I Overview

Guy Meredith, and Ulrich Baumgartner
Published Date:
April 1995
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Ulrich Baumgartner and Guy Meredith 

This volume brings together various analytical studies the IMF staff has undertaken on the Japanese economy, focusing on two areas of particular interest for both longer-term economic performance and recent cyclical developments. The first is Japan’s saving behavior; the second is the remarkable swing in asset prices that occurred in the late 1980s and early 1990s. As regards saving, Japan for many years has had the highest national saving rate among the major industrial countries. While its domestic investment rate has also been higher than that of other major industrial countries, the excess of saving over investment has been reflected in Japan’s significant current account surplus since the early 1980s. Japan’s saving performance raises several issues. Does Japan save “too much” on economic grounds? How has Japan’s saving been channeled abroad? What effect will an aging population have on future saving patterns of the private and public sectors? Answers to these questions are the focus of Sections II through V of this volume.

Section II considers whether Japan’s saving can be characterized as excessively high. To address this issue, Kenneth Miranda invokes three criteria—based on “golden rule,” dynamic efficiency, and marginal productivity conditions—to shed light on whether a country is over- or undersaving. The golden-rule approach allows calculation of the optimal level of saving based on parameters for productivity and population growth, capital depreciation, the capital share in output, and the social rate of time preference. In practice, the rate of time preference cannot be observed directly but is inferred from observed saving data and the other parameters. The evidence is consistent with a rate of time preference ranging from ½ of 1 percent to 2 percent a year, suggesting that the assumption of abnormal rates of time preference is not needed to explain Japanese saving. The dynamic efficiency approach, in contrast, provides a nonparametric test of whether a country is oversaving: if investment, on average, exceeds the share of profits in output, then long-run consumption possibilities could be increased by reducing saving. For Japan, the investment rate has averaged less than the share of profits in gross national product (GNP) since the mid-1970s, indicating that the economy has operated in a dynamically efficient range. Finally, marginal productivity tests assess whether the return to capital has exceeded alternative estimates of the opportunity cost of capital: again, results suggest that capital is unlikely to have been overaccumulated. All of these indicators of excess saving are subject to caveats, but they provide a broad range of evidence against the proposition that Japanese saving has been inefficiently high.

Section III, by Juha Kähkönen, analyzes developments in Japan’s capital flows since 1980. Japan has been the world’s largest exporter of capital over this period, despite having the highest domestic investment rate among major industrial countries. Trends in Japan’s capital account since 1980 can be divided into three phases. In the first half of the 1980s, the liberalization of external capital flows coincided with a surge in long-term capital outflows, especially of portfolio investment. In the second half of the decade, further steps toward financial liberalization—both external and domestic—as well as the surge in asset prices led to a further rise in long-term capital outflow, financed in part by short-term external borrowing. The share of foreign direct investment (FDI) in Japan’s capital exports increased sharply during this period because appreciation of the yen made overseas investment more attractive. These developments were reversed in the early 1990s. The collapse of the asset price bubble and the introduction of Bank for International Settlements capital-adequacy guidelines led to a sharp retrenchment by financial institutions—short-term foreign liabilities were repaid by sales of long-term assets, causing long-term capital exports to fall. At the same time, the economic downturn reduced corporate profits and led to a sharp rise in excess domestic capacity, reducing the attractiveness of FDI. The section continues with a more detailed exploration of the composition of Japan’s FDI and its effects on other countries. Both structural factors (such as evolving comparative advantage) and macroeconomic developments have played important roles in driving FDI. The benefits to other countries consist not only of the usual gains from international integration, but also of positive spillovers in the form of new technology and organizational skills.

Sections IV and V deal with the potential impact of an aging population on Japan’s saving rate. In Section IV Guy Meredith assesses the effect on saving behavior at the household level, and in Section V he presents a simulation analysis of the impact on aggregate public and private saving. Population aging is an important issue for Japan because of the projected size of the demographic shift in coming years: during 1990–2020, Japan is expected to experience the sharpest increase in its “old-age dependency ratio” (the ratio of the elderly to the working-age population) among the major industrial countries. As discussed in Section IV, if households behave in accordance with life-cycle consumption theory, private saving will fall as the share of the elderly—who are net dissavers—in the population rises in relation to that of other segments of the population. The magnitude of this effect has been questioned by some observers, however, because some microeconomic data suggest that the saving rate of the elderly is not significantly different from that of working-age households. The analysis in this section shows that, when properly measured, the saving rate of the elderly is indeed well below that of working-age households. Furthermore, shifts in demographic structure will generate changes in the saving rates of individual population cohorts through their effect on public pension contribution and benefit rates. The overall impact of population aging on the aggregate saving rate is quantified through simulations of a life-cycle model of household behavior. The results suggest that the household saving rate will decline significantly as a result of population aging, although the drop may not be as large as some studies using macroeconomic data have indicated.

