Japan Needs a Total Plan for Economic Recovery

Takahiro Miyao (International University of Japan
William S. Comanor (UC-Los Angeles and Santa Barbara)
August, 1998

While the California economy has taken off in recent years, and performed in an exemplary fashion, there are storm clouds on the horizon. The Asian economic crisis threatens to engulf us; and while the entire country could be affected, the impact on California would be staggering. The world economy is increasingly interconnected, and nowhere is that more evident than in the close economic ties between California and Japan.

The most likely scenario for a decline in the California economy proceeds as follows: Japan's economy remains stagnant despite any financial reforms, and Tokyo financial markets decline even more sharply than before until they reach a point where another round of currency devaluation in Asia is inevitable. Since Japan is the largest economy in Asia, the entire Pacific Rim is further engulfed in this process. As a result, American, and especially Californian, exports to Japan are sharply curtailed, and so is Asia's investment in our region. On both accounts, there is a substantial decline for the need for American productive capacity, and unless there is sufficient domestic demand to replace it, our own economy falters.

Particularly with the political uncertainty that currently exists in Japan, with a new prime minister taking office, these issues must concern us. The economic ties between our two countries are so strong that neither is immune to the economic ills suffered by the other. The question instead is what we have to offer the new Japanese leader.

The United States has not had so substantial an economic decline since the 1930s. While, to be sure, the Japanese decline of the past few years is not so great as that which occurred sixty years ago in the United States, there are fearful similarities. The economic downturns in both countries were accompanied by a stock market crash and an overwhelming loss in consumer confidence. As a result, consumer expenditures, which represent the largest share of economic demand for goods and services in both countries, declined sharply; and the layoffs and bankruptcies which resulted led only to further declines in consumer demand.

Although the two situations are hardly identical, still there are lessons to be learned. Foremost among them is that policies directed towards "recovery" are not necessarily the same as those directed toward "reform." And this dictum applies no matter how necessary are the elements of reform. As late as 1938, nearly a decade after the Great Depression in the United States had begun, millions of workers remained unemployed. Similarly, while there may be important needs for economic reform in Japan, there is considerable doubt that such actions can return that economy to its former level of prosperity. As in the United States during the 1930s, more is required for that.

While the Japanese people are appropriately known for high levels of personal savings, which in the right circumstances can lead to faster rates of economic growth, these high savings rates can also lead to diminished economic activity when there is not sufficient aggregate demand. For this reason, President Clinton and other American officials have called for permanent tax cuts in Japan, which former Prime Minister Hashimoto had reluctantly accepted.

However, even permanent reductions in income taxes, or consumption taxes for that matter, may not be enough. And here, there are also lessons to be learned from the US experience of the early 1990s, when there were substantial declines in the housing market, leading to what Federal Reserve Chairman Greenspan called the "balance sheet recession." Just as American consumers were severely harmed by the sharp decline in property values in the early 1990s, Japanese consumers have been badly hurt by the sharp decline in property values, and many would suffer enormous capital losses on their own homes if they were now to be sold. According to a recent Japanese government report, there are more than 600,000 families in the Tokyo metropolitan area alone living in condominiums with a potential capital loss of $100,000 per unit; These potential losses thus equal $60 billion! No wonder, so many Japanese households are paying off mortgage loans as rapidly as possible, while at the same time, spending as little as possible.

An essential fact about the current Japanese recession is that consumer spending has been sharply curtailed as a result of sharp declines in both the housing and securities markets. As these values have fallen, consumers have sought to replenish their asset accounts by spending less and saving more. For this reason, Japan's new leaders must deal directly with both sets of markets, for otherwise tax cuts will not lead to the increased consumer spending needed for recovery.

In the case of property values, the objective should be to reduce the burden on consumers of the existing volume of mortgage loans. To this end, Japan's new leaders should consider a long-standing American policy. The Japanese tax code, unlike that in the United States, does not permit mortgage interest and residential property taxes to be deducted from reported income. As a result, the costs of home ownership are much greater in Japan, and it is no wonder that many Japanese home owners would use any increased revenues to reduce outstanding mortgage loans. If mortgage interest were deductible, as in the United States, the gains from doing so would be lessened, and presumably, less would be used to pay off these loans and more used directly for consumption. While we do not know the magnitudes associated with this type of change, it would surely lead to faster rates of consumer spending and a more rapid pace of recovery.

Another policy action would be for Japan to adopt policies similar to the US IRA or 401(k) tax code provisions. Their purpose would be to direct Japanese pension funds into the securities markets. Currently, Japanese workers have little say on where their pension funds are invested, and such provisions can lead to more funds channeled into the stock market rather than to bank deposit or postal savings accounts.

The enormous declines in property and security values over the past few years has cast a dark shadow over the entire Japanese economy. There will not be recovery until specific policies are adopted which deal with these issues. Actions must be taken to boost both sets of markets, and the tax code provisions suggested above are steps that President Clinton and others in his Administration should recommend to the new Japanese leadership. The gains from such actions will benefit not only the Japanese economy, but also our own.