The Path from Economic Success to Disaster

A decade ago, many argued that Japan would overtake the United States as the world's pre-eminent economic power.2 Some even speculated that Japan, not the Soviet Union, was America's most pressing security concern. For instance, prior to his tenure as Secretary of the Treasury, Lawrence Summers stated that "an Asian economic bloc with Japan at its apex...is clearly in the making. This all raises the possibility that the majority of American people who now feel that Japan is a greater threat to the U.S. than the Soviet Union are right."3

These warnings seem misplaced today as Japan struggles to escape from its decade of economic stagnation and recession. Despite recent poor performance, however, there is no denying Japan's remarkable success over the past 50 years. With economic growth that outpaced the average of Western economies, Japan became one of the world's wealthiest nations on a per-capita basis. Growth in real gross domestic product (GDP) averaged 5.1 percent between 1960 and 1999, including a remarkable average of more than 10 percent during the 1960s. And Japan's GDP per capita increased fourfold from $5,343 in 1975 to $23,257 by 1998.4 This growth outpaced the OECD average on a purchasing power parity basis between 1975 and 1999.5 (See Chart 1.)

Japan's development from a war-torn economy to an economic superpower was based on its tradition of strong ties between the government and the private sector, which date back to the Meiji Restoration. This political and economic reform movement was launched in 1873 by a group of samurai who overthrew the ruling Tokugawa shogunate that had allowed Japan to ossify under a century of stagnation. The reformers were successful in invigorating Japan by entwining its traditional values of hard work, enterprise, and social cohesion with Western entrepreneurial institutions and practices. However, they also left a legacy of government-led industrial policy and market intervention, such as protectionism and managed trade.

While the Meiji Restoration set the stage for the industrialization of modern Japan, the process was completed in the post-World War II reconstruction period. The American occupation of Japan from 1945 to 1952, much like Admiral Perry's arrival in 1853, transformed Japan's society and economy. American reconstruction efforts focused on establishing a democratic government, decentralizing industry, devolving government authority, and broadening access to education. Although imposed by a foreign and victorious power, these changes corresponded with principles of the Meiji Restoration and, therefore, were more readily acceptable to the Japanese people than they might otherwise have been.6

The liberalized economy of post-war Japan, however, was not a free market. Japan's government remained actively involved in its economy, providing vigorous protections and concentrating on manufactures for export.7 Foreign investment was closely regulated and even discouraged unless Japanese partners retained control. The government subsidized new industries and the modernization of old ones; purchased patents and licensing agreements for promising technologies; and supported students and professionals studying abroad--all in an effort to encourage rapid industrialization.

Government intervention in the economy also included directing capital and resources into favored sectors, subsidizing exports and restricting imports, and artificially suppressing the value of the yen.8 Japan's financial system and interest rates were rigidly regulated and controlled by the government to support export-led economic growth.9 Additionally, government policies successfully encouraged high rates of household savings. Private markets played only a minor role in guiding those savings to the corporate sector.

Government activities were spearheaded through bureaucracies such as the Ministry of International Trade and Industry (MITI), the Federation of Economic Organizations (Keidanren), the Industrial Structure Council, and the Economic Planning Agency. These agencies maintained contacts with industry and other government bureaucracies to coordinate efforts, including working with the Development Bank to provide subsidized financing for favored businesses or industrial sectors.10 Such a coordinated strategy helped launch many Japanese industries as world market leaders of exports in their sectors.11 However, many private-sector industries, such as the auto, machine tool, and computer industries, defied government efforts to limit competition, and to the benefit of their businesses as well as the overall economy, their competitive efforts earned them great success in international markets.12

Weaknesses Camoflaged by Past Success

Following such a pattern of development, Japan was widely trumpeted as the ideal model for economic success in the 1970s and 1980s. Developed and developing countries alike, including even the United States, were urged to follow Japan's blend of industrial, trade, and financial policies of government-guided protectionism combined with an emphasis on capital markets, high personal savings, and an educated, disciplined workforce.13

But many of the policies credited for Japan's dramatic economic success in the 1970s and 1980s are now at the heart of its current malaise. The government's success in aiding certain industries, such as steel and auto manufacturing, is overshadowed by its failure to develop industrial dominance in other industries such as the chemical, plastics, aerospace, aircraft, and software industries.14 This suggests that government successes were achieved when policies simply boosted industries in which Japan had an existing comparative advantage but that government efforts to support industries that lacked comparative advantage were insufficient to counter market forces.

