Some coworkers and I had a discussion back in 2006 about which stock market would perform best over the coming years. The others said Japan, because the market was extremely cheap relative to the other markets. Ah, I agreed that Japan was cheap...but it was cheap for a reason. As you can see, Japan's financial markets (as represented by the Nikkei stock index) have fallen off a cliff (was down over 80% at one point) since hitting its all time high back in 1990.
The country went through an extreme financial bubble (at one point, the Imperial Palace was worth more than the state of California), and it never recovered from the subsequent collapse. Japan had benefitted from an export driven economy which led to high productivity gains that fueled strong increases in GDP. However, by the end of the 1980s, Japan had grown to be too large to support itself based on exports. Living on exports is similar to a parasite-host relationship; if the parasite stays small the host can continue to support it, but it can kill the host if it grows too large, which is what was happening by the end of the 1980s. But while the country had a dynamic export sector (though this was overtaken by other cheaper and more aggressive exporters like Korea and Taiwan, the by China), the rest of its economy was sclerotic. The services sector was closed to outside competition, the agricultural sector was inefficient but had strong political clout, and the government was acting like a gravy train for special interests (especially farmers and the construction industry). On top of this, Japan had benefited massively from a demographic boom in both overall population and working population, which substantially increased demand and output. Unfortunately, this started to come to an end in the early 1990s. What's worse, the country is now starting to go into a disastrous population decline which will halve the number of people by the end of this century. This point is the crux of the problem for Japan. The Black Plague was effectively the last time a major country lost such a significant proportion of its population (other than through war or famine), and it will be a very difficult uphill struggle for Japan's economy just to stay in place, much less grow.
Japan's government, with fairly strong finances throughout the 1970s and 1980s and backed by its people's massive personal savings, thought it could buy its way out of the early 1990s economic downturn. As the OECD data below shows, gross government debt as a percentage of GDP tripled over the next two decades, but this still did not pull the economy out of its stagnation. The government finally came to the realisation that the economic structure had to be reformed, but it was only during the term of Prime Minister Junichiro Koizumi (2001-2006) when the government actually had the guts to press through with reform. The economy strengthened dramatically during the middle of the last decade as public confidence came back.
Unfortunately, Koizumi didn't stay long enough to see his reforms through, and the subsequent governments proved too weak to even prevent infighting, much less to push through reforms.
Usually, the country which doesn't pursue reforms simply stagnates in low growth. While stagnation isn't great, it also isn't the end of the world either, hence why things don't seem to be so bad when you walk through the streets of Tokyo. The problem which makes the current situation unsustainable is the original issue, demographics. To understand the scale of this demographic problem, one only has to take a look at the working population to dependents and to retired people ratios. The number of workers to support each dependent is falling dramatically, and worse, most of that increase in dependents is retirees, who are typically more expensive for an economy than children (healthcare and pensions are more expensive than schools).
The country and its government is now running out of money to support this massive increase in retirement costs. On the personal side, the Japanese use to save more than 20% of their incomes. In a twist of circumstances, 2012 was the first year the Japanese had a negative savings rate, as they are now starting to draw down heavily on their savings for retirement. On the government side, if we merely project the government's current fiscal deficits per year without adjusting for population changes, we see that the Japanese government will have a debt to GDP ratio of 400% by 2050 (blue line). But that is only half the story, if we adjust for the population decline, the debt to GDP ratio goes up to well over 500% (see red line), and that doesn't take into account the increase in healthcare and pension costs from more retirees (likely the real figure is probably greater than 600%). And here we're worrying about a Eurozone crisis where the likes of Greece don't even have 150% debt to GDP! Japan without reforms is for intensive purposes is bust. That's not a far-fetched prediction; it's a mathematical certainty. The credit ratings agencies still give it an investment grade credit rating, but that's because the current debt will be paid off before the country goes bust. But at some point investors won't trust the government to repay them, so what happens then? The world has never experienced a default as big as Japan (not to mention that many other developed countries will be facing the same problems at the same time).
But there is a saving grace. If inflation, currently negative, were to be 2% each year through 2050, then (as shown by the green line) government debt would only increase by a small percentage versus GDP. All of the sudden the debt level looks a lot more sustainable, as inflation devalues the entire amount of existing debt, making any additional deficits that much more affordable. This is essentially one of the pillars of Shinzo Abe's new economic policy. Creating inflation by injecting a huge amount of money into the economic system should ignite a level of inflation, which would ease the debt burden on the country. It also debases the currency, making the country's exports more attractive; the yen has lost a quarter of its value versus the US dollar since it became obvious that Abe would be elected, as shown below.
So there is a potential light at the end of the tunnel if Japan is able to reinflate its economy, but this optimism comes with a lot of scepticism. Creating inflation but holding interest rates low destroys the value of savings (and Japan has one of the largest savings pools in the world), making it more difficult for savers to pay for their retirement. The demographic burden still remains, and reducing the value of savings will significantly increase the hardship of retirees.
Japan has also long been one of the biggest DESTROYERS of financial wealth (though China may have exceeded it) as much of the economy (other than the multinational sector which has to compete globally) has allocated capital inefficiently. Inflation alone doesn't solve this competitiveness and capital misallocation problem. Significant reforms need to be made to the services, agricultural, and government sectors. Quantitative easing is just the beginning, and frankly, it is the easy part.
Abe has the majority in the Diet (Japan's parliament) in order to pass reforms, but will he have the force of character to ram through changes against very entrenchment interests? After all, the agricultural and construction sectors are some of the biggest backers of Abe's LDP party. Unless Abe proves everyone wrong and becomes a Maggie Thatcher-type force of nature, the odds are desperately against him. Whereas the UK is fairly centralised, which allows the head of government to push through reforms top-down, the Japanese government is very weak. This can be attributed to the country's weak constitution, courtesy of United States (the US intentially implemented a constitution after World War II providing weak central authority to ensure a military dictatorship couldn't arise again). This weakness is easily visible when one merely flies into Narita airport, Tokyo's international airport. The northern runway at the airport is particularly short, as the government doesn't have the power to get one sole farmer holdout to sell his land in order to complete the runway.
So in order to pass the necessary reforms, Japan likely needs a new constitution. This is not necessarily beyond the realm of possibility, but it'll require the Japanese people to pull together like they did in the aftermath of the devastation of World War II or the Fukushima earthquake. But it's much more difficult now that people have more individual wealth and greater personal rights. Likely the impetus will be a Greece-type of financial crisis situation...they won't have a choice.
More importantly, other countries, including the US, China, Korea, the UK, Russia, and Eurozone countries all have similar demographic problems, though most are not nearly as bad as Japan's. It will mean a continuing debt problem coupled with economic stagnation, unless those countries can find ways to significantly increase productivity (which raises GDP and lowers the debt burden). But it will require governments to take strong and decisive action to make this happen. My bet is that the process of reform will come in stops and starts, with bitter political opposition at times leading to mini-crises. We've always muddled our way through previous problems. Let's hope we can muddle through this one as well.
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