1. INTRODUCTION
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Much has been said about the stagnation in the Japanese economy and a variety of interesting reasons have been put forth for the reason Japan continues its secular stagnation more than 20 years after its bubble burst in 1991. Michael Pettis, for example, has examined this issue in great detail from the demand-side. His demand-side research provides clear insight into Japan’s growing imbalances in the 80s, its efforts to correct those imbalances (i.e. ‘rebalance’) in the 90s, and the resulting stagnation in Japan that was but a necessary consequence of this rebalancing.
Source: http://mpettis.com
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For the general reader, here is a quick synopsis of Michael’s demand-side analysis of Japan’s stagnation:
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A) Imbalances keep growing during the 80s
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In the 80s, particularly after the credit-binge response to the Plaza Accord, investment grew faster than GDP while consumption was suppressed such that GDP-growth exceeded consumption-growth (i.e. Japan had investment-driven growth in the 80s).
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This led to a growing imbalance in the economy, with consumption-share of GDP falling and investment-share of GDP rising in an unsustainable fashion during that period.
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B) The Inflexion Point arrives
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The Bank of Japan, which had dropped interest rates in response to the Plaza Accord in 1984, raised interest rates sharply in 1990 to ‘cool-off’ the credit-binge driven investment-bubble. As seen in many other cases all over the world, the sharp-increases in the interest-rate finally burst the bubble in 1991.
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C) Imbalances are corrected during the 90s
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The collapse of the credit-bubble led to a collapse in investment-growth, leading to a sharp slowdown in over-all GDP-growth, and was accompanied by a smaller slow-down in consumption-growth during the 90s. During this 'rebalancing' period, therefore, investment-growth was lower than GDP-growth and consumption-growth was higher than GDP-growth (i.e. Japan shifted to consumption-driven growth in the 90s).
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This led to a slow rebalancing of the economy, with consumption share of GDP rising to more sustainable levels and investment share of GDP falling in a corrective fashion (i.e. rebalancing) in the 90s.
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D) The stagnation was a natural result of rebalancing
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Just as the credit-bubble induced investment-binge had ‘pulled up’ GDP-growth (i.e. created imbalance) during the 80s, the collapse of investment growth-rates after the bursting of the credit-bubble ‘pulled down’ GDP-growth (i.e. rebalanced) during the 90s. This was the cause of the lost-decade in Japan in the 1990s and this low growth continues to this day.
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Michael's rigorous demand-side analysis has certainly revealed good insights into Japan’s imbalances, its efforts at rebalancing and the resulting stagnation there. However, his demand-side research does not shed any light on the famous “Two Japanese Puzzles”.
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2. THE FIRST JAPANESE PUZZLE
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When the terms ‘bursting of a debt-bubble’, ‘lost decade’ or ‘stagnation’ are used, most economists immediately think about what happened in Latin America (e.g. Brazil, Mexico) during the 1980s. They recall the pain & misery they saw across the continent after the bursting of the petro-dollar debt bubble in 1981, with high unemployment, falling productivity, stagnant economies and falling living standards in what came to be called the ‘lost decade’ of Latin America.
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And yet, when the same economists travelled to Japan during the 90s, they saw no such pain or misery. This left them ‘scratching their heads’ and they spoke of a Japanese ‘puzzle’ which they just could not understand. How was it possible for Japan to ‘stagnate’ into a ‘lost decade’ without any pain and misery? This is called the First Japanese Puzzle.
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In order to understand this issue, it is first important to go over what happened in Latin America during the 1970s & 80s.
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2.1 The Latin American Example
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We note that Michael has already explained the Latin-American example from his demand-side viewpoint, and so the following overview is merely a brief synopsis (or quick recap) of his previous work for the convenience of the hurried reader.
Source: http://mpettis.com
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As in Japan, we can divide the critical period of the Latin American crisis into three phases: (a) the growing of the imbalances, (b) the inflexion point, and (c) the correcting of the imbalances.
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A) Imbalances grow during the 70s
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The rise in oil prices in the 1970s led to trade surpluses in OPEC countries and these petro-dollars surpluses were then recycled into Latin America as debt.
