Understanding the Japanese Economy (Video)

How did Japan industrialize so quickly in the 20th century? Why did the country experience a “lost decade” in recent times? Find out in Art and Finance’s first-ever vlog post! (Thanks for your patience regarding the quality, I have a budget of zero right now!)

Script:

You might come across it in the news – “How will the US, or China, or Europe avoid a Japan-style lost decade.”

But what does the media mean when they say “lost decade”? In Art and Finance’s first-ever vlog post, we take a trip to Tokyo to eat some seriously good food, AND also get a basic understanding of the success and challenges of Japan’s economy.

Welcome, to the Art and Finance Vlog.

(pause)

Welcome to Tokyo, Japan.

My name is Ramon Cuenca, and I’m the founder and director of Art and Finance, the website that makes learning about Finance fun and accessible. In this episode, we’ll be learning the basics of Japan’s economy. However. Before I begin, I want to acknowledge that many people have their own opinions on this subject, so what I’ll be giving you are just some of the mainstream theories. In other words, the basics. Now, let’s get started.

(card: Tokyo, Japan. December 2014)

Given some negative press that Japan’s economy has received in recent times, it may be easy to forget that Japan is one of the richest countries in the world, and its rapid economic development in the 20th century is the stuff of legend. Here we are in Tokyo’s Ginza district, a high-end retail mecca that is testament to a wealthy economy.

So, how did it all start? Let’s begin with Japan’s industrialization in the late 19th Century.

Japanese society was feudal up to the mid 1800’s, when foreign powers forced the country to open up to trade. Long story short, this led to a group of samurai staging a coup d’etat against the shogunate. This event was known as the “Meiji Restoration”, dubbed by historian Andrew Gordon as “The Samurai Revolution”. Now, I highlight the presence of the samurai because it was a distinguishing feature of Japan’s industrialization. The samurai were educated, but they did not own lands like the feudal lords did. Therefore, they didn’t have much to lose in industrialization.

As they consolidated power, these samurai effectively paid for an early retirement of the feudal lords, got rid of stipends for the samurai, and created a society based on more on merit than background. In short, they completely changed society within a generation – and if that doesn’t count as some of the most successful political maneuvering in history, I don’t know what does. Now, you could say that these samurai became the oligarchy in this new society, a valid argument, but you can’t deny that these leaders set the stage for Japan’s rapid industrialization.

Cut to Ginza

We’re still here at the Ginza. We’re having lunch at a popular restaurant called Torigin, which specializes in kamameshi – rice and toppings cooked in a kettle. Have a look.

If ever you’re in the area, you should drop by the Mitsukoshi department store, and, if you like cafes, you should check out the Tokyo branch of French luxury bakery La Duree, nestled within Mitsukoshi.

Cut to cards

So. Going back to the late 19th century. We have a new society in Japan, but what did they do industrialize the country so quickly? I highlight two distinct features about Japan’s economic policy that helped spur rapid industrialization.

The first is the presence of “zaibatsu” – these were basically monopolies. The key difference here is that instead of a zaibatsu monopolizing just one industry, it would span several industries, meaning that the zaibatsu were able to quickly mobilize resources, such as labor and capital. And, despite being family-owned organizations, the zaibatsu generally avoided nepotism by hiring talented workers from outside the family.

The second is the proactive role of the state. The government subsidized local industries, and also promoted technological innovation within the country. Some of the methods were… questionable, such as taxing imports and nationalizing the rail network. I don’t think tactics like these would work in our age, otherwise you might incur a trade war.

Cut to Ginza

It’s nighttime in the Ginza. We pass by Tokyu Hands, a chain were you can buy all sorts of Japanese-made goods. For some reason, this branch is named Ginza Hands. Dunno why.

Check out this stationary of Japanese artist Junichi Nakahara – a prominent fashion illustrator from the mid-20th century. Some consider his art to be a precursor to the manga or anime style you see today.

We finish off our night at Kyuubei, a sushi restaurant in the Ginza – let’s take a minute to drool over some sushi.

Cut to cards

So the Samurai Revolution laid the foundation for Japan’s rapid development. However, development all but halted in the immediate aftermath of the Second World War. But from 1950 to 1973, real GNP grew 10% every year! What led to this economic miracle? Certainly, the Allied powers helped with reconstruction, but let’s discuss some other key factors that most likely helped.

