Bill Emmott - International Author & Adviser


The world crisis and its impact on Japan
Voice - 2009

If we can trust the economic statistics, then the global economic crisis of 2007-09 has come to an end. As 2010 began, output was rising again in Japan, the United States, France and Germany, and economic growth has rebounded in both China and India. Wall Street banks are again reporting huge quarterly profits and are paying out vast bonuses to their staff. The oil price is hovering at about $70-80 a barrel, which is more than double the level of March 2009 and almost ten times the lowest level the oil price reached in the late 1990s. Ministers and government officials from 192 countries have just gathered in Copenhagen to negotiate about climate change, and succeeded in settling upon a political framework for a full treaty to be negotiated during the course of 2010. The war in Afghanistan grinds tragically on. There is little prospect of a peace deal between Israel and Palestine, nor much chance of persuading North Korea to give up its nuclear weapons.

            Based on that description, someone who fell asleep in early 2007 and woke up now, in a modern version of the American story (by Washington Irving) of Rip Van Winkle, might think that nothing had changed—except in domestic politics. He would see a black president in the White House, in the person of Barack Obama, he would see the first proper and strong non-LDP government in Japan since 1955, in the shape of Hatoyama Yukio´s DPJ-led coalition, and he would see a re-elected female Chancellor of Germany, in the person of Angela Merkel, forming a new centre-right coalition with the small pro-market Free Democratic Party. But in economics and in the capitalist system, our awakening sleeper would struggle to spot anything much that was new, while he was rubbing the sleep from his eyes. Many things would just look normal to him. Greedy bankers, greedy oil producers, rising economic strength in China and India, increasing concern about carbon-dioxide emissions, even the pressure of ageing populations: the big long-term trends would look intact.

            Yet that first impression would be wrong—or at least highly misleading. Many of the big long-term trends are indeed intact. But as a result of these two years of crisis, the world really will be different in many ways. It will not be as utterly different as some rather hysterical analysts or commentators predicted when the financial crisis was at its most shocking and scary: capitalism is not dead, and neither is globalization. The state is not going to take over leadership of the economy from the market system. Banks are not going to disappear, and the people who run them and trade securities for them will still be paid extraordinarily large sums of money. But that does not mean that life will be unchanged.

            After all, although the global recession of 2007-09 was nowhere near as severe as was the Great Depression of the 1930s, to which it was often compared, it has nevertheless been worse on many measures than any other recession since 1945. In the United States, the drop in real GDP, the fall in industrial production and the reduction in employment have all been worse in this slump than in the previous worst, that of 1957-58—though only just. The drop in real GDP from peak to trough was 3.8% in 1957-58 and on the latest figures has been 3.9% this time. So far, the unemployment rate in America has not reached as high a level as it did in the 1981-82 recession (10.8% against 2009´s peak of 10.2%), but the total loss of jobs has been greater since unemployment began this recession at a lower level.

In Japan, still the world´s second-largest economy, this has clearly been the worst post-1945 recession, by far, with a 6% drop in real GDP likely for 2009 as a whole. In fact, among the 30 member countries of the Organisation for Economic Co-operation and Development (OECD), which groups together the world´s richest and most developed nations, the drop in Japan´s output between September 2008 and March 2009, when the crisis was at its height, ranked it the 26th worst out of the 30, with only Turkey, Ireland, Mexico and Slovakia suffering more. In terms of the drop in its exports during that period, Japan was clearly the worst affected.

            Although Japan´s economy has performed worse than have its main equivalents in Europe and North America, in another very important sense the rest of the rich world is now sharing the Japanese experience. For one crucial difference in this crisis and recovery, compared with the recessions of the 1970s, 80s and 90s, is that in the rich, industrial countries this is now a crisis of deflation and of excessive debt, not a crisis of inflation. The implications of deflation and of the process of reducing excessive debt levels are now familiar to Japan, given its experiences since the mid 1990s, but they are entirely new to America and to Europe. The speed of the recovery, the changes in consumer and corporate behaviour, the new situation of the banks—all can be described as uncharted territory for the West.