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This petro-dollar debt created a debt-driven investment bubble that resulted in spectacular GDP growth in Latin America during the 1970s.
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Rapidly-rising debt-financed investment led to investment-share of GDP rising spectacularly during the 1970s, partly driven by the rise in the petro-dollar current-account deficit.
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B) The Inflexion Point arrives
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Once oil-prices began to fall from 1980 onwards, the petro-dollar oil-surpluses of the OPEC countries vanished.
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With the vanishing of the ‘oil-savings glut’, international interest-rates rose and lenders began calling in the previous loans issued to Latin America so that they could lend to Paul Volcker who was offering amongst the highest interest-rate at that time.
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Faced with the demand for repayment, Latin America was caught without sufficient foreign-exchange reserves, and a textbook balance of payment (BOP) crisis followed, forcing the IMF had to bail everybody out.
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C) Imbalances are corrected during the 80s
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The Latin-American countries began to correct the imbalances (i.e. rebalance) by switching to current account surpluses during the 80s. This surplus was used to pay-back the IMF and the remaining lenders for the petro-dollars that had been lent to Latin America in the previous boom-decade.
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In order to run this surplus, either investment growth, or consumption growth, or both, had to collapse such that capital could be exported to retire the debt.
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D) Stagnation is a natural consequence of the Rebalancing
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This export of capital from a capital-starved Latin-America naturally resulted in a severe reduction in GDP growth after 1981, thus leading to its ‘lost decade’ in the 90s as it slowly paid back the debt from the previous decade.
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Almost overnight, Latin-America switched from being a growth-leader of the world in the 70s to being a growth-laggard that trailed the rest of the world in the 80s.
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2.2 Why Japan is different from Latin-America
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When we look at the ‘lost decade’ of the 1980s in Latin America from the supply-side, we can see the pain & misery that resulted from rising unemployment, falling productivity, falling living standards during the decade of low GDP-growth.
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On the other hand, when we examine these same ‘misery index’ parameters in Japan during its own ‘lost decade’, we see no such pain & misery. The rise in unemployment was modest, and neither productivity nor living standards fell during the 1990s.
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These differences are the symptoms of the underlying essence of the “First Japanese Puzzle”. To resolve this puzzle, we need to further understand the differences between Japan and Latin America and explain the underlying reasons behind why Japan’s ‘lost decade’ was not as painful as Latin America’s. In order to do this, we need to go beyond Michael’s excellent demand-side analysis of Japan and also look at things from the supply-side.
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3. A SUPPLY-SIDE ANALYSIS OF JAPAN
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In order to determine the supply-side cause(s) of Japan’s stagnation, we should compare it to an economically-similar country that is known to be not stagnating. By carefully observing the differences between the supply-side sources of growth between them, we can then isolate the underlying cause(s) of Japan’s stagnation. The natural comparison for Japan would be with the other economic powerhouse in Eurasia-- Germany.
We will use a standard supply-side analysis as follows:
We will use a standard supply-side analysis as follows:
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(a) Comparative trends in total GDP
(b) Comparative trends in per capita GDP
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The supply-side sources of this ‘growth’ are:
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(i) Comparative trends in the Productivity
(ii) Comparative trends in the Participation-rates
(iii) Comparative trends in the Demographic Profiles
(iv) Comparative trends in the growth of Population
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Quick summary: On the whole, it looks like Japan’s productivity growth matched (or slightly surpassed) Germany’s and so productivity (unlike in Latin America in the 80s) cannot be said to be the cause of Japan’s ‘stagnation’. Japan’s population was as steady as Germany’s, with Germany actually having slightly lower population growth, and so population cannot be said to be the cause of Japan’s ‘stagnation’. It appears that the only real difference between Germany and Japan lies in their composite demographics. Japan had worse demographics than Germany, and this is the only reason that Japan is said to be ‘stagnating’ and Germany is not.
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Using this supply-side analysis, we are now is a position to explain why the Latin American stagnation of the 1980s was so painful, whereas the Japanese stagnation of the 1990s (and often said to continue to this day) was not:
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1) Latin-America had a favorable demographic profile when it entered into its ‘stagnation’ period in the 80s. This implied that even as the stagnant economy in the 1980s created very few jobs, a large number of workers were entering into the workforce due to the falling age-dependency curve. This is what led to the misery of very high and rising under-employment (or unemployment) in Latin American during its ‘stagnation’ in the 1980s.
