Borrowers nowhere to be seen as Japan enters its post-deflation era

Japan suffered a balance sheet recession lasting more than two decades after its debt-financed bubble burst in 1990. Because the bubble was so large — at its peak, the Imperial Palace Garden in the centre of Tokyo was said to be worth as much as the entire state of California — it took many years for businesses and households to rebuild their balance sheets by paying down debt and replenishing savings.

But if someone is saving or paying down debt, someone else must borrow and spend those savings to keep the economy going. While the Japanese corporate sector was eagerly borrowing and investing household savings to the tune of 12 percent of GDP in 1990, it reduced its borrowing rapidly thereafter and became a huge net saver to the tune of 11 per cent of GDP by 2003. The 23-percentage point loss in corporate borrowings and corresponding loss in corporate demand pushed the economy into a deflationary cycle.

The economics profession at the time had never considered the possibility of a recession caused by the private sector minimising debt instead of maximising profits. Fortunately, the government increased spending to reinject the excess private-sector savings back into the economy.

Government spending partially prevented GDP from falling below the bubble peak for the next three decades, a tremendous achievement, given that the asset price collapse wiped out national wealth equivalent to three years of 1989 GDP. In comparison, the United States lost 46 per cent of its nominal GNP during the Great Depression when it lost wealth equivalent to just one year of 1929 GNP.

By 2012, Japanese companies had finished paying down debt. Some had even resumed borrowing, indicating that their balance sheet repairs were complete. The Japanese government pushed for deregulation, improved corporate governance and privatisation. The easing of visa requirements produced an explosive increase in inbound tourists. Japan also opened its domestic market to imports and foreign workers, resulting in huge inflows of goods and labour that would have been unthinkable 30 years prior.

Still, the non-financial corporate sector continues to run a financial surplus despite low interest rates, clean balance sheets and willing bankers.

The experience of paying down debt for years on end may have caused this aversion to debt. Many Japanese businesses adhere to ‘cashflow management’. This means doing everything, including capital expenditure, within cashflow and never borrowing money, a typical response to a balance sheet recession. Many Americans forced to deleverage during the Great Depression never borrowed again.

Many businesses in Japan may also not be borrowing at home despite clean balance sheets because the return on capital expenditure is higher in emerging economies than domestically.

With the household sector still saving but the corporate sector no longer borrowing, the government must continue to borrow and spend surplus private-sector savings to keep the economy going. Further deregulation and tax cuts to increase the return on capital at home can encourage more domestic borrowing and investing.

Observers have attributed Japan’s economic stagnation to its shrinking working-age population, which peaked in 1995 and has since shrunk by about 15 per cent. But this fails to note that the number of employed persons in Japan is currently at an all-time high due to more women entering the workforce and older people continuing to work. This has allowed the economy to grow, albeit slowly, with stable prices and wages.

Yet there is a limit to the resilience of Japan’s labour market. Since the reset of the labour market forced by the pandemic, many industries have faced severe worker shortages, especially in the services sector. Economic growth should pick up if businesses serving domestic customers started borrowing and investing domestically in improving labour productivity. That will also allow the government to reduce its fiscal deficit for the first time since the onset of the balance sheet recession. At that point, the Japanese economy will finally return to normal.

But this positive outlook poses a challenge in terms of normalising monetary policy. The Bank of Japan’s (BOJ) astronomically large quantitative easing program, launched in 2013, failed to revive inflation until the COVID-19 pandemic. A lack of borrowers meant that funds were not leaving the banking system and entering the real economy. But the monetary easing program left 474 trillion yen (US$3 trillion) in excess reserves in the banking system, equal to 79 percent of Japanese GDP.

These funds, while harmless when there are no borrowers, can cause huge inflation problems when they return. And borrowers will return when technological breakthroughs or other developments force them to invest in new facilities or equipment. A return will force the BOJ to curb loan demand by raising interest rates. But it must then pay the same higher rate of interest on the 474 trillion yen in reserves, which are a liability of the central bank.

Those interest payments reduce the effectiveness of monetary tightening efforts while increasing the fiscal deficit. A one percentage point increase in the BOJ interest rate will require a two-percentage point increase in the consumption tax rate to keep the fiscal deficit from increasing. Japan has waited 34 years for borrowers to return. But they must come back slowly, to give the BOJ time to gradually adjust monetary policy and avoid major disruptions to the economy and government finances.

Richard C Koo is Chief Economist of Nomura Research Institute, Tokyo, and author of Pursued Economy: Understanding and Overcoming the Challenging New Realities for Advanced Countries (2022).

Image by Wiiii and sourced from Wikimedia Commons here.