By Purv Soni and Maya
Japan, once an economic marvel of the world, seems to have finally endured the three decades long
socio-economic fallacy, as markets and hopes both rebound in the island nation.
The Japanese yen tumbled to its 1990s level against the greenback last week. The distressing memories of the 90s, in the immediate aftermath of the Japanese “bubble economy”, have long clouded economic confidence in Japan as the nation lingered from deflationary pressures. Long known for its stagnation, the Japanese economy has shown signs of positive momentum recently. While challenges remain, several key developments suggest a gradual shift towards a more robust and sustainable growth trajectory.
In 2013, when Haruhiko Kuroda, a former finance ministry official and an outsider to the central bank, was appointed head of the Bank of Japan (BoJ) by former Prime Minister, the late Shinzo Abe, he promised to create two percent inflation in two years by doubling the BOJ’s balance sheet. Moving beyond the Fed’s QE, Japan would have QQE, adding in the idea of qualitative to quantitative easing, meaning that the bank would not buy just government bonds but also riskier assets. The result was indeed a massive expansion in the balance sheet, in effect monetising the government’s steady diet of fiscal overspending equal to around 30 percent of the total budget each year. Even though the balance sheet more than quadrupled over Kuroda’s 10-year term, the idea of a “virtuous cycle” of higher wages driving higher prices remained elusive for almost all of his tenure, with the consumer price index stuck around zero. Hence, two percent inflation target has been a long sought and treasured aspiration of the BoJ. Recently, they attained it, however, it was not a central bank policy miracle rather the unpredictability of our fraught world that delivered the desired success.
When even America was intimidated by the economic sensationalism of Japan:
“I know from a common sense financial standpoint that something has to burst. When a country is losing billions and
billions and billions of dollars a year and when other countries are making hundreds of billions of dollars, something is going to burst.” – remarked Donald Trump, not President Trump, but businessman Trump of the 80s on the US’s trade deficit with Japan. The United States had a staggering trade deficit of $ 49 billion in 1989, right before the “bubble burst” of Japanese economy. In 1988, commentator Paul Harvey warned of “an economic Pearl Harbor” in an article titled “Japan buys US with our money.” By 1980s, museums in Tokyo and Osaka possessed some of the greatest works by Van Gogh and Picasso. As Japan rival led America’s economic power, “Japan-bashing” became commonplace in politics. Such was the extent of wrangling that surrounded the economical prowess that was post-war Japan.
In the aftermath of World War II, Japan lay in ruins. Its cities were devastated, its industries crippled, and its infrastructure destroyed. Yet, within a few decades, the nation had risen from the ashes to become an economic powerhouse, a phenomenon dubbed as the “Japanese Miracle.” This remarkable transformation is a testament to a confluence of factors, from strategic government intervention to a dedicated and innovative workforce. The American occupation initially focused on demilitarization and preventing a resurgence of Japanese militarism. However, the Cold War’s geopolitical landscape shifted priorities. The US, concerned about the spread of communism in Asia, began to view a revitalized Japan as a strategic ally.
The Japanese Ministry of International Trade and Industry (MITI) emerged as a central planning agency, guiding industrial policy and fostering cooperation between government and private businesses. This collaboration, known as “industrial targeting,” focused on identifying high-growth sectors like steel, shipbuilding, and automobiles and directing resources and investments towards them. A close relationship developed between banks and corporations, known as the “main bank system.” Banks provided long-term, low-interest loans to favored companies, fostering long-term investment and growth strategies. This system fostered a focus on long-term planning and patient capital, prioritizing investment over short-term profits. Japanese labor relations also played a significant role. Lifetime employment, seniority-based pay, and strong company loyalty characterized the workforce. This fostered a sense of shared destiny between companies and employees, leading to high levels of productivity and worker motivation. Furthermore, Japan heavily invested in research and development, focusing on adapting and improving upon existing technologies. This emphasis on “catch-up” innovation allowed Japanese companies to quickly close the technological gap with Western nations.
The Japanese economic miracle wasn’t without its downsides. The focus on heavy industry and exports led to environmental pollution and resource depletion. The emphasis on conformity and rigid social structures could stifle creativity and entrepreneurship. Additionally, the “main bank system” could lead to inefficiencies and a lack of transparency in the financial system. The rapid growth slowed down in the late 1980s due to various factors. The Plaza Accord of 1985 led to a significant appreciation of the yen, making exports more expensive. The bursting of the “bubble economy” in the early 1990s, fueled by overheated asset prices and speculation, further crippled growth. Japan entered a period of stagnation known as the “Lost Decades.”
