Issues Facing the Japanese Economy in 2008

The Japanese Economy in 2008: Has volatility really declined?

Senior Fellow, RIETI
Senior Researcher, Japan Productivity Center for Socio-Economic Development (JPC-SED)

Has the business cycle been stabilized?

The Japanese economy has been continuing its sustained recovery. Japan's real gross domestic product (GDP) exceeded the government's initial forecast for the five years since fiscal 2002 (ended March 2003); a period characterized by extremely low volatility in economic growth. In the 1990s, not only was the absolute level of economic growth low, but business-cycle volatility was high. The average growth rate for the decade period stood at 1.2% per annum with the standard deviation of 1.6%. In contrast, real GDP growth in the ongoing recovery period has been surprisingly stable. After posting 1.1% growth in fiscal 2002, the real GDP grew by 2.1% in fiscal 2003, 2.0% in fiscal 2004, 2.4% in fiscal 2005, and 2.3% in fiscal 2006, with the growth rate falling within the narrow range of 2.2% = 0.2% for the past four fiscal years (based on the annual GDP revision for FY2006). The moving standard deviation for the five-year period from fiscal 2002 through fiscal 2006 came to a record low of 0.5%.

The United States and other major developed countries have witnessed a widely recognized and remarkable decline in business cycle volatility, known as the "Great Moderation," which first surfaced in the mid-1980s. Cited as reasons behind this phenomenon are 1) advancement of technology for inventory and production control, 2) improvement of monetary policy, and 3) "good luck" - the absence of exogenous shocks. It appears that Japan has finally become one of the stabilized economies. The year 2008 is a touchstone for testing the Japanese economy as to whether its business cycle has truly become steady.

The world economy is in a delicate situation due to a range of factors, such as growing uncertainty over the future course of the U.S. and European economies prompted by the subprime loan problem, rising crude oil prices, and the possibility of post-Olympic bust of the Chinese economy after the Beijing Olympics in August. Both the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) predict that the economies of developed countries will slow for the second consecutive year in 2008; the OECD predicts real GDP growth of 2.3% for its member countries in 2008, down 0.4% from 2007 and the IMF predicts 1.8%, down 0.8%, for advanced economies (World Economic Outlook Update). In Japan, an increasing number of indicators - deteriorating business sentiment among companies and individuals alike, leveling off of the growth of corporate earnings, etc. - are suggesting that the business cycle has peaked. Particular factors, such as declining housing starts resulting from amendments to the Building Standards Law, are adding to the impact.

Tough challenges facing monetary authorities

Discussion on the future course of the Japanese economy often begins with discussion on the outlook for overseas economies, particularly the U.S. The Japanese government first assumes a specific growth rate for the world economy based on forecast figures provided by international organizations and then, based on that figure, estimates the growth rate for the economy in the coming fiscal year. This procedure makes sense because the overseas economies are given conditions. The turning of the business cycle is also often attributable to changes in overseas economic trends; the potential cross-border spread of financial instability poses a particular risk factor. However, serious recession or long-term stagnation often stems from internal problems, such as structural problems in the domestic economy and government policy failure.

In the 1980s, the Japanese economy grew by an average of 4% in the real term. But the U.S. economy during the same period suffered from the twin deficits. Conversely, during the latter half of the 1990s, U.S. economic growth achieved an average of about 4% but Japan's average real growth rate fell below 1% with nonperforming loans and deflation weighing heavily on the economy. The economic growth rates of Japan and the U.S. were thus non-correlated - or, more accurately put, somewhat inversely correlated - from the 1980s through the 1990s. Decomposition of the volatility in Japan's real GDP growth rates found that a large part of the volatility for each period could be attributed to changes in domestic and external demand while the direct contribution of external demand is very small. Also, the correlation between fluctuations in domestic demand has been shown to be negative in almost all periods, indicating a tendency for domestic and external demands to move in opposite directions.

The business cycle of the Japanese economy is certainly, to a degree, affected by fluctuations in the overseas economy. To some extent a positive correlation naturally exists between two "normal" economies that trade with and invest in each other. Yet the priority in managing macroeconomic policy is not to remove minor fluctuations but to avoid a deep plunge or long-term stagnation. Even in cases where countries experiences minor fluctuations tied to changes in the overseas economy, it is important is to prevent these fluctuations from developing into a serious recession and important not to generate endogenous shocks. In this regard, monetary policy plays a significant role.

Since lifting its zero interest rate policy, the Bank of Japan (BOJ) has twice raised the target rate but the policy interest rate's absolute level still remains very low at 0.5%, leaving little room for maneuvering in the event of negative shocks. The GDP deflator has fallen below the government forecast for the past 15 consecutive years and fiscal 2007 is highly likely to be the number 16. Supported by a rise in the prices of petroleum products, etc., the consumer price index (CPI) has maintained positive year-on-year growth, but only by a small margin. The BOJ will likely face extremely tough monetary policy challenges in 2008.

Ensuring complementarity between growth strategy and monetary and fiscal policy

The abovementioned average growth rate for the past four fiscal years happens to coincide with the target growth rate of 2.2% presented in the government's New Economic Growth Strategy 2006 as a policy target to be achieved in the 10 years through 2015. This target may seem as if it has been already achieved and this rate of growth will naturally continue over the next 10 or so years. However, the U.S. GDP growth rate's standard deviation has stayed above 1% from the mid-1980s onward, a period characterized by very low business cycle volatility. Fluctuations in the business cycle are unavoidable. Thus, the growth rate at the peak of a recovery phase must be above 3% even if the volatility of the Japanese economy has been reduced by half the level it was in the 1990s. Otherwise, it will be difficult to achieve an average growth rate of slightly more than 2% during the target period, which includes years of economic slowdown, In order to achieve higher growth, Japan needs to maintain and further improve upon its growth policy; focusing on the supply side and implementing measures that help improve productivity and increase the labor participation ratio.

Greater macroeconomic stability provides greater predictability for companies and individuals alike, contributing positively to productivity. The New Economic Growth Strategy assumes that 0.2% of the target rate of 2.2% comes from stabilization of the macro economy. Ideally, sound monetary and fiscal policies will be implemented in parallel with growth policy on the supply side. Companies and households will then be, to some extent, able to cope with the predicted problems. However, an unpredictable event, such as a major natural disaster or a sudden change in government policy or rules and regulations could trigger unexpected responses. The year 2008 will likely see full-fledged discussion on major changes to the fundamental economic systems of taxation and social security. In the course of this process, steps ideally will be taken to improve the medium- to long-term predictability on key issues such as clarifying the prospects for reductions in government debt.

January 22, 2008

February 7, 2008

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