The Current State of the Japanese Economy
and the Challenges Facing It:
Long-term Stagnation and Structural Reform

The Japan Society
September 15, 1997

I am honored to have this opportunity to address this distinguished audience at the Japan Society, an organization with a long and illustrious past. As Mr. Clark kindly introduced, I currently hold the post of Chairman of the Advisory Council at the Nikko Research Center, or NRC. Until 1989 I was on the staff of the Economic Planning Agency of Japan, where my duties included analyzing various economic surveys, producing forecasts, and helping formulate midterm economic plans. One of the legacies of my work at the EPA that remains with me to this day is an enduring interest in the state of the Japanese economy and in its future, and it is on these subjects that I would like to share some of my thoughts today. In addition, I would like to conclude with a few observations on the subject of the American economy as well.

The Current Economic Climate in Japan

Let me start with the current economic climate in Japan.

From fiscal 1992 through fiscal 1994 the Japanese economy endured a period of severe weakness, with economic growth rates hovering around the zero level. But thereafter the economy began to rally finally, posting growth rates of 2.4% for fiscal 1995 and 3.0% for fiscal 1996. In the aftermath of the extended economic boom that had continued from November of 1986 until April of 1991 - the era of the so-called speculative bubbles that accompanied the rapidly upward spiraling of both property values and stock prices - the economy had fallen into a serious slump, but by 1995 the repeated fiscal and monetary measures introduced to revive the economy appeared to finally be paying off. By the third quarter of 1996, it looked as though the economic growth rate would continue to accelerate despite a reduction in public spending; the going trend was one in which, even without support from public-sector demand, the climate for economic activity would improve on its own as a result of greater demand from the private sector.

As a consequence of the increase of Japan's consumption tax from 3% to 5% in April of 1997, however, a reversal of the sudden prior demand - demand that developed as people rushed to make their purchases before the April rate increase - began to be seen in consumer spending following the tax rate hike. Residential construction had already begun to fall off prior to April, in the first quarter of the year.

At first it was expected that this reversal of the sudden prior demand would end during the second quarter, and it was expected that from the third quarter on the economy would once again resume the process of recovery. However, the third quarter has arrived without any clear indication that demand has recovered. This has led to fears that the economy will remain in its weakened state for some time to come, causing the stock market to decline and long-term (10-year) government bonds to linger at the all-time low yield level of around 2.0%.

The rise in the consumption tax has also had a disruptive effect on trade accounts. Specifically, in the first quarter of this year imports rose as a result of the sudden demand that had developed, and this increase in the supply of goods destined for the domestic market blunted the growth of exports. Consequently, Japan's trade surplus declined by 13% in comparison to the previous quarter (based on seasonally adjusted figures). In the second quarter, however, the trend was reversed, with imports falling and exports rising, causing the trade surplus to soar to a level 63% higher than that for the previous quarter. Because this reversal was triggered by a temporary situation, the huge upsurge in the trade surplus witnessed in the second quarter of this year will not continue. If the economy remains stagnant, however, we may see some growth in the surplus in the future.

Absent the disruptive influence from the consumption tax rate hike, the Japanese economy was on track to continue the trend that was apparent in the latter half of 1996, that is, to proceed toward a genuine recovery. At that time, the exchange rate stood at roughly \110 to the dollar, a level at which there would have been no marked growth of the trade surplus.

The Impact of Deflationary Fiscal Measures

Now, I would like to turn to the impact of deflationary fiscal measures.

The disruptive fallout from the increase in the consumption tax rate is a temporary phenomenon. However long it lasts, once the reactive drop in demand ends, the economic climate should return to its original course. During fiscal 1997, however, the situation has been further complicated by a number of deflationary factors arising from certain fiscal measures that have been enacted.

The first factor to consider is the impact of the consumption tax hike itself. An increase of 2% in the tax has been readily translated into a 2% rise in prices, the effect of which has been to restrain both consumer spending and residential investment. Nikko Research Center, or NRC, has calculated that the impact of the tax increase in terms of the reactive dampening of pre-emptive demand effectively lowered the nation's GDP by 0.4%; by contrast, the tax hike itself is calculated to have lowered GDP by 0.6%.

The second factor is the impact of the discontinuation beginning in June of the special income tax relief, worth \2 trillion. According to NRC calculations, the impact can be estimated as 0.2% of GDP.

The third factor is the \750 billion rise in the public's share of the cost of health insurance, which has just gone into effect as of September. Add to this a \250 billion jump in the public's share of government-sponsored pension plan payments.

