Why Japan’s economy is still stumbling

You call this a rebound?

In any case, while determining the implications of the 1990s is valuable, it may encompass only half the story: The 2000s are rapidly becoming a second lost decade.

They did not start out that way, however. Again using the gap between potential and actual output to compare the two economies, Japan finally began to close the American advantage by 2002 and through 2005, in a long-expected and much-needed bounce, from the period of underperformance. But in 2006-2007, the belated Japanese cyclical rebound faded and the two countries fared roughly equally. Unfortunately, output gap data for Japan are not yet available for 2008.

What is available, though, is shocking, perhaps even more so than the headline 12.7 per cent GDP drop. A very simple comparison of quarterly results in current yen shows that the Japanese economy was likely smaller in the fourth quarter of 2008 than it was in the fourth quarter of 1995.

Even worse, there is no sign the first quarter of 2009 will be stronger. If annualised growth "recovers" to only a 10 per cent decline in the first quarter, the Japanese economy could be smaller than it was in the first quarter of 1992. If the outright contraction continues through 2009, the futility will continue. What has been lost is not a decade, but 17 years: prolonged stagnation combined with the collapse of an unsustainable rally is pushing Japan backwards in time.

Drawing different conclusions

That situation is "unsustainable," not "unsustained". When Japan was sliding backward in the late 1990s, there was vigorous debate over the need for structural reform - to forcibly reduce both the ultimate dependence on exports and the distortion of monetary policy in service of currency stability, in order to boost domestic private consumption. The debate was muffled by the relative success of 2002-2005.

That success has turned out to be a chimera. The reversal of the output gap in 2002 coincides exactly with a sharp jump in Japan's trade surplus. The higher surplus persisted for several more years before flattening out, timed with the leveling of comparative Japanese output performance.

Now, as export markets are drying up in the face of the global recession, the trade surplus is plunging, and Japan is again sharply underperforming (based on simple GDP, at least). Structural weakness in the form of export obsession has come home to roost. Looking forward, there is good reason to believe it will be more difficult for balance-of-payments surplus countries to fully recover from the current crisis than for deficit countries. The angry disagreements over whether structural reform could have saved some of the 1990s must be extended to include whether such reform could have improved the transient, wasted recovery this decade.

Possible lessons for the US should likewise be extended. Rather than only examining 1990s Japan to see what should (not) be done in response to today's financial crisis, America must look well down the road. Japan has suffered over a decade of effective economic stagnation, a loss so great that it is in many ways no longer a regional economic leader, let alone a challenger for global economic leadership.