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Japanese Economy to Lose to Germany

Germany Surpasses Japan's Economy.

The International Monetary Fund made an astonishing statement when it released a report that predicts that Germany will overtake Japan’s place as the country with the third-largest economy in the world by the end of 2023.

This would’ve been unbelievable in the early 2000s, as Japan’s economy was 2.5 times bigger than Germany’s. In fact, Japan’s economy was the second largest in the world until China overtook it in 2010.

The IMF’s forecast brings up some questions, like what has Germany done to surpass Japan’s economic growth? And what has Japan done or failed to do to find itself with a declining GDP?

The Lost Decade

Japan’s economic issues are not recent. The problems it faces now are actually repercussions of events that occurred 44 years ago. So, in order to understand its present predicament and how it got here, we need to look to the past.

Japan’s economy was great in the 1980s, with its GDP growing 3.89% during that period. However, its problems began in the 1990s when the Japanese Yen began rising rapidly, which caused a shock in the economy.

This may have been an unintended consequence of the 1985 Plaza Accord, an agreement initially meant to manipulate exchange rates by depreciating the U.S. dollar relative to the Japanese yen and the German Deutsche mark. It succeeded at first as the Yen and Deutsch mark strongly increased in value relative to the US dollar.

After the Plaza Accord agreement, Japan fell into a web of loose monetary policy in the years following. The Bank of Japan decreased interest rates in 1986, leading to a rapid increase in stock and real estate prices.

This caused a real estate and equity bubble starting in 1989 as the Japanese invested more heavily in their stocks and real estate. However, the Bank of Japan decided to decrease the money supply as a way to counter inflation in late 1989.

The BOJ was particularly concerned with the overvalued real estate market and kept increasing interest rates to counter it. Meanwhile Japanese stocks were crashing. In turn, the stock market crashed and a debt crisis began in late 1991.

The bank then reversed its decision and decreased interest rates again but by now it was too late.

The experience caused Japanese people to turn to saving their money instead of investing it, in what is called a liquidity trap, which is a situation in which interest rates are very low but savings is high.

The money-hoarding also didn’t translate into consumption, so a period of deflation began in 1991. Thanks to this lack of consumption and investment, the term “The Lost Decade” was coined to describe the 1990s in Japan.

The IMF Forecast

The Lost Decade has been expanded to include the last 30 years, bringing us to the report by the International Monetary Fund. According to the IMF’s forecast, Germany is on track to take over Japan’s position as the country with the third highest GDP in the world by the end of 2023.

According to the report, Japan’s unadjusted for inflation GDP is expected to fall 0.2%, year-on-year, to $4.23 trillion in 2023. On the other hand, Germany’s is forecast to increase 8.4% to $4.42 trillion.

What Did Germany Do Right?

To understand why Germany is forecast to overtake Japan, we must again look to the past to understand the present.

After losing the second world war, Germany was quite literally a torn-up country. The Allies who occupied a divided Germany reluctantly agreed to establish a West German state and help develop its economy.

Germany’s economic reform began with the economist and politician Ludwig Erhard who helped reform West Germany’s economy by introducing a new German currency. It was a combination of this new currency, tax reform, and a free social market that helped Germany recover eventually after West and Eastern Germany reunited.

Thanks to this economic foundation, Germany was able to rise up and recover from the world war – eventually becoming one of the world’s leaders in tech and automobile industries.

Even before WWII, Germany had the most patents in Europe and its passion for research and development continues to this day. In fact, its R&D expenditure reached a new all-time high in 2021, amounting to 112.6 billion euros. This is the highest amount spent on R&D by any European country.

This penchant for innovation and technology is what has really set Germany’s growth apart in the last 70 years.

Evidence for this can be seen in the country’s automotive industry, which is also a big industry in Japan.

