Japan's Lost Decades Revisited

 |  Includes: EWJ, FXY
by: Shareholders Unite


Japan's experiment with Abeconomics remains widely misunderstood.

It is modelled on an earlier successful Japanese reflation attempt in the 1930s.

Since the eurozone is plagued by similar ills which threaten the stability of the world economy, the experiment has special relevance here.

David Stockman's blog Contra Corner comes out with a rousing headline from Peter St Onge:

Krugman And The Keynesian Chorus Are Lying: Japan's "Lost Decade" Is A Myth

A little later, the same article is reproduced at ZeroHedge. We didn't know that the term "Japan's lost decade" was exclusively Keynesian, or Krugmanite. It's a widely used term in the press, Keynesian or otherwise. The article argues, convincingly that:

Adjusting for inflation and population is Macro 101. It's so basic, in fact, that we might wonder if the "lost decades" macroeconomists are being intentionally forgetful. Why on earth would they do that?

Why indeed. The correct way to measure economic performance is to compare real GDP per head, which the article does in a graph, and the results shows that US and Japan had a similar development this century:

Click to enlarge

The funny thing is, we are generally considered Keynesians (full disclosure, we only became Keynesians after the financial crisis, which left a distinctly Keynesian world full of output gaps and liquidity traps), and we have also written about Japan. Here is what we wrote about Japan's lost decades:

While many speak of a lost decade, or even lost decades, there is really little that warrant such a description. In fact, one can make quite a convincing case for arguing that what Japan went through is nothing less than a sort of miracle.

We arrived at that opinion (in that and a couple of follow up articles here and here) by realizing some things:

  • Japan's asset bubble of the late 1980s was three times the size relative to GDP compared to the US bubbles in the late 1920s and 2007. It really was the mother of all asset bubbles (one should study the graphs in this awesome presentation by Richard Koo)
  • Despite an epic burst (the Nikkei is still under half its 1989 Christmas peak of 39000 today, land and real estate values have only recently started to recover), Japan never experienced double digit unemployment nor any economic depression (nothing like the lost half decade and counting of the eurozone periphery today).

We even reproduced a graph (from The Economist) in the article:

There you have it, real GDP per person. So we, at least don't feel guilty as charged, rather the contrary. What about Krugman? Here is another rousing headline, this time from Forbes(!):

Paul Krugman Says It Again: Japan's Stagnation Is A Myth

And he's quoted as saying:

"That's actually not bad," says Krugman. "You can argue that demographically adjusted, the whole tale of Japanese stagnation is a myth."

Indeed (and here is Krugman himself on the topic). Now, who exactly is lying we'll leave for the reader to decide, but Japan remains an extraordinarily interesting economic laboratory, as they experienced the bursting of a much bigger bubble, with ensuing massive balance sheet recession that turned into deflation.

For a good while, this looked like having little relevance for the Western economies and few thought it would (with the notable exception of.. you guessed it, Krugman, who wrote a book called The Return of Depression Economics in 2000 and published an article on the liquidity trap in 1998).

But we now know better. As we have argued, there are really uncomfortable similarities between what happened in the US post 2008 and the Japanese crisis, both entered periods in which credit infused asset bubbles burst and the private sector decreasing borrowing and spending in order to repair the damage to their balance sheets.

Such deleveraging gives ordinary monetary policy little or no traction, as households (or firms, in Japan) prefer to pay off debts no matter how low interest rates are. The risks are that this situation ends in protracted economic downturn, debts spiraling out of control and/or deflation. How have these countries fared?

  • Japan managed to stave off the economic stagnation but suffered from debt spiraling out of control and deflation. The main instrument they used was fiscal policy.
  • The US has avoided deflation and its economy and debt trajectories are not alarming but could be better
  • The eurozone (or at least significant parts of it) suffers from debt spiraling out of control and protracted stagnation and near deflation.

What have the main policy means been to arrive at these outcomes?

  • Japan's policy measures have been mainly fiscal, notable expert Richard Koo argues that if it hadn't embarked on this its GDP would have shrunk by 40-50%, but it hasn't done enough to reach 'escape velocity' and got stuck in deflation, even if GDP per head kept growing.
  • The US has mainly embarked on unconventional monetary policy (QE)
  • The eurozone has embarked on little monetary policies and many countries were forced to significant austerity measures.

