Japan’s economy always seems to surprise – unfortunately, on the downside – and it has done so once again in the wake of the devastating quake and tsunami that hit the northeast coast on March 11. GDP in the January-March quarter contracted by a staggering annualized rate of 3.7%, sending the economy into yet another recession. Economists had been steadily lowering their growth forecasts for the quarter as the scale of the economic disruption became clear. Factories across the country shut or slowed output due to supply chain upheaval, power outages caused by the chaos at the Fukushima nuclear plant, or outright damage from the natural disaster. Still, the depth of the downturn in the last quarter was far worse than expected.
At first glance, it seems obvious that we should blame this latest Japanese recession on an act of God. There is little policymakers and politicians can do to offset the damage done by a natural disaster in a just a few weeks time — aside from boosting government spending, which did increase in the quarter. But that’s not the whole story. In order to be in a technical recession, an economy needs to contract for two consecutive quarters, which Japan managed to achieve. GDP shrank in the fourth quarter of 2010, before the quake hit. Even as the recovery in much of the rest of the global economy was proceeding along nicely, Japan was losing momentum, and more than we originally thought — the fourth quarter contraction was revised downward as well. So the causes of Japan’s recession go much deeper than the quake. It is a result of two decades of misguided economic policy that have left the country incapable of surviving any sort of unforeseen shock.
I’ve written at length about Japan’s failed economic model, and the inability of policymakers to change it, but here’s a quick summary: Japan’s invest-and-export-at-all-costs economic system, which served it so well during its catch-up, rapid development decades, became out of date with the realities of high costs and competition from the rest of Asia, but the devotion to the system among the nation’s powerful bureaucrats hasn’t wavered. As a result, the domestic economy is stunted, suffering from a lack of investment, poor services, low productivity and high costs. But policymakers haven’t been willing to open the system up to more competition to foster entrepreneurship or encourage consumer spending. The result is an economy that effectively hasn’t grown ever since the unwinding of a stock-and-property price bubble began in the early 1990s. GDP has increased by more than 2% only six times since 1992.
So anytime Japan is confronted by something unexpected, the economy gets slammed. There’s no buffer to support growth when times turn bad. That’s why the Japanese economy suffered a sharper economic contraction in 2009 than the U.S., even though the financial crisis began in the U.S. Now we have the quake. Japan would not be in recession right now if growth was more solid overall. Perhaps this latest recession is caused by something out of man’s control. But it has been made much worse by matters within man’s control. Here’s how HSBC economic Frederic Neumann put it in a report today:
Japan’s economy is stuck in a dangerously low orbit…It is difficult to attribute the disappointing GDP reading solely to the effects of the March 11 earthquake. True, industrial production slumped at a record pace during the month, with service sector activity also down sharply. However, the event affected only the last three weeks of the quarter and thus doesn’t fully account for the surprising weakness for the whole period.
And the pain may not be over. Most economists expect this current, April-June quarter to be worse than the last one. The quake, after all, hit when the January-March period was already near its end. This quarter, however, the effects of supply shortages and disrupted production could last the entire three months. Perhaps economists will adjust their thinking in light of the unexpectedly awful data released today, but it seems very likely Japan will post a third consecutive quarter of contraction.
After that, there is hope among economists that the process of reconstruction will start to boost growth due to fresh spending on infrastructure and homes. Most see a strong rebound starting later this year. Perhaps that’s true, but unless that spending goes hand-in-hand with some reforms to the real economy, any bounce is likely to be temporary. The underlying malaise of Japan’s economic model will eventually show itself again and drag economic growth back down. In fact, the reconstruction effort could make matters even worse, by further burdening national finances already in miserable shape. At 200% of GDP, Japan’s government debt burden is the heaviest in the industrialized world. More deficits and debt will only weigh down Japanese growth in the future.
So the lesson here for the U.S., China, India and everyone else is quite clear. Japan is suffering today because of an unwillingness to reform obvious flaws in its economy over an extended period of time. If you don’t deal with your economic problems now, they’ll bite you when you’re down. The U.S. has learned that running big deficits in good times (the George W. Bush years) means government finances fall into deeper trouble in bad times. Delaying hard fiscal choices now will only make the economy more vulnerable in the future. China should take rebalancing more seriously by implementing more serious steps to make the economy less dependent on investment (and especially property investment) for its growth. India needs to improve its governance so all of the money it is spending on rural development actually goes towards boosting farmer incomes, raising food production and eradicating poverty. If policymakers aren’t proactive, the next time an economic quake rolls around, we could all end up like Japan.