Originally published: February 2021
“Japanification” in the economic sense refers to the stagnation that Japan’s economy has faced over the past three decades, and is typically applied in reference to the concern among economists that other developed countries will follow along the same path.
As a visual, here’s Japan’s long-term nominal GDP in US dollar terms:
Chart Source: Trading Economics
The chart is pretty similar in yen, too. It’s three decades of economic stagnation, any way you look at it.
However, there are a lot of misconceptions about what exactly Japan’s economic policies were during this period. There is a widespread narrative that Japan printed a ton of money and still ended up with deflation, which is not quite an accurate characterization.
In short, the process that the United States is beginning to go through in the 2020s is in most ways quite different than what Japan went through during the past few decades. This article compares and contrasts the process of Japanification with the United States as it pertains to the question of deflation or inflation going forward.
This article has several sections:
- Japan’s Epic Bubble
- Inside Japan’s Long Stagnation
- US and Japan: Polar Opposites
- Summary Thoughts
Japan’s Epic Bubble
Japan is a remarkably hard-working, homogenous, and efficient society, which led them to become an industrial powerhouse after they recovered from World War II.
In 1944, the US led other countries in putting together the Bretton Woods system, in which most currencies were pegged to the dollar, and the dollar was pegged to gold.
In 1971, however, the US defaulted on this system, rendering the dollar no longer redeemable for or fixed against gold. After that, all currencies rapidly fell vs gold, and along with oil embargoes, this played a role in a big commodity boom and period of high global inflation that persisted through the 1970s.
In the aftermath of this default, the United States created the petrodollar system from the mid-1970s and onwards to keep the dollar in the center of the global financial system, which contributed to the formation of structural US trade deficits in exchange for maintaining global power projection:
Chart Source: Trading Economics
Basically, we engineered a way for the whole world to need dollars (most major oil producers would only sell oil in dollars), and as a result, the forces of supply and demand hold open our trade deficit to provide the rest of the world with dollars.
Export-driven countries like Germany and Japan were able to rise to the occasion on the other side of that equation, and run big trade surpluses, exporting far more to the United States and the rest of the world than they imported.
Japan led the way during the 1980s and 1990s, while Germany became an export powerhouse in the 2000s after the creation of the euro, and China a bit after that. Singapore, Taiwan, South Korea, Switzerland, and others have also been on the surplus side of the equation during these decades.
Chart Source: Trading Economics
When Paul Volcker became the chairman of the US Federal Reserve in 1979, after years of the United States being unable to control its worsening inflation problems, he proceeded to sharply increase interest rates to approximately 20%, which is associated with finally quelling inflation. The inflation-adjusted yield on bank accounts was very high at that level, which attracted savings and strengthened the dollar from its weakened state.
At the same time, President Reagan, faced with a stagnant economy and ongoing Cold War competition, cut government taxes while continuing to increase government spending, leading to large fiscal deficits and a sharp rise in US federal debt as a percentage of GDP (after decades of consistently declining debt to GDP). The combination of loose fiscal policy and tight monetary policy was a potent cocktail for economic growth while it lasted, and resulted in a sharply rising dollar vs a basket of foreign currencies.
This strengthening dollar, however, became such a problem for the global system, including the US industrial/export sector, that major countries got together and agreed on the Plaza Accord in 1985. The purpose of the accord was to sharply devalue the US dollar vs other major currencies, and the Japanese yen in particular, in order to make American exports a bit more competitive and, more broadly, to try to bring balance back to the Force.
Here’s a chart of the US dollar vs a basket of major foreign currencies since the floating exchange system began:
Chart Source: Trading Economics
This naturally caused a bit of a problem for Japanese exporters in the latter half of the 1980s, as their currency rapidly strengthened against the dollar. While a strengthening yen would benefit Japanese consumers, the products of various Japanese exports became a bit less competitive. Fortunately, their quality-to-cost ratio was very high.
Japan responded with monetary easing, fiscal stimulus, and financial reform. Along with myriad other internal factors (on which there are multiple books written), Japan quickly entered what was arguably the biggest bubble the world had ever seen.
Japan’s stock market in the late 1980s became even more overvalued than the US stock market would later become during the 2000 dotcom bubble, with a cyclically-adjusted price/earnings ratio that was nearly twice as high. At the same time in the late 1980s, Japan’s real estate market became even more overvalued than the US real estate market would later become during the 2007 subprime mortgage crisis.
So, unlike the United States which would later go through separate equity (1997-2000) and real estate (2004-2007) bubbles, Japan encountered them both together in the late 1980s.