Japan VS. Germany

In 2022, Japan exported around 3.81 million motor vehicles, decreasing from 3.82 million in the previous year. To compare it with Germany’s exports of around 2.65 million cars for the same year, Japan is doing more. However, most of the Japanese vehicles aren’t exported from Japan, but from China, where many Japanese automotive companies manufacture their cars.

Many automotive manufacturers, including the Japanese Mitsubishi, are now pulling out of China and losing money, as they’re finding it hard to compete with local Chinese manufacturers.

Japan has a few brands that manufacture in China, including Toyota, Honda and Nissan. Two German brands, Volkswagen and Audi, are also manufacturing in China.

In addition to their automotive industries, Japan and Germany are also major key players in the semiconductors industry. The two countries agreed in March of 2023 to strengthen the ties between them and supply chains in semiconductors, minerals and batteries.

This comes in the midst of a U.S.-China trade war that focuses on semiconductor and AI chips, so two U.S. allies teaming up for chip technologies and diversifying their supply chains in order to counter the rising competition from China doesn’t come as a surprise.

Japan’s Economic Problems

There are also some persisting problems with Japan’s economy other than the Lost Decades. For example, Japan’s economy isn’t helped by a declining population, which resulted in a decrease of the Japanese workforce consisting of those ages 15 to 64.

As of Jan. 1, 2023, Japan’s population, including foreign residents, stood at 125,416,877, a decrease by 511,000 from the previous year, according to a demographics survey by the Ministry of Internal Affairs and Communications.

This is because many Japanese young people think they can’t afford marriage and children, and see a lack of good job opportunities, especially for men.

To cope with the labor shortage and with the aim of reviving the slowing economy, the Japanese government has encouraged more seniors and stay-at-home mothers to re-enter the workforce in the past decade. And it relatively worked: there are now 9.12 million elderly workers in Japan, a number that has been constantly growing for 19 years. The Internal Affairs Ministry said that workers aged 65 years and up now make up more than 13% of the national workforce.

Prime Minister Fumio Kishida warned about the population crisis in January that Japan is “on the brink of not being able to maintain social functions.” due to the falling birth rates.

He believes that solving the issue can’t wait any longer, and wants the government to double the amount it spends on child support programs. He also added that supporting childcare was the government’s “most important policy.”

The Japanese economy was also hit hard by COVID-19, shrinking by 4.8% in 2020 due to the pandemic. Japan has suffered its worst post-war economic contraction as the global pandemic hit domestic consumption and exports.

What’s Next For Japan?

Right now, Japan is in a critical moment to transform from 3 decade stagnation to “a mild nominal growth” period, and by the end of 2023, the country saw signs of returning growth.

This can be attributed to a shift in society’s expectations of wages and prices, and a stronger than expected stock market, which was among the best performing markets in Asia, and closed 2023 up by nearly 30%.

Multinational investment bank, UBS Group, forecasts a 1% growth in real GDP for 2024 and 2025, which could decrease depending on the performance of the U.S., in which the bank expects a mild recession by the middle of 2024, and China, which is currently battling an economic crisis caused by a weak real estate sector.

Still, growth will resume in 2025 with the recovery of global demand. This expected pace of real GDP growth may not sound impressive, but is still higher than the potential growth rate of around 0.5%, which is likely to accelerate somewhat in coming years with an increase in investment, especially in digitalization and human capital.

However, the Japanese economy still faces a lot of challenges when it comes to transitioning from a no nominal growth to a decent growth regime, and the country should carefully manage its monetary and fiscal policies in order to ensure a smooth transition.

If Japan tightens its policies too early and too much, the transformation could fail. On the other hand, if inflation or expectations of inflation rise faster than the BOJ and markets currently anticipate, market yields would rise faster and significantly.

A sharp increase in yields would threaten the BOJ’s finances, fiscal sustainability (including the risk of downgrade in sovereign ratings), and financial system stability. So, the BOJ must consider its every move, and not make the same mistakes that sent the Japanese economy into the Lost Decades.


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