Japan's recent economic decline: an explanation

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Japan's recent economic decline: an explanation (Reading for Self-Test questions, Lesson 9 Part 3)

By the 1980s, Japan uprooted itself from war devastation and became the second largest economy in the world. Yet starting in 1991, the Japanese economy went on a decline, and it has been in a long recession through 2006. In July 2001, Japan's trade surplus was down 64 percent from the previous July. What were the causes of this decline? What are the similarities and differences between it and the economic recessions in the United States? I will try to address these two questions here. 

There are generally speaking two major causes of this economic decline, one is more specific to the postwar Japanese economic and political structure, and the other has got more to do with a universal factor for all developed economies in the world.  There are a number of other lesser but still quite significant factors as well. 

1. Post-WWII Japanese economic and political structure and economic development

Some of the characteristics of postwar Japanese economic and political structures are the welfare society, state regulation of the economy through incentives such as Research and Development loans, other liberal loans in the key industries and companies designated usually by the Ministry of International Trade and Development (MITI) and the Ministry of Finance, and also attempts to protect the "sunset industries" in the form of cartels to guarantee full employment.  Up until the early 1990s, these characteristics have to an extent served to boost Japanese economic development: the generous loans enabled many companies to focus on research and development, making famous the "made in Japan" label because of the high quality of the product.  Sony was famous for the slogan that they would not anticipate what the consumer wanted, but would create a product and then persuade the consumer to want it.  State planning enabled important industrial structural transitions, e.g. from heavy industry up to the 1970s to the energy saving computer and bioengineering industry in the 1980s.  In the early 1970s Japan explored the welfare state option because of social problems such as pollution and the dual track economy. The First Oil Shock (1973, OPEC as a cartel raising oil prices for the first time) led to recession and shortage in state tax revenue, which forced the state to abandon the welfare state and refocus on welfare society. Protection of the sunset industries through cartels helped maintain full employment so that the state did not have to spend tremendous amounts of money on unemployment benefits.  On the other hand, the same factors that boosted economic development also slowed down Japanese economy.  This problem became especially prominent in the 1990s.  "Decades of corporate collusion and protective regulations have steadily eaten away at productivity, limiting potential economic growth to around one percent a year in the past few years, even at full capacity. Worse yet, Japan cannot even come close to full capacity despite enormous budget deficits and zero interest rates, because high prices suppress real household income and therefore consumer purchasing power.  Until the 1990s, 'peaceful coexistence' between growth and Japan's structural flaws was possible.  That is no longer the case.  Japan's average annual growth since the spring of 1997 has been a negligible 0.3 percent.  Manufacturing output is 10 percent below its 1991 peak.  In a dramatic reversal, Japan's share of both global output and exports is shrinking for the first time in a century.” (Richard Katz, Foreign Affairs Jan./Feb., 2003.)

"Collusion, regulation, and bank loans to the uncreditworthy all serve as covert social safety nets in a country where only half the work force is covered by unemployment insurance. These practices shore up moribund firms and industries, sustaining millions of unnecessary jobs.  High prices allow covert income redistribution from Japan's efficient sectors to the inefficient ones: for example, Toyota pays high prices for glass, electricity, and steel, and then passes on the cost to consumers. Furthermore, much of the support base of the ruling Liberal Democratic Party (LDP) -- as well as that of the opposition parties -- relies on such practices. Each party's base is divided between those who would benefit from reform and those who would be hurt by it. The same is true of many of the corporate-financial conglomerates known as keiretsu. The very things that make structural reform economically necessary also make it politically difficult.  Japan's economic crisis is thus a crisis of governance in both government and business. Revival will therefore require a fundamental overhaul of institutions. But even reformers disagree among themselves as to what constitutes reform. Defining the programs, reaching the intellectual consensus, and forming the necessary institutional coalition will take several more years."  (Richard Katz, Foreign Affairs Jan./Feb., 2003.)

