When 777.7% Doesn’t Equal Growth

Story Highlights

• Japanese GDP shrank in Q4 2010, highlighting past problems.
• Importantly, Japan's long-term woes are influenced by mercantilist trade policy.
• Japan signed a new free trade agreement last week, and there is talk of more to come.
• This type of reform is an important step to move Japan forward, but it's anyone's guess if it will continue.

Last week was a busy one for Japanese economic news, highlighting two central themes: The problems in Japan's recent past, and a potential path to aid future growth.

Since Japan's 1980s economic boom ended, the land of the rising sun has frequently been held as a glaring example of how not to foster economic growth. After all, Japanese GDP is still below its mid-1990s high—a long period of stagnation the likes of which are extremely rare in the developed world. And, adding to growth woes, Japanese Q4 2010 GDP slumped -1.1% annualized. That beat expectations for a -2.0% decline, but largely due to a downward revision to Q3 2010 growth from +4.5% to +3.3%. This dip, combined with China's fast growth, has officially pushed Japan from the world's second largest economy to third.

Some blame a strong yen for Japan's woes, and this likely does influence some short-term economic fluctuations. But behind the long-term trend, there are far bigger forces at work. One of many major issues, Japan has long sought to insulate domestic industries from foreign competition. This includes preventing foreigners from purchasing Japanese companies, inhibiting foreign firms' access to certain industries within Japan, and promoting exports over imports through tariffs and trade barriers—a form of neo-mercantilism similar to that whichthat dominated global economics in the pre-industrialized world. Exemplifying these unfriendly regulatory practices are Japanese agricultural tariffs, like the 777.7% tariff (you can't make this up) on imported rice or the 252% tariff on wheat—ostensibly to "protect" Japanese farmers. Tight trade restrictions are often reciprocated by trade partners, and the lack of competition from imports can cause higher prices. So ultimately, Japanese citizens end up footing the bill to "protect" domestic industry through both higher domestic prices and lower economic growth.

Last week, Japanese Prime Minister Naoto Kan (we understand if the name is unfamiliar—Japan blows through prime ministers more frequently than the Oakland Raiders change head coaches) proposed greater free trade. Kan said, "The key is to open up the country, both in terms of thinking and the economy." An excellent point. And beyond Kan's words, India and Japan inked a 10-year free trade agreement eliminating tariffs on a wide array of goods (including some agricultural products) and allowing Indians to work in Japanese health care facilities. A decent start! And now there's talk (though hotly debated in Tokyo) of Japan joining negotiations to expand the Trans-Pacific Partnership. This free trade zone (currently existing between Brunei, Chile, New Zealand, and Singapore) is engaged in massive expansion talks that seek to add the US, Australia, Malaysia, Peru, and Vietnam. Japan's entry into a potential agreement would be an enormous benefit to all involved. But to join, Japan will likely have to reduce protectionist measures.

This type of free market reform would be a boon to Japan's economy, but it's anyone's guess whether it happens. We typically favor political gridlock, but Japan is an exception. Long term, Japan needs capitalistic reforms to shun mercantilist policies (not to mention badly needed banking reform, tax rate changes, etc.), but accomplishing these feats likely requires broad political support—something uncommon in Japan recently.

We hope Mr. Kan successfully shifts Japanese economic philosophy toward greater openness. Perhaps then, instead of being known for its lost decade and economic stagnation, the land of the rising sun could shine as an example of successful capitalistic reform.