Japanese economy overview and structural characteristics

Japanese economy has been struggling for over a decade now, the fact remains that it is still the world's second largest economy, which probably accounts for the worldwide concern over its fortunes. In fact, the cause for global concern is evident given that the Japanese economy is seven times the size of China's and Japan still produces approximately seventy percent of all goods and services in East Asia (Ellington, 1999). Indeed, Japan continues to cause concern even though its economy is currently showing signs of recovery with a first quarter 2004 GDP annual growth rate of 5.6%, more than the 3.8% that economists had predicted. The current recovery is largely spurred by an increase in exports, business investment and consumer spending (Zaun, 2004). Despite such encouraging trends, however, it is still widely believed that the Japanese economy may not be able to show sustained recovery, as its problems are not cyclical but structural (Nakamae, 2003), and that many of these structural problems have yet to be resolved.

The view that the Japanese economy is not yet out of the woods is largely due to the extensive government, scholarly and business analysis of its decade long problems, which led to a wide consensus that the same set of distinctive institutional characteristics that significantly contributed to Japanese economic success in the period post World War II right up to the mid-1980s (Matsuura et.al, 2003), ended up triggering a decade long recession (Ellington, 1999). One major reason for the preceding conclusion is the comparison between the performance of the Japanese economy during the decade of the 1990s with that of other economies: "A number of other advanced economies also experienced collapses in asset prices in the early 1990s, and in several of the Nordic countries a severe banking crisis followed the collapse in asset prices, as in Japan. But the aftermath of the asset price collapse in these countries was characterized by a deep recession that was followed by a robust recovery in output. Why has Japan been subject to a protracted slowing of growth, instead of experiencing the sharp decline and quick recovery observed elsewhere?" (World Economic Outlook, 1998)

The answer to the above question lies in understanding the effects of the economic turbulence since 1985 on the institutional foundations of the Japanese economy, which can be considered as the "main bank" system; the Japanese system of lifetime employment, seniority wages, and enterprise unionism; the distinctive inter-corporate relationships in Japan known as the "production keiretsu"; and the interventionist role of the Ministry of International Trade and Industry (MITI). These cornerstones of the Japanese economy worked well pre-1985 with the "main bank" system successfully recycling domestic savings into manufacturing investment at a time when the stock market was underdeveloped; the lifetime employment system enabling investment in firm-specific training and skill development, besides reducing competition for skilled labor; the keiretsu relationship between main firms and their suppliers in the manufacturing sector facilitating knowledge sharing, quality control, and flexibility in planning; and all the preceding aspects being supported by the government via the MITI (Matsuura et.al, 2003).

However, the Japanese economic formula for success proved to be fallible with the rapidly changing global political and economic environment post 1985. For one, the Japanese system of state-assisted capitalism worked in an era where Japan had few economic competitors in Europe and Asia, and till such time that the United States turned a benign eye on Japanese policies that discouraged imports (Ellington, 1999). In fact, Japan's macroeconomic instability can be traced back to the September 1985 Plaza Accord, when the United States and Japan reached an agreement aimed at reducing the value of the dollar-yen exchange rate (Matsuura et.al, 2003), and the United States began applying pressure on Japan to open up its economy to imports and investment (Ellington, 1999).

Thus, beginning in the first half of the 1980s, Japan began gradually dismantling controls on capital movements, and deregulating interest rates on deposits. In addition, the emergence of new financial instruments enabled large Japanese corporations to reduce their dependence on the "main bank" system by borrowing less expensive capital from domestic securities and international capital markets. The combination of financial liberalization and inadequate prudential regulations seems to have played a key role in the sharp increase in asset prices in the early 1990s. Take, for instance, the undeniable fact that banks, who were deprived of their traditional client base and who were facing competition from the non-banking financial sector for the first time, began indiscriminately lending to smaller firms that did not have the same access as larger ones to either the capital or property markets. Add to that the fact that Japanese bank lending was heavily influenced by collateral values, and one begins to see the root causes behind the firm, rather than individual driven, asset price bubble in Japan (World Economic Outlook, 1998), which led to so many bankruptcies and the piling up of bad debts among Japanese financial institutions (Matsuura et.al, 2003).

The collapse of the Japanese economy triggered by a rising yen and the asset price bubble led to the country's lifetime employment system coming under pressure as well. For the simple reason that firms began to look for ways to save costs on older workers, and younger workers began to demand higher wages on noticing such trends. Unfortunately, for Japan, the timing of its economic problems coincided with a changing population composition with an aging workforce that further exacerbated the problem (Matsuura et.al, 2003). Further, the global economy itself was changing from labor intensive manufacturing to a more technology driven, services oriented one. The centralized and institutional driven nature of the Japanese economy made it difficult for businesses to make swift decisions in order to remain competitive (Ellington, 1999). In addition, pressures from the trend of globalization and the gradual opening up of the Japanese economy led to a significant hollowing out of Japanese manufacturing. It is estimated that Japanese multinationals have created over two million manufacturing jobs outside the country, leading to the loss of one million jobs in Japan. The trend towards offshore manufacturing affected the traditional "keiretsu" relationship between firms and their suppliers as well, with small and medium sized suppliers experiencing a sharp decline in profits as their share fell from 55 to 37% in the period 1986 to 1996 (Matsuura et.al, 2003).