Revisiting business cycle theory

By Homin Lee, Macro Strategist - Asia

No country refutes the basic tenets of business cycle analysis better than Japan. Market observers tend to term “recession” any quarter or two of negative real GDP growth. The problem is that such a classification scheme loses all value in a country like Japan where 41 of the last 122 quarters saw negative real GDP growth – as compared to only 11 for the US. If “recessions” are so frequent, then there is little value in even trying to detect or classify them.

One could counter that Japan’s real GDP performance is indeed poor, due to well-known demographic factors. While true to some extent, such justification of conventional business cycle analysis only serves to further undermine its case, since many other industrialised countries are headed for a similarly stark demographic situation. If an analytical framework is likely to prove useless at some point in the future, why cling to it now? More importantly, such a counter-argument does not explain why quarterly real GDP growth has been more volatile in Japan than in the US, despite relatively low trade dependency (17% of GDP). Worse, Japanese unemployment fell and equity markets rose during the 2014 “recession” that followed the consumption tax hike. These are by no means “recessionary” indicators.

A financial news columnist once described Japan as an “economic laboratory where theories go to die”. By simply being at the forefront of the global struggle with ageing demographics and deflation, Japan has bedevilled many outside observers who used to think that a limited set of macroeconomic and market principles acquired from other countries would also apply there.

At the root of Japan’s high output volatility, stagnant nominal GDP, towering debt and deflationary expectations lies Bank of Japan (BoJ) policy. It is thus more important to pay attention to the longevity of the current easing framework than to business cycle classifications. With the terms of its top decision-makers ending in the spring of 2018, uncertainty is slightly higher today than in previous years. The BoJ is of course expected to continue to fight deflation, but political commitment could come to lack. After all, it was pushback from the banking sector with respect to negative rates that forced the BoJ to adopt the confusing yield curve control policy last year – and implicitly embark on a tapering of bond purchases. Should the Board be fully replaced or a new prime minister disparage its ineffective easing, will the BoJ stay the course?