16 February 2015
Japan's economy -- from miracle to mystery to pious hopes

Japan's economy -- from miracle to mystery to pious hopes

After four decades of miraculous development, Japan's economy then experienced twenty years of mysterious stagnation. Despite "Abenomics" new hopes, hope is now turning to despair, argues John West.

After four decades of miraculous development, Japan's economy then experienced twenty years of mysterious stagnation. The advent of "Abenomics" two years ago brought new hopes, but hope is now turning to new despair, argues John West.

Out of the ashes and destruction of World War 2 (which finished seventy years ago), Japan enjoyed over four decades of miraculous development. In the 1950s and 60s, annual economic growth was around 9-10% (the same as China's in its first three decades of the reform period). It then slipped down to the still respectable 4-5% in the 1970s and 80s, again as China's is also slipping down today.

But since crisis struck Japan around 1990, growth averaged around 1%, reflecting a sharp slowdown in productivity growth. Full catchup to the US economy is a vain hope, as Japan's GDP per capita is stuck at around 70% of the US's.

Role of infrastructure

One critical factor behind Japan's post war rise was the government's rapid reconstruction of the nation's infrastructure, notably trains, roads, ports and airports. According to the World Economic Forum, Japan now has the world's sixth best infrastructure, just behind Hong Kong, Singapore, UAE, the Netherlands and Switzerland, and just ahead of Germany. The US is further down the list at 12th.

Japan has outstanding airports, with each connected to their cities by trains and buses. Tokyo's subway, which began operation in 1927, today has 13 lines, 290 stations and a daily ridership of 8.7 million. Japan was also the world's first country to build a high speed train service, with its Shinkansen or "bullet train". The first one opened in 1964, linking Japan's two largest cities of Tokyo and Osaka. The present network links most of Japan's cities in Honshu and Kyushu. Tokyo's successful hosting of the 1964 Olympic Games was a testimony to the rapid rebuilding of its infrastructure after the World War 2.

But there is also a dark side of Japan's "construction state" through collusion between politicians, government officials and construction companies. This involves large-scale bid-rigging (dango), financial kick-backs from construction companies to politicians and government officials, wasteful infrastructure projects (white elephants), and construction companies acting as vote-gatherers and money donors for political candidates.

Some argue that today, after more than two decades of fiscal stimulus spending, Japan has too much infrastructure. Indeed, Japan's experience shows that while hard (physical) infrastructure is crucial for development, soft infrastructure in the form of education, and a creative, entrepreneurial culture may be equally, if not more important.

Role of education

Japan's very well educated workforce clearly helped foster its miraculous development. Even today, the Japanese are one of the world's most educated peoples. Japan features in the world's top ten (well ahead of the US and Germany) in the OECD's PISA study, which measures the performance of 15 year olds in mathematics, reading, science and problem-solving (the city of Shanghai has topped the last two editions of PISA, in 2009 and 2012).

Japan also came top of the OECD's recent survey of adult skills (PIAAC) which tests literacy and numeracy in 24 advanced countries. Although performing slightly less well than their male counterparts, Japanese women rank highest among the women covered by this survey, and ahead of men in most other OECD countries.

Despite its excellent performance in these surveys, many questions are asked about the quality of Japan's education system, and its relevance in the 21st century. Like much of East Asian, Japan's education systems still emphasizes rote learning and memorization. Students are trained at performing tests in cram night schools. The costly nature of cram schools is a source of inequality, as poor families cannot afford to send their kids to cram schools. It is also one factor behind Japan's low birth rate. Long hours and lots of homework contribute to student stress and are reportedly one factor behind high student suicide rates.

Japanese students are less strong when it comes to critical thinking, problem solving, creativity and self expression. English language skills, essential in today's service-driven economies, are mediocre at best in Japan. And the education system could do much more to foster an entrepreneurial and risk-taking culture, and an international orientation. Less and less Japanese students now undertake studies overseas, in sharp contrast to their Chinese counterparts.

The reflections of Japanese Nobel Prize winning scientist Susumu Tonegawa are insightful. In an interview with the Japan News on January 8, 2015, entitled "Only individual thinking can make big discoveries", he said:

"Having spent a half century abroad since I went to the United States to study, I now regard Japan as a society rather dictated by rules. Within a fixed framework, the Japanese are able to produce things with extreme precision. The Japanese are traditionally good at detail-oriented work, and the quality of handicrafts and dyed goods is remarkable.

After the war, they developed industry by combining reliable precision technologies to make excellent automobiles, for example. Their high-level technologies were not something that other countries could easily copy.

A climate that respects individualistic thinking — thinking not bound by conventional wisdom — will produce revolutionary discoveries that shatter the framework.

