Case Scenario: HOW THE HUGE JAPANESE TRADE SURPLUS BACKFIRED
The story of the rise and fall of the Japanese economy over the past 50 years is one of the most striking in economics. The principal elements of this saga are as follows: 1945-65. Devastated by losing World War II, a poor country without substantial national resources was rebuilt by saving and investing an unusually large proportion of GDP. Also, American aid was at least as important as the famed Marshall Plan for Europe, although it has received far less publicity. Growth was primarily driven by domestic demand, not exports. Japanese consumer products were then considered shoddy and low-tech, similar to Chinese goods today, although the US bought a great deal of merchandise from Japan during the years of the Korean War, giving the Japanese economy an additional boost. 1965-73. Spurred by a sharp increase in exports stemming from the Vietnam War and the undervalued yen, Japan became one of the world's leading manufacturing nations. Exports soared and the trade surplus rose - until worldwide commodity prices suddenly soared. 1973-81. Stung by the ‘‘oil shokku'' and skyrocketing agricultural prices in 1973, which was exacerbated by the counterproductive US export embargo on soybeans, Japan rethought its long-term strategy. The government decided that since Japan would never have adequate supplies of food, energy, or raw materials - and since it thought that relative prices of these commodities would continue to rise - it had little choice other than to shift to the production of high-tech goods, which required far less of these inputs.
The trade surplus reappeared in the mid-1970s; although it slipped back into a deficit at the time of the second oil shock, the reverberations the second time were not as severe. 1982-5. Helped by the overvalued dollar, Japan increased its trade surplus in spite of having to pay high prices for energy. The trade surplus accumulated rapidly, but the yen did not appreciate because of the intense pressure pushing the dollar higher. 1986-91. The dollar returned to normal, and oil prices fell by half. Japan now had a huge trade surplus and the yen strengthened sharply, rising significantly relative to European currencies as well as the dollar. Yet the trade surplus continued to widen. In order to keep the yen from appreciating even further, Japan lowered short-term rates. That created an enormous and unsustainable boom in stock market prices and land prices. However, Japanese consumers received only limited benefits from the general prosperity, because the government refused to reduce import barriers. Archaic distribution and trade policies also kept consumer prices artificially high. Thus the growth in consumption lagged the overall gain in GDP - which was temporarily ignored because of the large gains in investment and exports. 1992-5. Finally the roof caved in. The land price and stock market bubbles burst. Not only did the Nikkei fall 60%, but it failed to recover that loss over the next six years and eventually ended up more than 75% below its peak levels. Even worse, the yen continued to appreciate. That not only reduced export growth, but gutted the manufacturing sector, as many firms moved their operations to Asian nations with lower costs. However, the trade surplus continued to widen because consumption remained weak, so the yen continued to appreciate. As a result, real GDP rose an average of less than 1% per year from 1992 through 1995. The unemployment rate failed to soar only because the Japanese count their unemployed differently than in North America or Europe. 1996-2002.
The yen reached its peak in April 1995 and finally turned around. Exports and real growth rebounded, but just when it appeared that the Japanese economy was about to return to normal growth rates, the other shoe fell, which was the collapse of the growth tigers. The Japanese economy fell back into recession in 1998. Since then, real growth has averaged only about 1% per year, with yet another recession in 2001-2. In addition, the Japanese banking system was exposed as corrupt and rotten. Most banks had ‘‘cooked the books,'' reporting asset levels far above reality. They did this in part by posting stock market values at the time of original purchase rather than at current market value. Banks were no longer able to extend as much credit, especially for international loans. Several important lessons can be learned from ‘‘the story of Japan.'' First and most important, a huge trade surplus does not guarantee prosperity. Instead, by pushing the value of the currency well above PPP levels, Japan penalized a rapidly growing export industry and cut the growth rate almost to zero. The situation was exacerbated because of the J-curve effect, so the trade surplus continued to widen even as the yen surged, and the volume of exports grew far more slowly than the volume of imports. Second, it is much more difficult to be a leader than a follower. When Japan was still catching up to leading-edge technology, its growth rate was phenomenal; once it approached the technology frontier, its growth rate fell below that of the US. Third, the increase in the Nikkei index to almost 40,000 in late 1989 - with many ‘‘blue chip'' stocks trading at triple-digit P/E multiples - was clearly unsustainable, and the bursting of that bubble caused a major drop in capital spending.
After the bubble initially burst, the Nikkei continued to decline and never recovered over the next decade. Fourth, a well-functioning financial sector is a prerequisite for continued rapid growth. When the stock market declines by three-quarters and the capital asset base of the banking system erodes, investment falters. The problem was worse in Japan than in the US because many financial institutions continued to carry stocks on their balance sheets at the price they bought them, rather than the much lower market price. When the banking system attempts to cover up these miscues by false accounting, the ultimate result is even worse. Yet when we strip away all the exogenous disturbances caused by recessions elsewhere in the world, the boom/bust cycle in the stock market, and the faulty financial accounting, what remains is the unmistakable conclusion that the Japanese economy initially faltered because the value of the yen was too high, and Japanese exports became less competitive in world markets, especially compared to the growth tigers. It should be emphasized that the overvalued yen was not caused by relatively high rates of return on either physical or financial Japanese assets. The rate of inflation was about the same as in Europe and the US. Interest rates were low and falling, and after 1990, the stock market was rapidly sinking. Profit margins were also shrinking.
