1 Diagnosis: Macroeconomic Mistake, Not Structural Stagnation Recent calls for Japanese economic stimulus, most notably at the G-7 finance ministers meeting on 15 April 1998, have been pitched in terms of two concerns: Asia cannot recover without greater Japanese growth and import demand, and data indicating that Japan is slipping into reces- sion make the situation more serious than it was when Japan was merely growing slowly. While both of these concerns are valid, they do not address two issues of Japanese economic performance in the 1990s that must come first for Japanese policymakers: First, is macroeconomic stimu- lus the appropriate response to prolonged Japanese economic stagnation? Second, if stimulus is appropriate, how much growth should be the attain- able goal of that stimulus? More detailed discussion of the role and form of fiscal expansion can only be tackled once these issues are resolved. An inadequate countercyclical policy response to the 1980s asset-price bubble and its burst accounts for most of the Japanese growth slowdown in the 1990s. There appears to be little justification for invoking additional factors such as a wholesale decline in Japanese economic potential or in the competitiveness of the ‘‘Japanese model.’’ While there are significant structural problems in the Japanese economy that, if removed, would increase its long-run growth rate, there was no sharp worsening of these factors during this period that could be a proximate cause of the 1990s slowdown. The Japanese growth slowdown, therefore, merits a policy response of macroeconomic stimulus. Properly designed and imple- mented, that should be sufficient to restore growth. Deep structural reforms, although beneficial for both Japan and the world economy over 13 Institute for International Economics | http://www.iie.com the long run, are not a necessary response to this short-run crisis.1 This is because Japanese potential economic growth remains high even in the aftermath of the bubble. Accordingly, the goal of that macroeconomic stimulus should be to make the Japanese economy grow faster than poten- tial—which, I argue, is likely between 2.0 and 2.5 percent annual real GDP growth—until the current output gap is closed by reemploying unemployed workers and unused industrial capacity. An economy in recession is analogous to a plant temporarily deprived of sun and food: the plant, once taken into the greenhouse and fed to make up for its deprivation, will bloom as if nothing had waylaid it. Why Japanese Slow Growth Merits a Macroeconomic Response The potential growth rate of the Japanese economy is a benchmark for the extent to which current Japanese slow growth can be dealt with by macroeconomic policy rather than structural reform. If the decline in output in the 1990s could be fully explained as a drop in the potential growth rate of the Japanese economy—where that potential growth rate is the long-run trend rate at which the economy would grow and around which business cycles would fluctuate—then the appropriate fiscal and monetary policy response would be to do nothing. In other words, if the structure of the Japanese economy reset to a slower growth path in the 1990s, the change would represent the best possible result of Japanese markets as presently constituted. The only way to raise growth in that case would be deregulation and wholesale structural reform. Such a structural change in potential growth would require an explana- tion, however, and no obvious one is available. While the asset bubble’s collapse certainly was damaging to balance sheets throughout the Japa- nese economy and especially to those of banks, such a shock would not disrupt the fundamental capacity of the economy to grow. The basic financial ‘‘infrastructure’’ of intermediaries and bond and equity markets still exists, and technological capabilities more broadly in the economy were not lost. Certainly, no physical or human capital in the Japanese economy was suddenly destroyed or rendered obsolete during the 1990s (Kobe earthquake aside). As noted, there were no international shocks on par with the combination of the breakdown of Bretton Woods and the first oil shock in 1973, which marks the last great drop in the rate of 1. See Bergsten and Noland (1993) and Bergsten, Ito, and Noland (forthcoming) for a discussion of an agenda for Japanese structural reform. It must be noted that most microstruc- tural reforms (such as retail deregulation) are usually accompanied by short-run contraction- ary effects at the macro level, even as they offer long-run benefits (see the discussion in chapter 6). 