The first is that international trade in general tripled during the post-war period

The second factor was, similar to the pre-war era, the proactive role of the state. This time around, the government provided “administrative guidance.” Although private enterprise flourished in this period, the government made it very clear that they would support specific industries, via initiatives such as lending programs, and, of course, protectionism

Japan’s Ministry of International Trade and Industry (which we will refer to as MITI) was a major actor in this respect. It could pressure individual companies to collude and improve the industry as a whole. For example, MITI pressured major iron and steel producers to share the cost of a key technology license, speeding up the competitiveness of this industry as a whole.

Lastly, let’s talk about labor. Regarding the Japanese labor force, two important events occurred. The first was quality control, or QC. An American import, quality control meant sophisticated analysis of workflow to become more efficient. The Japanese furthered this concept of QC by getting its entire workforce involved. They would form “QC circles” and analyze their workflow and propose solutions.

The second event was the relatively weak power of labor unions. By the 1980’s, given its economic success, Japan had become a corporate-centered society where many believed that what was good for the corporation was good for Japan as a whole. (And although QC identified redundancies in the workforce, extra workers were reassigned to other jobs.)

So all in all, times were good… What happened?

(Back to movie)

Back in Tokyo, we’re here at the Hotel New Otani in Akasaka, which was built for the Olympics in the 1960’s – a testament to Japan’s spectacular economic growth.

Let’s not forget that economic power also helped spread Japanese aesthetics and media around the world. Think of Uniqlo, one of the most successful fashion retailers around.

You could also think of the global popularity of anime and manga. If you’re into that, make sure to drop by Akihabara if ever you’re in Tokyo.

Of course – anime Jason Voorhees and Freddy Krueger.

(Back to cards)

Things came to a halt starting in the mid 80s. While there are numerous reasons for an economic recession, let’s start with one singular event, the 1985 Plaza Accord. Essentially, as international trade grew throughout the twentieth century, different economies became intertwined. However, foreign imports sometimes mean negative results for local industries as a result of competition.

Sometimes this has to do with currency exchange rates. For example, if the Japanese Yen is cheaper than the US dollar, that means it takes fewer dollars for Americans to buy Japanese products, which was the case in the early 80s.

So, rather than risk a trade war and protectionism, the major developed economies convened and agreed to coordinate the exchange rates of their currencies.

The reason for that is this: when the US buys from Japan, it pays in US dollars, and Japan earns in US dollars, and vice versa. This is how international trade works. What the Plaza Accord stipulated was that Japan would allow the Yen to strengthen even as the US dollar weakened, thus making Japanese exports less competitive, as US exports became more competitive. This marked the first time national economies got together and decided on coordinated actions in the foreign exchange market.

The immediate result of the Plaza Accord was a halt in Japanese exports and GDP growth. To counter a recession, the Japanese government responded with monetary stimulus, which basically meant cutting interest rates to boost business and consumer confidence. This meant that cheap money was readily available.

Meanwhile, the 1970s and 80s were a time of financial deregulation, meaning that banks could make riskier loans, which they did. One reason for banks taking larger risks was that firms, who were the traditional borrowers from banks, now had access to the capital markets. This meant that firms could get borrow money by other means, such as from issuing a bond rather than borrowing from the bank. So banks began lending to real estate developers and households in need of mortgage, using real estate as collateral.

Another factor was euphoria. Due to the two factors above and an economy that has seen rapid growth over the past decades, asset prices – including real estate and stock prices- surged. (Clips of Omotesando)

So that was the Japanese asset bubble, and as all asset bubbles do, it popped.

By the fall of 1989, the bubble began to burst. Stocks fell 60% from late 89 to August 92, while real estate fell throughout the 90’s by 70%.

Following the bursting of the bubble, unemployment increased, while total factor productivity, a rough measure of human capital in GDP calculations, flatlined in the 90s. Some would call those who experienced this the “lost generation” of Japan.

But why was this recession so severe? Let’s look at three factors.

