A weak Japanese economy is again making Americans nervous. For the fourth quarter of 2008, Japan reported a painful 12.7 per cent annualised drop in GDP - a low point in a history of disappointing economic performance that stretches back to the early 1990s.
The extent of Japanese stagnation has been understated - much more than a decade has been and is still being lost. The relevance of this stagnation to America's current economic crisis therefore goes beyond how the Japanese handled their financial crisis almost 20 years ago, to a continued failure to revitalise the Japanese economy in sustainable fashion. This traces back to Japan's failure to move its economy away from structural reliance on exports and trade surpluses. The US has the mirror problem: a reliance on imports, including imported savings.
A heated and important debate is underway as to how America should respond to its financial crisis and the deepening recession. Another lesson from Japan is that, if the US wants to secure long-term prosperity and the future of American leadership, it must also be concerned about the next two decades. If the US does not fundamentally change its tax, spending, and regulatory policies, this nation risks replaying Japan's two lost decades, with all that entails.
The loss of the 1990s
On December 29, 1989, Japan was completing the fourth decade of its economic ascent. The Tokyo stock market set yet another record, and Japan was the world's second largest economy. Real GDP growth had easily surpassed that in the US the previous four years, the previous decade, and the previous four decades. The country was not only wealthy; it was dynamic. Many named Japan the crown prince of global economic leadership, replacing an America that could no longer compete.
A decade later, this all seemed a strange dream. Japan's retreat from the economic pinnacle has been illustrated in many ways. The loss was less one of wealth - Japan is still rich - than of the dynamism displayed for nearly two generations and the utter destruction of any aspiration to global economic leadership.
The stock bubble popped in 1990, followed by real estate in 1991. The impact of these bubbles on GDP growth was seen clearly in 1992. By itself, this was unremarkable. As has been made all too clear, financial bubbles are common. What sets Japan apart is that its relative weakness was most stark a full seven years after the Nikkei began its swan dive.
Data on the gap between actual output and potential output in Japan and in the US indicate the difference in their comparative performance was insignificant from 1991 to 1994. It is in 1995, five years after the initial shock, that comparative Japanese performance sharply deteriorates.
The low point in terms of that performance is 1997, but the gap between actual and potential output indicates a much weaker performance in Japan than in the US as late as 2000. The lost decade is not a tale of excessively slow recovery from financial shock; it is a story of initial weakness followed by extended slump due to a failing economic model.
This shapes the lessons that should be drawn from Japan's economic woes. There is consensus that Japan failed in maintaining financial transparency in the early part of the decade. There is no equivalent consensus on the ineffectiveness of the profligate use of fiscal stimulus: As the slump actually worsened as time passed, it is difficult to see the benefit of the stimulus. The standard response is to cite 1997, when Japan moved off net stimulus, as undermining the effort. It is at best a weak argument that seven years of colossal debt-financed spending was a clear failure but eight would have done the trick.
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