Alasdair Macleod – 15 July 2010
This is not perhaps a headline to be expected. After all, government debt is over twice GDP, and Japan has a rapidly aging population. After her stock market crash, which started in December 1989, she has been in a bear market for over twenty years with the Nikkei 225 Index falling over 80% at its worst. Since then she has just managed to avoid outright deflation, with GDP having shown virtually no growth between 1990 and 2008, and only showing some recovery in 2009, aided by global industrial investment.
This apparent stagnation is the nightmare the West is trying to avoid. But all those economists who gave their free advice to Japan over the years have generally given up, because there are now more interesting disasters to analyse closer to home; yet for an aging stockbroker Japan is interesting precisely because no one else is interested.
There is one key difference between Japan and those countries where her critics reside, and that is her propensity to save. Her critics reside in countries that are driven by credit and not savings. So to understand the Japanese condition, we need to briefly consider her post-war economic history from a non-Keynesian and non-monetarist perspective.
After her defeat in WW2 the Japanese economy was rebuilt from nothing. Even though the initial burden on the authorities was immense, tax policy at the outset was designed to protect savings at the expense of consumption, which ensured the finance for rebuilding the economy would become available. The pre-war samurai zaibatsu had been disbanded by the Allies, but they lived on in the groupings of businesses known as keiretsu. These keiretsu were organised into industrial and financial groups with cross-shareholdings, capable of re-investing profits across a wide range of manufacturing businesses. The eight major keiretsu were Mitsubishi, Mitsui, Sumitomo, Fuyo, Dai-ichi Kangyo, Sanwa, Tokai and IBJ, and they formed the commercial houses with which we are familiar today. Japan therefore had the finance from saving and an organised business structure for recovery.
The Americans, who ran the country under General MacArthur, had a large military presence in Okinawa and elsewhere in Japan, and in the early fifties used Japan as a base for the war in Korea. This presence helped kick-start the recovery. The keiretsu re-invested the profits from supplying the military, into manufacturing businesses, initially manufacturing quick and easy products – low quality cheap consumer goods.
Japan rapidly began to be associated with cheap low-quality products. It was time to move on, and at this stage two Americans who were the world’s leading advocates of quality and quality control, William Deming and Joseph Juran, persuaded Japan’s business leaders to switch production to high quality, reliable goods. This became the hall-mark of Japan’s post-war miracle, and by the late fifties she was setting quality control standards far higher than many of her foreign competitors.
While a number of events contributed to the post-war miracle, by far the most important was the propensity to save. Peter Drucker, the American management guru, recalled that a military officer deputed by General MacArthur to advise the post-war government on economic policy insisted that savings should be exempt from tax. The advice was taken, with taxes only applying on savings accounts for very large deposits. However, it was the account that was taxed, rather than the individual, so a saver could open further accounts to keep all his savings under the tax threshold.
The propensity to save reduced income available for consumption, ensuring that competition in consumer goods was intense. The keiretsu were able to respond rapidly to improve their products and reduce costs through capital investment, since the savings to finance it was available at low, stable interest rates. The Western consumer initially became aware of these advances through items such as transistor radios in the late fifties, and 35mm format reflex cameras at about the same time.
With competition at home for reluctant consumers intense, the keiretsu found export markets lucrative. Thanks to the advice of William Deming and Joseph Juran, Japanese products were better and cheaper than their Western equivalents, and exports expanded rapidly. The economic effect in Japan was to increase the value of wages, which allowed workers to save yet more, and so the cycle went on with savings and capital investment growing at an increasing pace. In the absence of inflation, these savings grew in value with interest rates of only two or three per cent.
This strong and growing savings flow allowed the keiretsu to expand their ranges of products and by the mid-seventies Japan was the largest shipbuilder, the largest car exporter, the largest exporter of electronic goods and the global leader in the commercial application of advanced technologies. In little more than twenty years she had achieved what had taken Britain seventy or so after the Napoleonic War. In both these cases the economy had developed without government intervention, relying only on sound money and a propensity to save. Japan’s development was quicker due to the pace of technological change, a factor that had also benefited America in the 1920s.
Japan was also helped by the monetary policies of foreign governments. By discouraging savings by taxing them, they had ensured their economies were driven almost entirely by consumption. Furthermore, by generating credit-driven boom-bust cycles of increasing magnitude, these governments crippled their own industrial capability, making home-produced consumer goods inferior and more expensive. So stark was the difference between Japan and her client countries that Japanese business was forced to invest in manufacturing capacity in these client countries, or face trade sanctions.
In the early eighties, car plants and electronics manufacturing were established in the UK for access to European markets, to be followed by factories in America and elsewhere. The capital investment was funded by Japanese savers through keiretsus’ in-house banks and by reinvesting profits, as was their custom. The workforces were properly trained, given the latest tools and probably for the first time in their lives had job satisfaction: a notable contrast to labour relations in indigenous businesses.
On the back of their in-house commercial lending, the keiretsu banks expanded into financial services during the eighties. Foreign speculators were keen to invest in Japan’s success, and for the keiretsu it was such easy money – taking it off the gaijin and investing it into associated entities – that the inevitable stock market bubble formed, followed by the equally inevitable collapse in 1990.
