currency crisis), but not on the second-largest economy in the world and also a major contributor to the IMF's coffers. Unfortunately, the only option appears to be long-term pain, as the short-term pain is simply unacceptable.

The Eventual Outcome is Clear, But Local Financial Institutions Can Probably Support JGBs for Longer than Foreign Investors Can Withstand Losses on their Time-Stamped JGB Bets

At what point does Japan’s government debt become a self-sustaining spiral? No one knows exactly, but some foreign economists like Simon Johnson, former chief economist of the International Monetary Fund, have raised the possibility of the risk of an eventual JPY crash or a sovereign Japan debt default, which in turn has prompted some overseas investors short JGBs on the assumption that the crisis could come to a head as early as 2010, at least to the extent that produces a significant increase in JGB yields sufficient to make their short trades profitable.

While basically agreeing with these investors’ long-term prognosis for the outcome of uncontrolled growth in Japanese government debt, we would avoid aggressive, “time-stamped” bets on a Japanese debt crisis and a substantial sell-off in JGBs, because foreign investors that ignore the still-substantial ability of domestic cash-rich institutions and even the Bank of Japan to support the market at their own risk, because these buyers can probably continue to support JGBs for longer than foreign investors can afford to lose money on bear JGB positions.

Disclosure: No positions in EWJ, FXY

Comments

[Davewmart]

Thanks for a very informative analysis.
In addition to the factors mentioned above, a couple more seem to me to make stagnant growth unavoidable.
Demography of course is the obvious one, doubtless too obvious for you to emphasise.
An aging and shrinking population makes any growth difficult.
Oil is also a factor - check out the price now, in the depth of worldwide recession.
They can't go anywhere but up if there is any sort of recovery.
The remaining factor that occurs is the sheer ineffectiveness of Government expenditure,which has gone to roads to nowhere rather than, for instance, breaking all oil dependency.
I can't see growth for Japan at any time that is envisonable.
An ever-increasing debt can't go on forever, and without growth I can't see it being paid down.

2009 Nov 24 08:39 AM

[Lok Sang Ho]

The only valid solution is depreciation of the Yen, which the Bank of Japan has given up out of ignorance.

2009 Nov 25 09:56 AM

[Orwell]

The market fundamentalism and the villains of the financial cults almost destroyed the Japan's wealth and assetts. But the tide has been changed. The privatization, deregulation and erosion of the public sphere investments were only illusions claimed by the neocons and the fundamentalists. Those money mongers demanded the structural reforms which would have only destroyed the Japanese traditions and cultures and stable econmy and balanced distribution of wealth. It demanded the dismantling of the seccessful medical insurance system and every other typical Japanese system while boasting the western system is superior ot none. It was only fool's gold. Japan luckily was not devastated, because there were segments of resistance remained to fight against the intrusion of the cults and villains. As Americans chaged their minds politically, Japanese also quickly adapted to the new world order which will emerge much for the human values and dignity. Even though there are some remnants are screaming, we can say briefly 'Go away' to those who supported the receding extremes of the market fundamentalism or money worship cults.

2009 Dec 01 07:36 AM

[Hillsfar]

Why does all this look so foretelling of what is happening now and in the next ten years with the United States?

2009 Dec 17 01:57 AM