As the Chicago Tribune described it in a 1989 article right near the top:
The 1.15 million square meters occupied by the Imperial Palace in the center of the Japanese capital, for instance, is said to be worth all the real estate in California.
A square meter of land in Tokyo`s opulent Ginza shopping district is worth more than $236,000. Land in some parts of Tokyo goes for the equivalent of $145 a square inch.
The entire value of Tokyo`s land (excluding the palace) is loosely estimated at $5 trillion, according to a May, 1988, report by the National Land Agency. This was 10 times the 1988 national budget.
Each year since 1986, commercial land in Tokyo has increased in value by 96.2 percent and residential land by 89 percent.
This dizzying upward spiral began in the mid-1980s. Outside observers say the increase in value is illusory, a deliberate scheme on the part of Japanese banks, companies, property owners and real estate brokers to raise potential collateral for more loans.
Whatever the truth of the matter, it is certain that Tokyo`s aggregate land value now equals half the total worth of all the land in Japan and that the total value of Japan`s land is 4.1 times greater than the total value of land in the United States.
Because America is 25 times as large as Japan, Japanese land therefore is roughly 100 times more expensive than American land, according to a report released in December, 1988, by Japan`s Economic Planning Agency.
This bubble unwound from its peak with a big crash, but with merely an economic slump rather than a catastrophe. Their unemployment rate always remained below 6%. Their stock market didn’t find a bottom until two decades later, as air came out of the balloon slowly rather than all at once. Here’s the chart of Japan’s Nikkei 225 stock market index:
Chart Source: Trading Economics
All of this happened while their population numbers peaked and rolled over. Japan’s median age is the oldest in the world among major nations; they have an extremely top-heavy age pattern.
Chart Source: Worldometer
As a result, for three decades Japan’s economy and stock market trended bearishly.
Inside Japan’s Long Stagnation
Like most things in life, Japan’s three decade stagnation was nonlinear and is largely misunderstood.
In fact, one of the arguments I see from analysts that expect to see a prolonged period of deflation in the United States, is that no matter how much money Japan’s policymakers printed, they couldn’t create inflation. If Japanese policymakers couldn’t create inflation, how could US policymakers possibly create inflation?
An oft-cited example is the vertical rise in the Bank of Japan’s balance sheet, which is nothing short of epic. Starting in late 2012, the Bank of Japan began rapidly expanding the monetary base and buying tons of government debt (aka quantitative easing or “QE”), and then even began outright buying Japanese equities (which did create asset price inflation- their stock market has been in a bull market for nearly a decade now).
Chart Source: Trading Economics
Their balance sheet is now 130% as big as their GDP, which is huge compared to the Fed’s balance sheet being only a little over 30% of US GDP.
Chart Source: Yardeni
And yet, no major currency devaluation occurred for Japan, at least compared to other major currencies. A dollar is worth about the same amount of yen as it was 25 years ago.
If Japan ran massive fiscal deficits, monetized those deficits, printed money to buy equities, and all sorts of other narratives, and got deflation instead of inflation, that must be a killer argument in favor of deflation for the United States, right? The deflationary trap must be insurmountable against government debasement, given how much debasement Japan did and still couldn’t get inflation for decades.
Well, no. In fact, the situation is quite the opposite. Let’s unpack that a bit.
First of all, we need to understand the big difference between base money and broad money.
Base money refers mainly to bank reserves and to a smaller extent, currency in circulation, and this combined number is mainly controlled by the central bank. When you see the Bank of Japan’s balance sheet going vertical, that’s basically causing base money to go vertical. Huge increase.
Commercial banks take that base money, and multiply it via lending in a fractional reserve banking system to create broad money. Broad money includes currency in circulation, checking accounts, savings accounts, and similar cash-equivalents, and is a much larger figure than base money. This broad money is what people and companies actually have as money to save and spend.
In the United States, for example, base money is $5.3 trillion, while broad money is $19.5 trillion. In other words, broad money is about 3.7x as much as base money.
In Japan, base money is ¥620 trillion, while broad money is ¥1,140 trillion, so broad money is about 1.8x as much as base money.
When base money goes up, especially in the form of bank reserves, we don’t really feel it in everyday purchases. Our bank accounts certainly don’t get bigger just because the Fed expands its balance sheet. At most, it helps push up asset prices, which is the effect we do feel indirectly.
We do, however, directly feel when broad money goes up, because it means our collective checking and savings account balances are going up. There’s a huge difference. For many people, the US Treasury is literally sending them checks.
As I showed in my article on banks, QE, and money-printing, expanding the monetary base is very different than expanding the broad money supply. Many people think that QE alone is inflationary, but it’s not. At most, QE alone is anti-deflationary, or inflationary for asset prices in particular. On its own, QE doesn’t result in more money in peoples’ pockets chasing more goods, or higher commodity prices.
