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Japan's Economy

How the Fourth Largest Economy Affects the U.S. and the World

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Job Fair

(Credit: John Moore/Getty Images)

Updated August 28, 2013
Before Japan's 2011 earthquake and nuclear power plant disaster, its economy was emerging from the deepest recession since the 1970s. It rebounded strongly in 2010, when GDP increased by a strong 3% -- the fastest growth in 20 years. It fell off briefly during the last quarter of 2010, but was expected to pick up again with stronger exports to fast-growing neighbors in Asia.

However, Japan lost much of its electricity generation when it shut down nearly all its nuclear power plants after the earthquake. The economy shrank .5% in 2011 as manufacturing slowed due to the crisis.

If that weren't bad enough, Japan's economy is still challenged by rising commodity prices -- the country imports most of its food and oil -- and a shrinking labor pool, as its population ages. Japan is also challenged by a debt-to-GDP ratio of more than 200%. Like the U.S, much of Japan's debt resulted from efforts to stimulate its economy out of a 20-year deflationary period and recession.

Japan's recession became official in Q4 2008 when GDP growth plummeted 12.9% from a year earlier, the worst decline since the 1974 recession. Japan's economic collapse was a shock, since Q3 growth was only down .1%, following a decline of 2.4% in Q2 2008. The severe downturn was a result of slumping exports in consumer electronics and auto sales, 16% of Japan's economy and a driving force behinds the country's economic revival from 2002-2008.

Japan's economy had only recently recovered from the deflation that hobbled it in the 1990s. Japan's economy was up 2.1% in 2007, and 3.2% in Q1 2008, leading many to believe it had finally grown out of its decade-long recession.

Japan's Importance to the Global Economy

Japan is the world's fourth largest economy (after the EU, U.S. and China), so its decline would drag down the global economy, as well. Japan also hires temporary workers from nearby South Asian countries, who are now being laid off in droves.

To combat recession in the 1990s, the Bank of Japan had lowered interest rates to 0% and bought U.S. Treasuries, keeping the yen low which made exports competitively priced.

The low yen caused investors to borrow money in yen at a low interest rate and invest it in higher-paying currencies, such as the dollar. This was known as the yen carry trade, and created much liquidity in the global marketplace. Last year, the yen carry trade collapsed, and the yen skyrocketed. The stronger yen made Japanese exports less competitive at a time when demand had fallen in the U.S.

Why Japan's Economy is Important to the U.S.

The Bank of Japan has traditionally been the largest holder of U.S. Treasuries. It did this to keep the yen low relative to the dollar, which kept Japan's exports competitive. This strategy caused Japan's debt to be 182% of total GDP output, weakening its economy. (Source: CIA World Factbook)

A low yen made Japan's auto industry very competitive. This was one reason that Toyota became the number #1 auto maker in the world in 2007.

A recession in Japan could cause it to purchase less Treasury bonds at a time when the U.S. is issuing more bonds to finance the economic stimulus bill and bailouts. Lower demand and greater supply of Treasury bonds will cause yields to rise, thus raising interest rates, further depressing the housing market.

Why a Japan-style Recession won't Happen in the U.S.

During Japan's recession, economic growth averaged 1% annually for ten years. Like Japan, the U.S. addressed the recession by cutting interest rates dramatically -- from 5.25% to 2% vs Japan's cut from 6% to 1.75%. Also similarly, the U.S. has pumped billions of dollars into the economy in the last year. Japan also pumped money into its economy by increasing public works, which increased its budget deficit by an annual average of 1.8% of GDP in 1992 and 1993.

Despite the similarities in cause and response, the U.S. will not be in a recession for a decade, like Japan was. American policy-makers are responding much more quickly and aggressively than Japan did, doing the same interventions in one year instead of two. Furthermore, the U.S. will either guarantee or buy the distressed loans from banks, who have written off $1 trillion so far. Japanese regulators, on the other hand, worked with banks to hide the bad loans, not write them off, poisoning the banking system for years. (Source: The Economist, Lessons From a Lost Decade, August 21, 2008)

Even now, Japan's government seems without direction. The Bank of Japan has again lowered interest rates to zero, and has bought shares of companies to revive stocks prices. However, the government has yet to develop an aggressive plan like the $787 billion Economic Stimulus Package or the $700 billion TARP fund.

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