How relevant is Japan's economic experience to advanced economies?
How relevant is Japan economic history over the past twenty-five years to understand the current challenges faced by other advanced economies? Japan has been the first country to implement quantitative easing policies, about ten years earlier than other countries, and also the first - and so far the only - country to experience in the recent period a protracted deflation and a level of public debt over the mark of 150 points of GDP - and counting. Japan has also experienced a sharp slowdown of economic growth, from a level significantly higher to other industrialized economies until the 1980s to close to a standstill. Since the 2008 financial crisis, deflation, economic stagnation, or an unsustainable build up of public debt are downside risks that seem to threaten repeatedly both Europe and America.
Scholars are sharply divided about the relevance of Japan's experience. Larry Summers for one is confident Japan is fully irrelevant to America. To quote but a few idiosyncratic features he identified for Japan in a 2011 debate: "the most rapidly ageing society… epic insularity and an inability to accept immigration… a massive retrenchment by its companies to their home markets, and an utter lack of capacity for entrepreneurial innovation…" By contrast, at the very same time, in the wake of the Greek crisis, Japanese academics were convinced that Japan's experience was not just relevant to Europe, Japan was the future of Europe. They saw a close match between Japan and Europe's symptoms: repeated denials of the crisis, a long-lasting financial crisis, and policy paralysis related this time to the difficulty in reaching consensus within the European Union. The same causes always producing the same effects, they predicted that Europe, just like Japan twenty years before, will also experience a few "lost decades" of economic growth.
1. Revisiting Japan's economic policies over the past twenty-five years
In a book with Sébastien Lechevalier (Lessons from Japan's experience. Towards a new economic policy? *), we revisit Japan's economic history over the past twenty five years with a focus on the policies implemented to address the financial crisis, deflation, and the growth slowdown. The book covers the period from the bursting of the real estate and financial bubble in 1990-91 to Abenomics, the name given to policies implemented since 2012 under the leadership of Prime Minister Shinzo Abe. Our research has two principal objectives: (1) to explain how a plain vanilla crisis - mainly financial - was associated with a prolonged downturn over several years; (2) to understand policy choices and constraints faced by policymakers in Japan.
Compared to earlier studies, we benefit from two major advantages: a longer time span, with about ten to fifteen more years than the initial studies on Japan's "lost decade"; new facts about the effectiveness of economic policies, derived from those implemented in several advanced economies since 2008 or with Abenomics in Japan. While fully benefiting from hindsight, we also endeavor to avoid a hindsight bias by striving to understand how policymakers perceived their menu of policy options based on the information available at the time. In our view, this method - certainly to our advantage over Japanese decision makers - is essential to identify the errors of the past and to avoid repeating the same mistakes.
Confronted to unprecedented challenges, Japanese policymakers faced difficult choices, to which occasionally neither economic theories nor past experiences offered clear solutions. In the face of the banking crisis, bank supervisors and regulators had to choose between a gradual adjustment where economic growth would improve bank balance sheets over time, or a shock therapy where a rapid clean up of the banking system could deepen the crisis and possibly backfire. Confronted with deflation, central bankers could implement a traditional accommodative policy until hitting the liquidity trap, or could enter the then unknown world of non-conventional policies. On the fiscal side, ministry of finance officials could implement an additional stimulus in the hope of jump-starting growth or attempt to curb the fiscal deficit at the cost of an economic downturn. Finally, policymakers also face the traditional trade-off between the short-term pains and sometimes elusive long-term gains of structural reforms.
2. How to explain the Japanese slowdown? Structural factors and policy mistakes.
Our reading of the Japanese slowdown emphasizes the combination of three main factors: (1) a financial crisis that is acknowledged and resolved with much delay; (2) a succession of exogenous or endogenous shocks, to which countercyclical policies respond imperfectly; (3) finally, a slowdown in growth, which reflects on the supply side the end of the catch-up period, on the demand side the cumulative impact of the first two factors, and also - at the microeconomic level - a decrease of technological and organizational spillovers between firms in a context of increasing heterogeneity of performance. The first three chapters of the book each discuss one of these factors.
We argue that Japan's economic slowdown was thus partly expected, but that policy mistakes also contributed to aggravate Japan's slowdown. To illustrate by one example, it took about twelve years to solve Japan's banking problem: it took three years to create the relevant statistics necessary to understand the issue; it took four years to abandon an optimistic gradualist strategy based on the hoped-for economic recovery until Japan was confronted with a full-scale systemic banking crisis in 1997; it took another five years to implement a partial strategy which improves bank core capital but with little effect on the quality of loans; finally, an aggressive strategy to reduce non-performing loans and force greater accounting transparency was implemented only in 2002, and managed to deliver results within two years and ahead of schedule. Similarly, the central bank until 2012 showed a marked cautious and even some reluctance in addressing the deflation issue.
