Japan’s Past Has Lessons For Beijing

Many Chinese respond worriedly to calls to raise the yuan by looking back at the Plaza Accord of September 1985, after which the value of the yen rose more than 60 per cent, from 240 to the US dollar to less than 150, within two years.

After five years of strong growth and surging stock and real estate markets, in 1990 Japan was forced into a painful 20-year adjustment.

For many Chinese, there was a causal connection between the two events. The post-1985 rise in the yen, they believe, caused the bubble whose subsequent collapse ended Japanese growth and threw the country into a lost decade.

This view is mistaken. What is worse, to the extent that it affects Chinese policy it almost certainly increases the chances that China will suffer its own lost decade.

It was not the post-1985 rise of the yen that caused Japan’s lost decade. Tokyo had waited so long before the inevitable currency adjustment that policymakers were then forced to choose between a sharp slowdown and a disastrous policy response. They chose the latter.

For Japan in the mid-1980s, a sharply undervalued currency and extremely low interest rates had helped to generate tremendous growth in the previous 15 years. But as in China today, this growth came with low and declining household consumption as a share of GDP. This left Japan extraordinarily dependent on investment and on a large trade surplus to generate growth.

Once it became clear, however, that the rest of the world, especially the United States, was unable to absorb Japan’s rising trade surpluses, in 1985 under threat of trade sanctions Tokyo allowed the yen to soar in value against the dollar.

This should have caused Japan’s trade surplus to fall sharply, and with it Japanese growth should also have dropped sharply.

But in an attempt to forestall the drop, Tokyo turned to the only set of policies that might reverse the impact of the devaluation. It reduced interest rates and forced banks to expand credit dramatically.

But Tokyo overdid it. The net result was the economy and asset markets soared. This in no way resolved Japan’s underlying imbalances. In fact, it made them worse than ever.

Investment always causes growth, but misallocated investment always subtracts more growth from the future than it causes in the present. Japan’s economy grew ferociously for five years, to the astonishment and admiration of the rest of the world, but at the cost of sharply worsening imbalances and massively wasted investment.

Finally in 1990, worried about rising risks, Tokyo finally did what it should have done years earlier. It began to raise the cost of capital in an attempt to choke off the out-of-control investment spree.

It was too late. Years of wasted investment had to be paid for, and they were paid for by a suffering household sector. Japan rebalanced the only way it could, with an even sharper contraction in economic growth.

The lesson of the 1980s is not that Japan should have resisted US demands to appreciate. It had no choice. Trade surplus countries have no bargaining power in a trade war.

Instead, the lesson is first, that Japan should have begun the rebalancing process much earlier, and second, that once the yen was forced to appreciate, it should not have responded by lowering interest rates and forcing investment to surge. This is the real lesson for China, although it will be a tough one to learn.

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About the Asia Program

The Carnegie Asia Program in Beijing and Washington provides clear and precise analysis to policy makers on the complex economic, security, and political developments in the Asia-Pacific region.