A persistent rise in broad money supply tends to be inflationary. An increase in base money on its own, without corresponding growth in broad money, doesn’t tend to be inflationary.
As a pop quiz, which of the following advanced currency areas had the fastest rate of broad money supply increase per capita over the past twenty years? The United States, Euro Area, or Japan?
Most people would probably guess Japan, since their central bank has been the epic printer.
The answer is actually the opposite. Japan grew their broad money supply far more slowly than the United States and Europe.
This chart shows the broad money supply of the United States, Euro Area, and Japan, normalized to 100 in 2000:
This is also true on a per capita basis, adjusting for population changes. Over the past 20 years, here were the annualized rates of broad money supply increase per capita:
- United States: 6.2%
- Euro Area: 5.5%
- Japan: 2.9%
It’s not surprising, then, that the dollar weakened vs the euro, and the euro and dollar both weakened vs the yen, from the beginning of 2000 to the end of 2020. It’s also not surprising that official US consumer price inflation “CPI” rose faster than Euro Area CPI, which in turn rose faster than Japan’s CPI.
That really goes against the narrative that Japan was a big money printer. Sure, they increased base money a ton, but it didn’t do much for broad money, which is the key inflationary variable.
Follow the (Broad) Money
There are two primary ways to increase the broad money supply significantly.
The first method is that banks have to lend more, which increases the “money multiplier”, or in other words makes the broad money supply many times larger than the base money supply. Inversely, if debts are paid off, that destroys broad money.
The second method is that the sovereign government has to run massive deficits and basically inject money directly into the economy, and the bonds they issue to fund that spending have to be bought by the central bank and commercial banks with new money creation, rather than extracted anywhere from the economy by private buyers. In other words, if banks aren’t increasing the money supply by lending, the government and central bank combined can go around them and increase the money supply directly with stimulus checks straight to people’s bank accounts, or tax cuts, or infrastructure spending, etc.
For example, the United States recently increased broad money supply by 25% in a single year, which is the biggest one-year increase since World War II, because the government went around the banking system, ran massive government deficits of 15-20% of GDP on top of the normal broad money supply growth rate of 5% or so, had the central bank buy most of those bonds with brand new base money, and sent checks to people and businesses.
This chart shows the year-over-year change in absolute dollar terms for the Fed’s balance sheet (red), broad money supply (blue), and federal government transfer payments (green):
Chart Source: St. Louis Fed
When the Fed’s balance sheet rose sharply from 2008-2014 via QE, it didn’t necessarily translate into broad money supply going up because there was no direct mechanism to turn base money into broad money. However, in 2020, the combination of QE and large fiscal deficits (literally sending checks to people) did cause the broad money supply to go up along with base money.
In contrast, during the three decades prior to 2020 (pre-pandemic), Japan never ran a budget deficit larger than 8.3% of GDP. Their deficits were big and persistent, but gradual:
Chart Source: Trading Economics
And from 1991 to 2019, Japan’s broad money supply never grew more than 5% year-over-year. Even last year in 2020, during this pandemic era of actual money-printing, Japan only grew their broad money supply by a little over 10% during the year, compared to 25% during the year for the United States.
Part of this historically slow broad money supply growth was because, as the Japanese government levered up and ran moderately large deficits, their private sector deleveraged. Here is Japan’s private debt to GDP over the past 25 years:
Chart Source: Trading Economics
In rough numbers, that represents a decrease of about 300 trillion yen in absolute private debt. When debts are paid back or defaulted on, that effectively destroys money. Just as bank lending creates deposits, paying back bank loans destroys deposits.
For some specific deleveraging examples, here are the debt/equity ratios of some of the major Japanese trading companies that I’ve been covering a lot in recent months:
That’s how Japanese broad money supply grew more slowly than average government deficits. With back-of-the-envelope numbers, about 5% in new broad money was created per year by monetized fiscal deficits and public debt accumulation, which was offset by about -2% of money supply destruction from private deleveraging per year. This resulted in roughly 3% broad money supply growth per year.
What the United States is doing since 2020, and to a lesser extent what other countries (including Europe and Japan) are doing since 2020, is nothing like what Japan did for decades from the mid-90s through 2019, which was to run moderate deficits while their banks weren’t lending, and thus just expand their base money without expanding their broad money by very much.
This is now sharp broad money supply growth in the United States and elsewhere, which hasn’t been seen in developed economies since the 1970s and 1940s. For the full detail on that, here’s a century of US fiscal and monetary policy.
