Prime Minister Shinzo Abe’s announced plan to step down has ushered in a period of uncertainty about Japan’s attempts to recover from the COVID-19 economic downturn. But whoever succeeds Abe, Japan is likely to continue experiencing low growth, low inflation, low interest rates, and excess private savings in the foreseeable future—a combination that some characterize as “Japanification,” a term that has been applied to other advanced economies struggling under the weight of these factors.
Japan’s difficulties arose after its asset bubble burst in the early 1990s, and it has yet to emerge from its slow growth stagnation despite the government’s support. Given the prospect of continued social distancing, cautious consumers, and a private sector unwilling to take risks, Japanese policymakers are certain to maintain fiscal stimulus to cope with the impact of COVID-19. Governments and central banks in many other advanced countries are facing the same challenges, including the necessity of additional fiscal and monetary stimulus to their economies. “Japanification” may soon become the new normal in these countries.
Even before the COVID-19 crisis, economic growth in major advanced economies was slow. That trend is certain to continue as recovery from the pandemic picks up, in part because the disruption of global supply chains has reduced industrial capacity. Social distancing is also dampening economic activity—for example, in the restaurant industry, demand has been low because customers avoid dining out. Precautionary saving is above normal due to high uncertainty, which has reduced investment and consumption.
The effect on inflation, meanwhile, is unclear. Supply chain disruptions, combined with low mobility of people and capital, might bring higher inflation, as they did during the oil supply shocks of the mid-1970s, which led to high inflation and stagnation known as stagflation. The COVID-19 crisis, however, affects both the supply and demand sides, contributing to weak inflation. Inflation expectations are also low because of rising household and corporate precautionary saving. In the short run, low inflation will continue. On the other hand, as public borrowing and debt increase some experts worry about inflation down the road.
Central banks continue to aggressively intervene with massive injections of liquidity, asset purchases, and promises to continue low interest rate policies for the time being. Potential growth rates are going down, keeping natural rates down as well.
Together these trends are leading to higher budget deficits and debts even as output is decreasing. In Japan, where the debt-to-GDP ratio is around 200 percent, GDP is projected to contract 5 percent and deficits to increase by about 10 percentage points, increasing the debt-to-GDP ratio about 20 percentage points in 2020.
A long-running factor slowing growth in Japan is its low birth rate, which tends to get even lower after recessions. Social distancing may exacerbate the trend because it reduces physical contact, although no data are available at this stage.
As countries lift lockdowns and national emergencies, new policy tools will become necessary. For the moment, policy should focus on helping affected sectors survive. Aggregate demand should be pursued under the assumption that public health measures are taken to keep the risk of infection under control.
Several economic policy tools are available for policymakers as lockdowns are lifted (see Blanchard, Philippon and Pisani-Ferry 2020). First, governments should do everything it takes to contain the virus. Second, they should provide subsidies and other assistance to keep businesses operating so they do not go under in an environment of low demand due to social distancing and other health measures. Firms heavily affected by COVID-19 should be provided with the needed capital. These measures should not be used to help zombie companies, but since this an unprecedented health crisis and infections are expected to be temporary, such extraordinary measures are justified.
Many governments are now running huge fiscal deficits and have higher public debt levels. Some point out the risk of high inflation and public debt crisis. Although low inflation/deflation is likely to continue in the short run, the risk of high inflation increases with rising debt levels.
This risk could materialize along four potential paths. First, large fiscal deficits continue to grow. Under adverse fiscal conditions, bond investors require higher risk premium. Second, the safe rate rises. If potential growth rises for any fundamental reason, the safe rate will rise. The third risk is fiscal dominance, where central banks cannot cope with inflation due to political constraints. Fourth, supply constraints and stagflation occur. Central banks have to raise interest rates to contain inflation during economic difficulty and declining tax revenue. Any single factor will not generate inflation; a combination of these factors will.
How should these risks be handled? The first risk is inevitable, and it is desirable to run deficits to maintain economic and social activities. For the first and second risks, central banks can kill the bad equilibrium while committing to low interest rates. The third risk is worrisome. As discussed in my PIIE Policy Brief with Olivier Blanchard, contingency planning is important as the government can automatically cope with the risk. The fourth risk is difficult. The government should raise revenue to manage the crisis. To prevent this risk, fiscal policy should be used now for productive purposes, including to ensure businesses survive during the COVID-19 recession.
In sum, the most likely scenario in advanced economies after the COVID-19 pandemic is prolonged Japanification: low growth, low inflation, low interest rate, and excess savings in the private sector. In this scenario, small reductions in debt levels are less persuasive. Economic stimulus should not be withdrawn preemptively. As for high inflation risks, the ability to cope with them is important. The risks should be dealt with through contingency planning rather than preemptive fiscal consolidation. After the COVID-19 crisis fades, nominal growth rates should exceed interest rates thanks to the economic recovery, and debts as share of GDP should stabilize.
The author thanks Olivier Blanchard, Egor Gornostay, Adam Posen, and Eva Zhang for their comments.