The fourth factor is an approximately \1.35 trillion drop in public investment (based on NRC calculations).

Because these deflationary fiscal measures have been enacted one after another, either increasing the financial burden on the public or reducing public expenditures, even if the economy were otherwise poised to improve, it is still being stifled and is unable to make a genuine recovery.

In September of 1995 the Bank of Japan lowered the official discount rate to the historically low rate of 0.5%, and for its part the Japanese government has undertaken a \14.2 trillion program of fiscal measures intended to revive the economy. This massive program of monetary relaxation is continuing, but budgetary policy has undergone drastic changes in the meantime. The change was made to reduce the giant budgetary deficits with firm determination for the structural reform of Japan's economy. The latter is a subject to which I will return in a moment.

Overall descretionaly spending for the fiscal 1998 is also going to be reduced in comparison to the previous fiscal year, with the portion reserved for public works spending to be reduced by 7%.

Economic Outlook for Fiscal 1997 and 1998

I would like to take a moment to illustrate the prospects for the Japanese economy in fiscal years 1997 and 1998:

Looking beyond the factors I have already described, there has been a clear indication of an increase in capital investment, owing to the completion of capital stock adjustments and also to growth in the field of information and communications. Given the expanding world economy and an exchange rate hovering around the level of \120 to the dollar, Japan's net exports, which were on the decline until fiscal 1996, are likely to turn around and show a gain in fiscal 1997.

Average figures drawn from recent economic forecasts produced by 39 private-sector think tanks in Japan show that, following the 3.0% rate of economic growth posted in fiscal 1996, a deceleration to 1.5% is expected for fiscal 1997, reflecting the impact of the tax increase. Furthermore, there is a disappointing anticipation of economic growth at the level of 1.8% for fiscal 1998. Subsequent to the \7.2 trillion current account surplus seen in fiscal 1996, the current accounts surplus for fiscal 1997 is expected to soar to \10.0 trillion, and the figure projected for fiscal 1998 is \10.5 trillion.

In terms of macro-economic performance, this would have to be considered an unsatisfactory showing, but owing to the necessity of fiscal consolidation it is probably unavoidable. The unemployment rate has recently been moving at the internationally low level of around 3.5% and real wages have gradually been rising. Based on such indicators, and apart from the trends in the business climate, Prime Minister Ryutaro Hashimoto is presumed to have decided that the fundamental health of the Japanese economy is such that it can withstand the pain of structural reforms.

Long-Term Stagnation of the Japanese Economy

Having commented on future prospects, I must touch upon the rather distressing situation in Japan, that is, the long-term stagnation of the Japanese economy.

As I mentioned earlier, during the period from fiscal 1992 through fiscal 1994, the Japanese economy recorded approximately zero economic growth, and thereafter it has progressed without significant rise. The continuation of such an extended period of low growth is unprecedented, and rather than a temporary slump this can be called a long-term stagnation.

Among the contributing factors are the impact of the collapse of Japan's first speculative economic boom, the bubble economy since World War II, as well as the economic blow caused by the extremely high valuation of the yen, which rose to the rate of \80 to the dollar in April of 1995. In addition, I believe another factor is the reduced ability of the Japanese economy to respond in a timely manner to changing economic conditions.

Japan's economy has been unable to realize the end of the era of trying to catch up with the developed Western nations, unable to respond to progressing economic globalization, unable to work efficiently due to its high cost economy - in short, unable to confront its new circumstances. All these things were pointed out some time ago, as was the need for radical reform of the structure of the economy.

Progress with Structural Reforms

Now, I would like to share with you the progress of the structural reforms.

The Hashimoto cabinet, which was formed anew following the general election of October 1996, pledges to enact reforms in six areas: the financial system, the economic structure, the fiscal structure , government administration, social security, and education. This truly represents a determination to tackle the need for structural reforms head on.

Outside Japan, the popular interpretation at the time was that reforms would not advance under the Hashimoto administration, since Hashimoto himself had formerly been perceived as a conservative and since his chief rival in the election, Shinshinto (New Frontier Party) leader Ichiro Ozawa, was identified as a reformist. Nevertheless, the manner in which the situation progressed after the election was eye-opening. Since the beginning of this year, the following initiatives have either been decided upon or have been unveiled as policy directions - progress that would have been regarded as unreal only a year ago.

