The Pulse of Capitalism

Issue 98-2, July 1998

The Japan Puzzle

The March 21 issue of the Economist devotes several articles to a discussion of what it calls "The Japan Puzzle." Initially, it has some difficulty defining just what that puzzle is. One article states:

"Not long ago, foreigners looked to Japan to see how things were done. The Japanese economy was the envy of the world, and its financial markets the source of stupendous wealth. Countries scrambled for Japanese investment. Much of it poured into America - to buy bonds, property and companies, and to build factories for Japanese manufacturers who had reinvented entire industries such as consumer electronics and car making. Japanese firms were studied as models of efficiency and innovation, and their ideas of employee involvement in quality control and design were put to work around the world. (p 21)

"Now, however, (Japan) invites despair, as it fails to escape from the economic stagnation of this lost decade, fails to reform its shaky politics and corrupt bureaucracy, and fails as a result to be able to lead East Asia out of its troubles. (p 15)

"So far, this has been more a cause for disappointment than for serious concern. Look around Tokyo or any other big Japanese city and you will not see the boarded-up shops or streets full of beggars that were typical of American or British cities during those countries recessions in the early 1990's. Japan is affluent, its living standards are high, and its unemployment is low.

"How has Japan, which was so lauded for the effectiveness of its government, got into such a condition? In a way, the problem is that there has still been no real crisis. There has been a vast fall in share and property prices, a succession of bankruptcies, a long saga of scandal, Yet, precisely because all those misfortunes happened to one of the worlds richest and most resilient countries, nothing has yet forced Japan to get to grips with its three biggest problems: the political vacuum at the heart of its policy-making; the sclerotic effect of interest group privileges; and the demoralizing effect of a limping financial system. (p 15)

"How, (foreigners) ask, could so many talented people make such a mess of things in so short a time? That is the Japan puzzle. The answers are complex, but unravelling them points the way for Japan to get out of its mess. (p 21)

The articles then go on to trash the Japanese bureaucracy, particularly the finance ministry, which they assert to be the wellspring of all legislation in Japan. "Since then (the mid 1950's), practically all new legislation has started life at some low level within a ministry." So Japan's problems are all due to the failure of its bureaucracy to come up with good new laws - a strange proposition for a publication that believes there should be as little governmental action in the economy as possible. Even more strange, the articles make almost no reference to the economy itself, aside from the financial problems.

The importance of Japan in the world economy cannot be overstated. Its economy is larger than those of Britain, France, Italy and Canada combined. Sixty percent of the development aid going into East Asia comes from Japan, compared with 30 percent from the European Union countries and only 8 percent from America. With billions of dollars already invested in Southeast Asia, Japanese companies are buying bigger shares of cash-strapped joint venture partners. One out of three products manufactured in Southeast Asia - from glass to computer parts to VCRs - comes from a Japanese subsidiary or joint venture. (Bus. Week 4/20 p 60) Japan's economy, the world's second largest, is equal to about 38 percent of the United States'.

The actual performance of the Japanese economy may be gauged from the following data:

It is important to keep in mind that the collapse in stock and property valuations occurred in 1990-91. These events ushered in the present slowdown just as the stock and banking collapse in the U.S. in 1929-30 ushered in the Great Depression. Since then, growth in real GDP, industrial production and retail sales has been significantly slower than in the years before, while unemployment has grown. Financial institutions have been weak due to losses on loans and declines in asset valuations, with a consequent disinclination to extend new credit. But the Japanese current account surplus, after declining, rose in 1997 to $94.7 billion, and Japanese foreign reserves are at an all time high of some $220 billion.

The Japanese response to the downturn has been essentially Keynesian. Interest rates have been reduced to virtually zero, while public works spending has soared. "Tokyo has pumped more than $550 billion into various packages since 1993. That is roughly twice what Germany spent on reunification." (Bus. Week 4/13 p 29) These projects are usually regarded in the western press as boondoggles. "At the time, (1985) big public works programs and other boondoggles were the only thing that kept the economy from contracting." (Econ. 4/14 p 42) This view may be mere carping, but the spending programs have had only limited and temporary success in reviving the Japanese economy. With "too much capacity, too much debt, rising interest costs, falling demand, declining profits: corporate Japan is clearly in trouble." (Econ. 3/14)

With unemployment inching up to a record 3.6 percent (well below the U.S. rate of 4.7 percent), it is easy to see why economic commentators are perplexed and frustrated by these developments. The Western prescription of deep, permanent tax cuts to "revive demand" contains a hint of desperation, and is clearly self-serving. The U.S. has fostered the illusion that its huge trade imbalance with Japan could somehow be redressed if Japan would only "open up" its markets to additional imports. Periodically diplomatic tiffs are conducted to force some policy change that results in more oranges or chips or even automobiles being imported, but these changes are minor, and with stagnant demand, almost meaningless. Moreover, since the Japanese already have a huge store of savings that they decline to spend on additional consumption, why would tax cuts cause them to do so? Also, tax cuts would further expand the government's budget deficit and debt, which have been rising since 1993. Government debt now exceeds 80 percent of annual GDP, compared with around 60 percent in the U.S. Ironically the Western prescription for Japan is the exact opposite of what it has been for their own economies - namely to balance the budget and cut government spending.

