What if Japan really did recover?

Economic revival in the Land of the Rising Sun would pose some interesting challenges for policy makers

THE JAPANESE GDP figures for the first quarter of 1999 came as a major surprise to financial markets in all parts of the world. The increase in real GDP of 7.9 per cent (quarter-on-quarter annualised) was not only the first positive return for 18 months, but more than half of this increase stemmed from a rise in private demand, thus raising hopes that a self- sustaining recovery (ie not reliant on fiscal stimulus) might at last be under way.

Breaking the demand components down further, the rise of 10.5 per cent in private capital expenditure raised even more eyebrows than the 5.0 per cent jump in private consumption. Less surprising, of course, was the 48 per cent increase in public fixed investment which followed directly from the implementation of the latest fiscal package.

Japanese GDP data have, in the past, been subject to some fairly strange quarterly aberrations, and this is probably just another one among them. To some extent, the first quarter data probably represent a bounce-back from the catastrophically weak numbers in the final quarter of 1998. Furthermore, the stimulus from public expenditure will peter out in the second half of this year.

Nevertheless, the figures published last week raise two key questions. The first is whether a self-sustaining recovery in private -sector economic growth is in fact now under way in Japan. The second - which might appear perverse - is whether it would be good or bad for the rest of the world economy, if such a recovery did indeed happen.

On the first question, most forecasters have been very reluctant to take the latest Japanese GDP figures at face value. Although private demand has rebounded encouragingly in the past few months, longer-term trends in the data counsel caution. Japanese GDP has stabilised in the past 12 months solely because of an almost unprecedented boost from public investment, which has added over 2 per cent to the level of GDP. Meanwhile, despite the first quarter rebound in private demand, this crucial component has still subtracted almost 2 per cent from GDP over the past year, primarily because of the decline in private investment. Hence, the big picture over the past 12 months has remained one in which the economy has been almost wholly reliant on fiscal stimulus in order to prevent a complete meltdown in growth.

It is dubious whether this big picture has really changed so far this year. A major overhang of excess capital equipment still plagues the economy, and the prospective rate of return on new capital expenditure is still very low compared to the real interest rate faced by companies. On private consumption, the outlook might be a little more hopeful, since the savings ratio seems to have started declining, following the shocks to financial confidence experienced last year. However, real disposable income is still set to decline by 0.4 per cent this year, and a further drop in the savings ratio seems far from assured, given the deteriorating picture for employment and personal income. Most independent forecasters therefore continue to take the view that there are deep-seated fundamental reasons why the private sector in Japan will remain weak, and that the economy cannot return to the 3-4 per cent per annum growth rates which were commonplace a decade ago. But what if this gloomy consensus is wrong? What would happen if Japanese economic growth really did return to "normal"? Obviously this would be wonderful for the citizens of Japan. But it would certainly pose some interesting new challenges for policy makers in the rest of the world.

There is no avoiding the fact that the weakness of the Japanese economy - and to a smaller extent the weakness of continental Europe - have been key ingredients in the "new world economic order" of the 1990s. This new world order has of course been dominated by the record-breaking upswing in the American economy, which in turn has relied to a remarkable extent on an inflow of capital from the rest of the world.

Naturally, this flood of capital has in part been attracted into the US for positive reasons, notably the high rates of return to be earned on investments in America, especially in hi-tech industries, and up to now there is not much evidence that this is changing. But in part we have simultaneously been observing something more negative - an exodus of capital from the ailing economies in the rest of the world. Many investors have simply been seeking to avoid the low interest rates and plummeting rates of return available on investments in Japan and in continental Europe.

It is the capital flows driven by this process which have financed the large American trade deficit, while simultaneously pushing up the value of the dollar. And a rising dollar has been crucial in helping to restrain inflation pressures in the US, thus enabling the Federal Reserve to keep down short term interest rates. At the end of this virtuous circle for the US economy has been the sky-rocketing stockmarket and surging consumer confidence. Hence, by a very circuitous route, the craze among American moms for e-trading in their kitchens has been fuelled in part by the economic troubles of Japan and continental Europe.

Until now, most economists - and indeed the US administration in Washington - have taken it for granted that a self-sustaining upswing in the rest of the world would have to be good for America, since it would boost exports and therefore cut the trade deficit. This would indeed occur. But it is critical not to overlook the fact that the trade deficit is only one part - and quite often not a very important part - of the overall balance of payments. For most of the 1990s, the dollar and other major exchange rates have moved in the opposite direction from that which would have been implied by the behaviour of trade deficits and surpluses, for the simple reason that capital flows (ie the cross-border purchase of factories, equities, bonds etc) have been more than sufficient to swamp the trade accounts.

If Japan and Europe were to embark on a strong recovery, the same could easily be true in reverse. Jan Hatzius of Goldman Sachs has recently pointed out that there is a correlation (as any free market economist should expect) between the relative return on investment in the US compared to foreign economies, and the resulting inflow of capital into America from overseas (see graph). A pick-up in GDP growth overseas would certainly raise the return on capital in Japan and Europe, and this may lead to a large drop in the capital inflow into America. Consequently, even though the US trade deficit should improve under these circumstances, it is quite likely that the dollar could suffer a sharp setback, thus puncturing the virtuous circle which has supported the American stockmarket.

For the whole of the past decade the US government has been urging the authorities in Japan and Europe to adopt more growth-friendly policies. It would indeed be a strange irony if, in eventually persuading the rest of the world to follow the Anglo-Saxon model, Washington managed to kick away a key prop supporting its American economic miracle. Fortunately for them, however, the chances of the Japanese suddenly embarking on a miracle of their own seem just about as far away as ever.

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