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On the other hand, Japan had a deteriorating demographic profile when it entered into its ‘stagnation’ period after 1991. This implied that even as the stagnant economy in the 1990s created very few jobs, a large number of workers were retiring from the workforce and fewer were entering due to the rising age-dependency curve. This is what led to the relatively modest rise in unemployment rates (which are still below that of its European counterparts) in Japan during its ‘stagnation’ in the 1990s.
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2) Latin-America had a rising population (i.e. higher population-growth at 2.25%) when it entered into its ‘stagnation’ period in 1981. This implied that even as the stagnant economy in the 1980s created very little additional wealth, a large of new “mouths” entering into society needed to get fed. This is what led to the misery of falling per capita GDP (or falling living-standards) in Latin American during its ‘stagnation’ in the 1980s.
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On the other hand, Japan had an approximately steady population (i.e. minimal population growth of 0.3%) when it entered into its ‘stagnation’ period in the 1991. This implied that even as the stagnant economy in the 1990s created additional wealth more slowly, it did not face the problem of a large number of new “mouths” to feed. This is what allowed the per capita GDP to keep from falling (or prevent falling living-standards) in Japan during its ‘stagnation’ in the 1990s.
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3) Latin-America was a capital-poor deficit-continent when it entered into its ‘stagnation’ period in the 80s. When it was forced to pay-back its lender during its ‘stagnation’ period by running a surplus, it was effectively ‘starved’ of capital. This is what led to the falling productivity in Latin American during its ‘stagnation’ in the 1980s.
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On the other hand, Japan was a capital-rich surplus-country, and the debt-problem created by its post-Plaza credit-boom was entirely internal. Therefore, it was not forced to payback foreigners and was hence not starved of capital during its ‘stagnation’ in the 1990s. This allowed Japan’s productivity to keep rising (and keep pace with its European counterparts) even during its ‘stagnation’ in the 1990s
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Having used the supply-side analysis to explain the underlying reasons why the Japanese stagnation has not been as painful as that experienced in Latin-America, we have now resolved the much-mentioned “First Japanese Puzzle”.
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4. ANALYSIS OF DATA
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Here are the tabulated end-point data for Japan extracted from the World Bank data linked in Section 3 above:
Similarly, here are the tabulated end-point data for Germany extracted from the World Bank data linked in Section 3 above:
Here is the tabulated comparison between the supply-side sources of growth over the last 20-years between Germany and Japan:
Observations: From the data, we can see that non-stagnant Germany grew faster than stagnant Japan over the last 20 years only because Japan had a ‘headwind’ due to its deteriorating demographics, while Germany had a ‘tailwind’ because its demographics had not deteriorated to the extent of Japan. In every other respect, Japanese growth outperformed German growth over the last 20 years and this is an astonishing achievement for a country that is universally-derided for being in ‘stagnation’.
Observations: From the data, we can see that non-stagnant Germany grew faster than stagnant Japan over the last 20 years only because Japan had a ‘headwind’ due to its deteriorating demographics, while Germany had a ‘tailwind’ because its demographics had not deteriorated to the extent of Japan. In every other respect, Japanese growth outperformed German growth over the last 20 years and this is an astonishing achievement for a country that is universally-derided for being in ‘stagnation’.
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If Japan’s stagnation was caused only by its deteriorating demographics, as the supply-side analysis indicates, how does this tie up with Michael demand-side explanation that the stagnation was caused by rebalancing? Clearly, GDP is GDP, whether we examine it from the demand-side or the supply-side. Therefore, both explanations must simultaneously be correct. In fact, it is only when we combine this supply-side explanation with Michael’s demand-side explanation that we are finally able to explain why Japan’s rebalancing stagnation has been so much less painful than Latin America’s rebalancing stagnation in the 1980s.
