Japan’s economic malaise has been in the news recently – it just reported the largest annualized GDP drop (12.7%) in 34 years in the final quarter of 2008, ranking it as the current leader in economic decline compared to the U.S. and the Eurozone [1]. Full-year GDP is expected to drop over 2.5%. Japan’s exports also declined 13.9% in the same quarter, its largest contraction ever. The slowing U.S. consumer demand is a contributor, as is the recent strength in the Yen, reportedly due to safe-haven buying on the world currency markets. Japan now has the highest debt load among industrialized nations, running at almost 160% GDP. With such a high debt load and falling demand for its exports, the Japanese government is finding it increasingly difficult to maneuver a recovery plan.

South Korea’s sharp decline in growth at the end of 2008 has also been news – an annualized GDP drop of 21% in its final quarter of 2008, the worst since its financial crisis in 1998 [2]. Korea’s growth rate has been brisk in the last decade, so its full-year 2008 GDP rose 2.5%. The late 2008 GDP decline is likely attributable to Korea’s own sharp drop in exports, 11.9% from its third quarter, the largest in three decades. Korean exports account for a much larger share of GDP (~40%, similar to China), compared to that of Japan (~20%). The Won (Korea’s currency) hit a decade low last October, with continuing weakness into 2009. Asian currencies ex-Japan as a whole have declined from shrinking exports all across the region, as well as from a drop in global investor demand for emerging market assets. In contrast to Japan, Korea’s debt load is not nearly as high – ~30% GDP. Though its central bank has just reduced the discount lending rate to a record low of 2%, it has cautiously reserved the right to go even lower, in the face of a sharply weakening Won. Nevertheless, Korea may be in a better position to maneuver a quicker turnaround than Japan, despite its greater dependence on export trade.

So why is Korea in a stronger position for a growth turnaround? Several factors: (1) lack of a stock or real estate bubble history due to its relatively conservative monetary policies, and a history of government fiscal control; (2) economic reforms instituted in its banking and corporate entities after the 1997 financial crisis; (3) moderate-low corporate tax rates to spur business investment and growth; and (4) a staunchly pro free trade agenda with the U.S. and other partners. Let us address each of these in turn.

Monetary and Fiscal Spending Policy 

Korea did not share Japan’s experience of a major housing and stock market bubble, which burst at the end of 1989, and that many argue has impaired Japan’s recovery for almost two decades. The Tokyo Nikkei stock market index, from its peak of 38,957 on December 29, 1989 to 7,750 on February 16, 2009, has lost over 80% of its peak value, and is now testing the low of 7,604 set in 2003. If that low doesn’t hold, one would have to go back to 1982 to test another local low point. Japan’s stock and real estate market bubbles in the 80s were caused by the very loose monetary policies of the Bank of Japan (BoJ), which cut the discount lending interest rate from 9% to 2.5% between 1980-1987 and kept that rate at 2.5% for two years, while increasing the money supply at over 9% per year in the same period. The bubbles were pricked once the BoJ increased rates abruptly to 6% from 1989-90. The cumulative capital losses from the 1990-91 stock and real estate bubble implosion continued to increase every year until a low trough was hit in 2002-3. Though there was a recovery in the Nikkei from 2003-2006, it is now almost back down to its 2003 low. The Japanese government estimates almost $15T in cumulative capital losses from 1990-2003.

In an effort to slow the capital losses and stimulate the economy, the BoJ lowered rates again from 6% in mid-1991 to 1% in mid-1995, and then a further reduction to 0.5% in late 1995, where it remained for almost 5 years. Over this decade long period asset prices continued to fall from their once stratospheric highs despite the aggressive easing. It is highly noteworthy to add that from 1990-2000 the Japanese government debt-to-GDP ratio went from 60% to 120% as a result of massive public spending and a huge influx of government capital to the faltering financial sector. Yet by most measures the Japanese economy remained stagnant, the real GDP growing on average only ~1.3% per year.

