The Japanese economy and the Japanese stock market are, by some measures, flashing recovery signals even more strongly than their American counterparts. Japan’s Nikkei stock index had, by mid-August, risen by 30 percent since late April, outpacing the 24 percent increase in the U.S. S&P 500 stock index between early March and mid-August. Japan’s first-half annualized growth rate, 1.8 percent, was virtually identical to the 1.9 percent achieved in the United States. In both countries second-quarter growth accelerated and was a full percentage point above first quarter growth.

Unlike the United States, Japan is not experiencing a jobless recovery. During the five months ending in July, employment in Japan grew at about a 1 percent annual rate or 130,000 per month. That is well ahead of the 81,000 per month contraction in the U.S. employment during the first half of this year.

Two Key Elements of Japan’s Recovery

Despite all these positive signs, obstacles to continued Japanese growth remain. Japan entered a period of strong growth in 1996 after large fiscal stimulus, only to choke off recovery with tax increases. An ill-timed rate increase by the Bank of Japan ended a 1999 recovery. Now, Japan’s prospects for a sustained recovery still depend on two factors: continued strength of external demand growth led by China and Asia and by the United States in the industrial world outside Asia, and continued efforts by the Bank of Japan to move from just containing Japan’s deflation to eradicating it so that domestic demand can grow steadily.

Prospects for external demand growth as support for Japan’s export sector look relatively good. China is reflating rapidly and higher growth there will help to support growth throughout Asia, thereby giving a boost to Japan’s exports to important Asian markets. The United States looks to be headed for stronger second-half growth, probably above a 4 percent rate. U.S. consumers are responding powerfully to improving confidence after the Iraqi conflict and to aggressive tax cuts passed in May that will add about $100 billion to household incomes during the second half of 2003.

Japan’s deflation and its negative implications for a recovery remain a serious problem, however. The broadest measure of Japanese deflation--the GDP deflator--recorded falling prices at a 3.5 percent year-over-year rate during the first quarter and a 2.1 percent year-over-year rate during the second quarter. Although the deflation is abating, it needs to be eradicated in order to stop the continuing damage that it does.

Deflation continues to increase the real burden of debt in Japan. Japan’s small and medium-sized companies continue to be awash in debt. The burdens of such companies translate into bad loans held by Japan’s still virtually nonfunctioning banking system. Beyond that, deflation, even at a lower rate, continues to encourage cash accumulation at the expense of current consumption. For Japanese households, a 2.1 percent deflation rate means a 2.1 percent tax-free real return on holding cash as opposed to purchasing other assets or buying goods.

The strong preference for cash by Japanese households and corporations is one of the reasons that, even though the monetary base in Japan consisting of cash and bank reserves continues to rise at a 20 percent annual rate, broad money growth, the result of money creation by bank lending, continues to languish. Between April and June, year-over-year growth of the money base accelerated from 11.5 percent to over 20 percent. Meanwhile, broad liquidity in Japan remained virtually stagnant.

Japan’s deflation has meant that the inability of the Japanese banking system to operate as a financial intermediary between savers and investors has persisted. While banks continue to dispose of bad loans or consolidate them, their inability to help sustain Japan’s recovery will continue as well.

Better Corporate Balance Sheets

While Japan’s banks have made little progress toward restructuring their balance sheets, Japan’s larger, private nonfinancial corporations have made substantial progress on theirs. During the fiscal year ending in March 2003, Japanese nonfinancial corporations repaid ¥30.6 trillion of debt owed to private and public lending institutions. During the last three years, debt paydowns by nonfinancial corporations have totaled ¥82.8 trillion.

The ¥30.6 trillion debt paydown during the last year is the equivalent of about 6 percent of Japanese GDP. A comparable figure in the United States would be $600 billion--one-third more than this year’s much-decried federal deficit.

Japan’s corporate debt paydown is both a good sign and a bad sign. It is a good sign because as Japan’s corporations reduce their debts, they enhance the probability that a sharp profits recovery will accompany a broader economic recovery in Japan. This possibility is one of the factors contributing to the sharp jump in Japan’s stock market since April.

The negative aspect of Japan’s corporate debt paydown is that it reflects the rising burden of corporate debt as deflation proceeds. Deflation reduces the pricing power of Japanese corporations just as it does the pricing power of U.S. producers of goods whose prices are falling. To protect earnings, cost reduction is essential, and so Japan’s corporations tend to devote positive cash flow to debt paydowns, thereby improving their balance sheets, and obtaining relief from the rising real costs of servicing longer-term debt with fixed interest rates. The debt paydown improves prospective earnings for Japanese corporations should demand recover, but of course, does little to expand current demand. In fact, it tends to contract demand and runs the risk of creating a paradox of thrift whereby if all corporations attempt to pay down debt, demand growth weakens, deflation intensifies, and the real burden of debt rises further.