2. Burst of the economic bubble

For years, an inefficient economy dragged on.  This stopped in 1991 when the economic bubble burst.  Besides the reason of inefficiency, there were a few other causes for the economic recession:

Pressure to end asymmetrical trade with the U.S.: After 1947, because of strategic reasons, the U.S. allowed Japan to freely export to the U.S. while Japan closed its door to American trade.  The end of the Cold War in 1989 and the fall of the USSR in 1991 made this U.S. accommodation unnecessary.  There was increasing U.S. pressure for opening up Japan for trade. One of the consequences of this U.S. demand was the government reduction in low-interest loans and other financial subsidies to Japanese companies in general. Corresponding to the phenomenon of fewer low interest bank loans, many companies sought another way to raise the company's capital: through the stock market. Therefore starting from the second half of the 1980s, one sees a sudden surge in Japanese companies that are listed in the stock exchanges around the world. Together with the appreciation of the yen, the values of Japanese companies listed at the stock exchange appreciated dramatically, creating a huge financial bubble.

The appreciation of the yen: The exchange ratio between the U.S. dollar and Japanese yen became more and more biased against Japan as the American trade deficit increased: the Japanese yen became more and more expensive, from the $1 to 360 yen in 1949 to $1 to around 100 yen in 1989. The appreciation of the yen was also exacerbated by the collapse of the Bretton Woods system.

The Bretton Woods system and its demise in the 1970s: In 1944, in Bretton Woods, New Hampshire, the International Monetary Fund (IMF) and the World Bank were founded. They came into operation in 1945. One of the agreements at the Bretton Woods conference was to link the U.S. dollar to the gold standard, and link all other currencies to the U.S. dollar. The asymmetric trade between U.S. and Japan led to a depreciation of the dollar and eventually the dollar’s disconnection from the gold standard in 1971.

With the yen off the linkage to the dollar, it appreciated quickly, leading to complexities of trade.  The indebted nations' currency fell in price in relation to the yen. The appreciation of the yen affected Japanese export as Japanese goods became more expensive abroad, hurting their competitiveness. Consequently Japanese exports abroad fell as Japanese goods grew more expensive. The strength of the Japanese yen led to a greater export of the yen, rather than just material goods (e.g., in Sony's purchase of Columbia Pictures and MGM Studios, and in the Japanese purchase of real estate in Hawaii and on the U.S. mainland). The Bank of Japan and the other Japanese banks' loose investment policies encouraged financial investments abroad. (Compare that with the U.S. savings and loans scandal in the 1980s when similar indiscriminate lending from banks to businesses led to many bad loans, consequently leading to a reform of U.S. banks.)

The gradual appreciation of the yen came earlier than 1991, and not just against the U.S. dollar but against all major currencies in the world, as the world became indebted to the Japanese economy. This situation eventually worked against the traditional Japanese style of export: to sell at below-cost prices and win market share. The strength of the yen and the increasing listings of Japanese companies in the stock markets around the world further increased the financial standings of these companies and led to an expansion of production (e.g., Toyota, Sony, Honda, Mitsubishi, etc.) with little regard for how much the world was buying. When these companies realized there was a gap between how much they produced and how little the world was buying (because of the rising yen and increasing prices of Japanese goods around the world), especially after the onset of the economic recession of Europe and the U.S. in 1989, there was a big drop at the Tokyo Stock Exchange in 1990. (Compare that with the U.S. stock market setbacks in recent years because of over-investments in the dot.coms and the technology sector.) Since in many cases the stocks of a company were used as collateral for companies to acquire bank loans, the fall of stock prices had a double effect: it led to less money for the companies from the stocks and smaller or no bank loans. This sudden reduction of Japanese bank loans led to a retrenchment of the Japanese economy.  Not only did it affect certain companies at home and abroad, but the banks also started to track down the performance of their loans, finding many of them doing poorly.  This led to further reduction of bank loans. Companies downsized or collapsed because of stumbling stock prices and loss of bank loans. Fearing the future, consumers decreased spending, which further fueled the economic recession.  Japan's economic bubble burst.  

