>Will earthquake mean a third lost decade for Japan?

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In 1990, Japan was the economic paradigm. Growth was outpacing every other leading country. Its car and electronics industries put the rest of the world to shame.
Even its banks were poised for domination. Economists were confidently predicting that in just 10 years, Japan would be vying with the US to become the world’s largest economy.
Roll the clock forward two decades and the picture could hardly be more different. Japan’s economy is one third the size of America’s and has been relegated to third spot behind China. Far from growing at record pace, it managed a woeful average of 1pc a year in the 1990s and no better in the 2000s. So began Japan’s “lost decade”, which swiftly became two. And there has been precious little evidence that a third would be averted.
Last week’s earthquake and tsunami struck after the slow devastation that has seen Japan’s economy derailed. In 1992, the debt-fuelled asset bubble burst – crippling the banks.
Rather than repair their balance sheets, policymakers allowed the banks to limp on. Credit was drained from the economy, just as its companies were challenged by low-cost Asian rivals.
Japan’s dependence on exports, for so long the secret of its success, became its Achilles heel as demand at home failed to pick up the slack. With slow growth came the peril of deflation, as falling prices deterred investment and increased the relative cost of borrowing.
The government’s debt burden is now more than twice Japan’s output and the country remains locked in a deflationary spiral. Making the crisis critical is its demographic burden. By 2050, the population is forecast to have fallen from 127m to just over 100m – leaving an economy with spiralling health and pension costs serviced by a shrinking working population.
Japan’s worst recorded earthquake will only add to its problems. Credit Suisse estimates the disaster will cost $171bn (£105bn) in economic losses, 3pc of GDP.
Although few predict a collapse back into recession, Royal Bank of Scotland economists warned that power shortages may “heavily damage business activities”, a period of “national mourning” would deter consumption, stock markets could fall and yields on government debt would rise, making the reconstruction programme more expensive.
The effect on the economy is expected to be largely similar to the Kobe earthquake of 1995, though Credit Suisse thinks it will be less than half as expensive as the damage has been to less economically significant regions.
In 1995, no one thought the downturn in Japan’s fortunes would be anything other than temporary but the underlying trend proved to be stronger than any force of nature. In the immediate aftermath of Kobe, growth slumped but rebounded sharply afterwards as the rebuilding programme provided an effective fiscal stimulus. Once back on track, the economy then continued its slow decline.
RBS predicts a similar path this time, downgrading its growth forecasts for the first half of the year but expecting “upward pressure [in the second half] on increased public investments in reconstruction”. Stephen King, HSBC’s chief economist, also noted: “It is hard to see the underlying picture changing.”
There is more reason to be worried now, however. Takuji Okubo, chief economist at Société Générale in Tokyo, said the economy’s weakened state means the authorities will be able to afford only a third of the 3 trillion yen (£22bn) emergency budget set aside after Kobe. Unlike then, the government is already considering raising its 5pc consumption tax.
Other surprise developments may play out. Japan’s public debt is 98pc domestically funded. Further borrowings to pay for the relief effort are likely to be “in the spirit of a war loan”, Mr King said, as the public and companies repatriate cash to rebuild the nation. Money is already flowing back to Japan, putting pressure on the yen.
A higher yen would be damaging for the nation’s exporters, which could negatively impact the economy. The Bank of Japan has already taken measures to offset those forces, doubling its “money printing” programme to 10 trillion yen.
Optimists hope the crisis will reinvigorate the country, giving policymakers cover for necessary reforms. The Kobe experience, and the Niigata earthquake of 2007, offer little support for the theory. More likely is that the Sendai disaster will derail efforts to build on last year, when Japan produced a rare positive record – the fastest economic growth of the G7 industrialised nations.