Pity the Japanese economic policymaker. Even before the triple whammy of earthquake, tsunami, and nuclear crisis struck in March, Japan was facing the mother of all fiscal headaches. With public debt climbing to new heights, the government was facing an increasingly urgent dilemma: should it try to improve public finances with fiscal austerity measures, or continue to spend in the hope that the persistently weak economy would rebound.
That dilemma is even more pressing now. Japan faces the most expensive recovery bill in history and a serious setback to its economy. Under the circumstances, fiscal hawks will need to wait. But at some point, Japan will have to combine deficit reduction with fiscal expansion. Orthodox approaches that put one before the other haven’t worked so far, and given demographic trends they are unlikely to help in the future.
The Road to Crisis
It’s customary to blame the economic bubble era of the late 1980s for Japan’s current fiscal mess, but in fact the bubble was merely a symptom of an underlying condition: Japan’s postwar hyper-industrialization policy. Widely written about at the time, the policy turbocharged Japan’s reconstruction and industrialization. By the 1980s, though, it had reached the end of its effective life—Japan had caught up and was at full industrial capacity.
That left business looking for new places to put its money. Always a combustible situation, the Bank of Japan (BOJ) added a match when it cut interest rates to combat a rising yen. The cheap money encouraged speculation, called zai-tech (literally, ‘financial technology’), a curious term designed to sound cutting-edge and sophisticated, but which really signalled companies getting in way over their heads with ill-advised investments.
Noted Tokyo-based economist Richard Koo estimates that the inevitable collapse of the bubble wiped out 1.5 quadrillion yen in wealth—about three years’ worth of Japanese GDP. This compares to about one year’s worth of GDP lost by the United States during the Great Depression. Yet Japanese economic activity never experienced anything like the collapse seen in 1930s America. In fact, GDP never dropped below its bubble peak, even though private-sector borrowing and investment contracted sharply as corporations and banks struggled with a mammoth debt hangover.
Japan was able to avoid the soup kitchens because the government responded throughout the 1990s with the classic Keynesian approach of vigorous fiscal spending, which plugged the gap created by the collapse in corporate investment. Combined with dwindling tax revenues from the reduced private-sector activity, this spending expanded the public debt throughout most of the 1990s, albeit to still manageable levels. The approach had the same effect as US spending during World War II, which finally ended the Great Depression.
A Pernicious Problem
Now, had Japan been enjoying the same population growth as 1940s America, the Keynesian approach would have sufficed. A rising population would have created fresh demand for houses, cars, washing machines, TV sets, and other products, and as soon as corporate Japan had paid down its debt—and it mostly had by the 2000s—it could have returned to investing in productive assets once again.
But Japan entering the 2000s was in a very different position: the working population was already in decline, and this was soon to be followed by overall population contraction. Long-term population decline is unprecedented for a modern industrialized economy, and conventional economics really doesn’t have an answer for it, because a shrinking population busts important assumptions about investment and borrowing. And yet the demographic impact on Japanese business is often overlooked by economists, including Keynesian spenders who are still waiting for the private sector to pick up the reins.