Post-recession economic reforms

The "big bang" reform of the banks (1996)

  • limited the budget deficits to 3% of the GDP till 2003.

  • reduced national debt by 4.3 trillion yen.

  • raised consumption tax from 3 to 4%.

  • withdrew personal income and property tax relief (1994-96)

The 1996 reform worsened the economic recession by cutting down on spending and strengthening the banks’ monitoring of loans.

  • 1997-98, banks and consumers preferred holding cash to investments because banks tightened monitoring of performance.

  • Short of credit, many companies went bankrupt.

  • Reduction of government spending and banking reforms led to deflation.

In conclusion,

  • The drop of the Nikkei Index at the Tokyo Stock Exchange in 1990 led to a chain reaction: banks and individuals preferred to hold cash rather than investments or to spend. In 1996, Japan went into a recession, which was exacerbated by the state policy to cut public spending, reinforce bank monitoring of loans, and tax increase, leading to even less spending.

  • In the face of an economic recession, many government policies that seemed to be virtues of Japanese economy in the 1980s now appear to be hindrances to its economic recovery. The government's continued protection to keep some of the large banks from collapsing, in particular the banks that are expected socially to help the smaller companies, and its protection of companies (e.g. department stores) to keep them from going bankrupt, perpetuates the existence of bad loans that prevent further economic development. Some companies have been allowed to go bankrupt, but some 17 million people are artificially kept on the payroll to prevent bankruptcies of their companies. Many large companies' slow decision to lay off workers, according to some critics, was also to blame for a slow economic recovery.

  • The government is loaded with tremendous debt because of the recession in the past years. Its constant decisions to cut spending is said to perpetuate the deflation, a result of the lack of consumer spending.

  • Many companies' decision to relocate to other countries (e.g. China), where the average worker's pay is 1/25 of that of the Japanese worker, only exacerbates the domestic economic woes. Many Japanese university graduates find it hard to find full time jobs, and some decided to do temporary and part time jobs for life. This only contributes to lower levels of consumption at home.

If this happened in the United States, the economic recession would immediately lead to bankruptcies, firing of workers, and so forth.  But in Japan, the government hesitated to let large scale bankruptcies happen.  It has bailed out banks, large department stores, and other companies, rescuing them from total collapse to prevent unemployment and the need for welfare measures. There were, in other words, attempts to let the banks and companies to a "soft landing" in the economic recession. Fear of meltdown paralyzes the hand of reform. A classic example came in 2003 when Prime Minister Koizumi himself instructed banks to bail out the huge Daiei supermarket chain -- a retailing empire with $17 billion in debt and 100,000 employees. Daiei was given $3.2 billion in debt forgiveness.  Koizumi urged bailout partly because officials convinced him that Daiei's failure would doom the entire banking system. Yet Daiei's debt to the big banks amounted to just 0.8 percent of their total loans. How could its failure have caused a collapse? (Richard Katz, 2003) This did not quite help matters as when the economy was not getting better, by the mid-1990s, the large companies had to start firing employees.

The international market that Japan, an export-oriented economy, relied so much on, did not help matters either. The global downturn that started in late 2000, coupled with persistent deflation in Japan over the last four years, has forced Japanese manufacturers to slash inventories, close factories and lay off hundreds of thousands of workers. Companies like NEC and Fujitsu were also cutting back plans for capital investment by late 2001. On April 1, 2002 Toray Industries, the country's largest maker of synthetic fibers, said it would shed one-tenth of its work force.