We also refute some common beliefs about Japanese economic performance over the past twenty-five years. Japan has not experienced "two lost decades", the diversity of the period covered contradicting clearly this interpretation. The Japanese slowdown is also not the result of a political paralysis, which would be reflected in the absence of structural reforms, on the contrary Japan's progress in implementing a structural reform agenda is broadly similar to other industrialized economies. The growth slowdown cannot be explained either by a growing duality between an export-oriented industrial sector and a domestic-oriented service sector, since within both sectors the productivity of firms has widened, contributing also to labor inequality. We also debunk the myth of the "happy stagnation" (low growth has little negative impact), as demonstrated by its impact on the contraction of tax revenues, the increase in public debt, or worsening conditions in the labor market - evidenced not in the unemployment rate but in the increasing duality between regular and non-regular workers. Finally, we also debunk the myth of the "good deflation" (deflation rightfully corrects excessive price levels), as contradicted by the difficulty in exiting deflation and the negative impact of deflation on the banking sector and on economic activity.
3. Will Abenomics succeed?
Abenomics, to which we devote the fourth and final chapter of the book, is difficult to understand without reference to the history of economic policy over the past twenty-five years. Abenomics innovates in three ways compared to the economic policies implemented by previous governments. Firstly, economic policy plays a central role in the strategy of Prime minister Abe, in contrast for example to his policies during his first mandate. Abe's approval rating is also clearly correlated to his focus on economic policy and tends to decline when he shifts his focus to political issues, more divisive and less central to his electors' interest. Secondly, the focus is on the three traditional pillars of economic policy (fiscal, monetary, structural), not just on one issue - such as the parliamentary approval of the consumption tax law for his immediate predecessor. Finally, the third and major innovation is about monetary policy. In this respect, M. Abe had the opportunity to nominate a new governor at the Bank of Japan, Haruhiko Kuroda, only four months into his premiership. While an innovative and welcomed change in the Japanese context, to some extend Abenomics is simply closer with a new international norm of active countercyclical policies following the financial crisis of 2008.
Three years after its inception, none of the most acute risks pointed out by Abenomics' critics (a currency crisis, an overshooting of inflation, or a spike in long-term interest rate contributing to a fiscal and a banking crisis) have materialized. Abenomics is already delivering positive results. This said, progress is also much more tentative than expected. Inflation is no longer in negative territory, but around 0.5-1 %, remains well short of the official target of 2%. GDP growth was boosted in 2013 by economic stimulus, but declined in 2014 due to the consumption tax hike, and remained mediocre last year (with GDP growth rate of respectively 1.6%, -0.1% and 0.4%). In terms of structural reforms, we argue that the government was bolder than expected in terms of the trade agenda, but more cautious related to other reforms, which are nonetheless much needed. The broad stability of wage earnings highlights also the needs of an income policy, a point Abenomics is belatedly recognizing.
4. How relevant is Japan's experience to Europe?
Japanese economic performance since the early 1990s has been followed closely by macroeconomists and economic policymakers in the U.S., but much less in Europe. Despite Summers' claim of Japan's irrelevance, this proximity is evident for example in the memoirs published in 2015 of the two most senior U.S. economic officials during the 2008-2009 crisis, the governor of the Federal Reserve Board, Ben Bernanke, and the Treasury Secretary, Tim Geithner. Both were extremely attentive to avoid repeating Japanese's "mistakes", in terms of letting the economy enter deflation or in terms of financial crisis management. Initially, such awareness was much more muted in Europe. We also argue that Japan's economic experience contributed to theoretical and practical changes in the conduct of economic policies and, as such, contributed to the development of macroeconomics.
We highlight the many parallels between Europe and Japan, from the initial denial of the banking problem (often presented as a ripple effect of the U.S. financial crisis) to the skepticism about the impact of monetary policy among some Europeans. The difficult choices of European policymakers are also very close to those of their Japanese counterparts. For example, some of the monetary policy debates in Europe mirror the ones in Japan over the previous two decades. It is telling that in a conference on the risks associated with low inflation in February 2016, Mario Draghi, the president of the European Central Bank, refers to Paul Volcker's policy from 1979 and to Haruhiko Kuroda since 2012 as examples that monetary policy is not ineffective. Whereas earlier orthodox views claimed that the high inflation in the U.S. or the deflation in Japan were structural - and hence beyond the reach of monetary policy - both central bankers demonstrated that monetary policy can be effective.
Despite the similarities, several factors distort the comparison between Europe and Japan. With respect to the banking crisis for example, Europe was confronted early on in 2008 with a systemic crisis, thus avoiding the seven year delay in Japan between the end of the bubble in 1990 and the 1997 systemic crisis. Overall, both the supervisory framework and the state of the financial system is better in Europe than it used to be in Japan two decades before. Greater attention has also been given to the risk of deflation. Yet Europe has also specific weaknesses that were not present in Japan, related to the institutional framework and the coordination between countries or the lack of a common fiscal policy. Overall, we argue that the risk for Europe as a whole to follow an economic performance similar to Japan is lower, but the risk remains high for specific countries, especially at the periphery of the euro area.
In conclusion, we argue that Japan's economic performance over the past twenty-five years is much more diverse that the usual perception of an economy mired in a permanent decline. Despite some evident policy mistakes, Japan is not just a cautionary tale, but deserves a much more balanced assessment. Beyond countercyclical policies, we also allude to other areas (greater efficiency of public expenditures, higher senior labor force participation rates, innovation policies...) where Japan could also be seen as a model.
Brieuc Monfort is an Associate researcher at the Centre for Advanced French-Japanese Studies of Paris (CEAFJP). He worked earlier in his career for the French Treasury in Tokyo and at the International Monetary Fund (IMF) in Washington.