In other words, of course Japan had low consumer price inflation over the past three decades and the yen remained relatively strong; their broad money supply grew very slowly compared to other developed countries, and slowly in absolute terms, as their private sector went through a long period of austerity. That’s not a road map for what’s happening now.
The Trade Balance Floor
I did a case study last year on the period of time where the Bank of Japan initially ramped up their balance sheet.
Here, for example, is the 25-year history of how many yen a dollar is worth. Whenever the line is going down, it means the yen is getting stronger, and vice versa:
Chart Source: Trading Economics
We see over this 25-year period that the yen and the dollar have been in a pretty consistent range of about 110 yen to the dollar on average, with a normal range of 90-120 or so.
However, during the 2007-2012 period, the yen became quite strong vs the dollar, reaching a level of about 75 yen to the dollar.
When the Bank of Japan ramped up its balance sheet with absolutely massive expansion of base money via quantitative easing in Q4 2012, the yen did sharply weaken vs the dollar from then until 2015. But then, even though Bank of Japan balance sheet kept ramping up without pause, the yen stopped weakening, and indeed started mildly strengthening. Why?
If we zoom in on that period, we can see that trade equilibrium was quite correlated to this change. This set of charts shows the Bank of Japan balance sheet, Japan trade balance, and USD to JPY from 2010 to 2020, with January 2012 and January 2015 marked via purple lines for reference:
Chart Sources: Trading Economics and XE
As the yen strengthened in those early years, along with general global economic problems, Japan developed a rare trade deficit, which is unusual in its multi-decade history.
When the Bank of Japan began massive QE in late 2012, it began sharply weakening the yen vs other currencies throughout 2013. And then, in 2014, the US Federal Reserve ended their QE, which resulted in a stronger dollar vs other currencies, and so the yen had a second leg of devaluation vs the dollar.
And then in 2015… the yen stopped weakening, despite the Bank of Japan continuing its balance sheet expansion at a rapid pace. Why?
Well by 2015, the weaker yen and other factors had helped Japan’s trade deficit turn back into a balanced trade situation, since it made imports more expensive for Japanese citizens, and made their exports more competitive and attractive. In other words, their currency became “fairly valued” on a trade basis. From there, despite holding rates at negative levels, and despite continuing to ramp up their QE at the same pace for a while, the yen was stable and even slightly strengthening vs the dollar.
Trade balances represent a natural “floor” for currencies. When a currency weakens enough that their trade balance is normalized, it’s challenging to keep weakening the currency further, especially if broad money supply isn’t increasing much.
Japan’s trade deficit was mild and short-lived, so a mild period of yen devaluation quickly brought it back to equilibrium and made further yen weakness unlikely.
US and Japan: Polar Opposites
We can catalogue a few ways that the United States and Japan are not only different, but indeed opposite.
Trade Balance vs Trade Deficit
As previously shown, Japan has a rather balanced trade situation, and has a current account surplus. This presents a natural “floor” for the currency vs other currencies.
On the other hand, the United States has a structural multi-decade trade deficit and current account deficit.
Because the US trade deficit is so large and structural, when we shift our fiscal and monetary policy around, it tends to result in big swings up or down for our currency. As the global reserve currency, the natural “floor” for the dollar has historically not been its trade balance (which is structurally held open via the petrodollar system), but rather the willingness among foreigners to buy US assets like stocks and Treasuries.
So, when the US starts doing Japan-like monetary policy at a time when foreigners are not accumulating much Treasuries on net, there’s plenty of room for dollar devaluation.
Creditor Nation vs Debtor Nation
A century ago, during the United States’ rise to power on the global stage during the era of the two world wars, the United States became the world’s largest creditor nation, meaning we owned more foreign assets than foreigners owned of our assets.
This is measured by the net international investment position or “NIIP”, which can be represented in absolute terms or as a percentage of GDP. Here’s the long-term chart for the US NIIP as a percentage of US GDP:
Chart Source: Ray Dalio, The Changing World Order
Americans built up that status by having a vibrant economy, running persistent trade surpluses, lending to allies during World War I and II, and then emerging from World War II as a superpower.
By 1985, however, thanks to accumulating trade deficits under the petrodollar system, our NIIP crossed under zero, meaning we shifted to being a net debtor nation. Foreigners now owned more of our assets than we owned of their assets.
As of the latest quarterly release, the NIIP is a bit lower than the long-term chart above. It hit a bottom of -67% in Q2 2020 and bounced to -66% in Q3 2020:
Chart Source: St. Louis Fed
Over the past decade in particular, as the charts above showed, this continued and accelerated, and the US is now the world’s largest debtor nation in absolute terms, and one of the worst in percent-of-GDP terms. Japan, on the other hand, is now the world’s largest creditor nation in absolute terms, and one of the best in percent-of-GDP terms.