The forerunner is reform of the financial system, the so-called Big Bang. Laws have been enacted that will completely liberalize foreign exchange services starting in April of 1998, grant the Bank of Japan greater independence from the government, and remove the conduct of financial inspection and supervision from the authority of the Ministry of Finance. It has also become clear that financial services will be deregulated so as to remove the barriers between financial services having different business classifications and liberalize commissions for stock transactions.

Policy directions regarding various areas of deregulation linked to economic structural reform have also been hammered out.

In the area of fiscal reforms, the government has decided on a policy of reduced public works spending and other measures that will make the years from 1998 to 2000 an intensive period of reform in order to reduce budgetary deficits to under 3% of GDP by fiscal 2003.

In the area of administrative reforms, the government's council on administrative reforms presented a midterm report on September 3, proposing to reorganize the 21 ministries and agencies that currently make up the government into 12 ministries and agencies.

Even given all this progress, it remains true that no laws have yet been passed to actually enact the proposed administrative reforms and that a great many complications are anticipated before any such laws will be passed. Moreover, no revolutionary or clear-cut positions have yet been taken with regard to the reform of the tax system, social security, or education. Even so, great leaps forward have been made in terms of the overall progress of reform.

Presuming that genuine efforts are made to achieve structural reforms, the macroeconomics impact at first will be rather deflationary, and this is the reason behind the widespread anticipation of low rates of economic growth for fiscal 1997 and 1998. As these reforms progress, however, the economy is expected to regain its former dynamism and economic growth will expand. According to the economic plan for fiscal 1996 to 2000 that was adopted by the Cabinet in December of 1995, without structural reforms the rate of economic growth would be limited to 1.75%; with reforms enacted 3% growth is expected.

If the structural reforms succeed, foreign firms would find Japan a more attractive place to do business. Foreign securities firms and others that have been pulling out of the Japanese market are taking note of the "Big Bang" reforms being enacted from this year on and are reportedly starting to return to Tokyo. The September 8 issue of Forbes includes an article that supports this trend, entitled "Buy Japan now. It's starting to wake up."

Issues for the U.S. Economy

Finally, I would like to offer a few remarks on the American economy.

Alan Greenspan, the chairman of the U.S. Federal Reserve Board, has observed that the current situation reflects the sort of structural change that occurs once a century. As this remark suggests, the current performance of the American economy is outstanding.

The present economic climate in the Unites States is one no one would have anticipated a year ago: the continuance of an extended boom along with low unemployment, low inflation, low interest rates, high stock prices, a strong dollar, and a large-scale reduction in the budget deficit. I am aware of the argument over the "New Economy". I am not here today to discuss it, but it seems clear in any case that a new American economy of thoroughly sound character has emerged, one that Japan, as it struggles with low growth and a budget deficit, can only look upon with envy.

One thing, however, that puzzles me is that although the budget deficit has been reduced, there has been no reduction of the current account deficit which increases foreign debt. The outstanding U.S. foreign debt as of the end of 1996 stood at $870.5 billion, the highest in the world. With such an enormous foreign debt being carried, the possibility of the dollar's collapse cannot be dismissed. We in Japan who have long suffered through wide fluctuations in the exchange rate need a stable dollar and strongly desire a reduction of the U.S. current account deficit.

In terms of a framework permitting a balance of saving and investment, the fact that there has been no reduction of the current account deficit even though the budget deficit has been reduced is explained by increases in investment by private industry. With increasing investment unavoidable, it becomes necessary to increase the household savings rate. The 1995 household savings rate for the United States (based on the National Income and Product Accounts) was 4.8%, while Japan's was 13.1% and Germany's was 11.6%, making the U.S. figure remarkably low. Now that the United States has to a significant degree succeeded in lowering its vexing budget deficit, it should not be impossible to raise its savings rate as well.

At the heart of the current account deficit is the increase of the U.S. trade deficit. The United States buys low-priced goods from other countries that helps to keep inflation under control, but the United States ought to be producing more of its own low-priced goods.

While I cannot suppress my admiration for the recent splendid performance of the American economy, given the status of the United States as the world's lone economic superpower I must say that we hope for a bit more stability.

Concluding Remarks

These, then, are some of my thoughts on the state of the Japanese and U.S. economies. Modest though my ideas may be, I hope perhaps to have presented you, in some small way, with a fresh point of view.

Once again, I would like to thank you for the plivilege and the pleasure of talking to you about this subject.

Thank you.

Masao Yokomizo