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The Dismal Science
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Japan: What went wrong?

By Paul Krugman
(posted Thursday, June 11, 1998)

       In an early-'90s Dilbert, an excessively trendy manager exhorted his team to "search for excellence in the total quality chaos, or whatever the Japanese are doing this month." Only a few years ago, the business sections of airport bookstores were largely given over to tracts revealing the supposed secrets of Japanese management and the menace Japan posed to the United States. Then it turned out the Japanese were human, after all, and everyone lost interest. Western pundits, having once placed Japan on a pedestal, now either prefer not to discuss the subject or see Japan's failures mainly as an occasion for smug self-congratulation.
       But the new story is much more interesting than the old one. How could a wealthy, productive, sophisticated country have gone from enviable growth in the 1980s to stagnation in the '90s, and now be slipping into a downward spiral of recession and deflation? True, Japan is not a country on the edge of chaos--as Indonesia or Russia is--but that only adds to the mystery. Japan isn't a place where the state is weak, unable to collect taxes or convince investors that their property rights are secure. Nor is it a country at the mercy of skittish foreign investors who must be persuaded to roll over its debt: Japan is still the world's largest creditor. So what's the explanation?

Inefficiency? Japan has many inefficiencies that limit its productive capacity--too many mom-and-pop stores, not enough computerization in the office, and so on--but inefficiency per se is not the immediate problem. What Japan lacks right now is not supply but demand: Japan's consumers and investors just aren't spending enough to keep the country's shops and factories busy.
       And the usual remedies for inadequate demand aren't working. Interest rates have been pushed down almost as far as they can go. Like the Fed, the Bank of Japan normally targets the interest rate on overnight loans that banks make to each other. The difference is that this rate is more than 5 percent here, but basically zero there. The big public spending projects the Japanese government launches every now and then do create some jobs, but they never seem to yield enough bang for the yen: The economy keeps relapsing, while government debt keeps mounting.

There are three common explanations for Japan's plight.
       Explanation 1 is that it is mainly a financial problem. Japan's corporations are too burdened with debt, its banks too burdened with bad loans that have never been acknowledged. On this view, what Japan needs is a long, painful financial housecleaning.
       Explanation 2 is that the problem is mainly psychological. When the "bubble economy" of the 1980s (remember when the square mile under the Imperial Palace was supposedly worth more than all California?) burst, goes the story, consumers and investors went into a funk that has depressed the economy, and the depressed economy has perpetuated the funk. On this view, what Japan needs is a jump-start--say, a massive but temporary round of tax cuts and public spending programs that will restore confidence and get people spending again. (Although it is tactless to say this, the model everyone privately has in mind is the way wartime spending jolted the United States out of the Great Depression. Thank you, Adm. Yamamoto!)

Illustration by Robert Neubecker
Explanation 1 doesn't make sense to me. If Japan's problem is demand, not supply, how do corporate debt and bad loans cause that problem? You might say that the answer is obvious: Overindebted companies can't borrow more, and the banks are in no position to lend anyway. But Japan's investment as a percentage of gross domestic product is the highest among major advanced economies. And banks have been lending, too--after all, where do you think those excessive debts and bad loans came from? The problem is that even these high rates of investment aren't enough to absorb the huge sums that consumers apparently want to save.
       Until recently I was more sympathetic to Explanation 2. But lately I have started to wonder whether the stubborn unwillingness of Japan's economic engine to catch is, as many foreigners seem to think, merely because the jump-start hasn't been big enough or sustained enough. And so (like a small but growing number of people, including at least one influential Japanese economist) I have started paying attention to Explanation 3--that Japan's troubles really stem from a subtle but deadly interaction between demography and ideology.

Here's the story: Japan, like the United States only much more so, is an aging society. Thanks to a declining birth rate and negligible immigration, it faces a steady decline in its working-age population for at least the next several decades while retirees increase. Given this prospect, the country should save heavily to make provision for the future--and lacking the kind of pay-as-you-go Social Security system that allows Americans to ignore such realities, it does. But investment opportunities in Japan are limited, so that businesses will not invest all those savings even at a zero interest rate. And as anyone who has read John Maynard Keynes can tell you, when desired savings consistently exceed willing investment, the result is a permanent recession.
       If this is the problem, there is in principle a simple, if unsettling, solution: What Japan needs to do is promise borrowers that there will be inflation in the future! If it can do that, then the effective "real" interest rate on borrowing will be negative: Borrowers will expect to repay less in real terms than the amount they borrow. As a result they will be willing to spend more, which is what Japan needs. In short, this explanation suggests that inflation--or more precisely the promise of future inflation--is the medicine that will cure Japan's ills. The trouble--the other half of the Japanese trap--is that while the conclusion that Japan needs inflation emerges from what looks like impeccable economic logic, we live in an era in which central bankers believe (and are believed to believe) in price stability as an overriding goal. The peculiar result of the credibility of modern central bankers as inflation hawks is that no matter how much money the Bank of Japan prints now, it doesn't matter: It can't lower the nominal interest rate, because that rate is already zero, and because people don't believe that it will allow inflation to break out any time in the future, it can't lower the real interest rate either.

This theory is offensive to many people. Deep economic problems are supposed to be a punishment for deep economic sins, not an accidental byproduct of swings in the birth rate. Inflation is supposed to be a deadly poison, not a useful medicine. Above all, it seems implausible that the proposed solution to such severe difficulties could involve so little pain. And while I think logic and evidence are on my side--that demography, not crony capitalism, is the villain, and inflation is the answer--it is certainly possible that I am wrong.
       But Japan worries me. It's not just that we are talking about a huge economy here, an economy whose woes can drag down a lot of smaller countries with it. What really disturbs me is this: If we don't really understand what has gone wrong in Japan, who's to say the same thing can't happen to us?

If you missed Krugman's assessment of Kazuo Ueda, click here.


A more technical exposition of Krugman's views on Japan is posted on his Web site. John Makin of the American Enterprise Institute offers a caustic assessment of Japanese policy. The Bank of Japan provides reports and statistics, as well as research papers, on Japan's economy. For more information on the subject, visit the Economic Planning Agency of Japan. Professor Kazuo Ueda's remarks at the Conference on Asia and the International Monetary Fund, are available here.

Paul Krugman is a professor of economics at MIT. His new book, The Accidental Theorist and Other Dispatches From the Dismal Science, was published this month. His home page contains links to many of his other articles and essays.

Illustrations by Robert Neubecker.

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