japan deficit demography deflation

INDIVIDUAL CASE STUDY

JAPAN: DEFICITS, DEMOGRAPHY AND DEFLATION

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Introduction

This objective of this case study is to explore on the strategies to overcome the

economic problems facing by Japanese due to deficit, demography and deflation.

Over the last decade (2002-2004), the Japanese economy has underperformed

dramatically, growing an average of 1.1 percent per year versus 4.1 percent per year in

the previous ten years. At the same time, the country’s financial system has fallen into

disarray. With a shrinking labor force, the standard estimate for Japan in 2012 – that is,

before Abenomics – had output per employed worker growing by 3.08% year on year.

1. What economic problem is facing in this case study?

After more than a decade of economic stagnation and deflation and then an

“intensive adjustment period” (2002-2004), Japanese bureaucrats were hailing the onset

of “concerted consolidation” (2005-2006), the final step of their return to return to

economic growth. Under the principles of “no growth without reforms” and “leave to the

private sector what can be done by the private sector,” the government would continue to

carry out structural reforms. Although “regulation, financial system, tax system and

government expenditures” were crucial to this agenda, the Koizumi government also

sought to privatize the postal services, to shift some obligations to the provinces through

a three-part reform package and above all, to fix the social security system.

While the sounded like an ambitious list, the problem facing Japan was

considerable. When its credit and real estate bubble burst in 1990, Japan began running

large fiscal deficits to stimulate the economy. By the end of 2004, government debt had

accumulated to 163% of gross domestic product (GDP). Debt service, even with

incredibly low interest rates was 38% of tax revenues. Prices in Japan had been falling

since 1998, pushing down nominal GDP and thus tax revenues.

Perhaps the biggest problem, however demographic – the rapid aging of Japan’s

populations. Because of Japan’s extraordinary longevity, it now had more than one

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________________________________________________________________________million people (out of 127 million) at least 90 years old. With fertility rates having

dropped below 1.3, Japan faced an absolute decline in its population beginning in 2007.

Over the next 20 years, Japan’s population over 65 would grow from 25 million to 35

million. The implication of these numbers for immigration policy and a competitive

workforce were huge. But for the government, pension and health-care costs were even

more immediate issues.

2. What are the causes of the problems?

The combination of slow growth and the decline of the aggregate price level have

each contributed to Japan’s financial crisis. The single most important problem for the

financial sector has been the anemic growth of the Japanese economy over the last

decade. Figure 1 shows GDP growth over the last 45 years to put recent performance in

context. After averaging more than 3.8 percent between 1974 and 1991, growth dropped

to 1.1 percent over the last decade. Obviously, if there had been more growth in the

1990s, the financial sector would be in better shape now.

The more challenging question is how much the financial sector problems themselves

independently contributed to the growth slowdown.. First, it is implausible to argue that

the decline in stock and land prices at the beginning of the 1990s can be blamed for the

financial sector problems today. This simple explanation fails because the banks and

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________________________________________________________________________government financial institutions continue to make losses on new loans today. Therefore,

the crisis cannot accurately be described as merely delaying the recognition of bad news.

Second, recapitalizing the banks (and insurance companies) would not be a

sufficient step to restore growth. The banking problems reflect the poor conditions of

their borrowers. Putting capital into banks to make up for past losses would be pointless

if the underlying corporate problems are not addressed. As Caballero, Hoshi, and

Kashyap (2002) emphasize, the growth problems today cannot be due solely to a lack of

solvent financial institutions. There have always been international banks (and insurance

companies) operating in Japan, and the number rose substantially as a result of the so-

called “Big Bang” deregulation that was completed. So the problem is not just that the

domestic financial institutions are undercapitalized.

Policies like these have been aimed at tackling a growing social problem for

Japan—the country’s aging population, which depends on a robust workforce for its

future welfare. But the government has been reluctant to follow other countries facing a

similar crisis that have thrown open their doors to immigration.

Despite having one of the world’s fastest-aging populations, Japan is a nation that

remains deeply anxious about the social consequences of letting in too many foreigners.

3. Is Koisumi’s and Takenaka doing the right thing is addressing the problems?

Japanese Prime Minister Shinzo Abe’s program for his country’s economic

recovery has led to a surge in domestic confidence. But to what extent can “Abenomics”

claim credit?

