Japan has endured an environment of low growth and low interest rates for thirty years. MATTHEW FEARGRIEVE explains how the country has responded to, and learned to live with, the aftermath of the 1990s market crash, and considers the lessons that the West must now learn from Japan in order to survive in a post-Covid global economy.
The scale of the financial blow that Covid and the pandemic lockdowns have dealt the world economy cannot be underestimated. The global economy is facing a crisis of unprecedented magnitude. After a contraction of 4.4% in 2020, the International Monetary Fund (IMF) forecasts global growth of 5.4% in 2021. Overall, this would leave 2021 GDP some 6.5% lower than in the pre-Covid projections from January 2020. This represents the largest drop in global GDP since World War II.
Since the 2008 financial crisis, the real yield of the 10-year inflation-protected US Treasury bond has mostly been below 1%, including a spell in negative territory both in 2012 and again in 2020. Negative real yields are now common to the G3 economies and beyond. In 60% of the global economy - including 97% of advanced economies - central banks have pushed policy interest rates to below 1%. In one-fifth of the world, policy rates are now negative.
Textbook responses to the covid economic crisis
Following the 2008 textbook on crisis response, central banks have printed money in waves of quantitative easing. This low-risk liquidity has, together with the already-low interest rates, pushed asset prices higher.
And, in adherence to the post-World War II crisis textbook, many central banks have issued bonds with yields well below the trend GDP growth rate, in a bid to gradually reduce national debt as a proportion of GDP.
Notwithstanding these desperately protective measures, there is now a real risk that the global economy cannot be reflated, leading to the prospect of significantly lower growth, which would leave marginal sections of the world economy vulnerable to collapse. Which brings us to the environment that central banks have sustained since the financial crisis of 2008, of modest growth and low inflation, that has propped up asset prices since 2008.
A theory was posited in 2015 that, rather than low central bank rates, it is low real interest rates (the economy’s real interest rate under full employment and stable prices), in combination with near-zero nominal interest rates, which restrict the effectiveness of monetary policy and which causes low inflation. Stabilising inflation in the medium term necessitates higher real interest rates; and, because central monetary policy alone cannot achieve this, structural policies are required.
Ever since central banks embarked, post-2008, on their near-zero interest rate policies and their large-scale asset purchase programmes, inflation hawks have predicted high and unsustainable inflation rates for the future. Reality has proved them wrong. The trend was towards deflation rather than inflationary pressures and, for the past five years, it has not been high inflation causing problems for central banks, but rather inflation rates stuck at low values with a tendency towards deflation. Realising that the conventional inflation measures overstated the ongoing increase of the price level by 0.5 to 1.0 percentage points, central banks decided to fix the inflation target not close to zero but close to 2%, thereby incorporating a safety margin to guard against deflationary risks. But studies have shown that, even in times of “normal” inflation, a target above 1% would in most scenarios be adequate.
Fast forward five or so years, to late 2020. Large parts of the developed world are now likely to emerge from the Covid pandemic with economies characterised by low interest rates and low economic growth, and a pressing need to maintain public confidence in central bank policy whilst simultaneously adjusting the public's expectations of growth over the medium- to long- term.
Lessons from Japan
It is at this point that we must look to Japan's economic experience over the past thirty years. Since 1990 - or, more precisely, since the boom years of the 1980s - Japan has had an average annual real growth of 0.8%, and inflation of 4%. The experience of Japan's central bank during that time effectively provides the rest of the world now with a textbook on how to deal with and survive a market crash followed by economic stagnation.
In the immediate aftermath of Japan's market crash in the early nineties, fiscal stimulation had little effect and, by the end of the decade, inflation was sub-zero. Finding itself in unchartered territory, Japan's central bank cut interest rates to zero. But where to go from there? A policy adviser by the name of Nobuyuki Nakahara, more recently adviser to Prime Minister Shinzo Abe, had an answer: quantitative easing (QE).
Nakahara's QE reduced interest rates, but had little effect on Japan's stubbornly low rates of growth and inflation. The attention of the Bank of Japan and economists started to focus on the country's ageing population. But the economic consequences of an ageing population - something that many advanced economies have in common- are unclear. Its impact on inflation is still debatable. Japan is the developed country whose population has aged the most, and its thirty-year long spell of low inflation naturally prompts speculation that an ageing population is deflationary. And yet there is currently no economic theory that has formalised a relationship between demographics and inflation.
It is generally accepted that an increase in the dependent share of a population (those too young or old to work) typically brings down the savings ratio and therefore pushes up the natural rate of interest. Those of a working age save more than the elderly and youngsters do, and elderly people draw on savings accumulated over the course of their lifetimes. So an increase in the dependent portion of the population is associated with higher inflation, and an increase in the share of the working-age population is associated with lower inflation. The critical point at which these dynamics crossover is not fixed, and differs from case to case. In Japan's case this question is still the subject of debate.
So what concrete theory or modus operandi emerges from Japan's three decades of low rates and growth? Perhaps the most salient, and valuable in real terms, is the need for central banks to control the growth expectations of the people. The Bank of Japan realised in the mid-2000s, after around fifteen years of low rates, that the people of Japan entertained expectations only of low growth in wages and buying power, and that this collective mindset was an unmovable counterweight against any amount of quantitative easing or other fiscal stimulus.
And so US and UK policy makers are now moving visibly to raise inflation and, moreover, to keep inflation expectations raised, in a determination not to let them fall to the floor. Japan's experience shows that expectations of zero interest and zero growth rates can become a self-fulfilling prophecy. In contrast to the US and UK central banks, the ECB seems dangerously close to falling into this trap.
In Japan, people young and old have learned to live with within their means. Apart from being an old axiom, it is one that is entirely apt for the low growth environment that is now a way of life in Japan. It is instructive to look at the attitude and outlook of Japan's millennials. A survey of the 20-40 age group showed that only 10% would consider using credit facilities or money-lending apps (the kind that are increasingly popular with the young in China and South Korea).
Instead, to supplement their earnings, Japan's millennials make modest bets on the stock market or, more usually, take a side job. Long gone are the day of their grandparents, who had jobs for life. Japan's young are accustomed to having different jobs and different employers. There is a widespread and generally accepted expectation that the state pension will be inadequate to support them once they reach retirement age.
Lessons for the West
Again that word, expectation. Central banks and policy makers in the the developed world are well aware that there is no comprehensive blueprint for preventing periods of low growth from turning into prolonged periods of economic stagnation. But Japan's thirty year journey is the closest thing to a textbook as there is.
The post-Covid environment of low interest and inflation rates may well herald a whole new era of expectation adjustment for developed economies; the expectation of lower growth, lower wages and lesser life prospects. Japan's population has, over the years since 1990, with the help of inevitable, generational base-line shifts, learned to live with this. Maybe the West will have to learn to do the same.