Japan is on the up. But its recovery will be as different from the textbook model as was its deflationary phase. During those 10 years, consumers kept spending. That, plus endless fiscal stimuli, is what kept the economy from imploding.
What made Japan's deflationary period really different was the nature of household wealth — about three years' annual GDP. This is not held in stocks as in the US or housing as in the UK. Rather, two-thirds of it is banked.
Deflation meant that the real value of bank deposits kept rising. So consumers were able to skim off a little each year without diminishing the real value of the deposits. Indeed, consumer wealth continued to rise slowly.
Japan is also an ageing society, meaning more is consumed and less saved. The driver of consumption switches from work earnings to pension benefits, and to income from investments and cash from selling them. Since 1998, Japan's households have lost ¥13 trillion in work income but gained ¥11 trillion in pensions — another support for consumption.
A final characteristic of post-bubble Japan is the way government spends. Deflation provided it with limitless, costless financing. There was a guaranteed buyer of government bonds — the Bank of Japan. This used JGB purchases, directly and indirectly, to flood banks with cash. This was costless to the government because interest rates were zilch.
The deflationary period was consumer heaven and corporate hell: living standards stayed up and profitability disappeared. Ironically, one reason why recovery is sustainable is precisely because Japan Inc is non-profit maximizing. That allows companies to recruit more people or keep them in non-economic jobs.
Keeping workers ungainfully employed and consumers happy comes at the cost of labour productivity. It makes most Japanese corporations lousy long-term investments. But that's not necessarily true in the short term.
Think of Japan as a company not a country. It has to employ and pay everyone and produces almost everything they need ? international trade is only 11% of GDP. As employment and wages rise the employees consume more of the company's output. Although its full employment labour policy makes the company an immensely high fixed-cost producer (with a lousy return on capital), such companies enjoy the biggest marginal increase in profits on the upside of any cycle.
Take a case where sales are 100 and the inefficient producer's costs are fixed at 99 compared with an international rival with costs of 85. When business expands 3%, the inefficient producer's profit rises from 1% to 4% of sales (a 300% increase); the efficient producer's margin only creeps up from 15% to 18% (up just 20%). That is what is happening in Japan. Of course, the inefficient producer comes unstuck when the cycle heads down and through a whole cycle it will earn poorer returns on capital. But that's some way away.
As the cycle picks up, employment will improve helping keep the Japanese shopping. And as interest rates rise so will deposit income. In the stagnation period, as interest rates fell, household investment income fell from ¥36 trillion in 1991 to ¥5 trillion last year. That is now set to reverse.
The same phenomenon — rising interest rates and falling savings rates — will affect the corporate sector, government (JGBs) and the yen. During deflation, the corporate sector did little to rationalize labour and everything to rationalize capital. Japan Inc stopped investing and ran a big savings surplus, using it to pay off debt. The upshot is that Japanese corporations now have to invest to catch up.
The second comforting thought is that at current low levels of debt companies are virtually immune to rising interest rates. But as the cost of capital rises, Japan Inc will learn to use it more profitably, benefiting shareholders.
The end of deflation is not so cheery for government and JGBs. The government needs households and corporations to be in surplus to fund its deficit. As corporate capex recovers, Japan Inc will move from surplus to deficit.
Of course, the banks will be glad to lend to healthy corporations rather than buy JGBs. But they will be squeezed for cash because households will also be saving less. And the government is already a long-standing net dis-saver to the tune of 9% to 10% of GDP.
So what happens when all the economic players are dis-savers and all want to borrow? If, as I suspect, the corporate deficit is natural, the household deficit is secular and government deficit intractable, Japan is about to shift from being a growing holder of foreign assets to becoming a marginal foreign debtor.
This suggests that beyond transient cyclical recovery lies a big fall in the yen. It won't happen just now because most foreigners will want to own more Japanese equities. That will bring short-term capital inflows, keeping the yen afloat a while longer.