            For Westerners, the past offers no real guide to how the future will unfold. And if they look at Japan´s "lost decade" as a guide, they are likely to become terrified about their prospects. Japan has suffered greatly, but thanks to its great social cohesion it has not faced social conflict or instability as a result. How many Europeans or Americans will be as confident that their countries would fare as well, if they too now "lose" a decade or more?

Psychology and globalization will hold the key

Whether or not America and Europe now follow Japan´s bad record will depend on a strange interplay: the interplay between psychology and globalization.

            In Japan during the late 1990s, a deflationary psychology set in among corporate managements, consumers and even policy-makers: companies kept on cutting their debts, for fear that deflation would make those debts harder to service and repay; consumers deferred spending once prices began to fall, and then found themselves forced to cut their spending once their wages began to fall, too; and government policy-makers encouraged wages to fall, though they may not have realized they were doing so, by reforming the labour laws in order to permit a large increase in the use of part-time and irregular workers, on lower wages and fewer employment benefits than full-time regular workers. They did this in the belief that what was needed was a boost to corporate competitiveness, by helping firms reduce their labour costs. But the result was a continual decline in domestic demand, as household incomes also declined. The saving grace for Japan was globalization: the ability to expand exports and thus exploit strong foreign demand, especially in China.

This interplay is now again going to be critical in America and Europe. Psychology is especially important. Here´s why. Many people have criticized economists for failing to predict this economic crisis. Part of that criticism is unfair: in fact, many economists warned that a crisis was going to occur. But the part that is fair relates to the difficulty economists faced in predicting the severity and magnitude of the crisis, which is also linked to the difficulty now in predicting the strength and nature of the recovery. This difficulty arises from the fact that economics is not a science, and nor can its ideas and findings be reduced to mathematical equations: it is, at its root, the study of human behaviour.

When a big shock occurs, human behaviour can change in essentially unpredictable ways: trust can disappear, caution can replace confidence. The disappearance of trust explains why the credit markets froze up in the way that they did; the shift to caution explains why consumer and corporate demand suddenly slumped after the collapse of Lehman Brothers, as households and corporate managers both decided that the prudent course of action was to suspend purchases of things like new cars, TVs, computers or machine tools. The severity of those reactions, of loss of trust and of confidence, could not be predicted in advance.

            Now, the extreme need for caution has gone: economies are not collapsing, and no apocalypse looks near. With economic growth resuming in so many rich countries and rebounding in China and India, the case for caution has been reduced. But it has not disappeared altogether.

            American households, for example, borrowed more than they were earning in the years running up to 2007: in technical terms, their savings rate was negative. Since the Lehman shock, they have cut borrowing and resumed saving: by September 2009 they were saving on average nearly 5% of their disposable incomes. A similar trend can be seen in Britain, where the savings rate had similarly turned negative before the crisis and has now risen sharply. The crucial thing we do not know, however, is how high those savings rates will go, which is another way of saying we do not know how far consumers and indeed companies will go in repaying debts.

            The long-term average savings rate in the United States, until about 2000, was 8%. Just as it did in Japan during the 1990s, psychology will determine whether consumers choose to return to that level or whether they feel satisfied with savings just of 4-5%. It will also determine whether companies decide they need to keep on paying down debts and hoarding cash, in case of another rainy day, or whether they start spending, investing and borrowing again.

            This psychological question must be linked to globalization because the truly original, special characteristic of the 2007-09 crisis is that it has been genuinely global. Japan was lucky during the 1990s in that its economic slump took place at a time of strong global growth, which helped to cushion the blow of Japan´s domestic crisis. But now things are different. Virtually every country in the world has been affected by this crisis. Of the richer countries, only Australia avoided having a recession. Linkages between countries in the form of world trade and global capital flows have meant that this crisis was shared far more widely than any previous postwar recession.