The bright side, analysts say, is that ultimately companies will make their investments more judiciously and seek better rates of return. "Higher interest rates will delay a full recovery in the economy," said Mamoru Yamazaki, an economist at Barclays Capital in Tokyo. "But Japanese companies still have too many workers and factories." (Ken Belson, NYT, Apr.2, 2002)

In late 2002, Japan's government unveiled proposals to revive the nation's ailing financial system by calling on banks to purge half of their bad loans over the next two years. But several economists said the package was little more than a vague and watered-down version of a tougher plan blocked by bankers, bureaucrats and parliamentarians.

To help erase the bad debts — officially estimated at $422 billion but probably two to three times that — the new program offered banks some carrots, including a new government agency to handle troubled loans, to go along with a few sticks like new inspections of banks and a stricter requirement to assess borrowers according to their future ability to service debts. (James Brooke, NYT, Oct.31, 2002)


3. The international market and the future of Japanese economy

  • Global capitalism, characterized by global capital markets, pushed many Japanese companies also to developing countries.

  • The growth of Japanese unemployment led to the crisis of privatized social protection. 

  • Offfshore production led to fewer jobs in Japan. 

While domestic policies of planned economy in the form of government advice and financial packages to private companies and cartels to protect sunset industries are one reason that stunted Japanese economic growth, another reason that has prevented a fast economic revival is a more universal factor true to all developed economies: as the Japanese economy went into recession and some people got unemployed, instead of getting boosters to market expansion, which usually is a sure bet to get the economy out of the recession, many Japanese companies are busy relocating overseas because of the high wages of Japanese workers. As Japan becomes a mature economy, it is faced with the same problem other mature economies are faced with: companies relocating overseas or contracting with overseas companies to manufacturing what used to be made in Japan.  [Brooke]

"Lately, the biggest magnet for Japanese manufacturing investment has become China, a nation with 10 times the population of Japan.  A Chinese factory worker, just a short freighter trip away from here, will work two days for the same pay that some Japanese factory workers earn in one hour." (quotes in this part are all taken from James Brooke, NYT, August 31, 2001.)

So, in 2001, Toshiba announced that it would shift all its television production for the Japanese market to China. Sony is making components for its PlayStations in China. Olympus is closing its digital camera factory in Japan to build one in China. And Honda is considering constructing a plant in China to build motorcycles to export to Japan. And Kyocera said it would shift more production to China. [Brooke]

In a survey of 562 major Japanese manufacturers in July 2001, 49 percent told Nikkei Research that they planned to increase overseas production. Of this group, 71 percent said they were aiming at China. Increasingly beaten at its old game of exporting high-technology products, Japan experienced a 77 percent drop in July in its trade surplus with Asia, compared with 2000’s levels. With China, Japan registered a record $25 billion trade deficit last year, a sevenfold increase over the 1993 level. (Brooke)

"China is eating Japan's lunch," said Ronald Bevacqua, senior economist for Commerz Securities. "More and more low-cost Japanese manufacturing is being shipped over there. Unlike the rest of Asia, China is doing high-end stuff as well."

Eamonn Fingleton, the American author of a book on Japanese production, "In Praise of Hard Industries" (Houghton Mifflin,1999), says that Japan is staying one step ahead of China, shifting increasingly to capital- and knowledge-intensive processes like the manufacture of printing presses and textile machinery.

But trade flows seem to contradict that analysis. During the first half of 2001, when Japan recorded a $12.6 billion trade deficit with China, machinery and equipment surpassed textiles for the first time to become the leading category of Chinese exports to Japan.

"China will become the world's manufacturing center," Yomiuri Shimbun, a conservative newspaper, said in an editorial in August 2001, noting that Japan's share of the global semiconductor market had dropped by half in a decade. "Unless something is done, Japan's economy has no bright prospects." 

During a decade of economic stagnation, the Japanese largely avoided the kind of company shutdowns and bankruptcy auctions that raced through Silicon Valley in 2001 and that devastated the manufacturing centers of America's Midwest and Northeast a generation ago. But the layoffs are picking up speed as Japan realizes that globalization is a two-way street; 20 years ago Japan Inc. was viewed as an invincible economic fortress by many in the West.