A Lost Decade

Japan must embark on a new economic path and depart from its "lost decade." In 1986, Japan began to experience rapid inflation in land prices and equity, and entered into what is commonly referred to as a "bubble economy." The bubble was created when the Bank of Japan pursued a policy of limiting the appreciation of the yen and simultaneously increasing liquidity and money supply. This excess liquidity was invested in assets, artificially driving up asset values.

The bubble burst when the Bank of Japan became concerned about the rapid escalation in asset prices and doubled the discount rate between May 1989 and August 1990, dramatically increasing interest rates and chilling new borrowing. The resulting collapse in asset prices led to Japan's most serious recession since World War II.18

This recession was the precursor to more than 10 years of stagnation and lackluster growth. (See Chart 2.) Japan has experienced a number of periods of real GDP contraction since 1990, and growth during this period averaged a dismal 0.37 percent. The recession of 1989-1990 hit the financial industry particularly hard by weakening balance sheets, and companies that were heavily invested in real estate took a strong hit.

Japan's response to the burst of the asset bubble was guided, as usual, by the powerful bureaucracy and was marked by denial, delay, and obfuscation. Asset prices fell below the borrowed values. In the United States, this would lead banks to call in loans or demand additional collateral.

In Japan, however, because of political pressure and business relationships, banks were reluctant to foreclose on bad loans that would show a loss, choosing instead to maintain non-performing loans on the books. Worse yet, many extended new loans to bankrupt businesses. (See Chart 3.) As non-performing loans account for an increasing portion of overall bank assets, there has been a decline in new loans, since debt-ridden banks lack the resources to extend new loans while they keep non-performing loans on the books. Failure to resolve bad debt has weakened the overall health of the financial system and stymied economic recovery.

The jusen--hybrid subsidiaries comprised of banks and insurance and securities firms--illustrate the problem facing the Japanese economy. First established in the 1970s to provide consumer credit, the jusen instead became heavily involved in the real estate bubble in the late 1980s.

Despite clear evidence of widespread insolvency throughout the jusen after the bubble burst, the Ministry of Finance did not close down the subsidiaries; instead, it allowed them to continue to operate based on the assumption that real estate prices would rise--a speculation that proved ill-founded. A 1995 Ministry of Finance audit of the jusen "found that of the total ¥13 trillion [$97 billion] of jusen assets, non-performing loans were estimated at ¥9.6 trillion [$72 billion], of which ¥6.4 trillion [$48 billion] was considered unrecoverable and ¥1.2 trillion [$9 billion] was considered a possible loss."19

The Current Malaise

Factors impeding the implementation of policies to address Japan's economic problems include bureaucratic intransigence, lack of political will, powerful interest groups with much to lose under reform, and the relatively minor impact of the crisis on the daily lives of the average Japanese citizen. This last is particularly important because it explains the lack of outrage among the Japanese people regarding the government's failure to take effective action.

Essentially, the Japanese government's strategy has been to borrow from international capital markets and live off the capital built up during its industrial boom a decade ago rather than undertaking painful but necessary reforms, overhauling weak industries and forcing banks to revamp lending practices. This has allowed Japan's citizens to maintain their standard of living, concealing the true costs of the lost decade of growth.

As a result, despite the economy's decade-long faltering, only in recent years has unemployment risen significantly and consumer spending fallen. (See Chart 4.) This delayed effect was the result of a government policy dedicated to propping up failing businesses to avoid restructuring and layoffs, which for a time allowed workers to continue their employment and consumption patterns.

The fact that unemployment has dramatically increased and consumption has decreased recently serves only to illustrate that government intervention can delay but ultimately cannot nullify the impact of poor economic performance. Instead of implementing the politically tough reforms necessary to restructure the economy and bring about a turnaround, the government has engaged in a series of ineffective stimulus packages and bailouts that have done little but increase the public debt, further exacerbating economic recovery. (See Table 1 and Chart 5.)