Yet that downside consequence of globalization should also point to an upside: that global linkages through trade and capital ought now to mean that the recovery can and will be shared, too, and that each country´s recovery could serve to reinforce those of others. Having been a cause of pessimism and some recrimination, globalization ought now to bring hope and the chance of a collaborative recovery, as capital flows across borders seeking good investment opportunities and as rising demand is quickly transmitted around the world through growth in trade.

            If governments had responded to the shock by closing their borders, increasing trade protectionism and imposing capital controls, this optimism would not have been possible.  But they have not done so, at least not yet. The existence of the World Trade Organisation and all the treaties that created it is a main reason why protectionism has not spread more widely and quickly. There has been some protectionism, but it has not been substantial and has not yet sought really to challenge the WTO treaties.

            A second barrier to protectionism has been the creation of the G20 (Group of 20) global summits, which have meant that any major economy that introduced severe protectionist measures would have faced public embarrassment at the G20, in the full glare of the global media. Ultimately, though, the main reason why trade and capital have been left fairly free is that countries and their governments still seem to believe that globalization brings them more opportunities than costs. They hope that globalization will reinforce their recoveries, that export growth will substitute for weak domestic demand.

            On the face of it, this cannot be true. Not everyone can export their way out of trouble. Some countries have to be buyers, replacing the buying role previously played by American consumers. This, though, is where global capital freedoms are just as important as free global trade. For capital inflows, to finance domestic investment and consumption, can substitute for a growing trade surplus as a promoter of economic growth. A country that does not benefit from a rising trade surplus can benefit from capital inflows instead. Or at least, it has the potential to do so.

            The world badly needs to achieve a better economic balance, between deficit countries and surplus countries. The financial crisis of 2007-09 was not triggered off by the imbalances, but it was made far worse by them. The need for a better economic balance means that the excessive borrowers and importers of the past decade, such as Britain and America, need to be able to export more and import less, while the excessive exporters of capital and goods, such as China, Japan and Germany, need to be able to import more and export less.  This will occur in part through domestic policies to encourage consumption, but also through adjustments in exchange rates. If this rebalancing of supply and demand does not occur, then we could risk a new period of protectionism and a genuine retreat from globalization.

That is why it is essential that China should revalue its Renminbi and, ultimately, also make the currency freely convertible, as I argued in the second chapter of this book. China is the biggest anomaly in the global financial system, being the only major economy and major exporter that does not have a freely tradeable currency. A Chinese revaluation would also prompt some other Asian currencies to appreciate too. This need for rebalancing is also, however, why it is welcome and inevitable that the Japanese yen has become stronger and that the Euro has also appreciated. The days of Japan´s huge trade surpluses are disappearing fast. The rise of the Euro is painful for the member countries that run deficits and want to expand their exports. But it is an essential result of Germany´s vast current-account surplus in recent years.

Japan´s new predicament

A Chinese revaluation would be good for Japanese exporters: it ought, in principle, to make imports from Japan more competitive in that market. But that is the only good news for Japan that emerges from this picture of the post-crisis world. Exports to America are not likely to revive very soon, and nor are exports to Europe, as long as those regions still suffer from deflation and while the world is rebalancing itself. High oil prices and new measures to control carbon dioxide emissions will raise the production costs of Japanese manufacturers. With Japan itself still suffering deflation, the yen is likely to keep rising too, especially while the dollar stays weak.

