Japan: How Bad Is It?
Expect the deepest recession since World War II.

Mr. Malpass is the Chief International Economist for Bear Stearns.
January 15, 2002, 8:00 a.m.

Meanwhile, the all-critical U.S. economic advice to Japan will continue to emphasize failed approaches — structural reforms, consumption measures, and competitiveness issues — rather than the fundamental change in monetary policy needed to stop the country's deflation spiral.

A key downside variable is whether there is capital flight. The Japanese will most likely stay in yen, and not take their savings off shore. Rather than seeing the strengthening dollar as a buying opportunity, the Japanese view the dollar as too risky. The worse the economic outlook, the more the attraction of JGBs over the Nikkei. This holds bond yields down at the expense of equity prices.

Likewise, widespread bank failures are unlikely. Deposits will continue to migrate from weaker banks to stronger ones. But the Bank of Japan (BOJ) and the Ministry of Finance should be able to handle the increasing pace of bankruptcies in the first quarter.

If Japan were to adopt a stimulative monetary policy, it would begin growing almost immediately. But there are no signs that the U.S. is encouraging Japan in that direction — nor is Japan finding its own way. While yen weakness would normally be a sign of a shift in monetary policy, Japan has gone out of its way to separate the yen weakness from monetary policy (or supply-side growth). In effect, the yen has gotten weaker without the BOJ participating.

Recent data show a continuing deflationary recession in Japan. Tokyo's CPI index fell 1.5% in the 12 months through December. December vehicle sales fell 7.6%. Unemployment rose to 5.5%. In dollar terms, the Nikkei fell 11.2% in the fourth quarter of 2001, severely under-performing most world equity markets. And the yen has fallen to 132 yen per dollar.

And the government has done a counter-productive job in explaining the yen's weakness. It is justifying yen weakness on the arguments that this will make Japan competitive and better reflects Japan's weak fundamentals. In effect, Japan is saying that it is doing so badly that it deserves a weaker yen. This simply reinforces the stagnation in Japan's bank loans, domestic investment, and consumption.

This chosen rationale for yen weakness — to achieve an even bigger trade surplus and a reduction in national wealth — will help the country grow. Instead, the yen's weakness is a negative in Japan's outlook, raising the risk of capital flight without improving the growth outlook.

To create growth, Japan should stop focusing on the yen and the banks and develop a stimulative monetary policy. The BOJ should announce its intention to stop the deflation by printing yen and purchasing JGBs to the extent necessary to break the deflation expectations and restart growth. If the yen weakened in response, at least it would be pointing toward growth. And the yen would probably not weaken under a stimulative monetary policy. Certainly, it would weaken less than it is doing under the current set of anti-growth policies.

Unlike developing countries, Japan's debt is largely yen denominated and locally owned. In the absence of capital flight, its economy can probably shrink without it spiraling into default, provided the global economy recovers. This leaves Japan in bad economic condition, but not in full-fledged collapse.