“The Lost Decade”: A Malison on the “Japanese Miracle”
The “Lost Decades” is a moniker given to the period of economic stagnation that gripped Japan from the early 1990s to the late 2000s. Following the remarkable post-war economic boom, this era stands as a stark contrast, a period of missed opportunities and unfulfilled potential. To understand the vehemence of the lost decade and the enigma that surrounds it, Charles T. Munger, the former Vice Chairman of Berkshire Hathaway, who passed away recently, commented – “Anyone has to be flabbergasted by Japan’s recession, which has endured for ten years, despite interest rates below one percent. The government is playing all the monetary games, but its not working. If you had described this situation to Harvard economists, they could have said its impossible.”
In a nutshell, the lost decade from the early 90s to 2000s, was the broader consequence of the Japanese bubble economy’s collapse. The burst, marks the event when artificially inflated real estate and equity prices in Japan were exposed. To provide some perspective on the expanse of the crisis, the Imperial Palace in Tokyo was worth as much as the entire state of California. The roots of the collapse were greatly complex, touching monetary policy, tax incentives, lack of banking regulations, demographics, government incompetence, and trade exports.
During the economic boom, banks and other financial institutions relaxed their lending standards. Many people took out loans to purchase real estate and stocks without much difficulty. This worked hand-in-hand with low interest rates to help fuel the rise in asset prices. If your bank’s savings account gives you a meager 0.05% APY, you’d rather put your money into an asset (like a stock or a property) that can give you 8% returns. Even if you’re investing in a bad business, your optimistic demand drives up the price. Many people were buying properties and stocks not because they believed they were a good investment, but because they believed they would be able to sell them at a higher price in the near future. This created an upward spiral of prices, which ultimately led to a market crash when the euphoria burst.
The Japanese government allowed banks to invest heavily in stocks. It’s not unusual for banks to invest in stocks, but the extent to which they were allowed to do so was not regulated. Not only was it easy for banks to borrow large sums of money. They also invested without significant due diligence. In the same way that derivatives were unregulated before 2008, no significant risk-mitigating regulations were being enforced in Japan. Once the bubble burst, many banks found themselves with large amounts of bad debt and were unable to meet their financial obligations.
The infamous “Keiretsu” system refers to the network of interlocking business relationships that existed between large companies, banks, and other organizations in Japan during this time. Banks had close relationships with specific companies and industries, and would often provide them with preferential treatment, such as low-interest loans and other forms of financial support. This created a lack of competition and inefficiency in the banking system, as banks were more focused on maintaining these relationships than on competing for customers. They were not doing their job of market-making. Additionally, many of these large companies and banks were part of the same “Keiretsu” group, and they would often invest in each other’s stocks and other assets. This helped fuel the rise in asset prices, but also made the economy more vulnerable to changes in the market, as a downturn in one company or industry could have a ripple effect throughout the entire network.
Japan has traditionally relied heavily on exporting goods and services to generate economic growth. To make its products more affordable to foreign buyers, the country also relied heavily on a weak yen. When the yen began to appreciate in the late 1980s, Japanese exports became more expensive. This made it more difficult for Japanese companies to compete in international markets. Japan’s export-oriented economy generated trade surpluses for many years before the recession. When the bubble burst and exports fell dramatically, the trade surplus disappeared. This led to something known as a large “current account deficit”.
When Japan ran that current account deficit, it meant that it was spending more money on imports and foreign investments than it was receiving from exports and foreign investments. To finance the current account deficit and to continue to meet domestic consumption needs, the Bank of Japan printed more money and the government borrowed it. It’s no wonder that Japan continues to hold the world’s largest government debt.
The Bank of Japan still maintains a low interest rate regime even today. This makes it cheaper for the government to borrow money. The government can finance its deficit spending through bond issuance, rather than by implementing more difficult and politically unpopular measures such as raising taxes or cutting spending. This is a vicious cycle. Japan’s high public debt levels (around 200% of GDP) have limited the government’s ability to increase spending to stimulate the economy. Today, Japanese government bonds are the main financial asset held by banks, companies, pension funds, institutions, the postal savings system, and individuals in Japan.
