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This independent study of Japan's economy was underwritten by
The Coca-Cola Company.
The Setting
The Japanese economy has undergone an extremely difficult period since its financial bubble burst in the early 1990s.
First, Japan experienced a "lost decade" of economic growth. Stagnation deepened by three or four separate recessions dominated economic performance after 1992. The financial system was strangled by a huge volume of nonperforming loans that sapped the confidence of both consumers and investors. Promising recoveries were snuffed out by premature tightening of fiscal policy in 1997 and of monetary policy in 2000.
Second, Japan and the United States have undergone a stunning "role reversal" in terms of global economic leadership. As recently as the late 1980s and early 1990s, the view was widespread that Japan was the world's most dynamic and competitive economy while the United States was faltering badly. As late as 1995, when the yen reached its all-time high against the dollar (at 79:1), Japan's total GDP came within 30 percent of that of the United States (which has two-and-a-half times as many people). Since that time, however, the sharp increase in US productivity growth has spurred rapid economic expansion in the United States (which is now booming again) in striking contrast to Japan's malaise.
Third, the dramatic surge of China has challenged Japan's economic leadership of its own region of East Asia. China has bypassed Japan (and the United States) as the main trading partner of virtually every country in the region and has clearly become its growth locomotive, accounting for almost one quarter of the increase in total world trade in 2003 and passing Japan as the world's third largest importer. Capitalizing on its economic strength and the dramatic globalization of its economy, and Japan's continued inability to liberalize its agricultural sector or to open its economy more broadly, China has also bypassed Japan in negotiating free trade agreements with the ASEAN countries (though Japan is now mounting a comeback) and has even neutralized Japan's previously overwhelming lead on regional financial issues (e.g., through its involvement in the Chiang Mai network of bilateral swap arrangements that may represent an initial step toward an eventual Asian Monetary Fund).
Japan has obviously retained major economic strengths throughout this period. Its world-class multinational firms have maintained, and in some cases even increased, their global leadership in their respective sectors. Partly as a result, Japan's trade surpluses and international creditor position have remained by far the largest in the world. Japan's per capita income has remained near the top of the world rankings despite its large shortfall from potential growth.
But the 1990s and early 2000s have been the roughest period for the Japanese economy since the early postwar years. The prospect of dramatic aging of the society, with the sharp drop in the total size of the population that is likely to eventuate over the next several decades, adds to the difficulties of correcting the large fiscal imbalance and thus to the pessimism in many quarters. There has developed a widespread tendency to "write off" Japan as a major global economy and consign it to the dustbin of economic history.
This paper will argue that such a view is decidedly premature and indeed almost certainly wrong. A period of "catchup growth" may already be underway and may in fact cast Japan as one of the major "upside surprises" of the world economy over the next few years. Moreover, available policy initiatives-especially the possibility of a free trade agreement with the United States-could both capitalize on such an improvement in Japan's economic fortunes and strongly reinforce such a comeback.
A Resurgent Japan?
As noted, two elements dominated the Japanese economic pattern over the past 12 years: (1) a massive deterioration of the health of the financial system and (2) premature fiscal and then monetary tightening that aborted two nascent recoveries. It is crucial to note that both problems represent severe policy errors, which are correctable, rather than any inherent structural deterioration of the Japanese economy. Japan has important structural problems, notably excessive governmental regulation and inefficient management in key services sectors along with a largely uncompetitive political system, but they have persisted throughout the postwar period and did not prevent the dramatic success of the Japanese economy for three decades from the 1960s through the 1980s. Moreover, there have been a number of improvements in Japanese efficiency and regulatory practices over the past decade: "big bang" financial deregulation, reductions in energy and telecommunications costs, and a genuine opening of retail trade.
There is now strong reason to believe that the Japanese banks and their regulators are in the process of overcoming the main problems of the financial sector. Nonperforming loans are declining substantially. Some banks have been allowed to fail while others have merged and/or accepted new (including foreign-based) management. Some of the large banks are even repaying the loans they had to draw from the government at the height of the crisis. Even more important, the credibility stemming from these supervisory reforms has prompted better lending behavior and attempts to raise fresh capital by other banks. Loans are increasingly made on commercial rather than political criteria, placing pressure on "zombie companies" to get their own houses in order or accept bankruptcy. More broadly, significant corporate restructuring has taken place in a number of sectors.
As a result, the crucial ingredient of confidence is returning to the Japanese economy. Corporate balance sheets have been rebuilt and private investment is surging. Consumer demand is starting to grow. Unemployment is declining. Housing is finally picking up. Growth has resumed for the past year and appears to be accelerating. Deflation is no longer a serious risk.