Without an asset bubble and deflation to contend with, Korea’s economy grew steadily from 1980-1997, the real GDP increasing at an ~7.6% annual rate during this period. In the 80s and 90s, instead of adopting the loose monetary policy of Japan, the Bank of Korea (BoK) maintained a conservative one, managing its discount rate to avoid price shocks and limiting its money supply growth to rein inflation. The BoK’s inflation-targeting actions have contributed to long-term price stability, in sharp contrast to Japan [3]. Government fiscal policy was also conservative, with budget growth in check: the debt-to-GDP ratio contracted from 22% in 1980 to 16% in 1990, and then was cut almost in half to ~8% in 1996. These conservative monetary and fiscal policies made it possible for Korea to enjoy almost two decades of economic stability and growth.

The takeaway here is that monetary policy, if too loose, as it was in Japan in the 80s, can cultivate massive asset bubbles that lead to rapid and unrecoverable devaluation. Responding to such an event with incessant government spending can lead to sluggish growth, especially if that spending is within an economic system that has no process in place for insolvent and non-performing companies and banks to fail, and a tax and regulatory structure that is unfriendly to business. Korea’s much more conservative approach to monetary and fiscal policies during the 80s and early 90s helped prepare it for future economic shocks, such as the 1997 crisis, despite the fact that at that time it shared with Japan similar structural flaws in its corporate and banking systems, an issue that we turn to detail next.

Economic Structural Reforms

The Asian Financial Crisis of 1997 triggered by the collapse of the Thai currency had a much larger impact on Korea than Japan. The reasons for this are not completely clear, but it appears Korea’s heightened exposure to currency exchange risk was a major factor. The rapid devaluation of the Won and the dangerously sharp decline in Korea’s foreign exchange reserves threatened government default on its debt. Financial institutions and corporations that were highly leveraged to the Won faced massive devaluation of their assets. The high growth rate in Korea spawned an expansion in leverage and credit, and exposed poorly run institutions, many of them large conglomerates and government run banks, to failure. By the end of 1998 bad debt mounted to almost 30% of the GDP and Korea received a loan from the International Monetary Fund (IMF) to help shore up its reserves. How Korea responded to this crisis is instructive [4]. The Korean government divested itself of failing insolvent banks through auctions. In some cases assets were sold at fire sale prices and the bank received new management and investment (complete privatization), in other cases the government partnered with investors to co-own the bad debt until the underlying assets could recover and be sold to a buyer. There are two important points here – Korea realized that propping up failing institutions was not in their interest, nor did they have the luxury of continuing to support national banks – they chose to receive IMF money or risk debt default. Changes in bank management to private hands with foreign involvement could also be argued as having been a way for Korea to modernize its credit system – a deficiency that also impaired Korea before the crisis hit. Several large conglomerate failures during the crisis also showed a need for reforms to Korea’s policy in supporting government-backed family-controlled multinational monopolies. The salient point is that companies were also allowed to fail and be sold off to other conglomerates and foreign investors. Korea’s tough reforms paid off – without the burden of poorly performing institutions, Korea grew its GDP almost 5.3% annually from 1999-2008. Its most recent downturn from slowing export demand will once again test Korea’s resolve in how they handle the hardship. If they adopt the same conservative no-nonsense approaches as they have in the past it will contribute to restoring growth and stability.