It is worth emphasising that the bubble arose not from Japanese credit creation, but from the importation of speculative Western capital. The Bank of Japan made the subsequent mistake of lowering interest rates to stop the yen from rising, which had the effect of spreading the asset bubble into the domestic property market.
The 1990 collapse in share and property prices hit the Japanese consumer hard, with unemployment rising from zero to five per cent. Margins on consumer goods were squeezed as a result of a further increase in the propensity to save, which was the natural response of individuals to the stock market and property crashes. Japanese manufacturers reacted by investing in new factories abroad, this time benefitting from the cheap and plentiful labour in South East Asia. The miracle continued from abroad, with the keiretsu building commercial empires in South East Asia.
This then is Japan’s post-war economic history as it perhaps should be understood, and there are some valuable insights to be gained. By far the most important is the role of real savings in driving an economy, compared with the Keynesian approach, which relies on credit. The detailed reasons behind why savings are so important and credit is so destructive to the capital investment process were covered in my article on capital theory dated 1 July. It is a lesson that has now been learned by China, which has almost certainly analysed the reasons for Japans’ success for her own benefit. While times are different, there are similarities in China’s strategy: she is now spreading her production beyond her borders as Japan did in the 1990s.
The Japanese savings-driven model is suitable for just about any other Asian country which shares aptitudes for hard work and thrift. It is the availability of capital investment driven by purely commercial factors that can rapidly turn a community from bare subsistence into a competitive modern workforce manufacturing advanced products. And for commercial factors to be the sole determinants of capital investment, the role of the state in the economy has to be minimised.
This has certainly been true of Japan, and fortunately her government has generally resisted many of the more hysterical Keynesian calls to action. The Japanese government has made policy errors, but none of them have been bad enough to destabilise her economy. It has avoided the inflation trap of printing money, with M2 more or less unchanged since 1990. Furthermore, once strong flows of capital investment are taken into account, her economy has grown more than the GDP numbers suggest. This is because much of her economic activity is not captured by the GDP statistic. GDP is the net domestic output of goods and services, and therefore does not capture the gross values which reflect expanding production activities. And now that so much of Japan’s manufacturing capacity is located elsewhere this is not captured in the statistics. By looking at the domestic statistics we forget the empire; taking these factors into account, Japan has actually grown significantly.
The land of the setting sun?
Those budget deficits, so keenly advocated by Keynesian economists are beginning to catch up with Japan. The cost of financing them has remained low, varying between one and two per cent, because there is no monetary and credit inflation. Nevertheless, the expansion of government debt has diverted savings from the private sector, corrupting the savings/investment cycle.
The rate of savings has been declining since the late 1990s as a result of several factors. Japan is burdened with an increasing population of retirees and a low birth rate, and these demographics are deteriorating and are expected to deteriorate more rapidly than in other countries, such as the US and UK. Improvements in state pensions and welfare have also reduced the incentive to save, and the general westernisation of society has increased allocation of personal income to consumption at the expense of savings.
This is something Western commentators fret over, but there are differences. Western governments actually have three separate pension problems. The first is the one most of us know about and which is shared with Japan: the ratio of retirees to those of working age is increasing. Second, the long-term effect of monetary inflation has effectively wiped out the value of bank and bond savings, replacing them with pensions funded substantially by asset speculation. Before the dot-com crash of 2000/03 and then the credit crunch of 2007/08 no one saw any risk in this investment strategy. Now that private pensions have substantial shortfalls and face further risks in current asset market conditions, the consumer-driven economies face a severe pensions crisis in the private sector. And lastly, the inflation protection offered to public sector employees in unfunded state schemes is extremely expensive, escalating in cost due to inflation and likely to become socially divisive.
So the consumer-driven economies have far greater pension problems than Japan, and the root cause of the difference has been monetary and credit inflation in the former compared with sound money policies of the latter. Government deficits in Japan have actually been funded by savings and not through the printing press, so the outlook for the public sector must be one of substantial cut-backs due to the fall in savings. The private sector, the keiretsu, also faces difficulties ahead. Economic growth for the last four quarters has been strong, averaging 4.2% fuelled by strong exports and one-off domestic subsidies for cars and home appliances. Export growth is driven by demand for capital goods at a level unlikely to be sustained in the months ahead.
The sun may be setting for Japan’s commercial empire, but her legacy today is a far stronger economy than those of the consumer-driven nations. She is also on China’s doorstep and has substantial investments within that sphere of influence. All she needs to do is unwind the Keynesian-inspired errors of economic policy: cut government spending and give savings more encouragement. So yes, her stock market is good value, on the basis there will be good reasons for the gaijin to buy again. Japan certainly was successful, and probably still is, at least compared with the West.
A cartoonist might draw an old man sitting in his rocking chair on his porch, smoking contentedly and at peace with himself. Younger men in their sharp suits observe him with pity, thinking he hasn’t got much. What they don’t know is he has lots more than they have.
The old man is Japan and the youngsters are smart-arsed economists.