Section V provides a long-run simulation analysis of the effects of population aging. Particular emphasis is placed on the impact of rising pension benefits and increased health care on public sector saving. In this context, Japan is often regarded as having a relatively healthy fiscal situation, in large part because of the substantial surplus in the social security system. The analysis shows, however, that, in the absence of pension reform, a social security deficit would emerge by early in the next decade; by 2025, the deficit on social security could amount to almost 15 percent of gross domestic product (GDP). Combined with the government deficit on operations not related to the social security system, this implies a substantial financing “gap” that will have to be filled by a combination of pension reform, higher taxes, and reduced spending on other government operations—or a combination of these—if an explosive rise in government debt is to be avoided. Part of this gap could be filled by the enactment of a tax reform package that would offset the loss in revenues from the 1994 income tax cut. In addition, the implementation of recent reforms to the pension system will play an important role in addressing the fiscal imbalance. Nevertheless, simulations show that further measures will need to be taken to put Japan’s fiscal position on a sustainable footing. From the point of view of the overall economy, a sharp drop in public saving, combined with a demographically induced decline in private saving, would cause a sharp swing in the external surplus in coming years.

The second area analyzed in this volume is asset price developments, during both the 1987–90 “bubble” period and the subsequent economic downturn. The boom in Japan’s equity and land prices during the bubble was accompanied by an extraordinary surge in private spending, especially on business investment. Output rose well above its supply capacity, leading to inflationary pressures in product markets, while the current account surplus declined sharply in relation to GDP. In the event, both the inflated level of asset prices and the boom in spending were abruptly reversed in the early 1990s, causing one of the longest and deepest recessions in postwar history. These developments and their effects are analyzed in Sections VI and VII.

Section VI, by Juha Kähkönen, describes the evolution of asset prices during and after the bubble period, assesses the role played by various factors in driving asset prices during this episode, and provides estimates of their effect on real activity. On the basis of equations summarizing the behavior of equity and land prices in the period preceding the bubble, it is it is shown that changes in “fundamentals”—such as economic growth rates, monetary policy, and corporate earnings—can explain at least part of the surge in asset prices during the late 1980s. Greater risk taking, owing to changes in the financial environment, and distortions in Japan’s land tax system may also have played contributing roles. But there remains an unexplained component of asset price movements, consistent with the view that speculative forces carried prices beyond the level consistent with underlying determinants. In terms of private spending, an important channel was the effect on investment of increased market valuation of the capital stock, which could have raised capital spending by about 10 percent in the late 1980s. Higher land prices may also have eased corporate borrowing constraints by raising collateral values. The effect on private consumption was smaller, since Japanese households are not large holders of corporate equities, and changes in land prices are estimated to have only a minor effect on consumption. Similarly, the surge in land prices does not appear to have driven the boom in residential construction.

In Section VII, Alex Hoffmaister and Garry Schinasi examine the relationship between macroeconomic variables and asset price inflation in the 1980s. The focus is on land price inflation, rather than on stock price movements; although stock prices are difficult to model empirically, land prices generally move systematically in response to changes in economic fundamentals. Several related questions are investigated: (1) whether there was a structural break in the way monetary factors affected asset prices in the 1980s; (2) whether monetary factors contributed to asset price inflation in important ways in the 1980s; (3) factors responsible for the divergent behavior of asset prices and consumer prices; and (4) whether there is support for the view that the effects of monetary factors were “concentrated” in asset markets rather than in goods markets. Strong evidence is found for a shift in the relationships between monetary factors and land prices in the early 1980s: in particular, the parameters imply a much more important channel of transmission in the second part of the sample than in the first. A key conclusion is that monetary shocks led to more asset price inflation (and less consumer price inflation) in the 1984–93 period than during 1970–83. This “regime shift”—which is largely attributed to the effects of financial liberalization—made it difficult to interpret the factors underlying the rise in asset prices in the late 1980s, perhaps explaining why policymakers did not fully perceive the implications of allowing the bubble to continue as long as it did.

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