            This is going to expose, quite cruelly, the failings of Japan´s own recovery and reform efforts during the 1990s and in this decade. That recovery and reform process changed many things, but they left the essential structure of the Japanese economy unchanged in all respects except that of the labour market. This is not always fully understood. In his article in Voice in September, Hatoyama Yukio launched an attack on "market fundamentalism" as the source of Japan´s problems during this economic crisis, and implied that when elected his DPJ government would follow a new course. In mid-November 2009 I went to visit Prime Minister Hatoyama at the Kantei, and asked him about his attack on market fundamentalism. He explained that he had not intended to criticize America. This, however, implies that his real target must have been Japan. On that basis, the attack was wrong, , in my view, and the idea of an anti-market course is also wrong.

            The attack was wrong, firstly, because there has never been any "market fundamentalism" in Japan. The Koizumi administration never attempted any significant expansion of market forces or freedoms during its time in office in 2001-06. It cut back public works spending, cleaned up the banking system and began (but did not complete) the privatization of Japan Post. Other than that, its deregulation efforts were very modest.

            The biggest economic or social change that occurred was the creation of a two-tier labour market, a process begun in the 1990s but greatly accelerated under Koizumi. This reform, which has resulted in 34% (in 2008) of the labour force being in part-time and irregular employment, while high protections and employment rights have been preserved for full-time, regular workers, has been responsible for the long-term decline in household incomes, for deflation, and for the huge rise in both poverty and inequality. But this is not "American-style market fundamentalism". Indeed, such dual labour markets do not exist in America. They are much more common in Europe. Like in Japan, they have emerged because of a lack of political willingness to reform the main labour market, the terms and conditions for the majority of workers. Instead, to cut costs and increase flexibility, a minority of workers—typically the young, women, and immigrants—have in effect been victimized.

            Such two-tier labour markets are not the result of brutal market fundamentalism. Instead, they are the result of the power of established interests in the form of today´s full-time, often unionized workers; and they are the result of political cowardice in refusing to confront those established interests. It is easier to victimize a minority than to confront the majority, and that is what has happened in Japan.

            Mr Hatoyama´s attack was wrong, secondly, because the basic nature of Japan´s economic expansion from 2002-07, its longest but not strongest post-1945 period of growth, was determined by the combination in that era of pro-market, liberalising reform abroad and the lack of liberalization in Japan. In 2002-07, fully two-thirds of Japan´s economic growth was provided by growth in its net exports—in other words, by the fact that Japanese exports expanded a lot faster than Japanese imports. The main source of this rising demand for exports was China, where liberalization produced rapid market growth; the second biggest source was the United States. Meanwhile, in Japan itself demand was weak. Why? Partly thanks to deflation and the decline in wages. But it was also the case that the decline in wages, and in demand, occurred because the service sector in Japan failed to increase its productivity and efficiency, and so failed to generate either rising incomes or profits.

Manufacturing, the sector that benefits most from rising exports, accounts for 20% of Japan´s GDP. Services, however, account for 70%. So the failure to liberalise, reform and otherwise reinvigorate service businesses weighed heavily on the economy. "Market fundamentalism" might have helped, but it was never tried. The result is that Japan during the Koizumi administration was like a four-engine jumbo jet in which only one of the engines was firing properly. Three of the engines—ie, the service industries—were barely ticking over. Looked at in that way, it is a wonder that Japan´s aircraft did not crash sooner. Certainly, though, once the global economic crisis sent demand for manufactures plummeting, Japan´s aircraft lost height extremely rapidly.

Better to make things, or to provide services?

To stick to that aircraft metaphor, what is now clear is that the manufacturing engine is unlikely to regain its power very quickly or strongly. What is also clear is that the huge weight of public debts inherited from the 1990s and now made larger by this crisis, will make the aircraft harder to get into the air. So too will the ageing of Japan´s population, which is going to carry on increasing medical and pension costs, while reducing the number of workers paying the taxes to finance those costs and to service the public debt.

            What this situation ultimately means is that a traditional assumption, the idea that Japan is best thought of as a monozukuri rikkoku, needs to be put aside, to be forgotten. That will be a hard thing to do. For it is very common to assume that manufacturing is good, that exporting manufactures is even better, and that Japan should play to its technological and sociological strengths in manufacturing by emphasizing it even more.

