Japan's Economy and Its Impact on the U.S. Economy

Is Japan's economy stuck?

Cyclist driving on busy road in Tokyo
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Japan's economy produced $5.5 trillion in 2019, as measured by purchasing power parity, a metric that allows you to compare the gross domestic product (GDP) of countries that use different exchange rates. It's the world's fourth-largest economy after China, the United States, and India.

Japan has 126.3 million people. Its gross domestic product per capita is $40,246.88 or the 35th-highest in the world. That makes its standard of living lower than the United States or Germany, but higher than its Asian competitor, China.

Japan has a mixed economy based on capitalism. But its government works closely with industry and its central bank works closely with the government.

Trade

Some of Japan's largest exports are automobiles, machine parts, precious metals, and electrical components. As the world moves toward electric vehicles to combat climate change, it will likely hurt Japan's economy. Electric vehicles use one-third fewer parts than gas-powered vehicles.

To meet these challenges, Japan’s government wants manufacturers to stop building conventional cars by 2050. China, the world’s biggest car market, already has a goal of one in five vehicles running on batteries by 2025.

Japan's main imports are crude oil, coal, and petroleum. It's trying to reduce these imports by increasing its use of renewable energy. It's also restarting nuclear plants that were shut down after the Fukushima nuclear disaster.

What's Wrong With Japan's Economy?

Japan relies on its central bank to prop up its economy. Government spending is around 16.4% of the country's GDP. But Japan can't finance this through taxes because that would slow growth even more.

Therefore, in order to spur growth, the Bank of Japan strives to keep interest rates low. It does this by continuously buying government debt, a tactic similar to the U.S. quantitative easing program, which was utilized during the Great Recession and is currently in use to combat the economic fallout from the global health crisis.

Currently, Japan's central bank owns $4.5 trillion in government bonds, roughly half the total. The bank’s discount rate is just 0.3%, and it promises to keep rates low. As a result, people expect low rates and falling prices, which reinforces Japan’s deflationary environment.

The expectation means that every time prices rise, consumers stop buying. They just wait for prices to drop again. Businesses can't raise prices or hire new workers. Employees don't get raises, so they just keep saving. Just look at Japan to see why a little inflation is a good thing.

The Bank wants to keep the value of the yen low, but the yen carry trade keeps raising it. Even when the dollar's value soared 15% in 2014, it didn't increase the price of imports. A lower yen normally increases the price of imported commodities, triggering inflation. But plummeting oil prices kept prices low, which made deflation worse.

The government and the central bank are trying to stimulate growth through expansionary fiscal and monetary policy. But you can't push a string and, as a result, Japan has fallen into a classic liquidity trap.

7 Characteristics of Japan's Economy

The following seven factors hinder Japan's growth. The country's leaders must address these challenges to restore growth.

  1. Keiretsu is the structured interdependent relationships between manufacturers, suppliers, and distributors. This allows the manufacturer monopoly-like power to control the supply chain. It also reduces the impact of free-market forces. New, innovative entrepreneurs can't compete with the low-cost keiretsu. It also discourages foreign direct investment. Non-Japanese companies can't compete with the advantages given by keiretsu.
  2. Guaranteed lifetime employment meant companies hired college graduates who stayed until retirement. Around 25 million workers, aged 45 to 65, benefit from the system. Most have outdated skills and are just cruising until retirement. That burdens corporate competitiveness and profitability by artificially raising wages for these workers. The 2008 recession made that strategy unprofitable. By 2014, only 8.8% of Japanese companies continued to offer it, but its influence remains.
  3. Japan's aging population means less demand to drive growth. Older families don't buy new houses, cars, and other consumer products as much as younger ones do. And the government must pay out more retirement benefits than it receives in income taxes from workers. It doesn't help that the population is also shrinking. By 2065, Japan will have 30% fewer people than it did in 2015. An influx of younger families would boost the economy. Instead, Japanese companies must rely on temporary workers from nearby South Asian countries. They send their wages back to their home countries, exporting Japan's growth.
  4. 4. The yen carry trade is a result of Japan's low interest rates. Investors borrow money in the low-cost yen and invest it in assets denominated in higher-paying currencies, such as the U.S. dollar. The demand for the yen keeps its value higher than the central bank would like, which diminishes exports and prevents inflation.
  5. Japan's massive debt-to-GDP ratio means the nation owes more than twice as much as it produces annually. The biggest owner of the debt is the Bank of Japan. Its ongoing bond-buying activities have enabled the country to keep spending without worrying about the higher interest rates demanded by skittish lenders. Unfortunately, government spending hasn’t provided a meaningful boost to the economy
  6. Japan briefly became the largest holder of U.S. debt in 2015 and again in 2017. Japan does this to keep the yen low relative to the dollar to improve its exports. 
  7. Japan is the world’s largest net food importer. The country has just over one-third as much arable land per person as China.

Japan's Lost Decade

In January 1990, Japan's stock market crashed. Property values fell 87%. The Bank of Japan fought back and lowered the interest rate from 6% to 0.5% by 1995. Unfortunately, this didn't revive the economy because people had borrowed too much to buy real estate during the bubble. They took advantage of low rates to refinance old debt. They didn't borrow to buy more.  

The government also tried fiscal policy. It spent on highways and other infrastructure that created the high debt-to-GDP ratio. By 2005, companies had repaired their balance sheets. In 2007, Japan's economy started to improve. GDP increased by nearly 10% from 2002 to 2007 and started strong in 2008. This led many to believe it had finally grown out of its 20-year slump.

