Download Economist Insights What rhymes with Japan?

Asset management
16 September 2013
Economist Insights
What rhymes with Japan?
Two decades ago, Japan experienced a sharp crisis
followed by a sustained weak economic performance.
Looking at countries that are experiencing a weak
recovery now and how closely they resemble Japan in
the early 1990s may tell us something about how likely
these countries are to repeat the experience of Japan.
In this week’s piece, we use six characteristics to compare
these countries with Japan in the 1990s.
At the height of the financial crisis, it was common for
economists and other commentators to compare and contrast
that crisis with the Great Depression. Such comparisons help us
to get a sense of the scale and in particular to gain some idea
of what policies might be effective. With the crisis part of the
financial crisis over but the subsequent recovery turning out to
be barely worthy of the name, the comparison that people are
now focusing on is one with Japan’s lost decade (or two).
Japan experienced a sharp crisis that was followed by a
sustained weak economic performance, so it is easy to see why
the comparison is made. For a long time the lost decade was
commonly blamed on uniquely Japanese characteristics that
made the economy behave this way. But blaming something
unusual on ‘unique’ characteristics is just another way of
saying that you do not understand why it happened. Now that
we have more countries with weak recoveries to look at, it
may be easier to identify those characteristics that some share
with Japan. In short, other countries can be ranked according
to how closely they resemble Japan in the early 1990s, which
may tell us something about how likely they are to repeat the
experience of Japan.
Inflexible markets. A recession is usually the economy’s way
of telling you that too many resources were allocated to the
wrong sectors. If workers become unemployed and businesses
go bankrupt then those resources become available for use
elsewhere, where they can be more productive. Efficient,
flexible labour and product markets would allow that to
happen easily: unemployment would rise rapidly but then
also come down quite quickly as resources were reallocated.
Despite the severity of the financial crisis that hit Japan in
the early 1990s, the unemployment rate increased only quite
gradually (although it kept rising for some time). Firms were
reluctant to lay off workers, adhering to the idea of lifetime
Joshua McCallum
Senior Fixed Income Economist
UBS Global Asset Management
[email protected]
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
[email protected]
employment. Contrast that with the US, where it is both easier
and more commonplace to lay off workers, and where the
unemployment rate shot up quickly but has since been falling.
The latter may be more painful for those involved, but for the
economy a dose of ‘creative destruction’ can be soothing and
eventually lead to a more rapid recovery.
As for other economies, the UK labour market most resembles
the US, but this time round it has been behaving a bit more
like Japan: unemployment did not rise as much as in the
US but also has moved sideways. This may suggest labour
hoarding but could also indicate greater flexibility in nominal
wages and hours worked. In Europe, labour markets in most
countries are far more rigid, much as in Japan in the 1990s.
But the difference in Europe is that the unemployment rate
has indeed risen rapidly – firms simply had no choice or were
going out of business. Rigid labour laws in many countries,
such as Spain, discourage firms from hiring unless they are very
confident of the economic outcome so the unemployment
rate has not fallen like it has in the US. The notable exception
must be Germany, where there was labour hoarding but
also flexibility on hours and wages which enabled its
unemployment rate to fall even after the financial crisis.
Demographics. Japan in the early 1990s was unique in
being the first major developed economy to experience a
shrinking working age population, reinforced by low female
labour force participation. It is no longer unique: much of the
Eurozone is now facing a shrinking labour force. The US and
the UK are seeing slower growth in their respective working
age populations but at least the growth remains positive.
Private sector deleveraging. The nonfinancial private
sector in most developed economies is in the process
of reducing debt, as Japan experienced, but there is
an important difference. In Japan, it was nonfinancial
corporates that cut back on borrowing while households
actually reduced their savings rate. In countries like the US
the nonfinancial corporates came into the crisis with strong
balance sheets, while households have had to correct their
savings. The impact of this difference is unclear, but the
Eurozone periphery is experiencing the worst outcome
with both the public sector and parts of the private sector
deleveraging at the same time.
‘Zombie’ banks. A ‘zombie’ bank is a bank that requires
artificial support to survive and/or is not really engaging
in the kinds of activity that a living bank should. Such
banks are hooked on artificially cheap financing from the
central bank or handouts from the government. And as
happened in Japan, zombie banks tend to roll over debt for
nonperforming loans (“evergreening”) and stuff their balance
sheets with government bonds – rather than get involved
in the riskier business of lending to new companies that
can bring growth. The US did a good job of exorcising its
zombies very quickly: many small banks (and a few big ones)
failed, but all were forced to face up to their bad loans, take
the hit and move on. In Europe the story is more complex
and mixed. Ireland and Spain have both set up ‘bad banks’
to absorb distressed assets, but in the core countries there
has been less openness about potential bank balance sheet
problems. Furthermore, banks in the Eurozone have indeed
cut their lending to the private sector in favour of lending
to their sovereign (although given sovereign debt problems
some would consider that another type of “evergreening”
of loans). Meanwhile the UK may have done a lot more in
terms of nationalising the banks, but it has not stripped out
the bad assets.
Monetary policy. The Bank of Japan may have been the
first to introduce quantitative easing (the rinban operations)
but compared with the QE of recent years this was barely
dipping a toe in the water – and about a decade late at
that. Of course, other central banks had the Japanese
experience as a warning, but even now the Bank of Japan
is implicitly acknowledging that the easing that went before
was grossly inadequate. The laggard now is the European
Central Bank, which still has quite some way to go to
remove market fragmentation and repair the monetary
transmission mechanism. This could become even more
challenging in a context where its balance sheet has been
shrinking substantially.
Fiscal expansion. The reaction of the Japanese government
to its crisis was to run increasingly large Keynesian-style
deficits through the 1990s. Europe was left with no choice
but to do the opposite after its fiscal crisis kicked off in recent
years. The trickier thing to establish is whether this makes
Europe less like Japan or does it make Europe more likely to
experience prolonged sub-par growth? A Keynesian would
argue that larger public deficits were the one big thing that
Japan got right. The US followed a different approach: an
initial fiscal expansion followed by subsequent tightening.
The UK did something similar, with less expansion but
a delayed fiscal tightening. The jury is still out on which
approach is likely to be the most successful.
Scorecard
Comparison of characteristics of different economies with Japan in
the early 1990s
Eurozone
US
UK
Core
Periphery
?
?
?
?
Inflexible markets
Deleveraging
Zombie banks
Demographics
Monetary policy
Fiscal policy
Most resembles Japan; Similarities to Japan;
Different from Japan;
Very different from Japan; ? Undetermined
Source: UBS Global Asset Management, authors’ judgements
So how good is the comparison with Japan for different
countries? Whatever the US is experiencing, it is likely to
be very different from what Japan experienced. The UK is
experiencing a few problems reminiscent of Japan, but differs
in some quite important ways.
Despite the progress since the onset of the recent crisis,
Europe still seems to have the most similarities to early
1990s Japan, but in some ways parts of the periphery look
worse while other aspects look better. There is still enough
similarity there to make the prospect of a lost decade in the
periphery of the Eurozone look likely. Even Germany had to
go through its own lost half-decade in the early 2000s to
correct the imbalances of its own economy. As usual with
historical comparisons, do not expect history to repeat itself –
but sometimes it does rhyme.
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