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Disinflationary economy? Made in Japan.

What is happening to Japan’s economy? Once the envy of the world, Japan has been in the doldrums since 1990, when its economic bubble of the late 1980s burst and the Nikkei stockmarket slumped. Since then Japan has only enjoyed short bursts of economic growth. This contrasts sharply with the US, where the economy has been buoyant and the Dow Jones index has soared. The last three years have been particularly turbulent in Japan. In spring 1995 the yen reached 80 to the dollar, appreciating to such an extent that it was pushing Japan to the brink of recession and financial meltdown. The government responded with a three-pronged policy attack, pushing the yen weaker, cutting official interest rates to an all-time low of 0.5% and unveiling a huge fiscal stimulus. This policy worked. Confidence recovered and in 1996 Japan enjoyed the fastest growth within the Group of Seven (G7) industrialised economies. Alas, this did not last … Believing the economy was on the road to recovery, the government decided it was time to remove its stimulus and tighten policy. The timing could not have been worse. It wanted to tackle the problem of Japan’s budget deficit. Japan has a rapidly ageing population: in 1990, one in eight people were over 65, but by 2020 one in four will be pensioners. This points to a big future welfare bill. To be able to cope, Japan has to aim for medium-term fiscal consolidation, improving the government’s budget position and reducing its debt. Unfortunately, last year was not the time to start addressing this future problem. Although the economy had grown strongly in 1996, the recovery had not yet become self-sustaining, with confidence fragile. The best way to address a budget problem is strong economic growth, which boosts tax revenues and lessens the need for government spending. The solution chosen by the Japanese government was to hike taxes and cut spending. If this course of action is chosen, the economy needs to be strong enough to cope. The Japanese economy was clearly not able to cope with the shift in government policy. In April 1997 taxes were raised. Consumer spending and the economy slowed sharply. Worse was to follow. Last summer’s Asian currency crisis was a big shock for Japan. Business confidence suffered since Japanese firms were big exporters to the rest of Asia and had many subsidiaries throughout the region. Furthermore, Japanese banks had lent heavily to Asia, although they were not the only ones. The combination of tax increases and the Asian crisis led to a significant shake-out in Japan, which is still continuing. Banks have taken a very cautious approach to lending, preferring to write off their bad loans. The weakness of the economy provided a big incentive for Japanese firms to restructure. Although deregulation and restructuring can bring longer-term rewards to an economy, the immediate impact can be negative. So it is proving in Japan. In response to last year’s problems and in an attempt to compete internationally, firms are cutting back, reducing unsold inventories, curbing investment and shedding labour. Output has fallen and unemployment has risen. As the economy has weakened the government has had to relent on its fiscal conservatism, reverting to its old ways and boosting spending. Japan is the world’s biggest saver and second largest economy. Problems in Japan should concern us. Because of the Asian crisis, the current performance of Japan’s economy becomes even more critical. As the major economy in Asia, a recovery in Japan is crucial for improvement in the region. For this reason Japan has been put under great pressure by the rest of G7 to do more. As the Americans have said, Japan should be a solution to Asia’s problems, not a symptom of them. If the Japanese economy does not recover it could exacerbate problems in Asia. A weak Japan provides no boost to the Asian economy and results in a weaker yen, threatening competitiveness elsewhere and triggering another round of currency devaluations. In recent weeks the news from Asia has not been good. In addition to Japan’s difficulties, there has been evidence of a slowdown in China and poor data in Hong Kong and South Korea. Riots in Indonesia highlight the social tensions resulting from economic difficulties. Faced with weakness at home, Asian economies are trying to export their way out of trouble. This is difficult if Japan is in recession. Although the US and Europe are growing, prospects in both regions are far from certain. Asia is exporting low inflation to the rest of the world. Devaluations have improved the attraction of Asian exports, reinforcing global competition and exacerbating trade tensions. The financial markets are naturally sceptical of Japan’s prospects. Despite aggressive government help in the early 1990s, the economy has stayed weak. There is a difference between now and then. Since it all started going wrong in 1990, Japan has faced a supply-side and a demand-side problem. The supply-side problem has been the need to deregulate. The demand-side problem has been the lack of spending. Previously, the government relied solely on a demand-side solution by spending more. But that only tackled half the problem. Now, the whole problem is being addressed. Not only is the government spending more, but the private sector is restructuring. Demand and supply-side solutions are being given. This is correct, but it may take time for the results to be seen. It is in Asia’s interests if the Japanese economy emerges soon from weakness. Although the immediate picture looks poor, one should not dismiss the economy’s potential to rebound. Dr Gerard Lyons is chief economist of DKB International, the London subsidiary of Japan’s Dai-Ichi Kangyo Bank.

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