Unlike the Japanese, Americans put their own ideas first, and what others think of them is secondary. It is essential to have education that respects individual abilities and preferences."

Post-war nation building

We should not underestimate the motivation to rebuild the nation after the trauma and humiliation of war-time defeat and American occupation. The nation was mobilized for reconstruction, in a similar spirit to its mobilization for war. This legitimated a prominent role for the state in postwar recovery. And the US government, which was concerned about the communist threats surrounding Japan, provided financial support in the early years, and open markets for Japanese exports, which played a crucial role in Japan's post-war nation building.

Some suggest that once Japan had basically caught up with the West, it lacked a national project and vision. What to do next? And while Japan remains a very strong US ally, China is now capturing much more of the US's attention. Indeed, it is widely agreed that the US/China relationship may well be the most critical relationship for global peace and prosperity. Japan, America's staunch ally, is now slipping on to the back-burner.

Exports and the development state

As a nation dependent on imports of energy and other natural resources, Japan focused on export-oriented development, as export revenues are necessary finance imports. And the Japanese government played a very active role in transforming Japan from an exporter of low-tech to a sophisticated high-tech manufacturing products.

Infant industries were assisted by subsidies, barriers against imports and foreign investment, and privileged access to finance ("the developmental state"). This assistance gave Japanese industry a jump-start, some breathing space for 'learning by doing', and enabled it to exploit economies of scale. While Japan did not practice free trade, it exploited its comparative advantage, based on its skilled and hard-working population.

This development strategy, engineered by the "iron triangle" of business, bureaucrats and politicians, was very successful in engineering the upgrading of the Japanese economy. But not all attempts to foster infant industries worked, such as the cases of aviation and chemicals. And while close relationships between banks, enterprises and their suppliers ensured stability, too many financial decisions were based on such close relationships, rather than rigorous credit assessment, resulting in many bad loans.

From export miracle to bubble economy

As Japan's exports flooded world markets, and it racked up large trade surpluses, Western governments pushed back. They tried to limit Japanese exports through protectionism, and encouraging Japanese enterprises to invest in their markets.

In 1985, Western leaders pushed Japan to allow the yen to rise through the 'Plaza Accord'. As the higher yen adversely affected the export-dependent Japanese economy, the government responded with an easy money policy.

This easy money was one factor behind a subsequent bubble in Japanese stock and real estate prices. From March 1986 to December 1989 stock prices rose by 130%, while land prices increased by 60% from March 1986 to September 1991.

The other factor driving the bubble was hubris and irrational exuberance. Many in Japan did not see this as a bubble. They genuinely believed that the country's stock and land were worth these exorbitant prices. During the height of the property bubble, the grounds of the Emperor's Palace in Tokyo were valued by some as more than the value of all the real estate in the state of California.

By the 1980s, Japan had become a new global power, while the US was seen at the time as a declining power. In the US, there were genuine fears of the rise of Japan, just as there are in some quarters about the rise of China today.

Japanese companies went on an international spending spree, as Mitsubishi bought the Rockefeller Center in Manhattan, and Sony bought Columbia Pictures. Japanese banks, the biggest in the work, seemed to be taking on the world, as manufacturers had done before them.

Not surprisingly, in retrospect at least, following a small increase in interest rates at the end of 1989, Japan's bubble began bursting. Japan's stock and land prices came crashing down, wiping out billions in wealth and leaving the nation's banks, enterprises and citizens with mountains of bad debt. In fact, enterprises were left with three excesses -- debt, staff and capacity.

Japan thus entered a balance sheet recession. With debt exceeding assets for many companies and citizens, Japan started a long period of deleveraging, as debt was paid off and assets rebuilt.

Japan's perfect storm

In the early 1990s, Japan found itself not just in a financial crisis, but in a perfect storm, a rare combination of circumstances.

As financial crisis was striking, it had also become clear that the developmental state model had run out of steam. Japan's export-oriented manufacturing sector was very competitive, and continued protection was now counter-productive for an innovation-driven future. By contrast, the inward-looking service (like retail, energy, distribution) and agricultural sectors had very low productivity and were very inefficient.

It was time to remove the protections and assistance of the developmental state, and open the service and agricultural sectors to international competition in order to boost their productivity and efficiency. And yet the very success of the development state model, and the constellation of interests that coalesced around it, have made subsequent reform difficult, as Mark Beeson has argued. This includes the parachuting of retired officials into high-level corporate positions, known as amakudari.

Further, the effects of Japan's rapidly aging population were beginning to bite. Japan's work force began declining in 1995.