One. Zombie lending. Remember how those banks lent to real estate developers and underwrote mortgages backed by real estate as collateral? Well, as real estate values plummeted and borrowers defaulted, banks could not get the money back from the loans they underwrote.

Remember that a bank makes a profit by borrowing money from depositors and lending to borrowers at a higher rate. Even if the borrowers default, the bank still has to pay back depositors. Normally, banks go out of business when this happens. But in the case of Japan, the government delayed forcing the banks to recognize losses, letting them to continue lending to insolvent firms, known as zombies. The results stifled regular competition and impeded economic productivity.

Two. Balance sheet recession. Because of the euphoria prior to the crash, many firms and households had borrowed a lot of money. With weaker sales, firms spent relatively more of their capital just paying off debt rather than growing their business. So, the government’s efforts to cut interest rates and stimulate the economy was useless, as any extra cash printed was used to pay off debt. By the way, this situation where the government cuts interest rates and prints money but can’t get the economy to recover is also known as a “liquidity trap”. The situation was so severe in Japan that firms were making net debt paydowns for an entire decade, from 1995 to 2005.

Three. Deflation. Throughout the 90s and early 21st century, Japan has had to face bouts of deflation. Deflation is a phenomenon where prices of goods are actually falling. While that may seem like a good thing, it’s a sign that firms and households aren’t spending. Moreover, borrowers find it harder to payoff debt, as their debt is fixed even as their profits weaken.

The severeness of the Japanese recession led to another problem – surging government debt.

As of end 2014, Japan’s national debt stood at 8.4 trillion dollars, more than twice the size of its economy. While this debt load may seem unsustainable, Japan’s borrowing costs are the fourth lowest in the world. How is this even possible?

It’s because most of the holders of Japanese debt, are, well Japanese. Foreigners only held 8.9% of the debt as of end 2014. Compare that to US treasuries, of which 48% is held by foreigners. By the way, the three biggest holders of Japanese debt, accounting for 46% of the total, are the Bank of Japan, public pension funds, and… the Japan post office bank.

So, how did the debt burden get so big? Aside from attempts to stimulate the economy by spending, the government has also had to solve a demographic problem. Japanese society is aging. Currently, about 30% of Japan’s population is elderly, and that number is expected to grow to 40% over the next 30 years. That’s a lot in social security payments.

So you could think of Japan’s massive debt burden as partially a de-facto tax to support social security. What’s wrong with that?

It’s because of another demographic issue. Japan’s population declined for the first time in 2009, and has been declining ever since. Essentially, there are fewer and fewer young people to pay for the elderly. To paraphrase CFA blogger Ron Rimkus, people would have to work harder and harder just to maintain the status quo.

To summarize, Japan currently faces two interrelated economic problems – a lackluster economy and an increasing debt burden.

What can be done to solve this problem? Enter Shinzo Abe, Japan’s current prime minister, elected December 2012, whose economic policy, dubbed “Abenomics” aims to do just that.

Abenomics has 3 distinct programs to fix the economy, dubbed “arrows”

Arrow #1 – Fiscal boost to the economy via government spending

Arrow #2 – Monetary easing; basically, low interest rates and printing money

Arrow #3 – Regulatory reform – among other things, a lower corporate tax rate, free trade agreements, labor reform, and increasing the female workforce

How has Abenomics fared? So far, the results are… mixed.

Arrows 1 and 2 have been fired, and have successfully rekindled inflation; in other words, defeating deflation. Also, GDP grew for the first few quarters since Abenomics began.

However, to address the debt issue, Abe raised Japan’s sales tax in 2014, leading to a technical recession (meaning two quarters of negative GDP growth). This forced a snap election in December, with Abe and his party emerging as the winners.

Meanwhile, controlling inflation now becomes an issue, with Bloomberg recently reporting that current inflation in Japan is outpacing wage growth. It doesn’t help that Japanese firms continue to sit on cash, a sign that they are not too positive on Abenomics.

Arrow 3, which aims for regulatory reform, remains to be implemented, potentially bogged down by politics. But even if the reforms outlined are enacted, some critics say further, deeper reforms, a fourth arrow, is needed to definitively fix the economy.