While it's perhaps a bit of a crude simplification, but we could argue that the US embarked on monetary stimulus, Japan on fiscal stimulus and the eurozone did neither, with the latter clearly producing the worst outcome.

What's perhaps even more interesting is how Japan is now, under Abeconomics, trying to get out of deflation and spiraling out of control debt levels. Here is what the Contra Corner article had to say about Abeconomics

politicians in Japan need the sense of crisis to push their vote-buying schemes. It's a lot easier to sell harmful policies if you can just convince the voters that everything's already fallen apart. They've got nothing to lose at that point. In a crisis we are all socialists.

Whether Abeconomics is harmful remains to be seen. In nominal terms, Japanese GDP has been more or less stagnant since 1990. That's one big reason their debt level has spiraled out of control, the result of the 'denominator' effect.' A combination of low or negative growth and low or negative inflation producing a stagnant GDP, the denominator in the debt/GDP ratio.

Large and persistent public deficits are the other reason why Japan has such high debt levels, what can be done? In principle, there are only a few choices:

  1. Eliminate the deficits and turn them into surpluses
  2. Default on the debt
  3. Let the central bank, the Bank of Japan (BoJ) buy the debt and retire it
  4. Reflate the economy to get rid of the denominator effect

Reducing (let alone eliminating) the deficits whilst the private sector was deleveraging isn't a good idea. A deleveraging private sector produces a large private sector surplus (savings exceed investment by a big margin), if the public sector adds to the savings pool, the deflationary effects (and hence the denominator effect) are strengthened, not countered.

Japan tried this in 1997 and promptly entered into recession. Notably, Japan has tried again in April, with a sales tax hike from 5% to 8% (with a further rise to 10% planned for next year) and again the economy has faltered, although it's too soon to say whether this is just a temporary blip.

Defaulting on the debt isn't really an option either, it would bankrupt a host of domestic institutions, banks, pension funds, institutional investors, as well as a host of households, not to mention the overseas implications (although luckily enough, Japan is a net creditor to the world).

Suffering from deflation has one advantage in the sense that buying up the debt by the central bank is a realistic option, and under Abeconomics the BoJ has taken to that with gusto. It has several advantages but also a significant risk:

  • It directly retires debt
  • It's reflationary, thereby tending to decrease the exchange rate, increase spending, growth, asset prices and inflation, all of which reduce the denominator effect by increasing nominal GDP
  • The big risk is that inflation overshoots and the BoJ will be forced to retreat or even revert the policy

Reflating the economy is certainly an option and Japan has three approaches. Apart from fiscal and monetary stimulus there are structural reforms, which are supposed to increase the growth potential. The most promising measures involve getting more women, amongst the highest educated in the world, to work.

The first signs, after a year or so, are mildly encouraging. The Japanese bond market, after some early volatility, has settled. The yen has fallen quite a bit, the Nikkei had a very strong year last year and deflation has ended, but it remains to be seen whether it has been conquered permanently.

The crucial variable are wages and this constitutes a bit of a balancing act. With inflation rising, real wages risk falling behind, which could easily affect consumption and snuff out the recovery and prices could fall back into deflation territory again. Here is BoJ president Kuroda:

"The Bank of Japan's price stability target can serve as a benchmark for wage setting," he added, speaking on a panel alongside central bankers from Brazil and Britain. "Once the bank has succeeded in firmly anchoring (inflation) expectations at 2 percent this could provide the basis on which wage negotiations are conducted." [Businessinsider]

It isn't widely known, but Abeconomics is modelled on an earlier, and by and large successful Japanese attempt to escape deflationary forces, in the 1930s under finance minister Korekiyo Takahashi (despite the fact that he was assassinated by the military in 1936 for trying to rein in spending).

While Japan hasn't yet achieved escape velocity this time around, these experiments are still very interesting and relevant, especially for the eurozone. Eurozone debt levels are ratcheting up due to the dreaded denominator effect and the area is teetering on the brink of deflation. We previously argued that this is one of the biggest risks for the world economy.

While there is significant structural reform going on in the eurozone, there is very little in terms of reflationary policies. Fiscal policy has actually been countercyclical just when the negative effects of that are strongest, but after years of stagnation, insight is growing about the damage this has done.

We expect something of a monetary blitz from the ECB, although perhaps not immediate. As the US experience shows, while no miracle cure, it can at least help to stave off deflation.

Deflation is basically is the last thing the eurozone needs because growth, well, what growth?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.