More generally, the post-war international order was changing. 1989 saw the end of the Cold War, with the fall of the Berlin Wall. 1992 saw the rehabilitation of China following the 1989 Tiananmen Square incident, with Deng Xiaoping's southern tour. In the early 1990s, South Africa turned the page on apartheid, while Latin America put its lost decade behind it. At the same time, Hong Kong, Korea, Singapore and Taiwan had confirmed their status as rising Asian powers.

In short, we had entered the era of globalization, and Japan needed to adapt to this more open and competitive global landscape.

Responding to the storm

This perfect storm required a rapid, decisive and comprehensive response. Banks should have been recapitalized. Good companies should have been saved, bad ones should have failed. Liberalization and deregulation of the developmental state should have been launched as a new source of growth.

But that was not to be. Japan went through the five stages of grief -- denial, anger, bargaining, depression and acceptance.

The government reacted too slowly to the crisis. Banks also reacted too slowly, with many "zombie" (insolvent) companies hanging round for years. With much finance absorbed by zombies, less finance was available for new entrepreneurship.

Japan thus entered a period of post financial crisis stagnation, now referred to as "Japanization".

Why the slow response to the crisis?

First was the sense of disbelief. But there was also no acute sense of crisis, like a foreign exchange shock. Japan was perversely protected from market discipline by its large foreign exchange reserves. More fundamentally, as Mark Beeson has argued, "the developmental state is deeply socially embedded in a complex inter-locking array of institutions which are resistant to rapid change".

From "Japanization" to Abenomics

There have been multiple symptoms of the Japanization syndrome of economic stagnation following the financial crisis.

Over the past two decades, Japan's economic growth has been around only 1%. Deflation (falling prices) has been a recurrent feature, and is both a cause and a consequence of stagnation.

Gross public debt has risen to 250% of GDP, the highest in the OECD group of countries. This is the product of continuous attempts to stimulate the economy, low tax revenues fron the weak economy, and the social costs of its aging population. Working age citizens are now losing confidence in the capacity of government to finance their retirement, further exacerbating economic weakness.

Japan's life time employment system has been gradually frittering away, as companies search for more flexible working systems. Some 40% of Japan's workforce have "irregular" status, either part-time, casual or short-term contracts.

The gap between rich and poor is growing, as is poverty, another factor driving down demand. This trend is the product of growing irregular employment and a declining share of national income going to labor.

Restrictions on immigration remain draconian, despite the growing need for imported labor. For example, population aging and construction for the 2020 Olympic Games has led to reports of labor shortages. And Japanese mothers who might wish to return to full-time work are unable to find nannies for their children.

While the Japanese government and big business worked hand in hand to build a strong Japan in the post-war period, corporate interests now seem more motivated by overseas investment, especially in Asia, than investing in Japan. They are chasing the fastest growing markets, which are now elsewhere in Asia. There has thus been a significant hollowing out of Japan's industrial base, pushing wages down.

Today Japanese companies boost economies and productivity overseas, and create many jobs (1.4 million jobs in the US automobile industry alone, for example). But Japan receives a fraction of the same benefits in return because of continued restrictions on inward investment. Despite present efforts underway to attract investment, the stock of foreign investment in Japan represents 4% of GDP, much less than that of even North Korea.

About two years ago, Prime Minister Shinzo Abe launched his "Abenomics" initiative, with the three "arrows" of monetary expansion, fiscal stimulus, and structural reforms. The monetary and fiscal arrows provided a short-term fillip to the economy, though their effects have already faded. But very few structural reform initiatives ("the third arrow") have been taken.

However welcome this Abenomics initiative might be, it comes two decades too late. Moreover, it is fundamentally ill-conceived. The structural reforms to unwind the developmental state will certainly have a negative short-term impact. The process of creative destruction, whereby new dynamic activities replace old inefficient ones, takes time. It is thus critical for the three arrows to be launched at the same time, rather than sequentially, for the stimulus of the first two arrows to balance the short-term negative effects of the third.

Today, Japan is in an aweful predicament, weighed down by an aging and declining population, massive debt, an inefficient economy, and a lack of fresh dynamism. As the old saying goes, "when you are in a hole, you should stop digging". In other words, Prime Minister Abe should stop caving into vested interests and show more decisive leadership.

Overestimating our rivals

For the West, and especially America, the fate of Japan has been a very big surprise. It had previously overestimated the strength of the USSR, based on its space program, without seeing the rot inside the economy. And it then overestimated Japan based on the strength of its export industries, without seeing the weakness of its domestic economy and the poverty of its politics.

Could today the West be also overestimating the strength of China, in light of the fragility of its authoritarian system?
Tags: japan, infrastructure, weforum, global competitiveness report, education, oecd-pisa

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