Corporate cost cutting has also reduced household disposable income in Japan, which fell at a 4.1 percent rate during the first half of 2003. This reduction in household income growth occurred despite rising employment because of increased use of part-time workers (some part-time workers are counted as “employed” in Japan) and because of reduced bonuses, which can amount to over twenty percent of workers’ base pay in good times. The weakness in household income growth has reduced Japan’s legendary personal savings rate from 14.4 percent in fiscal year 1991 to 6.6 percent in the fiscal year ended March 2002.

Supportive Monetary Policy

As banks continue to struggle and corporations restructure their balance sheets, Japanese policymakers are broadly supporting the economy. While fiscal policy has hovered between neutral and slightly contractionary, the monetary policy at the Bank of Japan has turned more accommodative. Since April, when its new governor, Toshihiko Fukui, took charge, the Bank of Japan has increased the liquidity it supplies to the Japanese economy. As money flows into Japan have intensified, especially during the second quarter of 2003, the Bank of Japan has increased its purchases of dollars in order to prevent the yen from appreciating. During the period from January through July 2003, Japanese dollar buying totaled about $75 billion--a record level. The previous highest intervention level was $65 billion during all of 1999.

The increased foreign exchange intervention by the Bank of Japan has been left largely unsterilized. That is, when the Bank of Japan is purchasing dollars in the foreign exchange market, the yen proceeds of those dollar sales by Japan’s private sector are being left in the system with the result that the monetary base expands more rapidly. This unsterilized intervention by the Bank of Japan can probably be credited with slowing Japan’s deflation rate during the second quarter.

Japan’s increased dollar buying (it purchased over $30 billion during May alone) is also helping to move the U.S. economy toward recovery. The Japanese government uses the dollars it accumulates in foreign exchange operations to purchase U.S. government securities, the supply of which has increased sharply along with higher U.S. budget deficits. Japan’s purchases of U.S. government securities help to push down rates when they are falling and to contain rate increases when rates start to rise, as they have done since June.

Higher Stock Prices Help

The Bank of Japan’s increased expansionary activity can, so far, be characterized as defensive. Specifically, at the behest of the Ministry of Finance, the Bank of Japan has purchased dollars in an amount necessary to prevent the yen from appreciating past the range between 118 and 120 yen per dollar. This strategy has resulted in an easier monetary policy in Japan, but one not yet sufficient to eliminate Japan’s deflation.

The outlook for the second half of the year may be brighter, provided that the U.S. economic recovery and the economic reflation in Japan proceed at a rate sufficient to boost stock markets. If the U.S. stock market rises 10 percent over the next six months, the Japanese stock market will probably rise 15 percent because Japan’s economy is, at this stage, so highly dependent on rising external demand. Rising stock markets in the United States and China would help boost demand for Japanese exports.

A surge in Japan’s stock market would provide the Bank of Japan with an opportunity to accelerate its easing of monetary policy through more aggressive, unsterilized intervention. As global investors spot a rapidly rising Japanese stock market, more funds flow into Japan, which already has a current account surplus. The increased demand for yen causes the yen to appreciate, thereby applying a deflationary force to Japan. But if the Bank of Japan continues to aggressively sell yen and purchase dollars to keep the yen stable and leaves the proceeds in Japan’s financial markets, the chances of ending Japan’s deflation improve. Beyond that, a higher level of unsterilized intervention results in the purchase of more U.S. government securities by the Japanese government, thereby providing additional support for continuation of the U.S. economic expansion. In short, the Bank of Japan can play a critical role in helping to sustain further economic expansion both in Japan and in the United States.

A U.S.-Japan Global Growth Locomotive

Japan’s economy and stock market can continue to recover and in so doing can help sustain a global economic expansion. Japan’s corporations have contributed to making this outcome possible by repairing balance sheets, cutting costs, and investing in cost saving capital equipment. There have been modest increases in Japanese employment, probably concentrated in the export sector.

Japan still, however, needs to do more to boost domestic demand growth. Measured in current dollar or nominal terms, the most reliable metric in deflationary times, Japan’s net exports rose at a 1.7 percent annual rate during the second quarter of this year while domestic demand fell at a 1.1 percent annual rate. Faster growth in China and the United States can help to sustain the contribution of net exports to Japan’s growth. However, the Bank of Japan must expand domestic liquidity more aggressively to boost domestic demand growth.

A reduction and ultimate end to Japan’s deflation will slow the atrophy of demand growth in Japan. Corporations paying down debt and households accumulating cash may be acting prudently on a microeconomic basis but, taken to extremes, their actions only weaken the economy, which in turn frustrates the effort by households and corporations to improve their economic situation.

A combination of U.S. tax cuts that boost U.S. demand growth, and thereby the U.S. stock market, along with further easing of Japanese monetary policy represents a symbiosis that could help to ensure sustainable recoveries in both the United States and Japan, as well as in the global economy. Japan’s rising stock market, reduced deflation rate, corporate balance sheet restructuring, improved employment figures, and higher growth are all encouraging signs that the Japanese economy is recovering.

If the Bank of Japan undertakes another round of aggressive unsterilized intervention and deflation moves toward price stability, while the Japanese government avoids the temptation for further tax increases, markets will move from asking whether Japan is recovering to why it is recovering so vigorously.

John H. Makin is a resident scholar at AEI.