Japan is thus in an excellent position to enter a prolonged period of "catchup growth." A huge "output gap," probably on the order of 10 percent of GDP, opened up over the past decade as output potential continued to gain while realized GDP was flat or worse. It is impossible to regain all of this "lost potential" but a good deal can be recouped before any hint of inflation limits the recovery, given the extensive slack in the economy. Hence it is quite possible, even likely, that Japan will expand at 3 to 4 percent annually in 2004 and 2005, and perhaps for another couple of years, even if its long-term growth potential, as most Japanese economists believe, is only 1-1½ percent. That "catchup" period may in fact have already begun and my colleague Adam Posen, whose analyses and forecasts of the Japanese economy have been uncannily accurate over the past five years, argues that Japanese potential output has risen to 2½ percent per year, on the basis of the reforms and restructuring accomplished to date, and could rise even further if liberalization continues.
The second chief reason for Japan's prolonged stagnation was a series of fundamental errors of cyclical management. The economy started to rebound smartly in 1996, after the one truly stimulative budget of the entire decade, but the government choked it off by sharply raising the consumption tax in 1997. Another promising uptick in 2000 evaporated in the face of premature tightening of monetary policy by the (newly independent) Bank of Japan. One cannot be sure that either recovery would have terminated the "lost decade," particularly in light of the continuing unresolved problems of the banking system, but the policies that choked them off were clearly errors of the first magnitude.
At least so far, no such errors appear to be on the horizon at present. The Bank of Japan has stated clearly that it will not even contemplate tightening until deflation is decisively overcome. Prime Minister Koizumi has rejected any consideration of significant tax increases, despite the large continuing budget deficits, until the economy is on firm footing. The government's massive intervention in the currency markets, to keep the yen from strengthening further, has clearly been intended to avoid dampening exports or related investment spending while the economy is still fragile.
Thus Japan is now contributing importantly to the renewed boom of the world economy. It will of course be helped considerably by the fact that its two main trading partners, China and the United States, are the main growth locomotives for the entire global recovery. Japan's expansion is unlikely to match that of either China or the United States, or its own growth in earlier decades, and problems clearly remain to be solved before the country is wholly "out of the woods." But Japan seems likely to be substantially enhancing the welfare of its own population, and adding importantly to worldwide economic progress, for the foreseeable future.
The Exchange Rate of the Yen
As noted, Japan has intervened massively in the foreign exchange markets to keep the yen from rising and, for a while more recently, to push it to weaker levels. Its dollar purchases of $150 billion in the first quarter of 2004 were enough to finance the entire global budget and current account deficits of the United States. In light of the need for substantial further decline of the dollar to reduce the massive US current account deficit to a sustainable level, and the disproportionate share of the euro in absorbing the dollar decline to date, Japan has come under pressure from the United States and the G-7 to let its currency float freely, presumably to move further upward.
In the absence of intervention, the yen would probably have risen to at least 100:1 against the dollar. Most calculations suggest that the equilibrium rate for the yen is about 100:1. In light of the weakness of the Japanese economy, until recently, it was appropriate for the currency to trade in the lower portion of its putative "target zone" at around 105-110:1. A free float, even if it leads to some further appreciation, would now seem both appropriate and acceptable in light of the sharp pickup in the economy.
The main problem surrounding Japan's exchange rate in the recent past, however, relates to China. China's peg to the dollar means that the renminbi has ridden the dollar down over the past two years, enhancing China's competitiveness when it is already the world's most competitive economy. Other Asian countries, including Japan, have thus been understandably reluctant to shoulder their fair share of the substantial decline in the dollar that is required to correct the massive US current account deficit of $550 billion per year. (The problem has of course been even worse for Europe, whose euro floats freely and has risen by 40 to 50 percent against the dollar despite the absence of any large European current account surplus.)
The key to the global currency problem, including for Japan, is thus for China to let the renminbi rise in value by 20 to 25 percent (preferably through a one-shot revaluation but via a series of widenings of its trading band if that is more feasible for them). This would permit Japan to let the yen rise to 100:1 or so against the dollar, as its economy continues to strengthen, at the same time it depreciates substantially against the renminbi (and probably the Korean won and other currencies that are likely to follow the renminbi up). The trade-weighted average exchange rate of the yen would therefore not change very much, and might even weaken modestly, protecting the recovery of the Japanese economy as described above.
Free Trade with the United States?
Now that both the US and Japanese economies are growing robustly, and the exchange rate between their currencies is nearing equilibrium, it is time for the two countries to return to a positive agenda to strengthen their economic (and indeed their overall) relationship. Moreover, their present positions enable them to exercise the joint leadership of the global economy befitting the world's two largest national economies. In light of the major risks facing the world trading system, the most fruitful area for them to do so is trade policy-by launching negotiations for a free trade area between them.
Both Japan and the United States have dramatically reversed their trade policies in recent years. Both have traditionally been strong advocates of the multilateral trading system, rejecting preferential pacts and criticizing those adopted by the European Community and others. Both, however, have now begun aggressive programs of regional and bilateral liberalization.
The United States started with Canada in 1988 and NAFTA in 1994. It has recently completed agreements with 10 more countries (including five in Central America) and is now negotiating actively with about 10 more. It is also seeking a Free Trade Area of the Americas (FTAA) with 34 nations in the Western Hemisphere.