This chart is from last year but still directionally useful for showing NIIP as a percentage of GDP for various nations. US NIIP went deeper down since this chart, to -66%, and a number of others went up:
Data Sources: IMF and various central banks
While the US runs persistent current account deficits, Japan runs persistent current account surpluses, which is how these substantially different NIIPs were built.
This will be interesting for the United States over the next decade. Unlike Japan, which funds its own fiscal deficits domestically, the United States has historically been partially reliant on external financing for its deficits, as the global reserve currency.
Over the next decade, the US will likely do a lot of what Japan did, meaning it will gradually transform a lot of the private sector debt into public sector debt, with the Federal Reserve buying a significant part of that public debt with new base money. However, unlike Japan, we’ll be doing it with a structural current account deficit instead of a surplus, negative net international investment position instead of a positive net international investment position, and a structural shift from external financing to central bank financing. This is a recipe for currency devaluation.
If this ends up being the case, with a period of dollar devaluation and foreign asset outperformance, the US net international investment position could start to roll back up from a bottom of -67%.
Japan has among the lowest wealth concentration among developed countries and has relatively low levels of populism, while the United States has the highest wealth concentration among developed countries and has high levels of populism.
This chart shows the mean wealth and the median wealth of several large developed countries. Japan’s median citizen has a higher net worth than America’s median citizen, because their wealth is more dispersed while America’s wealth is more concentrated:
Data Source: Credit Suisse 2019 Wealth Databook
And here’s the percentage of wealth owned by the top 1% of several major countries:
Chart Source: Credit Suisse 2020 Wealth Report
We can also look at social mobility, which refers to how correlated children’s lives are relative to their parents as they become adults. Japan ranks 15th among nations, which puts them roughly in the middle of the pack as far as developed nations go. Meanwhile, the US ranks 27th, which puts us near the bottom of developed nations.
The bottom 50% of folks in most countries, including Japan, are struggling. Problematic fiscal policies, industrial automation replacing blue collar work, and offshoring, are impacting many people. However, in a relative sense, the US has more wealth concentration, less social mobility, and a weaker bottom half of the population, than many developed peers including Japan.
Japan spends a fraction of what the US does on healthcare and defense spending per capita. That is how they’ve managed to maintain moderate budget deficits despite a very aged population and slow economic growth.
Health expenditure per capita for the US is $11.1k while Japan’s is only $4.8k, despite the fact that Japan’s median citizen is ten years older, their life expectancy is longer, their infant mortality rate is lower, and they have about the same number of physicians per capita:
Chart Source: OECD
Translated into GDP, the US spends 18% of GDP on healthcare while Japan spends 12%. That’s a 6% of GDP difference, and with worse results to show for it on average. Since the majority of that is tied to government spending (Medicare, Medicaid, federal employee health plans, and veterans’ benefits), the US has about a 4% built-in extra fiscal deficit as a percentage of GDP compared to Japan to cover Medicare and these other programs.
As for the military, the US spends 3.5% of GDP on defense while Japan spends only 1%, which adds another 2.5% structural deficit for the US over Japan.
This is in part why the US has a larger structural fiscal deficit than Japan or Europe going forward; we have a much bigger chunk of government spending going to healthcare and defense.
Folks can agree or disagree with whether that’s the right approach but strictly from a mathematical perspective, it does play a role in assessing forward broad money supply growth and the propensity for inflation or deflation.
Putting all of this together, over the past few decades, Japan grew their broad money supply slowly while having structural current account surpluses, which together make for a rather strong currency, prone to disinflation.
“Japanification” from the early 1990s through 2019 was not the money-printing party that many folks imagine it to be. Broad money supply grew slowly, fiscal deficits remained at about 8% per year or lower, corporations deleveraged their balance sheets, and the massive rise in base money was contained in the financial system. It had issues, including zombification of aspects of the economy, but it wasn’t consumer price inflationary.
Most western nations, and certainly China as well, face a future demographics issue that looks similar to what Japan experienced over the past couple decades. That part is very true.
However, beyond that comparison, there are some notable differences. Europe going forward in many ways does look like Japan, in the sense that it’s older, slower growing, has a tendency to keep budget deficits narrow, has a structural current account surplus, and is growing its money supply more slowly than the US.
The United States, however, is on a very different path, for better or worse. With much faster broad money supply growth, a structural current account deficit, and fiscal deficits that are persistently larger mainly due to healthcare and defense differences, our economy has an inherently more inflationary aspect to it that must be considered in an economic analysis.