Monday, March 23, 2009

The Japanese Slump - Lessons for US (& me:)

I was asked this question in one of my IIM interviews:

“The economist Dornbusch said sometime back that ‘watch out for Japanese consumption’ to Fed. What did he mean?”

I said that - "he (Dornbusch
) probably meant that US cannot consume more than its income for a very long time, and referred to Japanese economy of 1990’s which was in recession too. Their MPC (propensity to consume) was also high like that of US till 2008 crisis..."

Well, this is the wrong answer. In fact contrary to US, the savings rate in Japan was very high and this perhaps, is at the root of Japan’s woes, as my analysis suggests. After 2 weeks of giving this question a thought, I think I have figured out the answer somewhat. So please read my analysis (I know it’s nerdy & verbose) but let me know if it makes sense.

Now it is important understand what a recession is – essentially a blip in the economic activity. Why does this happens? Do factories suddenly become non-functional? Do the sophisticated machines suddenly rust? Does technology abruptly becomes redundant? NO.

In fact recessions happen because of the constant interplay of the demand and supply. And they deepen because policy makers intervene with all the wrong tools. Japan is a classic example of this.

Now the Japanese economy is/was a great economy, look at the facts below:

1) The second largest economy of the world at the end of 1970s
2) Blessed with an educated, skilled & hard working population, modern technology & capital
3) Blessed with a stable government
4) (Still) A creditor nation, not dependant on whimsical foreign capital like Latin America or most East Asian countries.

Yet it spent the entire 1990s in a ‘growth recession’ (meaning literally no growth). Real GDP in Japan grew at an average of roughly 1.5% per year between 1991-1999, compared to a 10% average in the 1960s, a 5% average in the 1970s, and a 4% average in the 1980s.

Why did this happen? Well when Japan’s economy grew spectacularly in 60s, people attribute this to various factors like:
a) sociological factors (the Japanese were extra hard-working)
b) Good fundamentals (high savings rate, good infrastructure, good educational institutes, etc.)
c) A new superior form of capitalism was established in Japan (later this system was labeled as ‘crony capitalism’ and the bane of Japan!)

Paul Krugman (in his book “The Return of Depression Economics”) says that these factors were present but the fundamental reason for Japan’s initial success was because of the Govt. of Japan’s strong role in directing the bank loans and import licenses to favored industries. Moreover, Japanese firms were not concerned with short-term profitability pressures. They got bulk of their capital though the
Keiretsu system. & this system only fuelled the bubble economy of Japan.

In fact the Japanese bubble was so huge that at the beginning of 1990s the market capitalization of Japan Inc. was larger than that of the United States, which had more than twice the GDP of Japan. But sooner or later, bubbles always burst. In the early 1990s the Japanese government raised interest rate to deflate the bubble and with that started the downward spiral in Japan. Investors started losing confidence in the economy and the miracle like growth story of Japan became a thing of the past.

As is the present case with US, the Japanese govt. also tried all remedies to cure recession during this period, but kept failing.

->Japan started systematically reducing interest rates to revive the economy. Interest rates became zero & yet the economy didn’t take off. Why? Well Krugman thinks that the ageing population of Japan and the general sentiment of nervousness in Japan, made the public less and lesser willing to spend and hence idle capacity became the norm in Japan due to deficit demand.

-> Japan tried the Keynesian medicine of giving fiscal stimulus to the economy. This led to short bursts in growth but they also simultaneously increased the fiscal deficit in Japan which reached 4.5% of the GDP in 1996. This triggered panic in the Japanese govt. which could not afford huge fiscal deficits as it had a growing population of the aged people who needed fiscal support & who could not service future debts. So the govt. increased taxes. This option failed as well.

The economist’s concluded that Japan had fallen into the “Liquidity Trap”. The only way out could be an artificially inseminated inflation into the economy to spur demand. Well, that didn’t happen of course.
And finally Japan started showing signs of recovery in 2003. How? Well, by this time the deficit consumer demand in Japan had found a big consumer – US. Japan’s exports to US increased. Moreover the growing Chinese economy also imported a lot from Japan – which ended a decade long slowdown in Japan which finally touched a 2% growth in 2003.

So basically the flamboyant US economy helped the Japanese economy recover somewhat. But just as Japan started recovering from the liquidity trap, US started falling into the debt trap. And we all can see the result today.

Perhaps Dornbusch, had sensed this at the right time and had given the signals to Fed – who chose to ignore him. (No citations here, couldn’t find any!) So while Japan had a deficit domestic consumption, US had too flamboyant consumption levels.
Even in the 1980s, Dornbusch had been vocal that the US was incurring huge trade deficits vis-à-vis the Japanese economy. But some timely & precious warnings always go ignored.

The Return of Depression Economics (Paul R. Krugman)


«« hAdez »» said...

hmmmmmmmmm... kitna faltu time hota hai janta k pas :P

Sugandha said...

Aree this is not time waste.. still left with my L interview, wat if they ask the same question? I should hv a clue naa :P

Varun Reddy Sevva said...

Informative... Your answer may have been wrong, but it was well-guessed atleast...

Prat Mitt said...


btw, what is MPC :S

Anonymous said...

You might want to have a look at this too :-

bharath_enigma said...

The other main reason for Japanese slump has been the reduction of export due to the crisis. Japanese has always been a huge exporter of electronic/auto goods. Due to fall in global demand, the economy is now reeling.

Herewith lies the difference between Japan and Inaida/Chian where the domestic market/demand is strong.

Abhay said...

insightful....was a good read

Anonymous said...

Hi !!

Being an "economics"ically-handicapped engineer, i really find ur posts interesting, they are interesting and not at all fundu.....

This one was superb,though i have a few doubts regarding the facts in a lot of places.

BTW, can you give me a good non-wiki link of Keynesian Beauty Contest ??


PS- Congo for the LI convert...U were right ... a quant-retard wont crack the sec cutoffs year after year....there's only so much practice can help..

Rohit said...

makes me wonder which specialization have u chosen in L ?? Marketing or Finance..Marketing im guessing ...cuz u hate finance !!