Japan: Paying the piper 30 years on

Monday, November 9th 2015, 7:00AM

by Andrew Hunt

“Monetary Policy can only take growth from other countries or borrow it from the future” – Masaaki Shirakawa, during a private conversation, September 2015.

For obvious reasons, Japan was not represented at the original Bretton Woods Conference in 1944 but it was nevertheless decided around 1949–50 that the Japanese Yen should be a member of the system. Reliable legend has it that, at a dinner, McArthur's then economic advisor Mr. Dodge was informed that “yen” literally translates to circle and armed with this piece of information, Dodge chose Y360 as the yen's starting point against the dollar in the Bretton Woods System, an exchange rate that it maintained until 1971 when the system broke apart. Admittedly, given that Japan was suffering hyperinflation during the late 1940s, it is difficult to know with any certainty just what FX rate should have been chosen but economic histories suggest that the Yen would have been more fairly valued at Y250.

As a consequence of this seemingly random event, Japan experienced a long period of currency undervaluation and this, together with the government's penchant for heavy intervention and state planning, biased the economy towards what we would argue as an excessive development of its traded goods sectors. Over the Post-War period, Japan significantly overinvested in its traded goods sectors with the result that it virtually always enjoyed a surplus of goods production over the level of prevailing domestic demand that it was naturally obliged to export. Hence, Japan started to experience endemic trade surpluses, although its domestic economy frequently suffered “shortages” of non-traded goods and services, a situation that resulted in the high prices of the latter relative to traded goods.

During the late 1970s and early 1980s, the heightened level of global instability buffeted Japan along with the rest of the world but, by the mid-1980s as the world economy settled, Japan's trade surpluses were back in earnest and trade friction was unsurprisingly rising with its partners. It was then decided around the 1985 G5 Summit that the dollar should depreciate and the Deutschmark and Yen appreciate, with the result that, over the next 18 months, the Yen virtually doubled in value abroad and Japan's trade-dependent economy looked set to suffer a recession (that some in the Bank of Japan (BoJ) hoped would finally lead to a restructuring and modernisation of the domestic economy).

Rather than adopting a deregulation approach to the slowdown, though, Japan's government adopted for a massive easing of domestic monetary policy and the domestic credit-fuelled Bubble Economy/Heisei Boom was born. During the Bubble Economy, Japan's corporates and some of its households borrowed so aggressively that the private-debt-to-GDP ratio doubled in the space of four years and much of the borrowed money was poured into property speculation and the creation of industrial capacity. Because Japan's economy was still subject to many of the rules, regulations and established modes of behaviour that had been used to rebuild its industrial base in the 1950s, it was perhaps not surprising that the private sector used the credit boom to build “more of the same” with the result that, implicitly at least, Japan needed ever-bigger trade surpluses to justify its newly expanded capacity and to pay for servicing the new debts that had been incurred. Unfortunately, in the post-Savings & Loan Crisis/Gulf War I world, Japan could not achieve the surpluses that it needed.

With some considerable help from the then-new BoJ Governor Mieno (who, from all contemporary accounts, was philosophically opposed to the credit boom), Japan's economy slowed sharply from 1991 onwards and, despite a “false alarm” recovery during 1994, by the mid-1990s Japan's corporate sector was beginning to wilt under its high debt burden and relative lack of sales growth. Moreover, the all-important Yen exchange rate was seemingly being driven ever-higher by the corporate sector's constant attempts to source funds from abroad, either via the trade surplus or via the repatriation of its foreign assets. As the outlook for the economy deteriorated, Japan's government decided to enact both an easier fiscal stance and some measures that were designed to attempt to reverse the Yen's appreciation.

It was no doubt hoped at the time (as it is in China today) that the easier fiscal stance would have an immediate and powerful impact on economic growth, but in reality this was not the case. Certainly, the government expanded the fiscal deficit by building its infamous “bridges to nowhere”, but once companies received the public money, they tended to use it not to finance new investment (of which they had already done too much) but to retire some of their troublesome debt burdens. Hence, as the government's budget deficit soared, the corporate sector's deficit contracted and became a surplus; the government's money was in a sense swallowed up by debt repayments within the corporate sector and the result was what we at the time referred to as a debt-to-debt swap, corporate debt was replaced with public debt on the balance sheets of the banks. In the US, we suspect that a debt-to-equity swap might have occurred under these circumstances but, despite Japan's massive household wealth, its financial markets were not up to such a task.

The other “strand” of Japan's mid-1990s strategy was perhaps even less successful. The Yen was pushed down from Y85 towards Y120 but the effect of this was to trigger (or at least act as the catalyst for) the Asian Financial Crisis of 1997, an event that so weakened world trade trends at that time that Japan's weaker FX rate provided it with relatively little gain in terms of achieved export growth. Its attempt to take growth from the rest of the world failed because Japan and the Yen were simply too large relative to the system that they were operating within – a situation that, rather surprisingly, remains the case even today. It seems that whenever the Yen is weak, so too are world trade trends.

Thereafter during the 2000s, Japan's policymaking meandered through unfulfilled promises of structural reform, experiments with QE/Zero Interest-Rate Policy and a number of fiscal initiatives (in both directions), but these policies at best provided only temporary salves to what was a fundamentally compromised economic system, with the result that as Japan entered the 2010s, it was an economy that still possessed significant excess capacity within its manufacturing sector (that is, actual output remained well below what could theoretically be produced given the country's stock of either physical capacity or labour), an extraordinarily high level of public debt and a poor productivity performance. This was the economy that Abe inherited and he was certainly correct in his assessment that something needed to change.

As ever, what Japan needed at this time was structural change but, as ever, there were too many vested interests, with too many political connections, to allow this to happen quickly (hence the lack of progress on the third arrow of Abenomics). Therefore, Abe's strategy became an awkward hybrid of a desire for a lower FX rate (to take growth from other countries...), an attempt at an easier domestic monetary stance through Qualitative and Quantitative Easing (QQE) and a tighter fiscal stance in an effort to control the rate of growth of public sector indebtedness. In the marketing “materials” that accompanied Abenomics, the fiscal tightening was rather inventively portrayed as an easier fiscal stance, while the likely effects of the third arrow and the monetary easing were significantly overhyped in our view.

In reality, we must wonder if outside the impact on the FX rate (which has provided immensely damaging to the global trade environment – see above), it was ever intended that monetary conditions would actually ease. In a highly indebted and aging society, ultra-low interest rates have been shown to often do more harm than good and even the BoJ's asset purchases look suspiciously more like an attempt to take Japanese Government Bond (JGB) risk away from the commercial banks and to put it on the balance sheet of the non-profit-maximising central bank. Certainly, whatever may have been the original aim, the impact of Abenomics on real world monetary conditions has been very modest simply because the bonds that the Bank of Japan purchased tended to be sold to it by other banks – a transaction that had no real impact on the rest of the economy.

Given that the weak Yen has played a not-insignificant role in weakening world trade trends, we should not be surprised to find that, aside from some profit-translation effects, Japan has not gained from its weaker currency (in fact, had it not been for the fall in oil prices, it might even have lost some income as a result of the Yen-induced rise in domestic import prices). Moreover, as we show above, the impact of QQE on domestic monetary conditions in the real economy was very modest at best and certainly not enough to offset the impact of the tighter fiscal regime.

Andrew Hunt International Economist London

Tags: FX