Japan had its own banking crisis following the 1997 Asian shock, but escaped the immediate severity felt by Korea, in large part by being saved by the Yen, a highly developed currency, reducing Japan’s exposure to currency risk. Japan’s crisis stemmed from years of asset bubble deflation amidst a growing leverage environment. Bad debt on banks in Japan mounted to over 25% GDP, a substantial figure considering that Japan’s GDP in 1998 was 11 times that of Korea’s. Many banks (some 180 up to 2002 [5]) were completely insolvent, and instead of allowing these institutions to fail and cleaning out the bad debt, Japan chose to continually infuse poorly run banks with government money for a period of years, in the hope that they would eventually recover. Impaired banks continued to make loans to financially impaired businesses and individuals, without adequate risk assessment for future non-performing loans, and they were allowed to maintain unrealized losses by government regulation. Some claim these policies contributed to deflationary pressures on underlying assets, becoming part of a deflationary systemic spiral. Regardless, Korea’s swift moves to privatize insolvent banks and resolve its bad debt crisis might have been adopted by Japan, but they weren’t. From 1997-2005 Japan’s GDP grew by only ~1% per year. Modest financial and corporate reforms did finally start to kick in around 2004-5, when banks were required to submit to strict audits and technically insolvent ones were forced into receivership, and changes were made to Japanese bankruptcy laws, making it easier for firms to declare bankruptcy and liquidate their holdings. In 2005 Japan’s economy finally started to improve, in part by the rapid growth in the global economy and a weaker Yen. GDP grew from 2005-2008 at ~2% per year.

Now, with export demand weakening significantly along with the recent safe haven strength of the Yen, Japan is vulnerable unless it takes on significant economic reforms. Monetary easing by injecting money into the economy may help to weaken the Yen, but this is risky, as safe-haven demand for the Yen could unwind sharply. Some have suggested that Japan develop a greater degree of domestic consumption to spur its growth, eschewing its cultural propensity to save. But from its own history in the 90s, it is clear that a recurrent government fiscal spending spree will have little effect on spurring new growth, and Japan already is saddled with a large amount of government debt. Japan might do well to look to Korea’s recent history of economic structural changes for answers: adopt tough reforms on government budgets, pay down government debt, allow more insolvent banks and companies to fail, allow a greater degree of foreign investment in Japanese banks and businesses, and reduce its very high tax rates on businesses. The latter two points cannot be understated enough. Globally, Japan has one of the most protectionist domestic markets for foreign direct investment and it has the highest corporate tax rates. Protectionism of its domestic markets and a business-unfriendly environment only protect Japan from real growth.  

Tax Policy

Tax policy, particularly corporate tax policy, is one lever available to governments to spur growth and job creation. High corporate taxes encourage businesses to invest overseas or to hide their capital from domestic investment. Everyone pays for corporate taxes when they buy goods and services, so a high corporate tax is just another tax on consumers.

Japan has the highest corporate tax rate in the industrialized world, with a high effective marginal tax rate of ~41%. It has historically had one of the most business-unfriendly tax policies [6], imposing a significant impact on domestic and foreign investment. The recovery of bubble deflating land prices in the 90s was hampered by the imposition of a high land tax in 1992, discouraging a more liquid market and efficient price discovery, and preventing a release of capital to be allocated elsewhere. Similar effects were felt on stock and non-land asset sales with the imposition of a high capital gains tax rate. Japan maintained a high corporate marginal tax rate of over 50% before 2004, yielding an average tax revenue of 3.5% of GDP from 1998-2004. When tax rates were reduced in 2004 and 2005 to ~40% there was a marked increase (~40%) in corporate tax revenue from 2004-2006, to ~5% GDP. In fact, the reduction of corporate tax rates in countries worldwide has shown a remarkable correlation with increasing tax revenue [7]. Increasing tax revenue from these rate reductions stems from an increase in taxable growth from business investment and reinvestment.

Korea has moderate-low corporate tax rates of 13-25%, depending on company revenue (100M Won cutoff). Corporate tax rates have historically been below the international average among industrialized nations, and Korea has made an effort to reduce them every chance it had from 1983-present, from 20-33% to the current 13-25%. In December 2008, Korea announced that it would lower rates even further, to 11-22% for 2009, increasing the revenue cutoff to 200M Won for the lower rate, and then again to 10-20% by 2011. These commitments are in stark contrast to Japan and the U.S., the two countries with the highest corporate tax rates. Historical evidence is strong that Korea’s business tax policies have made it a friendlier place to invest, and have contributed to its remarkable sustained growth: from 1983-present Korea’s GDP grew ~6.6% per year.