Japan has completed only one bilateral agreement, with Singapore, but is actively pursuing several others (Korea, Mexico, Thailand, Malaysia, and the Philippines) as well as a regional initiative with ASEAN. It is also involved in officially sanctioned studies of a comprehensive East Asia Free Trade Area (the "10 + 3" initiative), or EAFTA, with ASEAN, China, and Korea.
These American and Japanese initiatives will have important effects on trade flows, and trade relations, between them. NAFTA already discriminates significantly against Japan and was a major motivation for Japan to launch its FTA effort with Mexico. US pursuit of FTAs elsewhere in Asia, already with Thailand but potentially (as advocated by several key Senators and Congressmen) with Korea and even Taiwan, would have much greater impact on Japan and virtually force Japan to seek its own FTA with the United States.
Likewise, any Japanese FTAs with major Asian countries would have sizable repercussions on the United States and induce it to seek equal treatment. A comprehensive EAFTA would immediately cost the United States about $25 billion annually in lost exports with much more to follow as investment was diverted to the region. Even a Japanese bilateral deal with Korea, a major trading partner of the United States, would probably be significant enough to induce the United States to seek equal treatment.
Hence there is a strong case for Japan and the United States, as they pursue their numerous bilateral FTAs with other countries, to anticipate these developments and to avoid the increasingly serious frictions that will otherwise affect their relationship, by launching a bilateral FTA negotiation themselves. Such an initiative, which could be labeled a "barrier-free economic relationship" like the one that the Trans-Atlantic Business Dialogue is seeking for the Europe-United States economic relationship, would also have numerous positive effects.
For Japan, the straightforward economic benefits of an FTA with the United States would be considerable; a recent study for the Institute for International Economics by Scott Bradford and Robert Lawrence (Has Globalization Gone Far Enough?) shows gains of about 3 percent of total Japanese GNP from any initiatives that could produce convergence between its high prices and the much lower levels that prevail in the United States and other industrial countries. In addition, the insurance policy represented by assured access to the US market would be a major plus for Japanese exports; America's recent safeguard tariffs on steel, for example, hit Japan but exempted FTA partners Canada and Mexico. Another major plus for Japan would be the provision of an economic counterweight to China through reaffirmation of the security relationship with the United States. Indeed, the renewed US focus on relations with Japan that would be implied by a bilateral FTA would represent decisive rejection of the "bypass Japan" strategy that so many Japanese now fear from the United States because of the rise of China.
These factors should be politically powerful enough in Japan to enable it to finally overcome domestic resistance to liberalization of agriculture, along with key services sectors, both of which would surely be required by the United States to conclude such an FTA. More generally, genuine opening to the United States would greatly enhance the pressures of competition on the Japanese economy, both generating the huge economic benefits noted above (adding a full 3 percent to the level of GDP) and reinforcing the current reforms that are beginning to revitalize its prospects.
For the United States, there would be enormous gains in pursuing an FTA to address "behind the border" barriers to true market access in numerous sectors in Japan. For the American Congress, an FTA with a major trading partner-especially a large purchaser of agricultural products-would be far more attractive than the currently planned agreements with Bahrain, the Dominican Republic, or even Thailand. Such an agreement would provide an enormous boost to United States Trade Representative Robert Zoellick's strategy of "competitive liberalization" and a major boost to reviving the Doha Round of multilateral liberalization in the World Trade Organization by raising the alternative specter of major trade discrimination emanating from the world's two largest economies. On the geopolitical side, an FTA with Japan would of course strengthen the most important US alliance in the region and help sustain domestic political support for American engagement in Asia.
For both countries, the opportunity to implement a new dispute settlement mechanism (à la NAFTA) would hold considerable promise. Such an agreement, along with several smaller transpacific FTAs (including Australia-United States, Japan-Mexico and Chile-Korea) could also provide a spur to the currently moribund APEC prospects for achieving "free and open trade and investment" in the region by the 2010 target set in the Bogor Declaration in 1994. It would reduce or even eliminate the risk that the current FTA strategies of the two countries will lead to the creation of two megaregional blocs, an FTAA and an EAFTA (perhaps partly in response to an FTAA), which would truly "draw a line down the middle of the Pacific" and create a three-bloc world economy (and perhaps world polity) with all the instabilities that would imply-and with the very major risks it would also imply for overall relations between the United States and Japan (and indeed all of East Asia).
It would have been impossible to contemplate a Japan-United States FTA during the 1980s, when the United States started pursuing bilateral as well as regional agreements, because Japan was then perceived to be such a superior competitor. It would have been impossible in the 1990s, when the roles were reversed and Japan had to focus on recovering from its "lost decade." Now that the United States is likely to retain its restored confidence and Japan is recovering, perhaps quite smartly for a while, the time may be uniquely ripe for serious exploration of a free trade agreement between the two largest national economies in the world.
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