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5. CONCLUSIONS
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Japan has now been in a very long period of stagnation and is the subject of numerous studies. Some economists have argued that Japan should run higher fiscal-deficits (Keynesianism), while others say that it should reduce its fiscal-deficits and contain the rise in government debt (austerity). Some economists have suggested that Japan should increase QE (unorthodox Friedmanism), while others argue that it should stop debasing its currency (classical). Some economists have recommended the throwing of the kitchen sink at the problem, while others suggest allowing that sink to remain where it is in the kitchen. Regardless of the approach, however, it has been observed that nothing seems to work. Regardless of what action Japanese government takes, the secular-stagnation trend just seems to continue. Why does the Japanese economy not respond to anything? Why does it continue sleeping the Long Sleep? This is the known as the Second Japanese Puzzle.
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5.1 The Futility of being Abe
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Shinzo Abe wants to bring Japan out of its stagnation by using the ‘Three Arrows’ of (1) Fiscal stimulus, (2) Monetary Stimulus, and (3) Structural-reforms. Let us examine these Arrows of Abe closely:
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A) Fiscal-stimulus and monetary-stimulus are policy methods used to pull an economy out of a low-equilibrium trap in which a high structural-unemployment rate keeps employment below the natural full-employment level (implying that output stays below maximum potential). But Japan’s stagnation is not being caused by high structural-unemployment. Japan does not have an unemployment problem at all, as its unemployment-rates are amongst the lowest in the world.
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B) Structural-reforms (e.g. flexible labor-laws, minimal regulation) are policy methods that are used to raise productivity via efficiency-increases and so bring an economy out of a lower-productivity equilibrium trap. But productivity-deficiency issues are clearly not causing Japan's stagnation. Japan does not have a productivity problem at all, as its productivity-growth has matched or exceeded most of its counterparts in the developed world. Japan today has the same productivity as most of its equals in the industrialized world.
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Clearly, given that Japan already has technical full-employment and high productivity, the Japanese economy is at its maximum potential-output by definition. It follows, therefore, that the ‘Three Arrows’ of Abe will only be trying to solve problems that Japan does not even have. None of his Arrows will have one iota of effect on the stagnation problem, because they will have no effect on the core cause of Japan’s stagnation: deterioration in its demographics factors. Therefore, it follows that anything that Abe does with his ‘Three Arrows’ will merely be an exercise in futility.
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5.2 The Second Japanese Puzzle
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This explains why Japan’s economy has not responded to all the various things that have been tried for the past 20 years. All those actions were based on a bouquet of economic theories that were developed in order to solve classical problems that Japan currently does not have. The problem Japan does have today is one that has never been encountered in history, and so no economic theory has ever been developed to handle it. Faced with a historically-unknown problem, Japan has responded over the last 20-years by desperately trying a variety of old solutions, none of which is actually relevant to the problem at hand. This is why Japan continues to sleep the Long Sleep.
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Having understood the common reason behind the failures of the plethora of policies tried over the last 20 years, we have now resolved the much-discussed “Second Japanese Puzzle”.
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5.3 The Fat Lady Sings
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Given that deteriorating demographics are the sole reason for Japan’s continuing stagnation and that Abe’s ‘Three Arrows’ cannot possibly help with that, we see that the only thing that can bring Japan out of its stagnation is immigration.
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Immigration is the only solution that can pull Japan out of its long stagnation. As seen in Germany, the arrival of working-age immigrants immediately increases the participation-rate. If they do not bring their dependent families with them, they also immediately improve the demographic age-dependency profile. In addition, if they come from countries with a culture of higher birth-rates, as seen in the US amongst Hispanics, their eventual family-formation helps prevent population growth-rate from falling too quickly and hence prevents the age-dependency profile from skewing excessively to the ‘old’ side too fast. Still further, arrival of immigrants and their families can also prevent the overall population from falling, as is now seen in Germany.
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However, given that Japan, as an ethnically-pure country, has never accepted immigrants and does not view itself as a society that can ever accept immigrants, immigration is not an option for Japan. Once we accept this as an iron-clad fact, we arrive at the inevitable conclusion that Japan is going to stay in a state of secular stagnation indefinitely. Japan is now inexorably entering into a high-income trap, and will never be able to escape it.
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It is over, because the Fat Lady is singing.
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