Interestingly, a closer look at Japan’s performance over the past decade suggests

little reason for persistent bearish sentiment. Indeed, in terms of growth of output per

employed worker, Japan has done quite well since the turn of the century. With a

shrinking labor force, the standard estimate for Japan in 2012 – that is, before Abenomics

– had output per employed worker growing by 3.08% year on year.

Nonetheless, as many Japanese rightly sense, Abenomics can only help the

country’s recovery. Abe is doing what many economists have been calling for in the US

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________________________________________________________________________and Europe: a comprehensive program entailing monetary, fiscal, and structural policies.

Abe likens this approach to holding three arrows – taken alone, each can be bent; taken

together, none can.

But Abe has two more arrows in his policy quiver. Critics who argue that fiscal

stimulus in Japan failed in the past – leading only to squandered investment in useless

infrastructure – make two mistakes. First, there is the counterfactual case: How would

Japan’s economy have performed in the absence of fiscal stimulus? Given the magnitude

of the contraction in credit supply following the financial crisis of the late 1990’s, it is no

surprise that government spending failed to restore growth. Matters would have been

much worse without the spending; as it was, unemployment never surpassed 5.8%, and,

in throes of the global financial crisis, it peaked at 5.5%. Second, anyone visiting Japan

recognizes the benefits of its infrastructure investments.

The real challenge will be in designing the third arrow, what Abe refers to as

“growth.” This includes policies aimed at restructuring the economy, improving

productivity, and increasing labor-force participation, especially by women.

4. What would you do to overcome the economic problems?

It would better to weak yen’s exchange rate, making Japanese goods more

competitive. This simply reflects the reality of monetary-policy interdependence: if the

US Federal Reserve’s policy of so-called quantitative easing weakens the dollar, others

have to respond to prevent undue appreciation of their currencies. Someday, it might

achieve closer global monetary-policy coordination; for now, however, it made sense for

Japan to respond, albeit belatedly, to developments elsewhere.

Monetary policy would have been more effective in the US had more attention

been devoted to credit blockages – for example, many homeowners’ refinancing

problems, even at lower interest rates, or small and medium-size enterprises’ lack of

access to financing. Japan’s monetary policy, one hopes, will focus on such critical

issues.

The real challenge will be in designing the third arrow, what Abe refers to as

“growth.” This includes policies aimed at restructuring the economy, improving

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________________________________________________________________________productivity, and increasing labor-force participation, especially by women. A good start

to help tackle Japan’s problem would be, in addition to boosting the female workforce, to

encourage more elderly people to go back to work, said Mr. Takenaka. However, Japan’s

job market looks far from ready to accept even such moderate changes.

What is needed is the right regulation. In some areas, more active government

involvement will be needed to ensure more effective competition. But many areas, in

which reform is needed, such as hiring practices, require change in private-sector

conventions, not government regulations.

There is every reason to believe that Japan’s strategy for rejuvenating its economy

will succeed: the country benefits from strong institutions, has a well-educated labor

force with superb technical skills and design sensibilities, and is located in the world’s

most dynamic region.

5. Conclusion

There are different reasons for the sizable losses lurking in Japan’s banking,

insurance, and government agency sectors. Yet, the problems in these sectors are inter-

related. The banking problems that attract so much attention will persist until the troubles

in the other two sectors are also addressed. A satisfactory resolution requires recognition

of the different driving factors behind the problems in all three sectors and would include

measures that address all at the same time.

“Japan will have to face the necessity of immigration sooner or later,” said Heizo

Takenaka, an advisor to former premier Junichiro Koizumi and now an economics

professor at Keio University. “Womenomics” alone is unlikely to deal with the scale of

the crisis, according to Mr. Takenaka, citing a forecast that Japan’s population will shrink

by one million people a year after 2030.

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REFERENCES

Bank of Japan, 2002a, “New initiative toward financial system stability,” public

statement, Tokyo, September 18, available at www.boj.or.jp/en/seisaku/02/sei0208.htm.

International Monetary Fund, 2002, “Japan: Staff report for 2002 Article IV

consultation,” Washington,DC.

Stiglitz, Joesph. May 30, 2014. The Promise of Abenomics. http://www.project-

syndicate.org/commentary/shinzo-abe-and-soaring-confidence-in-japan

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japan deficit demography deflation

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