Stephen King: China can learn from Japan's economic pain

Oddly enough, these two topics are related. If one country's policymakers understand China's economic impact better than others, it's Japan's. Next-door neighbours who aren't always in the mood to pop around for a natter, Japan and China have had, over the years, a relationship that has been at best a little frosty and at worst ... well, let's just say that they haven't always been on speaking terms. Yet they both recognise, despite their mutual antipathy, that they are better off, economically, working together.

Until Deng Xiaoping's ascendancy, China was, compared with Japan, an economic pygmy. While Japan was enjoying extraordinary growth in the 1950s and 1960s - expanding at an average annual rate of approaching 10 per cent - China was making no progress at all. China's GDP per capita actually declined from the 1950s through to the 1970s. Relative to its supposed promise, the Great Leap Forward now looks to have been a touch oxymoronic while the Cultural Revolution now seems to have been more a Cultural Regression.

Over the last 20 years, China's arrival on the global economic stage has been greeted with considerable fanfare and, at the same time, with growing trepidation. If the first major act of sustained modern economic development - the industrial revolution - left China on the sidelines, exploited (and drugged) by Western colonisers in the 19th century, and the second act - post-war economic catch-up for many European countries and Japan - left China sulking without a role, the third act has been marked by a barnstorming performance from the Middle Kingdom. While Japan and Europe have seemingly forgotten how to grow, China provides a very visible reminder of what is possible when the development wheels are set in motion.

Observers of the Japanese economy often explain Japan's poor performance purely in domestic terms. Japan's 1990s stagnation, on this interpretation, was the result of the late-1980s bubble, the poor allocation of capital, the inefficiency of the banking system and the inflexibility of the lifetime employment model. From this perspective, Japan's problems were domestically generated, with no influence coming from elsewhere in the world.

While these explanations make some sense, I'm not sure that they provide the complete picture. The bubble certainly was a late-1980s phenomenon and doubtless its implosion led, in turn, to Japan's deflation. But poor allocation of capital and an inefficient banking system are less helpful explanations: Japan suffered from these weaknesses long before the 1990s yet was still able, economically, to outperform countries elsewhere. Perhaps more pertinently, China suffers from the same kinds of difficulties today and yet is expanding rapidly. As for lifetime employment, it wasn't so long ago that Japan's labour market model was the one that others sought to emulate.

My impression is that Japan's economic problems were not entirely home grown. The policy-induced boost to domestic demand in the late 1980s that contributed to the bubble was partly a response to US pressure for a reduction in Japan's trade surplus. Given this experience, it's hardly surprising that China is proving resistant to similar pressures today. Japan also, though, found itself in the vanguard of sweeping globalisation, primarily because of its close geographical proximity to China. China's economic emancipation in the late 1980s and early 1990s provided fertile ground for Japanese companies which, faced with an excessively high domestic cost base, were having trouble competing with their peers elsewhere in the world. China offered these companies the option of reducing labour costs. The companies, in turn, lapped up these cost-cutting opportunities.

The consequences for the domestic Japanese economy were hardly pleasant. Japanese policymakers regard this fledgling move towards globalisation as a "hollowing-out" of Japanese industry. Jobs were lost, incomes came under pressure, consumption slowed, land prices declined and the economy stagnated. Good loans turned bad (or, in the vernacular, became "non-performing") and the banking system virtually keeled over. Japanese exports to China rose rapidly, not because of a rise in Chinese demand for Toyotas but, rather, because Japanese companies were simply relocating their capital across the Yellow Sea.

Today, the good news is that Japan may be reaching the end of its period of difficult adjustment. Domestic demand is recovering, corporate debt levels are back to pre-bubble levels and companies have, at last, started to hire full-time workers again. Yet, this more optimistic picture comes only after 15 years of economic pain.

Why did Japan find the adjustment so difficult? Its problems stemmed in part from the inflexibility of its economy. Lifetime employment may have led to excellent industrial relations and, hence, a comparative advantage relative to those European countries that suffered from terrible industrial relations difficulties in the 1970s. But lifetime employment becomes a ball and chain when your next-door-neighbour suddenly opens up his front door to your capital and offers up workers who are prepared to work at a tenth or a twentieth of the wages you pay at home. Ironically, Japan has endured over the last 15 years many of the same problems suffered by the UK in the 1970s, when Japan seemed to be the main globalisation threat.

When Japanese policymakers take a look at Europe, the scene in front of them seems remarkably familiar. For the likes of Germany and Italy, their new economic next-door neighbours pose for them problems similar to those faced by Japan. The difference, though, is one of timing. The Berlin Wall fell in 1989 but it wasn't really until the mid-1990s that central and eastern Europe began to make a more significant difference to the performance of western European economies. For Germany and Italy, right in the front line of this change, the experience has not been particularly pleasant. Both countries have stagnated, and both are finding it difficult to come to terms with the new challenges.

There are differences. German industry appears to have responded more aggressively than Italian industry, forcing down labour costs and, in the process, maintaining its share of world trade. Italian industry, in contrast, has struggled to deal with the new world order: its textile companies, for example, are among those who would rather build a "fortress Europe", barricaded from the onslaught coming from ever-more mobile capital and the competition from cheaper labour.

If Japan's experience offers anything to Europe, it's that an economic system simply has to change in order to survive. Change is risky, sometimes painful and always politically difficult. But avoiding change is simply not an option. Japan's experience of globalisation led to a radical restructuring of its industrial organisation, a reflection of the shift in comparative advantages both within and across its industries.

Even if Europe recognises that this shift is taking place, it seems unsure of what to do: Germany's federal election results surely demonstrate that the German population remains confused about Germany's economic role in the wider world. And so it should be: German companies may be feeling more optimistic these days and German exports may be performing well but there can be no doubt that Germany, too, is "hollowing out". All those extra exports certainly look impressive but German consumers must be wondering what on earth is going on. Their spending has been absolutely stagnant in recent years (see chart). No wonder German consumers, like their Japanese forebears, have a permanently hollow feeling.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com