Japan has recently surfaced the idea of cutting corporate tax rates from its high 41% level, but no action has yet been taken.

Trade Policy

Korea has unilaterally promoted both export and import growth since the mid-1980s, when policy makers diligently started removing barriers to their domestic markets, opening them to foreign competition and seeing this as a way to boost the international competitiveness of its own industries. Their stated objective continues to be that they will promote an advanced, free and open economy, and they have worked toward numerous multilateral free trade agreements with other countries, including the KORUS free trade agreement signed with the U.S. in 2007, which has yet to be ratified by the U.S. Congress or Korea’s National Assembly. With Korea’s heavy dependence on export and import trade, it is not surprising that their policy makers would want to be free-trade evangelists and cast Korea as a leading voice against global protectionism [8]. However, as we know historically, nations don’t always choose a liberal but prudent trade stand – protectionism of domestic markets has been an impulsive or reflexive reaction in economic downturns, instead of seeing free trade as a way to promote growth and stability. The bottom line here is that Korea itself must reform its trade policy – its weighted average tariff rates (~7%) are much higher than even Japan’s (~1.5%) or the U.S (~1.6%). In particular, Korea has stiff tariff barriers in its agricultural and auto sectors. KORUS would lift tariffs or quotas in these areas, and phase out tariffs on consumer and industrial products over a period of years. As a bonus to Korea, KORUS would further increase foreign direct investment, an advantage Korea has had for years over Japan, given the relative size of the two economies.

While Japan has liberalized its trade policy over the years to reduce tariffs, it has kept other barriers in place that appear to impede its growth – foreign direct investment (FDI) is one of the standouts. Looking at the data, in 2007 Japan received ~$111B in FDI, compared to ~$120B received by Korea. That puts them 24th and 23rd on the CIA World Factbook FDI list. Japan has the 2nd largest economy in the world, and Korea’s rank has fluctuated between 11th-14th. How can this be? An obvious explanation is that Japan’s markets are indeed protected, from FDI. Japan should be ranked in the top 10 but it isn’t. In fact, both Korea and Japan could stand to move their FDI rank up, past countries such as Poland and Denmark.

Lessons For The U.S.

With the U.S. in recession and ratcheting up on its own debt load, particularly with the recent passage of the $787B economic spending package and an estimate of well over $1T to bail out its insolvent financial institutions, Japan and Korea are noteworthy case studies. In fact, in three decades both together have encountered almost all of the crises that the U.S. has endured in the last decade. The opportunity here is to look at what macroeconomic and fiscal policies worked and what didn’t and then cultivate and apply those that were successful. In the final analysis:

1. Loose monetary policy leads to asset bubbles that when pricked, can lead to years of asset deflation and devaluation, which can be exacerbated by a leveraged environment. Japan encountered this to the extreme as its stock and real estate markets bubbled in the 80s and then deflated amidst a deleveraging financial system in the 90s. It took over 13 years for land prices to recover, and its stock market is still recovering. Did the U.S. learn from this in the 90s? No. Our own loose money policies contributed to the technology stock bubble peak in 2000 and to the more egregious real estate bubble peak in 2006, the latter accompanied by a period of extreme financial leverage. The takeaway lesson going forward can be provided by Korea: conservative monetary policies work and avoid asset bubbles and price shocks [3].
    
2. It will likely take years to work off the U.S. real estate asset deflation and devaluation, but one lesson from Japan from the 90s is that government attempts to stem the slide and fix prices had a detrimental effect on restarting real growth, and only grew Japan’s debt. Better to let the markets work to find a bottom in prices and then promote an environment for new capital to spur growth. As Korea has repeatedly shown, the latter can be done with corporate tax policy.
    