Government expenditure as a percentage of GDP has risen by 20 percent since 1990 and government debt has nearly doubled, due largely to the costs of large infrastructure projects and bailouts provided for the banking industry. Not only has government spending provided no discernible effect on economic growth, but the immense burden of national debt has escalated to levels that now raise serious doubt about Japan's ability to service it.

This deteriorating fiscal situation has been reflected in international sovereign credit ratings for Japan, which have been increasingly pessimistic. Since Japan was first graded in 1975, Standard & Poor's sovereign credit rating service consistently rated Japanese sovereign debt at the highest level. In the past year, however, Standard & Poor's downgraded Japan twice from AAA to AA+ to AA.20 Moody's Investors recently announced that it may further downgrade Japan's sovereign credit rating to that of the Bahamas and Botswana at A.21

While Japan's economic problems are not an imminent threat to international markets, there is no doubt that Japan's situation is worsening and that failure to reform will ultimately lead to a crisis. The situation will reach a point of crisis if Japan's sovereign debt rating falls below investment grade (BBB to AAA according to Standard & Poor's or Baa to Aaa according to Moody's). If Japan's sovereign debt should fall below investment grade, international investors would be reluctant to hold it and Japan would have to pay much higher interest rates to borrow in international capital markets. This would effectively put an end to Japan's budget policy of borrowing to finance domestic spending.

With the U.S. economy itself in a state of recovery, the Bush Administration must continue to pressure Japan to be aggressive in pursuing reform. After a decade of denying reality and refusing to implement the reforms necessary to spur a true economic recovery, the Japanese government must now undertake measures to salvage its own economy and ensure the stability of the global economy.

What Must be Done to Set Japan on the Path to Economic Viability

Prime Minister Junichiro Koizumi entered office in April 2001 on a wave of popular support for his campaign promises of much-needed reform. Nearly a year later, while political and economic reforms remain at the top of his stated agenda, little tangible progress has been made. Despite the efforts of his government, Japan has slid into its fourth recession since 1990 and unemployment has now exceeded 5 percent. Deflation is a reality, and non-performing private debt continues to hobble the banking system. In addition, extensive Keynesian-style stimulus initiatives through government-funded infrastructure projects have caused public debt to balloon.

The economic impact of a decade of lost growth is clearly illustrated by the decline of Japan's leading businesses. In 1989, reports Business Week, seven of the world's top 10 businesses according to market capitalization (including the entire top five) were Japanese. In 2001, not a single Japanese business was listed in the top 10 of the survey's list, and only two were in the top 25.22

Japan's lackadaisical attitude toward resolving these problems over the past decade can no longer be ignored. The Bush Administration obviously cannot solve Japan's economic malaise. That task awaits action by the government of Japan, particularly the ruling Liberal Democratic Party and current Prime Minister Koizumi.

Conclusion

Japan's economic performance in the past decade has clearly refuted the arguments of those who hailed Japan's economic system as superior to American-style capitalism. Japan's impending financial crisis belies such declarations as James Fallows' statement in 1989 that "Japan and its acolytes...have demonstrated that in head-on industrial competition between free-trading societies and `capitalist development states,' the free-traders will eventually lose."30

Rather than dominating the global economy, Japan is experiencing its fourth recession in a decade. Real estate prices have fallen to their 1982 value, leaving many people and businesses with mortgages greater than the value of their property. There have been four major bank bailouts since 1998. Whether Japanese industrial policy, protectionism, and autonomous bureaucracy contributed to Japan's rise or simply coincided with it, there is no doubt that these factors eventually destroyed Japan's economic vibrancy and are now hindering the country's recovery.

Japan's resistance to free-market capitalism is the source of its current malaise, and a failure to address this issue will make a future crisis in Japan inevitable. For the good of Japan and the global economy, the Bush Administration should work closely with the Japanese government and convince leaders of that nation to undertake long-delayed reform. If Japan is unable to forge a new path for recovery, its influence will continue to erode, and the centrality of the U.S-Japan relationship in Pacific affairs will correspondingly diminish.

Balbina Y. Hwang is Policy Analyst for Northeast Asia in the Asian Studies Center, and Brett D. Schaefer is Jay Kingham Fellow in International Regulatory Affairs in the Center for International Trade and Economics, at The Heritage Foundation.