The Moral of Japan's Lost Decade

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Includes: FXY, UDN, UUP
by: Lok Sang Ho

My statistics indicate that Japan’s Lost Decade had much to do with the strong Yen. As an export-dependent economy, the strength of the Yen simply strangled the economy to a halt.

Put simply, Japan had experienced such strength in its currency that its export machine was stalled. With Japan’s huge population and small resource base, Japan had to rely on exports to provide employment and to be able to import. Theoretically, Japan could earn big investment income from abroad and recycle them, but while investment income from abroad did help tremendously, it is not reliable, and “recycling” is not so easy in a market economy that wants to minimize taxes and transfers.

The Yen had appreciated by 40 per cent against a basket of currencies by the end of 1993 and by as much as 56% by the second quarter of 1995. In contrast, the US dollar had depreciated by 11% by the second quarter of 1995. Although the Yen started falling after the middle of 1995, by 2000, the Yen remained 50% above the value a decade ago. Only depreciation of the Yen in the 2000s helped push the Japanese economy out of recession.

Japan did try to stimulate domestic spending by an expansionary fiscal policy. But its openness and dependency on imports means that the expansionary fiscal policy could never bring much positive effect. Japan’s expansionary fiscal policy was more focused on tax cuts than on government spending. Total tax to GDP ratio declined from 21.4% to 17.5% from 1990 to 2000. The “failure of fiscal expansion to lift the Japanese economy” needs to be seen in the light of Japan being extremely import-dependent and that tax cuts did nothing to lift exports and employment.

My data shows that no other country ever had swallowed the kind of exchange rate appreciation that Japan went through. I have confidence to say that if the Yen did not depreciate to a level that allowed exports a breathing space, Japan’s economic recovery in the 2000s could not have happened.

As I have repeatedly pointed out, the strong Yen could not really lift imports. Indeed, with the economy weakened by faltering exports, the Japanese became miserly in their spending, and they only tried to save more. Throughout the 1990s, Japanese imports showed very little growth. On the other hand, with a weaker Yen, Japanese imports showed much stronger growth than exports in the 2000s. An excessively strong currency will definitely cause trade to shrink, hurting everyone.

The Yen was still trading in a range that allowed trade in the first half of 2008, but its sharp appreciation mid 2008 really broke the back of the economy. The economy stumbled in the third quarter and then collapsed at an annualized rate of 12.7% in the last quarter of 2008, in part as a result of shrinking demand due to the financial tsunami, and in part as a result of the strength of the Yen, an index for which jumped to 1.54 in January 2009, as compared to 1.20 in the beginning of 2008.

The story of Japan’s lost decade does not testify to the uselessness of fiscal tools to jump start the economy. The US is a much bigger economy and is much less import-dependent. Moreover, the US does not suffer from the curse of an excessively strong currency.

The moral of Japan’s lost decade is that the industrial countries have to work together to prevent currencies from moving to “corners” that kill off trade. It is high time that we dump the idea about “clean floats” of currencies. Currencies need to be flexible and need to correspond with economic fundamentals. The problem is that sometimes the free market disallows that.

Table: Effective exchange rate against a standard basket of currencies
Q4 1989 US index Japan Index
Q1 1990 1.00 1.00
Q2 1990 0.98 0.94
Q3 1990 0.94 0.96
Q4 1990 0.93 1.05
Q1 1991 0.99 1.09
Q2 1991 1.01 1.08
Q3 1991 0.97 1.05
Q4 1991 0.93 1.06
Q1 1992 0.97 1.12
Q2 1992 0.93 1.05
Q3 1992 0.92 1.09
Q4 1992 0.99 1.19
Q1 1993 0.99 1.21
Q2 1993 0.99 1.33
Q3 1993 0.99 1.38
Q4 1993 1.02 1.40
Q1 1994 0.99 1.37
Q2 1994 0.97 1.39
Q3 1994 0.95 1.43
Q4 1994 0.96 1.44
Q1 1995 0.91 1.40
Q2 1995 0.89 1.56
Q3 1995 0.93 1.46
Q4 1995 0.94 1.37
Q1 1996 0.96 1.34
Q2 1996 0.97 1.33
Q3 1996 0.97 1.32
Q4 1996 0.98 1.29
Q1 1997 1.03 1.26
Q2 1997 1.03 1.27
Q3 1997 1.05 1.31
Q4 1997 1.07 1.26
Q1 1998 1.08 1.25
Q2 1998 1.09 1.19
Q3 1998 1.05 1.11
Q4 1998 1.02 1.26
Q1 1999 1.05 1.34
Q2 1999 1.07 1.31
Q3 1999 1.03 1.35
Q4 1999 1.04 1.47
Q1 2000 1.08 1.49
Q2 2000 1.08 1.50
Q3 2000 1.11 1.53
Q4 2000 1.11 1.49
Q1 2001 1.15 1.45
Q2 2001 1.17 1.41
Q3 2001 1.13 1.38
Q4 2001 1.17 1.39
Q1 2002 1.17 1.31
Q2 2002 1.10 1.28
Q3 2002 1.11 1.37
Q4 2002 1.08 1.31
Q1 2003 1.07 1.33
Q2 2003 1.04 1.30
Q3 2003 1.02 1.29
Q4 2003 0.98 1.34
Q1 2004 0.99 1.36
Q2 2004 1.00 1.35
Q3 2004 1.00 1.34
Q4 2004 0.95 1.32
Q1 2005 0.95 1.34
Q2 2005 0.98 1.35
Q3 2005 0.99 1.31
Q4 2005 1.00 1.27
Q1 2006 0.99 1.26
Q2 2006 0.96 1.25
Q3 2006 0.97 1.23
Q4 2006 0.95 1.19
Q1 2007 0.94 1.17
Q2 2007 0.94 1.15
Q3 2007 0.91 1.14
Q4 2007 0.89 1.17
Q1 2008 0.85 1.20
Q2 2008 0.86 1.22
Jan 2009 0.94 1.54
Feb 2009 0.94 1.48