3. Allow completely insolvent banks and financial institutions to fail and be restructured, selling off or entrusting bad debt to pay back bondholders and creditors and spinning off good bank assets to new owners. Korea was forced to do this after the 1997 Asian Crisis and resumed its growth quickly. Japan took over a decade of soul searching to make these decisions, impacting growth and saddling it with more government debt. The U.S. proved in the late 80s that it could effectively deal with the hundreds of failing savings and loan (S&L) institutions  – it adopted the Resolution Trust Corporation (RTC) model to handle receivership of many failed S&Ls without the commitment of government funds to buy the assets. This same model can be adopted to handle the large bank failures.
    
4. Continual government spending sprees on public works and infrastructure had little effect in turning around Japan’s growth decline in the 90s, especially while it was undergoing asset devaluation and deleveraging. The U.S. is in the same position now, except it is making the decision to repeat the Japan’s mistakes. If we continue along the same lines as Japan, we will double our debt load from the current 75%GDP to 140+%GDP. High taxes in Japan did little to stem the expansion in debt during this period. When the economy is not growing, tax revenue will decline if tax rates are kept high.
    
5. Business-friendly policies such as lowering the corporate and capital gains tax rates have worked in stimulating growth and job creation. Korea has proved this by maintaining moderate-low corporate tax rates for decades. The U.S. was on the right track when it reduced capital gains tax rates for individuals in the late 90s and again in 2003. Top corporate tax rates need to come down to at least a moderate level (25%) to unlock business capital. The best time to do this is in a recession.
    
6. Trade policy is also a tool that can be used or misused – protectionism doesn’t work for any nation, especially in an economic downturn. The U.S. would do well to avoid it and start to negotiate fairly, allowing the best values to be embraced by our markets and encouraging our industries to be more competitive. The U.S. has the highest FDI and moderate weighted average tariffs, but this could change if our markets become more protectionist, impacting growth.
    
7. Currency exchange risk remains a real issue for Japan and Korea, more for Korea than Japan. Just this week, “Japan, China, South Korea and 10 Southeast Asian nations agreed to form a $120 billion pool of foreign-exchange reserves that can be used by countries to defend their currencies amid the deepening global recession [9].” This move will go a long way to avoiding a repeat of the 1997 Asian Financial Crisis. How does this apply to the U.S.? Down the line the U.S. dollar may not be considered the reserve currency it is now, exposing the U.S. to greater currency exchange risk. How do we avoid our own dollar crisis? Keep our debt load in check and maintain our reserves. With the Federal Reserve in high gear on printing money to pay for new ‘stimulus’ and bailout expenditures of the Treasury, and with an ever-increasing load of loan and bad debt guarantees weighing down the Fed balance sheet monthly, the picture doesn’t look pretty.

References:

[1] “Steep Export Slide Pummels Japan,” Wall Street Journal, 2/17/09.
[2] “South Korea Economy Shrinks 5.6%, Worst in a Decade,” Wall Street Journal, 1/22/09.
[3] “A Tale of Two Monetary Policies: Korea and Japan,” Thomas F. Cargill, FRBSF Economic Letter, 4/15/05.
[4] “The Seoul Solution to the Banking Crisis,” Wall Street Journal, 2/12/09.
[5] “Bank Failures in Mature Economies,” Basel Committee on Banking Supervision, April 2004.
[6] “Toward Meaningful Tax Reform in Japan,” Alan Reynolds, 4/6/98.
[7] “How Cutting Corporation Tax Would Boost Revenue,” M. Elliot, et al., 2008.
[8] “’Buy American’ Is No Hit in Korea,” Wall Street Journal, 2/12/09.
[9] “Asia Agrees on Expanded $120 Billion Currency Pool,” Bloomberg News, 2/22/09.
[10] Historical economic data on Japan and South Korea from Econstats.com, Economagic.com, Wikipedia, CIA World Fact Book, OECD, Japanese Cabinet Office.