The Japanese macroeconomic mystery

This paper examines Japan’s two decades of so-called ‘stagnation’ since the rapid the collapse of the bubble economy in the early 1990s brought the long period of rapid post-war economic growth to an abrupt halt. Successive governments have experimented with varying policy measures to restore growth without much success, though Keynesian fiscal measures have helped avoid high unemployment. A series of policy mistakes and demographic shifts that foreshadowed an aging and shrinking population led to a loss of confidence in the country’s long term economic prospects and hampered recovery. A major cause of continuing stagnation has been a sharp decline in private corporate investment to the point where it became a net saver. Surprising for a country with no regulatory barriers to cross border capital mobility, the bulk of Japanese savings have gone into government bonds yielding progressively lower returns despite better foreign options. This extreme ‘home bias’ has enabled governments to run debt financed fiscal deficits for a long period but now public debt has exploded to well over twice GDP, threatening fiscal sustainability. Direct government measures to channel investments overseas through a Sovereign Wealth Fund can not only boost Japan’s longer term income but also provide an immediate stimulus by depreciating its exchange rate. A fundamental lesson from the Japanese experience is that, to avoid a public debt sustainability problem, long term fiscal stimulus measures should make productive investments that enable subsequent debt repayments.