In the previous three chapters, we saw that when the relative rate of return on financial assets and the relative rate of inflation are not influencing the value of the currency, it depends on two other factors: the current account balance and the gap between investment and domestic saving. The decline in saving helped to boost the yen higher, but even that was not the major cause. It was the ever-increasing current account balance - even though the volume of exports was only rising 1% while the volume of imports was rising 6% - that boosted the value of the yen so much. It was the J-curve come to life with a vengeance. The Japanese government found itself in a dilemma. The economy was stagnating because the trade surplus caused an overvalued yen, yet politicians were loath to increase imports and, as they saw it, put more Japanese firms out of business. Hence the Japanese government acted in a way that most mainstream economists would have suggested, which was to employ more expansionary monetary and fiscal policies. Government spending programs, especially public works programs were greatly enlarged. Monetary policy was eased so much that the short-term money market rate fell all the way to zero by 1998. Yet this approach did not work. If the reasoning behind the Mundell-Fleming model presented in the previous chapter is accurate, though, that should not have been such a great surprise. According to that model, the currency is related to the ex ante gap between investment and domestic saving; if saving declines, the currency rises, ceteris paribus.
Hence bigger government deficits would boost the value of the currency in the absence of offsetting factors. To the extent that a lower interest rate boosts investment and reduces personal saving, it also raises the value of the currency, which is the direct opposite of the claim that a low interest rate will reduce its value. The principal thrust of Japanese economic policy should have been to reduce the value of the yen back toward its equilibrium value. Since the ever-increasing trade surplus was driving the yen higher, that development should have been reversed by opening the door wider and encouraging more imports - not by the traditional methods of stimulating the economy by more public works projects and lower interest rates. The value of the yen finally started to decline after early 1995, when its value was so far above equilibrium that the current account balance declined in spite of the J-curve effect. Largely as a result of this development, real growth rose from 0.6% in 1994 to 1.5% in 1995 and 5.0% in 1996. It seemed that the Japanese economy was back on track again. Then the devaluation of the growth tiger currencies caused a major decline in Japanese exports, pushing the economy back into recession in 1998. Even though the value of the yen was falling sharply, it was still overvalued. Furthermore, capital spending was now declining because more and more firms chose to invest overseas, where costs were lower. The inability of many major banks to make loans because of their shaky capital position also reduced capital spending. The Japanese government could have taken several positive steps. First, it should have reduced import barriers.
That would have kept the yen from appreciating as far above PPP, which would have reduced if not eliminated the need to reduce interest rates to the point where they generated a classical boom/bust cycle. Also, that would have boosted consumer purchasing power, which would have led to more robust growth from domestic sources. Second, Japan should have privatized and deregulated, especially in the retail sector, permitting consumers to buy goods at lower prices. In combination with the first point, that would have reduced both personal and foreign saving. Third, it should have required that the financial sector provide timely and accurate records. The attempt to hide losses was, as usual, an even more serious mistake than the bad speculative loans in the first place. Fourth, it should not have pursued the standard policies of fiscal expansion, since on balance that tends to drive the value of the currency higher by reducing domestic saving. For a while, the export boom covered up these sins, but eventually they were all exposed. The Japanese leadership has recently begun to grapple with these mistakes and institute some reforms. However, the failure to liberalize import restrictions after 1986 caused the Japanese economy to move from world growth leader to also-ran, a mistake that can only be slowly rectified in the coming years. Looking back with the clear vision of long-range hindsight, the seeds of destruction were actually sown in 1986, when the sudden drop in oil prices created a huge trade surplus that the Japanese did nothing to offset, and a severely overvalued yen that they tried to offset with overly easy monetary policy.
The resulting bubble in stock prices and land values led to the inevitable correction, which brought the economy tumbling down. The situation was then greatly exacerbated by false accounting by both major financial institutions and manufacturing corporations. When the yen continued to increase, manufacturing firms moved to overseas locations, and the economy became hollowed out. This section is about Japan, not the US. Nonetheless, the collapse of the stock market bubble and the revealing of the accounting frauds by Enron, Worldcom, Global Crossing, Adelphia, etc. in 2002 have raised the issue of whether the US is also heading for an extended period of stagnation. In this author's view, the differences are greater than the similarities. First, the accounting schemes, as heinous as they were, were quickly exposed and corrected. Second, financial institutions have long been required to mark to market, rather than valuing assets on their books at their original purchase prices. Third, housing prices continued to rise at above-average rates; there was no bubble in US land prices. Fourth, the US remains committed to free trade, and imports continued to rise in 2002 after a brief recession-related decline in late 2001. Fifth, once the recession got underway, the dollar quickly returned to equilibrium. The future path of the US economy remains to be seen, but the similarities with the Japanese collapse of the early 1990s are far smaller than was suggested by the popular press in 2002.