Japan: A Road Not to be Taken By Guest Blogger Buck Klemkosky

Japan experienced stock market, credit and real estate bubbles in the late 1980s, but with more intensity than the U.S. experienced later. Prior to 1990, the Japanese economy and financial system was considered to be superior to the U.S. as expressed in several books, such as Japan as Number One (1979). Japanese society was considered to be more thrifty and conservative than Western societies. By hindsight Japan was not immune to speculative euphoria and bubbles.

Japanese euphoria was reflected in both stock prices and real estate prices. By the end of 1989, the market value of publicly traded Japanese stocks exceeded those of the U.S. even though the size of their economy was of one-third that of the U.S. Stock valuations were astronomical even compared to the dot.com era in the U.S. While the stock market was soaring, the real action was in the property markets. By the end of 1989, Japanese property was valued four times more than that in the U.S. The grounds of the Imperial Palace in Tokyo were supposedly worth more than all of the real estate in California. Real estate prices in Japan had never declined in the post-WWII period, so investors, including households, corporations and banks, were convinced that property price increases were a certainty.

This increased stock market and real estate wealth eventually fed into the credit markets and the financial system. A massive credit bubble evolved based upon the stock market and real estate bubbles – a nasty combination of corporations, banks and individuals all on a speculative binge. It couldn’t end well and it didn’t.

The Nikkei index peaked at 38,900 in December 1989 and eventually declined more than 80 percent. Property values started to decline in early 1990 and also eventually fell 80 percent. Both have never recovered. The economic consequences of the bursting of the bubbles were catastrophic and long lasting. Banks were technically insolvent and became “zombie” banks. The corporate and household sectors suffered massive losses. Japan has never fully recovered from the collapse of the bubble economy even after two decades. Economic growth has been stagnant and deflation has been a problem. Japan has other issues, such as demographics, but there is no more talk of Japan Number One. In fact, Japan has recently become the third-largest economy in the world after China.

If this all sounds familiar, it should. The U.S. experienced the same phenomena with the stock market, real estate and credit bubbles that collapsed in 2007-2009, but with less intensity and magnitude and also without corporate sector involvement. Japan has been a role model for the U.S. as what not to do when bubbles burst and affect the financial system and real economy. Hopefully Japan’s experience is not a glimpse of the U.S. future after the financial crisis.

Japan has a long-term problem of a declining and aging population and virtually no immigration; the population peaked at about 130 million and is expected to decline to 87 million by 2060, and 40 percent will be over 65 years of age. Since economic growth is a function of population growth and productivity, Japan has to have higher productivity to overcome a declining population just to maintain the same growth as other developed countries. A difficult task. The other major problem has been political leadership; Japan has had 15 prime ministers in the last 20 years. Not a good recipe for making tough economic changes.

Many think, including quite a few Japanese, this may have changed when Shinzo Abe was elected prime minister last year and his political party has taken control of both houses of Parliament, resulting in political stability for several years. He has instituted economic reforms referred to as Abenomics. It may be the last chance Japan has to rid itself of its economic paralysis.

Abenomic economic policy has three main arrows as dubbed by the media. Arrow number one is monetary easing. Because of low or zero economic growth and deflation, Japan has the lowest interest rates in the world, so that tool of monetary policy is not operable. So the Bank of Japan (B of J), like the U.S. Fed, has instigated a massive quantitative easing program. Their goal is to double the monetary base (money supply) in two years. But there are risks associated with this first arrow. The balance sheet of the B of J is already large relative to Gross Domestic Product (GDP); it has doubled in size in 2013 and is the largest relative to GDP among developed countries. At some point, investors may lose confidence in the central bank and then the banking and financial system.

The second arrow is a massive stimulus package. This is nothing new as Japan has had several in the past. They have resulted in recurring government deficits; Japan’s government debt to GDP is 245 percent, one of the highest in the world, especially for a developed country. Again, a risk is bond investors lose confidence in the Japanese economy. Most of the debt is held domestically and denominated in yen, so it will be Japanese investors who may eventually question the credit worthiness of Japanese government debt; some foreign investors already have. No one knows where the tipping point is for the ratio of debt to GDP, but there is one. To alleviate this problem, Japan plans to raise the consumption tax from 5 percent currently to 8 percent in 2014 and possibly 10 percent in 2015.

The third arrow is longer term and involves structural reform of the Japanese economy. This would include industrial revitalization, deregulation, lower trade barriers, new markets for industry and a more global outreach for society. This may be the most difficult of the three arrows to achieve. Japan has world-class multinational corporations and most are doing well, like the auto companies, but some, such as several consumer electronics firms, are faltering. But it is primarily the corporate structure below the large multinationals that needs to be revitalized.

The aim of the three arrows of Abenomics is economic growth. There are signs that it may be working in the short term. Japan has had three quarters of solid economic growth, and consumer confidence has picked up as well as stock and property prices. Like Bernanke and the Fed, the Japanese government and B of J are targeting 2 percent inflation by 2015. With deflation, it pays to delay consumption as goods and services will be cheaper. So a little inflation may help domestic consumption.

Another result of Abenomics is that the yen has depreciated from 78 yen per U.S. dollar to 98 per U.S. dollar. A weaker yen will not only make Japan’s exports more competitive, but imports more expensive, helping foster a little inflation. Recent inflation has been close to 1 percent annually, but most of this is due to higher energy costs due to the weaker yen.

Perhaps Abenomics is the last chance for Japan to reverse more than two decades of stagnant economic growth and deflationary pressures. It may take time and be painful to some in society, but change is needed. Monetary easing and the stimulus may help in the short term, but structural changes of the third arrow are prerequisite to long-term economic growth. Given a declining and aging population, growth in domestic consumption is problematic, especially if base salaries remain stagnant. Exports would help the Japanese economy but slow global economic growth weighs against that. All developed countries would like to export more, including the U.S. but exports and imports are a zero sum game in totality. So the global economy may not be the solution either.

Japan has painted itself into a corner economically. Even though Japan is playing a diminished role in the world economy, it is important to the U.S. to have a strong Japan, given the growth of China, both economically and militarily. If these arrows of economic reform don’t work, especially the third arrow, there may be none left in the quiver. Let’s hope three are enough.