Unemployment figures released in August 2001 hit the psychological threshold of 5 percent, a level not seen since the post-World War II American occupation. More than 10 percent of young men between 18 and 24 years old who are just entering the work force are unable to find jobs.

Westerners who have seen the industrial erosion of their economies are not quite as gloomy. Many predict a world several decades hence when Japan, with its aging population, is a "headquarters country," living in large part off investments overseas and brain work at home.

"The reality is that the de-industrialization is happening very rapidly in Japan," said Jesper Koll, a German who is chief economist for Merrill Lynch Japan. "I can see the Nike model here, where you do the brand management in Seattle and the manufacturing in Indonesia. In Japan, you will do the brand management in Osaka or Tokyo and the manufacturing in China."   (James Brooke, NYT, August 31, 2001.)

4. Changes in financial practice after the recession

  • Tightened regulations and reduced bank loans.

  • Continued but sharp decline of reciprocal stock holding (could not afford to share risks)

  • Shareholders’ tightening of control: disclosure of company performance of those closely related. 

5. Which way should Japanese economy go?

The Japanese recession may indicate an international dilemma of global economy and finance. If so, Japan should aim at building a welfare state to handle issues of unemployment, and so on, and a greater market economy to adapt to change better.

6. Where is Japan now?

With banks uncertain to lend and people uncertain to spend, the recession has continued, up to 2006, and may go on for another four or five years. Meanwhile, with the growth of international economy, the Japanese economy is slowly improving, although the Japanese state remains the most heavily indebted country in the world, and state protectionism of bankruptcies still exist in some cases. With the revival of global economy, the Japanese economy, which heavily relies on export (70% of its products are exported versus 70% of American products that are consumed domestically) will finally be able to pick itself up.

7. What has changed in Japanese economy?

The old full employment system is gone, and with it, one can say the welfare society to a great extent.

The banks’ liberal lending is gone and with it, fierce competition and rapid technological innovations in some, but not all industrial sectors (in the entertainment sector, innovations continue unabounded).


The revival of Japanese economy depends on several factors: many argue that it needs to become a more market oriented economy that has fewer ties with state regulators in order to be more nimble and flexible in the face of changes.  It definitely needs to improve on the lending practices of the banks and give more background checks to the companies that receive their loans.  The Japanese government has hesitated to resort to market measures in this economic recession, e.g. letting ailing banks and ailing big companies to "die," through bankruptcies, because this would create great social instability, which traditionally had been avoided through a total employment policy.  Unemployment has received a historical high, for sure, but letting more companies go bankrupt would lead to a higher rate of unemployment.  So the government has allowed some companies to go bankrupt while bailing out some others.  This process will probably go on for another 5-10 years when the bad loans are either written off by the banks or through bankruptcy.  Meanwhile, lack of consumer confidence and a slow international economy has kept Japanese economy to grow at below 1 percent in the past few years.

Ironically, despite China’s drain on Japanese jobs, the ultimate hope for Japanese economic revival may still be China. As a New York Times article in Jan.2006 put it, it is Japanese export to China, a rapidly industrializing country and fourth largest economic power in the world today, that may eventually pull Japan out of recession. (paragraph added)


[Again, I'm going to need to make clear where the quotes begin and end in the above sections. Would it be worth assigning these articles? I can see about getting permission to reprint them or access them online.—it would probably be a good idea to have the students read the articles by themselves.]

RICHARD KATZ, "Japan's  Phoenix Economy," Foreign Affairs, January/February 2003 issue.

James Brooke. "Accelerating Decline in Japan Evokes Rust Belt Comparisons, " NYT, August 31, 2001.

Ken Belson, "Japan's Business Confidence Is Steady, Survey Finds," NYT, April 2, 2002.

James Brooke, "Japan Settles for Baby Steps to Help Banks Buried in Debt," New York Times, Oct.31, 2002.

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