Why less isn't More

What did we (fail to) learn from Japan?

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What happens when a government decides to meddle aggressively with the foreign exchange rate? What happens when an export dependent country loses incentives to export? What if prices keep falling and there doesn’t seem to be an end to the ordeal?

Prices of everything are rising, and let’s admit it, none of us like it. Imagine a situation where prices are actually falling instead of rising! Wow! Must be a wonderland of some sort! Only if you were stuck in that situation!

All these and more happened in Japan. It is one of the most fascinating ones to read, especially when you come to know that all the problems were ones that everyone knew was going to happen. Find it hard to believe? Read on to find out how no one missed a single thing, where everyone did their part right, and yet, there was a problem of huge proportions at hand.

We don’t have to go too much into the past for the reason for this one. (I can see the smile on the otherwise disgruntled reader)

During the 25 years from 1960 until 1985, all countries saw massive growth, and the fastest ones were Japan and Germany. It was the golden age of electronics and Japanese battery operated devices were beginning to flood global markets. Japan, a small island group in the Pacific had built a formidable reputation for quality in its products worldwide. It’s economy was export oriented, meaning, it gained most of its income from its Exports, as it didn’t have much of a domestic market. The effects of war had worn out, and in the post cold-war age, Japan was at the helm of technology.

There was a G-5 group at that time, with the 5 largest erstwhile economies of the USA, Germany, Japan, France and the UK. The USD had become a formidable currency and had gained comparative value amongst other currencies, making other currencies cheap to the Dollar. This meant that a dollar could buy more of these other currencies than it could previously. It appreciated by over 50% in a span of 5 years from 1980 to 1985. What this implied was that, consumers in the USA could now import things at half the prices they usually had to pay, so, it encouraged massive imports, and severely weakened the domestic economy.

Say, the Rupee is at 70 per a USD, and over a period, it goes to just 30 per USD. Now, we’d prefer more of imports as they’d be far cheaper than consuming domestic produce right?

Remember that the USD was the universal reserve currency (Read our post on Currency v/s Money to know about this), so, the partner countries were concerned about the relative overvaluation of the USD against their currencies. So, it was decided to bring down the value of the USD by about 50% over a span of 5 years from 1985 to 1990, initially. This was done at the Plaza hotel, and is called the Plaza Accord. But, little did they know that, dumping of USDs into the market by the central banks of the G5 led to investor panic, though it was a structured and pre-informed plan, they achieved their target of 50% devaluation as early as 1987 (In just 2 years). So, in 1987, an emergency meeting was convened, to stem the fall of the USD, and to control it, it was the G6 this time (The new country was Canada), they agreed to stop the falling Dollar. Meanwhile, with the reduced value of USD, exporters in the USA were happy, getting new customers from everywhere, but, they couldn’t get a firm grip over the Japanese domestic market, which was the main reason for the devaluation. (Japanese government had strict restrictions on imports)

Now, Japan faced a terrible problem at hand. Since the USD had fallen, and comparatively the Japanese Yen (JPY) had gone up, global importers preferred USA made goods over Japanese ones. To counter this, the government went on a bonanza scheme that would trigger one of the worst asset bubbles in the history of mankind. The government slashed Interest Rates by 2.5%. That wasn’t actually the problem. Little known, the poison had already formed in Japan. In the period of rapid economic growth, from 1981, until 1987 itself, the government had slashed interest rates from 9% to a mere 5%. Which meant loans were already cheap!

At the end of the decade, Japan’s interest rate was 2.5 %, a drop of over 70% in a span of 8 years. This led to excessive borrowing, and an asset bubble similar to the housing crisis in the USA. Property, stock, and asset prices had tripled in just three years, 1987-1990. When the Japanese government doubted the existence of a bubble in 1990, and decided to raise the interest rates, it was already too late. They were 8 years late.

The rise in interest rate, burst the asset bubble, and asset prices fell by over 60%, leaving companies holding them, and borrowing based on them bankrupt. Balance sheets dried up, and thousands were unemployed. Worse more, the Japanese government identified several bankrupt companies and banks which had already failed, but, kept infusing cash into them calling them too big to fail, and somehow tried their best to revive them. But, it was not meant to be. The companies failed, taking in the additional cash infusions with them. The Japanese government lowered interest rates to less than 1% for the first time in 1994, and it has never gone above that yet. Japan has had negative interest rates for more time than any country.

In the 90s when assets failed, Japanese companies didn’t want to borrow anymore, as they felt the effect of slackening domestic demand as the population hadn’t grown. International demand for their products were also now less, facing competition from their Korean counterparts, who could offer comparable quality at a far lesser price.

The Japanese situation With virtually no scope for growth in demand, Japanese companies decided to pay off their debts before doing any expansion plans. By 1998, the entire Japanese population was Saving, rather than spending, on a net basis. This means, for every rupee that a Japanese Corporation earned, it saved over 51%, in some cases, it went upto 90%. Remember the basic equation of economics? One’s spending = Another’s income With reduced spending, their GDP fell, causing even lesser investment, and there was only negative investment every year. But, several economists even today argue whether this particular act of the Japanese corporations actually helped it avoid a post-2008-USA-like-scenario, where asset prices crashed by over 80%. Nonetheless, everyone agrees on the fact that, when you don’t have demand, and you don’t have corporations ready to borrow, the economy can’t go up, even if you give loans for free.

In the wake of the new millennia it was argued that the worst decade for Japan was over, and that export would pick up. It did seem so for 1 year. But, after the Dot-com bust (Don’t worry that’ll be another topic), and the mass production by the Chinese, there seemed little hope for the Japanese economy to ever recover from the worst asset bubble it had ever faced. Today, after over 30 years, nominal prices are just back to 1987 levels. Imagine, buying property, and 30 years later, the price hasn’t changed. Is there any motivation to invest? Is there any motivation to work? Is there any motivation to buy anything?

There was a net decrease in real wages and salaries by over 13% from 1990s till date. No matter what the Japanese government did, it just didn’t boost growth.

Just the same way we know more about outer space than we know about what is inside the earth, Economists have a great deal of research done and experience in controlling inflation, but, every attempt at a quick fix for deflation has led to an asset bubble and a rather ugly recession.