            In truth, this assumption ought already to have been put into doubt, thanks to the way the crisis itself has evolved since it began in 2007.  For since that time, perceptions of which sorts of country were being worst affected have continually changed: service countries, those led by "financial capitalism" or by manufacturing? Initially, it was assumed that the greatest pain would be felt in countries where banks had expanded most dramatically in the credit derivatives markets and where households and companies had become most indebted: in other words, America and Britain first of all, and then Ireland, Spain and Eastern Europe once the problem of high debts came into focus. America and Britain were where the biggest banking collapses were taking place, such as those of Lehman Brothers and the Royal Bank of Scotland. Japan, whose banks had played little role in the credit derivatives market and which had not been expanding internationally, expected to be fairly immune.

            Yet things did not work out that way. The financial dramas were centred on Wall Street and the City of London, with a big involvement by Swiss and German banks too, but that is not where the greatest economic pain took place. The biggest drops in GDP and in factory output took place not in America or Britain but in those countries that had remained strong in manufacturing: Germany, Japan and the emerging economies of East Asia. As consumer spending and corporate investment froze up, so demand for durable manufactured goods such as cars, machinery and consumer electronics also dropped like a stone.

            That is why, in 2009, as was previously mentioned, the biggest falls in real GDP were in Japan and Germany, with drops of about 6% each, roughly double the drop in American GDP during that year. The old idea, that by sticking to manufacturing those economies had avoided the frothy volatility of service businesses and had stayed virtuously hard-working, making real things, was instantly shattered. Far from insulating Japan and Germany from financial shocks, their reliance on manufacturing had seemingly made them more vulnerable.

As economic recovery began, during the summer months of 2009, that perception of vulnerability started to change again. The first rich countries to move out of recession were also the bigger manufacturers: Japan, Germany and France. They beat America to recovery by three months, and Britain by at least six months.

Yet this sort of short-term comparison is fairly meaningless. Short term comparisons between manufacturers and service economies are meaningless because they mix up the natural effects of economic cycles with the true, underlying sources of wealth and rising living standards. An economic cycle in which consumers and corporate investment suddenly stopped, as in 2008, was a type that was bound to hurt manufacturers the most, in the short term. The reason is that the slow decline in demand that preceded the Lehman shock in September 2008 had already left factories holding inventories of goods and parts that were larger than they needed. So when demand really began to slump they found they had to cut output by even more than that, in order to get their inventories back into balance. If "inventories" sounds rather abstract, think of Toyota or Honda with their car parks full of new, unsold cars. That was their excessive inventory. The car production lines had to be halted until those parking lots were a great deal emptier.

            Yet when demand starts to revive, the effect of inventory adjustments works in the opposite way. Manufacturers find that their inventories have fallen too far: they start to think they might not be able to supply the market properly. So they increase output by even more than the rise in demand, in order to rebuild their inventories. They need to refill those parking lots.

            That is why countries in which manufacturing still accounts for quite a large share of GDP had a worse slump than the service-led economies but also a faster rebound. In Germany and Japan manufacturing provides about 20% of GDP, compared with about 12-13%  in Britain and the United States. Yet this cyclical movement provides no guide to the longer term. It tells us about volatility, not about sources of wealth or sustainable growth.

            That is especially true in a "rebalancing" world, in which the previously strong export markets of America and Europe are going to become weaker, and where the big trade surplus countries such as Japan are going to have to reduce their surpluses by exporting less or importing a lot more. But it is also true for a more fundamental reason, completely separate from this crisis: this is that the old idea, of Japan as a "monozukuri" nation, makes no sense at all, because the distinction between manufacturing and services is now meaningless. Worse still, it is economically irrelevant. As I will argue in the final chapter of this book, the only meaningful and economically relevant distinction is that between "intelligent" and "unintelligent" economic activities.


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