Cumulatively, these factors caused Japan’s economy to lose a decade, endure prolonged deflation and continue its struggle with regaining economic momentum.
What Changed Recently:
In March end of 2024, Japan ended its eight years long period of negative interest rates. In a 7-2 majority vote, Japan’s central bank decided to increase short-term interest rates to 0-0.1%. The decision increased rates from the previously held minus 0.1% and marked the first rate hike in Japan in 17 years. Negative rates are a mean to combat deflation and stimulate economic growth. The landmark decision of interest rate hike by the BoJ, made Japan the last country in the world to end the policy of negative interest rates. In a statement announcing the policy change, the BOJ said that the economy has “recovered moderately” and that it is “highly likely that wages will continue to increase steadily.” The central bank, which also abandoned yield curve control (CC), did not indicate whether or not more rate hikes can be expected.
Hence, the question rightfully arises, what had changed in today’s fraught world that gave Japan the confidence to boldly ameliorate its economic stagnation. The principal driver of this fundamental policy change was, obviously, strong results of the annual spring-time wage negotiations, revealed just a few days before the policy meeting. According to the initial press release by JTUC-RENGO, one of the major labour union confederations, the average base wage rate has risen by 3.7%, accelerated from 2.3% last spring that was already historically high. This wage growth has also exceeded current inflation rates: Japan’s CPI this February recorded an increase of 2.8% year-to-year. However, the question remains, how and why did these conducive circumstances emerge now? And are these encouraging signs purely circumstantial, and if so, till what extent can they assist in reviving growth in Japanese economy?
In January 2023, the consumer price index jumped to 4 percent, the highest level since 1981 and well over the 2 percent target set by the BOJ. Within this, hotel prices surged by 63 % as foreign tourists again pack central Tokyo and Kyoto. For Japanese shoppers, much of the impact has been in the form of “shrinkflation” as food producers try to hide the higher costs. A bag of coffee in central Tokyo can still be found for around $4—it’s just that the same package now holds 40 percent less coffee. No wonder major food packaging companies saw their earnings jump 33 % last year. For decades, the BoJ has desired these propitious circumstances, however, it were inadvertent global developments that handed them their targets.
The world’s recent No. 1 game-changer: COVID-19, gave the Japanese, the much coveted economic momentum. With
higher import costs and supply chain disruptions, higher prices, albeit at a modest level by global standards, became visible in virtually every sector of the economy. As a result, stagnant wages finally started to show signs of movement as a shrinking workforce, good economic growth, and skills shortages have bid up salaries. Wages in October 2023 were up 1.5 percent year-on-year, and union workers logged average increases of 3.6 percent in their spring round of labor negotiations. The war in Ukraine, followed by the war in Gaza, the crisis in the Red Sea, long crumbling supply chains, sanctions affected global trade, and a confluence of other geopolitical factors under a larger gloom of uncertainty – made certain the prospects of the BoJ to hike interest rates.
All is not done yet for Japan. At the moment, investors are being driven to offload the yen due to a yawning gulf in interest rates between Japan and the United States. A weak yen is a mixed bag for the economy. Japan’s weakening yen has helped boost exporters’ profits by making their products cheaper to buyers overseas. The slide has also encouraged a record influx of foreign tourists – there were 3.1 million visitors to the country in March alone – whose spending helps support local businesses. But the yen’s slump has sharply raised the cost of imports, particularly food and fuel, putting a strain on household budgets. The advantage of a falling yen for exporters has also been dampened by the fact that many large Japanese companies carry out a significant portion of their operations overseas.
Japanese officials have repeatedly expressed concern about the yen’s excessive depreciation and indicated they are prepared to intervene if nec-essary. Authorities can pull on two main levers: buying up the yen or raising interest rates. While BOJ Governor Kazuo Ueda has indicated that the central bank could raise rates if inflation picks up, price growth has slowed in recent months. On Friday, the BOJ held interest rates steady, bolstering expectations that its ultra-loose policy is here to stay. Meanwhile, the US Fed’s recent signals have dampened expectations that significant interest rate cuts are on the cards this year amid persistently stubborn inflation.
Although, concerns still surround the Japanese economy, which is set to loose its spot as the 4th largest economy of the world to India in 2025, as per the IMF projections for nominal GDP – one thing is obvious – Japanese policy makers have not harboured, in recent memory, the confidence level for the economy as they do now.