It will likely take a new financial crisis in Japan — something that may befall the nation in the short run — for the country to finally make the economic adjustments needed to pull out of its long-time downward spiral, says Wharton finance professor Franklin Allen.
That downward spiral lately has been accelerating, with recent economic reports looking very bleak and possibly leading to a breaking point. GDP fell an annualized 3.5% (0.9% actual) in the latest quarter. The trade deficit hit a record for the quarter, with September’s exports dropping by 10.3% (versus September 2011), the fourth-straight monthly decline. First-half fiscal year results were similarly dour: Japan’s trade deficit hit US$41 billion, the largest ever for a six-month period as exports dipped 2% and imports rose 2.6%.
New forecasts suggest that GDP in the current quarter will fall 0.4%, which would push the country into its third recession since 2008.
Although unsustainable economic conditions in a country can sometimes drag out much longer than most observers think is possible before a serious break occurs, in the end there is usually a reckoning. And reckoning day may not be far off for Japan, says Allen.
The long-term trend is well known – some 20 or more years of relative economic stagnation, though the Japanese population has continued to live comfortably for the most part, largely because the unemployment rate has never soared like it has in the U.S following the 2008 financial crisis.
What is behind the new rash of bad economic news coming out of Japan over the past couple of weeks? “China is a big factor,” Allen says. The Chinese are continuing to avoid buying Japanese goods in response to a dispute over control of islands in the East China Sea, and that certainly contributed to the devastating drop in exports in September. That dispute has taken on outsized importance because of sensitivities dating back to Japan’s ruthless occupation of large swaths of China for several years before and during World War II.
Notes Allen: The dispute with China “may well get much worse before it gets better. It looks like [Liberal Democratic Party leader Shinzo] Abe will become the new prime minister in upcoming elections. This is likely to lead to deterioration in relationships from their current low level.”
Saber rattling between China and Japan over the territorial issues has caused great uncertainty recently, but there are, of course, many long-standing reasons for Japan’s economic quagmire. “Demographics is a part of it,” Allen notes. “[Japanese] are getting older on average; the workforce is shrinking, and gradually [Japan] will start to dissave as a country as the older generation runs down their savings.”
The other big factor contributing to Japan’s economic malaise, says Allen, “is that Japanese companies are losing their competitiveness. The problems at Sharp, Panasonic and Sony are symptomatic of this.”
So what would it take for Japan to start turning things around?
“The decline will continue until there is a crisis,” Allen adds. “I think this is going to come sooner rather than later…. The timing is very uncertain, though. They need to let the market set interest rates.”
The relatively high level of the yen, meanwhile, has hurt Japan on the trade front. Yet, given that Japan is the world’s largest debtor – its debt is double the size of its economy — why has the yen held so strong? “This is a fascinating question. Since Japan finances its own debt it is still regarded as a safe haven. But now that it is running trade deficits, this may well change. Moreover, it may change quickly.”
The yen may get a policy push to add to any market push-down that may be coming, if Abe wins the December 16 election, as polls suggest is likely. He has pledged to attack deflation and weaken the high yen, which has been making life so difficult for Japanese exporters and manufacturers. Last week, he said he would set a 2% inflation target through monetary easing that would involve the Bank of Japan (BoJ) buying up Japanese debt to finance infrastructure projects.
But that arrangement would require changes in current BoJ law that would curtail its independence. How doable that is remains an open question. Abe’s comments drew a sharp response from BoJ Governor Masaaki Shirakawa, who looked unlikely to give up any of the BoJ’s independence without a fight. “Central bank independence is a system created upon bitter lessons learned from the long economic and financial history in Japan and overseas countries,” he said during a press conference.
Expect rough economic seas ahead for Japan regardless of the election’s outcome.