Commentary Type

Japan Must Dip into Its Rainy Day Fund

Carmen M. Reinhart (Harvard University) and Vincent R. Reinhart (American Enterprise Institute)

Op-ed in the Financial Times


The recent scenes of devastation in Japan were staggering. The price tag for rebuilding will be no less significant, running into hundreds of billions of dollars. Such a financial burden would be difficult to bear for a healthy economy. Japan is not a healthy economy.

There has been much talk of the nation's resilience but, of late, Japan has shown few signs of being economically resilient. At the time of the disasters, national output had barely begun to recover from the 2008-09 global financial crisis, while its trajectory in the past two decades has been nothing short of depressing.

In fact, Japan's economic and financial system had never really recovered from the bursting of the equity and real estate bubbles (and the attendant systemic financial crisis) in 1992. Per capita gross domestic product growth averaged almost 6 percent between 1950 and 1991, and was heralded as a miracle of the mixed economy. But growth then slowed sharply, to a little above 1 percent. Wealth was badly hit, with inflation-adjusted residential real estate prices falling by about 50 percent since their peak.

The hemorrhaging in equities has been even greater, with the Nikkei still below its 1989 peak. Put another way, that index has made no net gains in the past 30 years. Real GDP per capita is 13 percent up since 1992, but nominal income is at about its 1995 level. Japan's fiscal position is no less dismal. Government debt is 226 percent of GDP, by far the highest of advanced economies. Even with low interest rates, such levels constrain the state's ability to respond to shocks. It is a major understatement to note that rebuilding will put a major strain on the resources of this rapidly ageing economy.

Rebuilding is not Japan's only problem however: It must also avoid a recession. In a recent study, we examined how 15 economies had responded to recent financial crises. The bad news is that large-scale banking crises, such as that recently suffered by Japan, leave a long trail of destruction-with real GDP growth about 1-1.5 percentage points slower in the decade after a financial fall. Worse, 7 out of those 15 suffered a second recession during the post-crisis decade. In all seven it was possible to point to an external force-such as a natural disaster-that pushed an already sluggish economy back into a slump. Japan is similarly vulnerable now.

So what should be done? Thankfully, Japan has a war chest of liquid assets at its disposal: Its authorities have been carefully stockpiling foreign exchange reserves (mostly US Treasuries) for years. At present, this stock is worth more than $1,000 billion, or slightly below 20 percent of GDP. To rebuild, the logical thing is to cash in some of this horde.

The problem is that few countries with large reserves seem to want to spend them. Economists have therefore puzzled over why they build up such foreign exchange reserves at all. Holding them is costly, given that yields on the safe assets favored by reserve managers are comparatively low.

One explanation says that states stock up on liquid assets to deal with unforeseen emergencies. Proponents of this view point out that demand for reserves went up after the Asian crisis of 1997-98, which might have taught authorities the value of self-insurance against volatile funding markets.

The more likely reason, however, is that central banks buy dollars to curb currency appreciation. This theory fits more of the facts. The 2008-09 global crisis was a shock to emerging markets, if there ever was one. Even then, however, authorities didn't touch their reserves. Indeed, in most cases they added to them.

The Japanese government seems reluctant to sell its holdings. If its reason for gathering them was fear of a stronger yen, as we suspect, they are likely to fear parting with them for the same reason. But whatever their provenance, these reserves do exist and Japan should sell some of them. Official estimates put rebuilding costs at more than $300 billion, which may well prove to be lower than the ultimate price. Financing those efforts through a government deficit, or the gimmick of an off-budget reconstruction authority, is risky. Debt-sustainability exercises already cast a pall over the nation's large financial obligations, in part because its rapidly ageing population will struggle to shoulder greater burdens.

Given Japan's weak financial position, and the risk of economic contraction, selling liquid foreign reserve assets is the sensible way to facilitate recovery. Rebuilding will provide a spur to spending that can offset potential yen appreciation. Relying less on debt will reassure both Japanese households, whose savings already fund most of the government, and global investors. Japan wisely built up a stock of foreign reserves for a rainy day. That rainy day is here, and Japan should move quickly in response.

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