Bloomberg columnist William Pesek outlined some of these deeper reforms:

  • Support for entrepreneurialism
  • Civil service reform
  • “Smart immigration” – for example, adopting an immigration policy that selects foreigners with specific skills, similar to Singapore’s policy
  • Support of alternative energies
  • Decreasing import tariffs, and:
  • Quotas for female employment

In short, fixing Japan’s economy would involve deep, lasting reform. This, obviously, requires political willpower. It would help if Abe had the backing of the people – unfortunately, even though he won in the snap election, voter turnout was at a postwar low at 52%.

Many feel that Abenomics, with its goal of achieving inflation, has eroded real incomes. Many also see the current government as more of the same and don’t bother voting. Other political controversies haven’t helped either, such as the government’s pro-nuclear energy stance and a cabinet resolution to re-interpret Japan’s pacifist constitution. Moreover, some of the proposed solutions to Japan’s economic woes are unpopular, such as immigration, with a majority of the population against a more open immigration policy.

In closing, I would like to add my own opinion. I believe that the Japanese public, just like the populations of most other countries, has to engage more with the economic issues of the nation. At the end of the day, Japan is a democracy, so if people want economic reform, they can vote for it, whether through Shinzo Abe’s party or another. I also believe encouraging entrepreneurialism and a more open immigration policy will give Japan’s economy a particular edge and here’s why:

In 2012, the Wall Street Journal published an article called “Made Better in Japan” – highlighting the Japanese principles of “perfection, specialization, craft, and obsession” that are now being applied not just to their own culture but to everything else from the rest of the world. For example, Tokyo holds the world record for Michelin stars and, as of 2012, had more stars than Paris, New York, and London combined. Now, imagine if you combined these Japanese principles with entrepreneurialism and smart immigration. This would really help make the economy more globally competitive.

Sounds like a tall order, but stranger things have happened. We only need to look to the recent past to see a country that went from feudal to modern in a generation. (show three pictures)

Fin.

(Endcard)

Thank you for watching, and we hope it was entertaining and educational. If you liked what you saw, you can support us in a number of ways:

  1. Visit our website, artandfinance.net, which features a) more great blog posts, and b) Ilusion, our webcomic on finance,
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Links are in the description. Thanks and see you next time!!

Ramon Rodrigo Cuenca, CFA
Equities Analyst
Artandfinance.net

Assistants:
Mack Agbayani
Regina Tan

Sources/Links:

Gordon, Andrew. A Modern History of Japan: From Tokugawa Times to the Present.  pp. 49, 52-53, 59-63, 98-99, 245-246, 249-251, 299-300 (2003 Oxford University Press, Inc.)

“Did the Plaza Accord Cause Japan’s Lost Decade?”. International Monetary Fund.

“The Plaza Accord: The World Intervenes in Currency Markets”. Twomey, Brian.

“Yes, Japan Lost a Decade. So did US”. Smith, Noah.

“Lessons from Japan: Fighting a Balance Sheet Recession”. Koo, Richard C.

“How Japan’s National Debt Grew So Large”. The Economist via Barry Ritholtz.

“The Japanese Debt Crisis (Part 1): Has Japan Passed the Point of No Return?”. Rimkus, Ron CFA.

“The Japanese Debt Crisis (Part 2): When Does Japan Cross the Event Horizon?” Rimkus, Ron CFA.

“Bloomberg Quicktake: Abenomics”. Bloomberg Staff.

“Japan: The Third Arrow of Abenomics”. Deloitte University Press.

“Abe Orders Japan’s First Sales-Tax Increase Since ’97: Economy”. Mogi, Chikako and Reynolds, Isabel.

“Japan Unexpectedly Enters Recession as Abe Weighs Tax: Economy”. Fujioka, Toru and Ujikane, Keiko.

“Families hit as inflation outruns wage rises”. Bloomberg staff.

“How to Give Japan a Second Wind”. Pesek, William.

“How Low Can He Go? The Election Math for Abe to Stay in Command”. Reynolds, Isabel and Takahashi, Maiko.

“Abe Scores Commanding Majority in Japan Lower House Election Win”. Reynolds, Isabel and Takahashi, Maiko.

“How Japan Borrows $9 Trillion Practically for Free”. Mayger, James and Ujikane, Keiko.

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