Japan, nominally lost, not really so
Al Breach was Russia economist with UBS and Goldman Sachs and is currently managing partner of TheBrowser.com. The views expressed are his own.
HOSTENTAL, Switzerland – How bad was Japan’s “lost decade”? As we look east for clues as to the possible fate of western economies, it is worth dwelling on what actually happened, and not just how it was reported.
Japan’s stock market bubble burst at the end of 1989, and house prices started to fall about a year later. Asset prices at the peak were wildly inflated. Stock prices were trading at ratios of well above 50 times boom-time earnings, while the total value of housing represented around 300 percent of GDP.
These bubbles had formed after decades of rapid growth and, critically, even more rapid credit expansion. Total bank credit to the private sector had risen to 200 percent of GDP, doubling over 20 years.
What dominated the following years was the private sector trying to deal with that debt. The result was soft demand, as surplus cash flows and wages were used to pay the debt down.
This led to frequent recessions. The amount of credit in the economy fell, because of a lack of demand and a reluctance on the part of weakened banks to lend. True, Japan’s predicament differed from our own in one big respect: it was Japanese companies, rather than consumers, that were excessively leveraged. But this still affected consumption through wages, asset prices and low or non-existent dividends.
Japanese policymakers, faced with such a dramatic change from the “Japan no.1″ they were used to, made serious mistakes. They failed to cut interest rates quickly enough. They got down to 0.5 percent only in 1995. More importantly, they took ages to get to grips with the devastating impact of falling asset prices on bank balance sheets. They allowed banks massively to under-report their non-performing loans and thus avoid recapitalizing themselves.
Only in 2002 did they finally tackle this. But policymakers did prop demand up by massive deficit spending. Gross public debt surged from 70 percent of GDP to 180 percent of GDP today. And a good portion of this expenditure was financed by the Bank of Japan — narrow money more that tripled between 1990 and 2008.
Meanwhile, the fact Japan’s society was aging, not reproducing much, and not open to immigration, meant that its workforce and population started to contract modestly. This contributed to weak demand growth and exacerbated the problem of overcapacity in the economy.
But although mistakes were made, the outcome was not the disaster it is often presented to be. The combination of the forces unleashed — deleveraging, excess capacity, zombie banks and companies, and the aging, closed society on the one hand; the huge stimulus packages, budget deficits and money-printing on the other — resulted in a dull but not disastrous reality.
Disinflationary forces reigned, leading to flat prices and the mild deflation of 1998-2005, when consumer prices fell a cumulative 3 percent. But real growth, incomes, and spending per capita — driven by the steady, hard-won productivity improvements — were decent, if not great.
Nominally Japan did poorly. In the chart below, 1990 GDP = 100:
The reason? Declining credit there; booming credit here. Claims on the private sector as a percentage of GDP:
But real output per working person was similar in each:
And consumption, too, except in the debt-guzzling UK. See real household expenditure per capita:
In other words, while the nominal record was indeed poor the real record was rather better. And it is the real outcome that counts. Who cares what the market value of a house is if you continue to live in it, are able to service the liabilities you took on to buy it and your income is modestly up?
Indeed, some would even argue that the experience has been good for Japanese society. An unhealthy obsession with growth-at-all-costs has given way to a renewed focus on quality of life. Many people, particularly the younger generation, have turned their back on the salary-man culture. Unemployment never soared.
What makes the example of Japan since 1990 so relevant to the west now is that we face a similarly sized debt mountains (c200 percent of GDP), built up over a similar period, and accompanied by big real estate bubbles.
What can we learn from Japan’s experience? The biggest lesson is that it is hard to generate nominal growth in an economy where debt is not growing because people are deleveraging — even if you chuck vast amounts of money at it.
Notwithstanding zero interest rates, rapid base money growth and big fiscal deficits, anaemic nominal growth can well be the outcome, made up largely of real growth (driven by productivity gains, not demand increases) and flat or even falling prices.
In short, the rapid credit expansion was what drove much of our nominal growth before 2008. Without it, nominally we’ll struggle, but really we should be all right.
And there are actually reasons to think that much of the West will fare better than Japan.
For the U.S., the housing bubble was smaller, peaking at 160-170 percent of GDP, and has adjusted much more quickly — it is now down to more normal 110 percent or so. Meanwhile its stock market was only modestly over-valued versus historic averages, rather than Japan’s crazy bubble. The policy response has been much more impressive too: rates were cut rapidly and the banks have been forced to recapitalise relatively swiftly.
Germany, and quite a lot of continental Europe, meanwhile never really experienced a bubble. And no western country suffers the same structural rigidities that Japan did (and largely still does).
That said, things look more worrying for the United Kingdom and the likes of Ireland and Spain. The policy response has again been much better, but the starting point was more closer to Japan’s: housing peaked in the UK at 260 percent of GDP and has declined only modestly so far. The departure of east Europeans and a rising nationalist backlash against immigrants means these countries could face a declining labour force.
Most importantly for Britain, North Sea oil and gas — a huge, if often overlooked, boon these last three decades — is declining rapidly, exacerbating future fiscal and trade deficits.
But even for the British, Irish and Spanish, where a Japanese outcome is more likely, this doesn’t mean the outcome will be disastrous. Instead, the likely nominal outcome is low or no inflation, slow nominal growth and flat or declining asset prices at home. But real output and income should be tolerable.
On the bright side — and there is one even for capitalists — rates should remain low, emerging markets should boom, and commodity prices with them.
The simple lesson from all this? Just as a borrowing binge leads to a boom — fast nominal growth, made up of rapid investment growth and some inflation — the inevitable subsequent bust brings with it mass deleveraging with low investment and inflation. But all the while, productivity growth — the main driver of progress over the decades — chugs along unless demand is allowed to completely collapse, 1930s-style.
With western governments following 1990s Japan in doing enough to avoid such a depression, a “dull” period of soft nominal but tolerable real growth is our probable fate.