However, the 2008 financial crisis sent GDP growth plummeting 12.9% in the fourth quarter. It was the worst decline since the 1974 recession. Japan's economic collapse was a shock, since Q3 growth was only down 0.1% following a decrease of 2.4% in Q2 2008. The severe downturn was a result of slumping exports in consumer electronics and auto sales.

The Tsunami and Fukushima Disaster

On March 11, 2011, Japan suffered a 9.0 magnitude earthquake, which created a 49-foot tsunami that flooded the Fukushima nuclear power plant. It occurred just as Japan's economy was emerging from the Great Recession. In 2010, GDP had increased to a healthy 4.19%, the fastest growth in 20 years.

Japan lost much of its electricity-generating capacity when it shut down almost all its nuclear power plants after the earthquake. The economy shrank 0.12% in 2011 as manufacturing slowed due to the crisis.

Japan adopted more stringent regulations, under which it is reactivating at least 30 reactors that meet the new requirements. Its energy plan is to have 22% nuclear, 24% renewable energy, and 26% coal by 2030.

Abenomics Tried to Fix the Problems

On December 26, 2012, Shinzo Abe became Japan's Prime Minister for the second time. His first term was from 2006 to 2007. He won in 2012 by promising economic reform to shake the country out of its 20-year slump. He resigned in August 2020 for health reasons.

"Abenomics," named after Abe, has three principal components, called the "three arrows."

Expansive Monetary Policy

First, Abe instructed the Bank of Japan to initiate expansive monetary policies through quantitative easing.That lowered the value of the yen from $0.013 in 2012 to $0.0083 by May 2013. That's expressed in terms of the value of the dollar, which rose from 76.88 yen in 2011 to 124.27 yen by 2015. But by 2019, the yen strengthened against the dollar. One dollar could only purchase 110.5 Japanese yen.

Making the yen cheaper should have increased exports. Their prices drop in dollar terms, making them more competitively priced. But Japanese companies didn't increase exports as expected. Some companies didn't lower their foreign prices but pocketed the profits instead. Others had already outsourced factories to lower-cost areas, so the devaluation didn't help. Still others weren't helped because they had moved production into their markets. For example, Toyota made nearly 2 million vehicles in the United States in 2017.

The devaluation hurt Japanese businesses that rely on imports. Their costs rose. It also hurt consumers, who had to pay more for imports.

Expansive Fiscal Policy

Second, Abe launched expansive fiscal policy. He increased infrastructure spending and promised to offset the rise in Japan's 235% debt-to-GDP ratio with a 10% consumer tax in 2014. It backfired when it briefly returned the economy to recession.

In 2016, Abe spent another $276 billion. Of that, $202 billion was government loan programs. The rest went toward infrastructure construction including a magnetic levitation train.  

Structural Reforms

Third, Abe promised structural reforms. He pledged to modernize Japan's agricultural industry, reduce tariffs, and expand plot sizes. That put him against the powerful rice lobby. But in 2015, the Central Union of Agricultural Cooperatives, also called JA-Zenchu, agreed to reduce its power over farmers. That allowed the government to promote more efficient production methods.

Japan was the first country to ratify the Comprehensive and Progressive Agreement for Trans-Pacific Partnership. The massive trade deal includes 10 other countries from the Asia-Pacific region. They signed it after President Donald Trump pulled the United States out of the agreement.

How Japan Affects the U.S. Economy

On July 17, 2018, the EU signed a trade agreement with Japan, which reduces or ends tariffs on almost all goods. It came into force in 2019 after ratification. Critics say the deal will hurt U.S. auto and agricultural exporters.

The Bank of Japan had been the largest foreign holder of U.S. debt until China replaced it in 2008. Both Japan and China do this to control the value of their currencies relative to the dollar. They must keep their exports competitively priced.

A low yen made Japan's auto industry very competitive. That was one reason that Toyota became the No.1 automaker in the world in 2007. But if Japan's central bank decides that a low yen isn't boosting growth and oil prices rise, then it may let the yen strengthen to reduce inflation. It would purchase fewer Treasury bonds. That would allow yields to rise and boost U.S. interest rates. 

Japan's aging population gives it a dependency ratio of 65, meaning it has 65 dependents for every 100 working-age person. The U.S. ratio is 51, but it also has an aging natural-born population. Its ratio is lower because it allows immigration. But Trump's immigration policies threaten to slow that growth. Without immigration, some economists forecast the U.S. economy could fall into a slump similar to Japan's.

The Bottom Line

Although it’s the fourth-largest economy in the world (as measured by purchasing power parity), Japan has been suffering from deflation and slow growth since the 1990s. Shinzo Abe’s “Abenomics” failed to correct low prices, expensive imports, and a high debt-to-GDP ratio.

But a devalued yen has made the nation a top manufacturer and exporters of automobiles, machinery and equipment, steel products, and electronics. To spur exports and earn more, Japan keeps its yen low relative to the U.S. dollar. Japan signed huge trade agreements like the TPP and a bilateral one with the EU. These agreements do not include the United States. As such, these may soon pose serious competition to the U.S. agricultural and manufacturing sectors.

The drive to extend their global market share comes from Japan’s burgeoning debt and a declining population of a taxable, working-age group. Both pose considerable economic challenges.