The recent release of government data showing that the Japanese economy grew at a 10 percent annual rate in the first quarter might lead one to believe that a Japanese economic recovery is well underway. Certainly, the Japanese government and the Bank of Japan lean in that direction. But Japan’s first quarter GDP statistics, such as this year’s 10 percent growth number, have been notoriously misleading, tending to far overstate the strength of the economy. The current numbers are no exception, and one can only hope that Japanese policymakers do not actually believe what they are saying about the Japanese economy.

The inaccuracy of Japan’s quarterly GDP statistics throughout the year as a guide to the state of the economy stems from two sources: faulty seasonal adjustment, and a failure to consider the impact of persistent deflationary pressure in Japan. The way to solve both problems is to look at year-over-year nominal data. That procedure compares this year’s first quarter with last year’s first quarter and thereby removes the seasonal adjustment problems that have persisted in the Japanese data with respect to first quarter numbers. The use of nominal numbers captures the effect of deflation, which Japan, with its rising indebtedness and frightened households, needs to avoid.

The contrast between annualized real quarterly data for Japan’s GDP and year-over-year nominal data is striking. The money value of Japan’s total output in the first quarter of this year (its nominal GDP) was 1.1 percent lower than the comparable figure a year ago. This fall in nominal GDP is due to a 1.7 percent deflation rate over the last year coupled with a tepid 0.7 percent increase in real output. In fact, Japan’s economy measured by the broad gauge of year-over-year nominal GDP growth has been either flat or shrinking since the first quarter of 1998, save for a tiny 0.1 percent rise in the third quarter of last year.

Japan’s economic problems are actually intensifying at a time when most observers, encouraged by the Japanese government and its counterproductive habit of data manipulation, are hoping that a recovery has begun in Japan. The fact that the stock market has dropped by 25 percent from its highs earlier this year is consistent with the idea that not only is the Japanese economy not recovering but its problems are becoming more profoundly serious and dangerously self-reinforcing.

The Paradox of Thrift

The key to understanding the fundamental problem facing the Japanese economy can be found in the Keynesian notion of the paradox of thrift. The paradox is this: if individuals try to increase their wealth by saving more and accumulating assets, demand collapses, prices and output fall, and everyone is made worse off. Without rising demand, the assets acquired with increased savings cannot yield returns to their owners.

For nations, as opposed to individuals, the parallel to the paradox of thrift is the mercantilist
doctrine. If a nation restricts consumption in order to run a balance-of-payments surplus and accumulate gold, the shortage of demand depresses output, prices, and employment and leaves the nation worse off. By the late eighteenth century it was recognized by David Hume and others that the accumulation of gold should be allowed to increase the money supply and thereby propel spending on domestic and foreign goods so that prices and output rise and the economy is revived. Japan’s need to have the Bank of Japan buy dollars to avoid more deflationary yen appreciation is a contemporary version of Hume’s specie-flow mechanism, whereby the money supply of a country with a balance-of-payments surplus is increased. But the Bank of Japan has short-circuited such reflationary pressure by not allowing its dollar buying to push up the Japanese money supply. This is called sterilized currency intervention.

The idea that thrift is at all times a virtue either for individuals or for nations has never really died, although it was intellectually vanquished for nations by the free-trade doctrines that grew up in England in the later eighteenth and early nineteenth centuries and, one would have thought, for individuals by Keynes in The General Theory of Employment, Interest, and Money. Near the end of the General Theory, Keynes presents a collection of notes on mercantilism that includes reference to Bernard Mandeville’s Fable of the Bees. The Fable of the Bees sets forth the problem encountered by a prosperous community in which all the citizens suddenly decide to abandon luxurious living and the state decides to reduce its armaments, all in the interest of more saving. Mandeville concludes his allegorical poem the Fable of the Bees as follows:

Bare virtue can’t make Nations live
In Splendor. They that would revive
A Golden Age, must be free,
For acorns as for honesty.

Mandeville meant to show the paradox of thrift by suggesting that, if no one spent money and everyone saved, th ere would be no employment and no growth.

Japan’s government and the Bank of Japan would do well to read the Fable of the Bees. For in Japan, a "paradox of fear" parallels and mimics the paradox of thrift because the central bank still embraces the pre-eighteenth century view that thrift is always a virtue. As households grow more fearful of the future while the economic depression drags on, government debt piles up, pensions for a rapidly aging population must be "reformed," that is, reduced, and stock prices fall while the yen rises. In this environment, fear is driving Japanese savers to the "riskless" asset--government bonds. As deflation continues to intensify, the desire to own bonds that appreciate more rapidly as deflation intensifies will grow. Indeed, at current deflation rates, real (purchasing power) return on Japanese bonds is not far below the long-term average real return on such bonds, but it is destabilizing deflation that is making government bonds attractive at very low market interest rates. Efforts by Japanese households to alleviate their fears about lost jobs and shrinking pensions only creates results that add further to those fears.

