Wednesday, November 25, 1998
Japan's capital stock is too large for the country's own good. And rates of return are too low. Policies that do not address this fundamental problem will not restore Japan to vigorous economic growth.
To be sure, the only way that nations get rich is through capital accumulation, and Japan has been no different. High rate of investment encouraged by economy-wide yields approaching 40 percent in the 1950s propelled the Japanese economy into the front ranks of the world's economic powers. By the early 1970s, the accumulated stock of nonresidential capital relative to gross domestic product had climbed above the U.S. level. It did not stop there; Japan's businesses continued to invest at an elevated rate; by 1995 its capital-output ratio was 55 percent higher than America's. Driven down to an estimated 3.9 percent by the high capital intensity of production and low productivity, returns on capital are now approximately two-thirds of the U.S. and European levels
Why did capital continue to grow as yields plummeted? One reason is profit-blunting collusive business relations encouraged by the governing Liberal Democratic Party to protect its financial and business clients in the aftermath of Japan's slowdown in the 1970s. But, the principle explanation stems from the implicit guarantees that government gave to financial institutions and to major bank customers to protect the banks from failed borrowers. The explicit policy of the Ministry of Finance's "convoy" system for banks and tight regulation of other financial services providers did not allow such firms to go bankrupt during most of the postwar period. If one somehow slipped out of the convoy and found itself in difficulty, it was merged or otherwise saved through MOF's arrangements.
With such guarantees, neither lenders nor borrowers used expected rates of return as their investment criteria. Rather, they based decisions on the profits that would accrue if their optimistic expectations prevailed, assuming that bad bets would be covered by government. On average, of course, the best of all possible worlds was not realized. Indeed, because of the moral hazard generated by the government's implicit guarantees, corporate investors took even more risk than would ordinary investors. As a result, investment is higher and actual returns are even lower than in a more normal situation.
Today, the credibility of Tokyo's guarantees are evaporating. But the process is not yet complete, as demonstrated by the LDP's hesitation over the recent nationalizing of the bankrupt Long-Term Credit Bank. Nevertheless, indications that the government cannot be counted on to save defunct borrowers and lenders have been spreading, especially with the financial failures of such former giants as Yamaichi Securities, Hokkaido Takushoku Bank and the Long-Term Credit Bank. Moreover, the impact of vanishing implicit guarantees is reinforced by gradual financial market deregulation, which is requiring that firms pay closer attention to how they use their capital.
Corporate Japan, exposed to more intense market forces, finds itself with excess capital. Firms are unlikely to invest as rapidly as in the old days when profitability mattered less. Although new investment opportunities undoubtedly will arise, especially if encouraged by continued deregulation, the excess capital will have a restraining effect on future investment and, in turn, will lead to slower economic expansion.
Estimations of future growth rates in Japan must account for the economic rather than book value of the capital stock. Without gains in efficiency and profitability, capital stock should be written down by approximately 40 percent to bring rates of return into line with American and European figures. This reduced value is what should be used in making projections about Japan's economy. Macroeconomic stimulus by itself is likely to be insufficient to put the economy back on a solid expansion course.
High Japanese savings the foundation of its low-return investment may itself be a growing factor in permanent underconsumption. Underconsumption was the Keynesian explanation for recession as savings greater than domestic investment reduced aggregate demand below capacity output. The opening of international capital markets in the 1970s, however, virtually eliminated the negative domestic impact of excess savings, which could now be invested abroad to finance a trade surplus; the rest of the world would make up the demand deficit.
Japan's trade surpluses of the past 20 years are the counterpart of an outflow of savings into assets abroad, which, in turn, generate an increasing return flow of income. Such return income on foreign assets competes with and reduces the trade surplus. When the escape hatch for excess savings that a trade surplus provides is thus blocked, the result is too little aggregate consumption to soak up capacity output. Such an economy could sink into permanent recession. In 1997, Japan's return flow of investment income already was equal to 1.4 percent of GDP. Japan's inability to sustain growth in the 1990s without government deficit spending in part reflects this drag. If recent trends persist, the income from foreign assets as a share of GDP will double in little more than a decade. That shortfall would increase every year that the country saved more than it invested.
If returns could be raised, underconsumption could also disappear since some two-thirds of household savings is designated for such targets as education, marriage, housing, and retirement. If households saved less when returns increased because their savings targets were more readily attained, rising yields would solve the underconsumption problem as well.
Policies that raise the profitability of investment will act on several fronts to rouse Japan's lethargic economy and push it back on a growth track that is profitable and sustained. Policies that energize the market for corporate governance, promote mergers and acquisitions, and facilitate bankruptcy together with further financial deregulation will push recapitalization and the revaluation of assets. Greater attention to workouts of problem borrowers will clean up bank balance sheets and revalue assets at more realistic prices than the presently recorded book values. A more dynamic capital market, including active foreign participation, already is forcing corporate managers to pay more attention to profitability and should raise future rates of returns. Policies that ignore such objectives will leave Japan stranded in stagnation.
"JEI's Spin on the News" are the opinions of one of more members of JEI's staff and do not necessarily represent the views of the organization.