Mr. David Asher, MIT Japan Program

March 29, 2000

How closely is Japan today repeating the economic performance and policy errors of the 1920s? That era was the previous one in which Japan systematically attempt to open to the outside world. Today, after a decade of decay, Japan's economy remains mired in stagnation. This was also the case at the end of the twenties. Similarly, democratizing reforms and financial crises characterized both periods. By further investigating the similarities in the economic situations between the periods, we can better understand the possible implications for Japan's grand strategy in the future.

Today, the economic situation in Japan can be characterized as suffering under the five "Ds": debt, deflation, default, demography, and deregulation. Regarding the first of these, Japan today is on the cusp of a debt crisis of the scope the world has not seen. Currently, Japan's government held debt is fifteen times larger than its tax revenues. This ratio is twice as high as the next highest historical record, Britain following world war two. Furthermore, Tokyo's annual interest payments account for some 65 percent of its annual tax revenues, leaving very little for financial stimulus. Rather than facing a liquidity trap, Japan today faces a debt trap. There are only two possible solutions to this. First, Japan might rely on expansionary monetary policy to inflate its way out of the current problem. This would have tremendous effects on social stability. Alternatively, Tokyo might choose to implement IMF style orthodox economic reforms, involving large scale writing off of assets. This too would have substantial costs, necessitating deep changes in the economic system that produced the miracle of Japan's post-war growth.

The second "D" of default manifests itself in a bankruptcy rate that accounted for three percent of the gross domestic product (GDP) in 1997 and 1998. This rate is higher than ever seen in an OECD economy. As firms exercise their exit options, the unemployment rate has risen to post-War highs, and the number of businesses eliminated per year now exceeds the number created.

Deflation has been a third characteristic of Japan's current recession. More than a decade after the bursting of the Japanese bubble, asset prices continue to spiral downward. The decline in land prices accelerated to 4.4 percent last year, an even steeper decline than the prior year. Deflationary pressure is likely to continue as a result of deregulation, which reduces the cost of many consumer goods (however, at least this has some positive impact given that consumer spending in deregulated sectors has been somewhat responsive to such price changes). As deflation continues, pressure on the corporate sector is likely to increase as much of their debt relies on land for collateral --land that was valued at the peak of the bubble economy.

Demography presents the fourth key challenge to the Japanese economy. Japan is entering a profound aging crisis. By 2002, its working age population will be decreasing by 2 percent a year. Attempts to address this concern through increasing the worker participation rate are unlikely to help substantially as the unemployment rates in the youngest and oldest age brackets (the usual targets for programs to increase the size of the workforce) are among the highest in Japan. Finally, the social security system in Japan, which has been running a deficit since the mid-seventies, will soon face accelerating difficulties. By 2005, its liabilities are expected to exceed income by nearly 13 percent. In the context of the worsening fiscal position of the central government, it is unclear how the shortfall will be funded.

The fifth "D" of deregulation presents short-term dangers while holding promise in the long term. Capital productivity remains problematic. Japan still invests a third more than the US does, and its investment levels remain fifty percent higher than the OECD average. While such high rates would be worthy of emulation if they led to higher growth, today there are reasons to question the productivity in Japanese investment: Japan's returns on investment are only half as large as those of the US. Deregulation is the only solution to such unproductive economic activity.

These five "Ds" describe an economy in crisis. But is Japan repeating itself? In each of the five above areas, the current Japanese experience eerily parallels that of eighty years ago. (Debt is somewhat anomalous, as in the 1920s government debt rates were not so high.) Furthermore, both today and at the beginning of the century, we see a decline in the power of the traditional ruling oligarchs. Both then and now huge economic problems compel the nation to open itself up to external investment. Both then and now recent democratic reforms constrain the government's ability to effectively implement adjustment policies. Both then and now reactionary forces have raised voices in protest of the economic deprivations. Both then and now the policy response to the economic crisis can be characterized as weak and ineffective. In both periods it has relied on fiscal and monetary stimulus, propping up a failing banking sector, mismanagement of currency relations, and dependence on gaiatsu for stimulus for reform.

Looking forward, we might imagine three possible scenarios that could characterize Tokyo's attempts to respond to this crisis. First might be a continuation of repeating of the Taisho experience. This would consist of half-baked reform plans, continued stagnation, a continued outward migration of business opportunities, and a withering (although not abrogation) of the US-Japan alliance. A second scenario might be characterized as a repeat of the Tory Renaissance period. This would posit a sea change in views within Japan. It would include aggressive restructuring of the economy, a massive inflow of foreign capital, and a true opening of the Japanese economy. In this scenario, the US-Japan alliance would become even stronger, as befits a "normal" Japan. A final scenario might have Japan play the role of a modern day Weimar Germany. Political inaction and a reliance on magic bullets such as monetary expansion could spark runaway inflation, capital flight, economic implosion, and the rise of reactionary movements at home. Such a scenario would have profound dangers for East Asia. A Weimar Japan, while not returning to its imperialist policies of the past, might still provoke arms races in Asia. If Japan turns inward and isolationist, it may feel a need to increase its military and operationalize its latent nuclear potential. Such action on its part would inevitably worry its neighbors.

None of these scenarios is guaranteed to come to pass. Notionally, we might assign probabilities to each: continuation of the Taisho experience, 50 percent; a turn to the Tory Renaissance, 25 percent; and a decline toward Weimar outcomes, 25 percent. While Japan today has more robust democratic institutions and stronger civilian control of the military today than it did eighty years ago, the prospects of the final scenario coming to pass bear watching.

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