Japan is wrong about its economy. Deflation was a symptom, not the cause

The economy stagnated as it was no longer as competitive, but misfiring central bank policies that propped up inefficient conglomerates made things worse
As Japan’s carmakers struggle to stay relevant and with monetary policy finally turning, the country must correct its course soon or face a dire future

Andy Xie

Published: 3:45pm, 19 Apr 2023

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Japan has mistaken its competitiveness problem for a monetary one. For decades, its central bank’s fight against deflation kept interest and exchange rates low, and in keeping a large and persistent fiscal deficit, government spending subsidised demand.

Uncompetitive companies were kept afloat as a result, depriving new and competitive companies of the resources they needed to rise. As a nation, Japan is being outcompeted and its living standards have steadily eroded. The disciples of Keynesian economics have helped the sun set on Japan.

Now, Japan’s inflation is at a four-decade high. Yet, Haruhiko Kuroda, who recently left as governor of the Bank of Japan and had vowed to revive inflation when he took the post in 2013, is not celebrating. It turns out that inflation can be bad, harming rather than reviving household demand.

Over the past three decades, many well-known economists have travelled to Tokyo to offer their advice on how to revive the Japanese economy.

The basic idea is that deflation depresses household demand because it makes it profitable to hold on to cash. Companies, in turn, become hesitant about capital expenditure – the major long-term investment needed for growth – thus, setting off a vicious circle.

The solution is to print enough money to cause inflation, which would reverse the psychology and revive the virtuous circle of rising household demand and capital expenditure.

A vegetable stand at a supermarket in Tokyo, Japan, on March 24. Inflation in Japan hit a four-decade high in February. Photo: Reuters

The idea of “helicopter” money to prevent or counter deflation was famously suggested by Ben Bernanke, who led the policy in the US in 2008 when he was the Federal Reserve chairman. His successor did this more aggressively during the pandemic. The disastrous consequences are not hard to see.

Interpreting Japan’s economic problems as simply a matter of consumer psychology has been calamitous. In 1992, Japan’s per capita income was four times South Korea’s, and one quarter higher than America’s. It is now on par with South Korea’s and less than half of the US.

In misdiagnosing its competitive challenges as a psychological issue – i.e., that deflation expectations were suppressing consumption, which was in turn prolonging deflation – central bankers decided to apply monetary policy like a course of mind-altering medicine.

The resulting zero-interest-rate policy and massive fiscal deficit subsidised and prolonged the lives of many uncompetitive and heavily indebted companies. Japan essentially froze its corporate structure, leaving it unable to cope with the coming digital revolution.

Japan dominated the semiconductor and consumer electronics industry in the 1980s. It was in a perfect position to lead the digital revolution. When Nokia dominated the mobile phone industry in the 1990s, Japanese companies were still making great phones for the domestic market. But by 2007, when Apple launched the iPhone, which was quickly followed by Android smartphones, Japanese companies faltered. Japan’s economic decline had become entrenched.

Japan’s Kyocera unveils the world’s first video mobile phone with colour images at a Tokyo hotel on May 17, 1999. Japan once dominated the consumer electronics market. Photo: AFP

But Japan has not just lost its dominance in semiconductors and consumer electronics. Many of the industries that Japan traditionally had strengths in had also been taken over by China, such as chemicals, steelmaking and shipbuilding. China also reinvented many traditional industries on an unprecedented scale by incorporating digital technologies in the manufacturing process.

In both the cutting edge and traditional industries, Japan has fallen behind the competition. This is the cause of Japan’s economic stagnation – deflation was merely a symptom. With central bankers like Kuroda seen to be taking on the “fight” against Japan’s decline, incompetent corporate and political leaders were free to do nothing.

Like Japan, South Korea’s large industrial conglomerates dominate the economy. But the 1997 crisis cleared out the many inefficient conglomerates that depended on political connections to survive. While former prime minister Junichiro Koizumi tried to reform Japan’s banking system, the country never had the corporate cleansing it needed.

As the central bank provided the ruling elites with an excuse not to act, Japan avoided necessary surgery and reached for homeopathy.

Its prolonged stagnation has had a profound socioeconomic impact. Japan’s poverty rate has risen from 11 per cent in 1985 to 16 per cent in 2020, and one in seven children live in poverty.

02:49

Schools close across rural Japan as birth rate plummets

And while all developed countries experience demographic declines, it is a catastrophe in Japan. Last year, nearly twice as many people died as were born. Many people who don’t have children would live in poverty if they did.

Economics is a big factor in Japan’s demographic decline. The inverse triangle in the population pyramid will devastate the country’s finances, making it even harder to have children.

Now, Japan faces yet another existential challenge. The global shift towards electric vehicles is imperilling Japan’s car industry, which accounts for 8 per cent of national employment and a quarter of its exports. A leading producer of internal combustion engine (ICE) vehicles, Japan is reluctant to give up this strength.

How Toyota, Honda and Nissan ceded the electric vehicle market to Tesla, BYD

As green government policies all over the world increasingly rule out ICE cars, Japan is watching its markets shrivel up. This is another iPhone moment for Japan. If it doesn’t correct its course soon, its economic future will be extremely dire.

Japan is an example of what not to do when a country faces competitive challenges. Corporate incumbents never want to die. They have established political relationships to sustain an environment for their survival.

For an independent central bank, the best option would be to hold the line on the new monetary policy and force out inefficient players. A financial crisis? Even better: it would clear the room for innovative new players.

Andy Xie is an independent economist

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