How Japan Escaped A Depression

Japan suffered a financial crisis that was, in a sense, as bad as the west in the 1930s, or today's financial crisis. Asset prices (land and equity) fell a whopping 1500 trillion yen's worth of wealth - that is three years of Japanese GDP. Compared to that, the 1930s Great Depression was garden variety stuff; the US lost only one year's GDP in wealth.

Yet, despite that mother of all asset price crashes, the Japanese economy kept on performing remarkably well. Many people speak about a Japanese lost decade, or even decades, but a cool look at the figures gives a radically different picture.

First, here you see that GDP kept on growing, contrary to other countries experiencing similar financial shocks (often of lesser magnitude, as it happens).

And here is GDP per head and unemployment. Quite a lost decade, isn't it?

One really starts to wonder whether von Mises had it right:

There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.

- Ludwig von Mises

We guess the jury is still out as Japan has developed a rather large public debt in the process, but on the other hand, one has got to give them credit for dealing with a Great Depression-like financial collapse while experiencing anything but a Great Depression.

What did they do?
Well, at first, not a whole lot as it happens. Japanese policy reaction was rather slow out of the blocks. The Bank of Japan (the Japanese central bank or BoJ) waited quite a bit before lowering interest rates. Banks were even much slower to react to their growing mountains of bad debt. However, corporations were pretty fast in reducing theirs.

Businesses used their free cash flow (FCF) to pay down debt, rather than paying dividends (traditionally very low in Japan anyway) or invest in new capacity. They, in the words of Richard Koo, moved away from profit maximization to debt minimization. The deleveraging of the private (corporate) sector is nicely illustrated below:

click to enlarge

You also see that bank credit to business fell from 85% of GDP at the high of the bubble to just over 50% of GDP just before the financial crisis of 2008, a low "last seen in 1956." Normally, one would expect that the combined impact of such a massive wealth destruction and credit contraction would have rather severe consequences for demand and the economy.

That this hasn't happened (at least not anywhere near to the extent that could be expected from the magnitude of the financial crash and the subsequent reaction in reducing credit demand and paying down debt) Koo attributes solely to the reaction of expansionary fiscal policy.

The fiscal policy reaction had three effects:

• The budget deficit widened and public debt rose (after two decades, public debt now stands at a whopping 200% of GDP).
• The fiscal policy maintained aggregate demand, hence Japan didn't experience a recession (let alone a 1930s style depression).
• This allowed the corporate sector to deleverage.

There are a number of reasons to argue why fiscal expansion maintained the economy afloat:

• Monetary policy is powerless in a balance sheet recession, according to Koo.
• Japanese money supply has been kept up by Government borrowing.
• Premature fiscal retrenchment caused a slump in 1997 and 2001.
• There isn't really any other convincing explanation of the same magnitude.

We'll look at monetary policy at another time (basically, it was only in 2001 that the BoJ embarked on quantitative easing, or QE, and one can't say that it has been a raving success), but here is the effect of public borrowing on the money supply:

And just like the US in 1937, premature fiscal retrenchment caused a considerable recession in 1997 and then again in 2001:

All this leads Koo to a rather remarkable conclusion:

Had there been no fiscal stimulus, the Japanese economy today would have contracted by 40-50%, if the U.S. experience during the 1930s is any guide. [Richard Koo]

Yes, apart from the 2001 recession (and of course the 2008 financial crisis), Japan has benefited from a rather benign international economic environment. But it has faced other headwinds. Its population is declining and aging at the fastest rate in the world. It's experiencing mild deflation and currency appreciation.

And there is something else that's truly remarkable about this Japanese experience. Even with budget deficits at 10% of GDP, Japan still generates a net savings surplus (which, through an accounting identity, also manifest itself as a trade surplus). Japan as a whole still spends less than it earns, accumulating foreign assets in the process. Japan is the world's largest creditor nation still.

This is nothing short of astounding, considering the type of financial shock it experienced and the unprecedented levels of deleveraging of private balance sheets, and the leveraging up of the public balance sheet. Whether these Japanese experiences are reproducible in the west, suffering from similar types of financial shocks is another matter altogether, which warrants an article by itself.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.