Japanese households’ preference for Japanese government bonds as the preferred asset, virtually by default, has further dangerous implications beyond reinforcing deflation. In effect, the Japanese government "bond market bubble" makes it nearly costless for the government to continue to finance dubious "stimulus packages." The problem is that the stimulus packages are being used to finance projects with no economic value. Many of the projects are simply pork barrel outlays by the ruling Liberal Democratic Party to shore up its waning popularity in a weakening economy. And, as government spending increases while the nominal economy shrinks, tax revenues decrease as well. The resulting increase in deficits and government debt, which has now reached 10 percent of GDP for deficits and over 130 percent of GDP for debt (accumulated deficits), raises expectations of higher future taxes and thereby depresses consumption further. The reduction in consumption causes deflation to intensify and increases the demand for bonds, and the cycle begins all over again. This deflationary cycle borne out of a "paradox of fear" in Japan constitutes a serious threat to both the Japanese and global economies.

Make no mistake. The mercantilist notion that Japan benefits from a current account surplus even though government spending exceeds tax revenue by 10 percent of GDP is misguided. Japan’s current account surplus arises from the fact that private investment opportunities are so limited that the rising flow of savings motivated by fears over job loss, falling pensions, and falling benefits--not to mention higher taxes--is more than enough to finance the government’s growing budget deficit. In effect, Japanese households fearful of falling pension benefits and higher taxes, and expecting lower prices, are purchasing more and more government bonds that, in turn, make it easier for the government to continue its counterproductive efforts to stimulate the economy by spending more on wasteful public works projects.

The Bank of Japan’s hawkish governor Masaru Hayami is right about Japanese policy needs in one sense and disastrously wrong in another. He is correct to point out that the current system of government bond-financed stimulus packages, in turn encouraged by very low interest rates on government borrowing, has been used to put off necessary restructuring in many Japanese companies. However, Governor Hayami is disastrously wrong in believing that Japanese interest rates should be raised by the Bank of Japan in order to encourage further restructuring. The way to raise Japanese interest rates is to allow rapid deregulation of Japanese industries so that many projects with higher rates of return become available and the competition to fund investment projects undertaken to restructure Japan pushes up real returns and, thereby, real interest rates.

Japanese households must be given some alternative to Japanese government bonds as an attractive investment. The fact that maturing postal savings deposits, one of the major assets of Japanese households, which had been yielding 6 or 7 percent based on the terms of their purchases a decade ago, are now maturing and being reinvested in government sponsored bonds yielding 0.20 percent, is testimony to the paucity of investment opportunities available to Japanese households. The problem will not be alleviated until rising investment spending, not Bank of Japan action, pushes up interest rates.

The tragedy of the economic picture unfolding in Japan is more profound than that suggested by Mandeville in the Fable of the Bees. Japanese households are not arbitrarily deciding to be more thrifty in order to increase future wealth. Rather, they are driven by absolute liquidity preference and risk aversion either to hold cash or to hold short-term government securities. The "paradox of fear" arises because they hope that by acquiring what seemed to be riskless assets they can alleviate rising fears about underfunded pensions, higher future taxes, and more costly health care as old age approaches. And, of course, Japan has the most rapidly aging population among the major industrial countries.

Add to Japan’s economic problems a lack of leadership emanating from its one-party parliamentary system. The extreme weakness of Japan’s economy and the troubles associated therewith would be a challenge for any government. If anything, the leadership of Japan’s Liberal Democratic Party appears to have grown even weaker in the months since the stroke suffered by former prime minister Keizo Obuchi, and followed by his sad death in May. As this goes to press, Japan is about to hold a national election in which all of the seats in the ruling lower house of parliament will be contested. Most commentators expect the LDP to hang on by a narrow margin to a ruling coalition majority. That may or may not happen, but even if the LDP is unable to form a government due to a loss of too many seats, it is not clear that a remedy for Japan’s many problems is on the horizon. One of the most unfortunate by products of Japan’s long-term, single-party-dominated parliamentary system is the failure to develop a viable alternative party. While some of the small opposition parties have admirable agendas, their ability to carry them out is seriously in question.

With the government rudderless, one might hope that Japan’s economic problems would be addressed by the Bank of Japan. However, it appears that the bank is preparing to begin raising interest rates to tighten monetary policy even though the country desperately needs an easier monetary policy and a goal at least of stabilizing falling prices. It is true that the Bank of Japan’s zero interest rate policy has served to subsidize the purchase of government bonds, which in turn have been utilized to finance unworthy public works projects. If the Bank of Japan allows short-term interest rates to rise, long-term interest rates will rise as well, and the financing costs for public works projects will increase slightly. It could be said that higher interest rates will not harm private investment since there is virtually no private investment being funded by bond issuance anyway--not a particularly consoling thought. That said, government spending on wasteful public works is not interest-sensitive, and higher interest rates probably will not do much to slow it down.

As it has since the disastrous tax increases of 1997, the Japanese economy needs a revival of private demand. The Bank of Japan is correct when it asserts that it will be difficult to convince Japanese consumers to spend more money in an environment dominated by the paradox of fear. However, the goal of stabilizing or, better yet, raising the prices of goods will create an incentive to save less and to spend more. More spending will increase employment and output and thereby will help to arrest the accelerating deflation in Japan. Massive restructuring is still needed, and that task will fall to a future, more forward-looking Japanese government that recognizes the need to create investment opportunities in Japan by means of a thorough restructuring of its domestic sector. But waiting for that transformation to occur or hoping to speed it up by raising interest rates, as some at the Bank of Japan feel is desirable, is too risky. Far better for the Bank of Japan governor to read the Fable of the Bees and learn.

John H. Makin is a resident scholar at AEI.