14 RESTORING JAPAN’S ECONOMIC GROWTH Institute for International Economics | http://www.iie.com productivity growth for the OECD economies (the Asian crisis, remember, followed over five years of Japanese stagnation). McKinsey & Company (1996) and Alexander (1997), among others, persuasively argue that Japan had a sharp decline in its relative and absolute rate of return on capital around 1980. While this implies that Japanese potential growth is at a lower level than it might have been, or many assume, it is not evidence of structural change since that time. If a shock is not to blame, then what has gradually changed either in the Japanese economy or in its environment to knock it from its previous status as a fast-growing economy, if not a model economy? In terms of its external environment, improvements in the United States’ or other countries’ competitiveness should not affect Japan’s ability to grow, unless Japan were being shut out of multiple strategic industries that offer special rents and growth spillovers. That would be a situation hardly consistent with either Japan’s continuing success at exporting high-value-added products or with the research evidence on the limited number of such truly strategic industries. It is difficult to imagine that a complex industrialized economy such as Japan’s could suffer a decline in its terms of trade that would affect a sufficient range of sectors in the way that a developing economy dependent upon one or a few commodities can be affected— especially without seeing a similar decline in similar countries. Nor could the much remarked upon burden of rigidities and distortions in the domestic economy, such as the legitimately criticized protection in the Japanese retail sector, have ‘‘caught up’’ with Japan over time. Without government efforts to actively expand rather than merely protect (even zealously) special interests, competitive sectors with a greater real return will grow faster over time and attract more resources, thereby shrinking the burden of protection as a share of the economy.2 For all the complaints about inertia on the part of Japanese policymakers in the 1980s and 1990s, the reality is not that they have increased regulation and inflexibility, but simply that they have not deregulated as quickly as is desirable. The government’s Strategic Impediments Initiative has had real if small effects, there was financial deregulation a decade prior to this year’s ‘‘Big Bang,’’ and some government construction contracts have been opened to more competitive bidding. As a result, the number of distortions in the Japanese economy has shrunk. For example, agricultural employment is down to 3 percent of the workforce, and more discount retail opportunities are 2. An additional effect is that many special interests benefit from remaining small, excluding new entrants, and maintaining the ability to coordinate action on their own behalf (see Olson 1971). A classic illustration of this phenomenon of a shrinking burden even in the face of entrenched interests is the protection of coal mining in Western Europe, where the benefits to miners (and their unions) have remained steady or increased over time, while mining with all its public costs has continuously declined as a share of GDP. DIAGNOSIS: MACROECONOMIC MISTAKE, NOT STRUCTURAL STAGNATION 15 Institute for International Economics | http://www.iie.com available to Japanese consumers than ever before. Structural reform cer- tainly offers further opportunities for efficiency gains, but an insufficient pace of reform cannot be the cause of the current growth slowdown. It is better to think about Japanese macroeconomic performance from the viewpoint of fundamentals. A country’s economic growth normally comes from three sources: growth in the stock of physical capital, growth in the stock of human capital (either the size of the available labor force or the skill and education of that workforce), and growth in the productiv- ity with which labor and capital are used (known as ‘‘total factor produc- tivity’’ [TFP] and thought to track technological progress). For a country’s potential growth rate to shift, either its accumulation of physical or human capital must slow or its rate of TFP growth must decline.3 Demographic and educational factors are slow to change, especially for mature societies such as Japan’s. The only aspect of growth in the stock of human capital in the 1990s to change noticeably in Japan is a rise in the employment/ population ratio (Haltmaier 1996), but this is hardly of size to account for the shortfall and is more sensibly understood as a response to temporarily declining income growth. Meanwhile, capital accumulation has slowed only slightly since the 1980s, as savings rates have remained high (even if returns to investment remain low). Productivity growth is calculated as the residual of growth in per- worker income after growth in per-worker physical and human capital have been accounted for. Following Bosworth and Collins (1996), the average annual contribution to growth of each of these factors is calculated for Japan during the periods 1984-1990 and 1990-1994.4 Assuming a con- stant capital share of 0.35 in production, the cumulative growth in TFP during 1984-1990 was 9 percent, and it declined to just under 4 percent in 1990-94 (i.e., a difference on the order of 0.5 percent a year).