Satyajit Das: Japan's 20 years of struggle hold a warning to other economies

Midweek View: The state can provide palliative care in a crisis but it may have limited ability to restore financial health

Japan's two decades of stagnation and Prime Minister Shinzo Abe's recent initiatives to revive its economy may provide insights into the world's economic problems.

Since the collapse of the bubble in 1990, Japan's policymakers have implemented a variety of stimulus programmes. Japan's public finances have deteriorated as the government has run large deficits, leading to an increase in government debt, which is now about 240 per cent of GDP. Monetary policy has been highly accommodative, including zero interest rates and multiple rounds of quantitative easing since 2001.

Despite these measures, Japan remains trapped in a period of economic stagnation. Policies designed to alleviate the slowdown have created anomalies and delayed essential structural changes, compounding fundamental problems.

Investment has increasingly been misallocated into expanding manufacturing capacity and excessive infrastructure spending, reducing returns on investment and Japan's potential growth rates.

The excessive manufacturing capacity and low domestic demand has exacerbated reliance on exports and a high trade surplus to balance production with demand. This puts upward pressure on the yen, reducing Japan's ability to be competitive as an exporter.

Much of the government-financed infrastructure investment is not productive. After the initial boost to activity, this investment – bridges, roads and tunnels – requires perpetual maintenance expenditure, absorbing scarce government resources.

Low interest rates allowed debt levels to remain high. They reduced income for savers, decreasing consumption and encouraging additional saving for retirement.

The low rates also allowed weak businesses to survive in a zombie-like state, where they exist to continue paying interest on loans. Banks avoided writing off loan assets, tying up capital and reducing lending to productive enterprises. The creative destruction necessary to restore the economy did not occur.

There are similarities and differences between the collapse of Japan's bubble economy and the post-Global Financial Crisis ("GFC") economies of developed nations. In both cases, low interest rates and excessive debt build-ups financed investment booms intended to drive recovery from recessions. Both ultimately collapsed. Both were characterised by overvaluation of financial assets and banking system weaknesses. Policy responses to the crisis have also been similar.

Japan's problems occurred against a background of strong economic growth in the global economy. Strong exports and a current account surplus partially offset the lack of domestic demand, buffering the effects of the slowdown in economic activity. The global nature of current problems means that individual countries will find it more difficult to rely on the external account to support their economies.

While its ageing population has increasingly compounded problems, Japanese demographics at the commencement of the crisis were helpful. Its older population had considerable wealth. Low population growth meant that fewer new entrants had to be accommodated in the workforce during a period of slow growth, alleviating problems of rising unemployment.

Reflecting a homogenous society and a stoicism shaped by its history, Japanese citizens were receptive to the sacrifices and transfer of wealth necessitated by the economic problems. The demographic and social structure of many troubled economies may not accommodate measures required to manage the crisis, without significant breakdowns in social order.

In reality, Japan highlights the difficulty of engineering recovery from the effects of major deleveraging following the collapse of a debt-fuelled asset bubble. It reveals the constraints of traditional policy options: fiscal stimulus, low interest rates and debt monetisation.

The Japanese experience suggests that the state can provide palliative care to an economy in crisis but may have limited ability to restore economic health. The real lesson from Japan's experience is that the only safe option to a prolonged period of stagnation is to avoid a debt-fuelled bubble and subsequent build-up of public debt in the first place.

Satyajit Das is a former banker and author of 'Extreme Money' and 'Traders Guns & Money'

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