It is likely that the current situation in Japan is simply an historic and inevitable stage in its economic development. As a result of their earlier successes and in response to protectionist pressures from other countries, Japanese manufacturers have now located factories in Asia, Europe, and the Americas, and they are still being expanded. Inevitably, they reduce the potential for growth at home. At the same time, physical limitations come into play. Japan's area is only a little more than half the area of Texas, and consists of hundreds of islands. American style homes of more than 2,000 sq. ft. are out of the question for the vast majority of Japanese. Consumption, accordingly, is modest by American standards. At the same time, there are constraints on the amount of infrastructure that can be economically justified, critics complain about the construction of bridges "that lead to nowhere in particular" and about "paving river bottoms." Traditionally, there has been a close relationship between the ruling Liberal Democratic Party and the construction industry.

These developments were, inevitably, going to affect growth at home. Exports from Japan now compete with exports from Japanese plants located abroad. These plants will earn profits for Japanese manufacturers but they will create few jobs at home. According to data published by the Economist, retail sales volume in Japan has been stagnant for at least six years, not just the past few months. With rising unemployment and falling profits, this pattern is likely to persist.

The Japanese experience has much in common with the western experience of the 1930's. In both cases, a financial collapse ushered in a long period of economic malaise. Banks failed, credit contracted, and a long series of scandals were unearthed. Governments tried to rescue businesses in financial distress (Reconstruction Finance Corp.) and resorted to public works spending to stimulate demand. None of these efforts succeeded, and it was not until World War II produced massive spending on all-out production that the depression ended.

These episodes reveal the basic contradiction of existing capitalism. Economies prosper only so long as there is continuous high growth (about three percent or more yearly). At the same time, endless high growth is not possible. Resources and, eventually, even technology have limits. As those limits are approached, we must find ways to involve all members of society in the productive process and its rewards with or without growth. Conservation will then replace exploitation and the pursuit of culture will supersede the pursuit of markets.

GDP growth continued strong during the first quarter in all countries except Japan; the Japanese decline deepened. The growth reflected high industrial production and strong retail sales.

Short term interest rates rose above the levels of the past two years in all five countries, and consumer prices advanced as well. Stock markets showed no sign of slowing and, at the time of writing, are again reaching new highs. Unemployment rates were little changed during the period, as the British rate is skewed due to a change in methodology.

The Japanese current account surplus grew in the first quarter, the German balance turned positive, and the U.S. deficit increased. Most foreign currencies weakened against the U.S. dollar, which regained the relative value it experienced in the base year of 1973.

Real GDP increased 4.8 percent in the first quarter over the preceding one. The increase was due to a sharp upturn in consumer spending and to a step-up in business spending for equipment.

Industrial production was strong but, through April, the index has remained below the December level of 127.9. The capacity utilization rate has been falling since December as well. Manufacturers' new orders show a similar pattern; orders through March remained below the November level.

New construction continued to advance in the first quarter, but the contracts index was slightly lower. Real investment, however, has been rising strongly since 1995 and this trend continued. The biggest contributors to this uptrend have been producers' durable equipment and inventory accumulation.

Business and retail sales and inventories continued to rise moderately, while inventory-sales ratios have stayed relatively low. Real per capita consumption again advanced strongly as disposable income rose and personal saving fell slightly. Underlying all these rising indicators, non-farm employment continued to grow at the same fast pace that has prevailed since 1993.

National income advanced a strong 3.8 percent in the first quarter, primarily in compensation of employees. Real per capita income rose 1.9 percent, and average weekly earning grew $6.46.

Gross saving rose at an annual rate of $99.2 billion thanks to a large increase in government saving and a smaller increase in business saving. The increase in government saving was due entirely to an increase in the current surplus of the government.

The commodity price index slumped below the 1990 base due primarily to weakness in metals prices, which by March were only 75.9 percent of the base level. Excess capacity underlies the weakness even though demand is strong. Producer prices also exhibit weakness; through March, the index had fallen for five consecutive months. Corporate profits peaked in the third quarter of 1997 at $827.3 billion but have been below that level since then. These three areas may presage a coming slowdown.

Interest rates at the long end slumped sharply in the first quarter; by March, the ten year rate was just .62 percent above the three month rate, whereas during 1997 it was 1.28 percent higher. M-3 money supply growth accelerated further over the high 9.1 percent change in 1997. Commercial bank loan growth also accelerated but consumer credit growth slowed. Credit market debt expanded at the high rate reached in the fourth quarter of 1997.

The deficit on goods and services accelerated in the first quarter as the goods deficit increased while the services surplus was little changed.

Investment flows both into and out of the U.S. slowed drastically in the first quarter. Whether this is due to Asian problems is unclear at this time. Acquisition of Treasury securities by foreigners fell precipitously, but purchases of other U.S. securities remained strong.