The nexus between causal macroeconomic relations in Japan

Zestos, George K.; Jiang, Yixiao; Patnode, Ryan Article The nexus between causal macroeconomic relations in Japan Review of Economic Analysis (REA) Provided in Cooperation with: International Centre for Economic Analysis (ICEA), Waterloo, Ontario Suggested Citation: Zestos, George K.; Jiang, Yixiao; Patnode, Ryan (2022) : The nexus between causal macroeconomic relations in Japan, Review of Economic Analysis (REA), ISSN 1973-3909, International Centre for Economic Analysis (ICEA), Waterloo (Ontario), Vol. 14, Iss. 3, pp. 419-440, https://doi.org/10.15353/rea.v14i1.4017 This Version is available at: https://hdl.handle.net/10419/328136 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc/4.0/ Review of Economic Analysis 14 (2022) 419-440 1973-3909/2022xxx 419 www.RofEA.org The Nexus between Causal Macroeconomic Relations in Japan Empty 15 GEORGE K ZESTOS Christopher Newport University Empty 15 YIXIAO JIANG Christopher Newport University HUNTER SIMONS Christopher Newport University Empty 15 Japan achieved phenomenal economic growth after WWII. Starting in the early 1990s, however, the Japanese economy began experiencing a prolonged deflation-stagnation period widely known as the “Lost Decades”. Based on data from the World Bank and the Federal Reserve Bank of Saint Louis, this paper employs an autoregressive distributed lags (ARDL) model to find evidence of a long run relation among the real GDP, real imports, the real exchange rate, and the public debt-to-GDP ratio for Japan. Once cointegration is established with the Bounds Test, Granger Causality tests are performed by employing an estimated Vector Autoregressive (VAR) model with the same variables. The empirical results support Granger causality in all directions. In particular, we found real imports and public debt-to-GDP ratio to directly cause real GDP. Interestingly, the real exchange rate causes real GDP indirectly via imports. The public debt had a negative effect on GDP but did not wreak havoc on the Japanese economy. The study also examines whether former Prime Minister Shinzō Abe’s unprecedented macroeconomic policies and structural reforms launched in 2013, known as Abenomics, are pulling Japan out of its economic doldrums. Keywords: ARDL Model, Economic Development, Japanese Economy, International Trade JEL Classifications: F14, F43, F63, C32 * We would like to thank Ryan Patnode for excellent research assistance and Professors Roark Mulligan, Thanasis Stengos, and Alexander Zestos for helpful comments and constructive criticism. We like to express our gratitude to Christopher Newport University for awarding us a Faculty Development Grant. © 2022 George K Zestos, Yixiao Jiang and Hunter Simons. Licensed under the Creative Commons Attribution - Noncommercial 4.0 Licence (http://creativecommons.org/licenses/bync/4.0/. Available at http://rofea.org. Review of Economic Analysis 14 (2022) 419-440 420 www.RofEA.org 1 Introduction: Japan, a reluctant trading partner Japan, because of its scarcity of natural resources, benefits more than most other countries from international trade relations. The Japanese, however, according to historical evidence, did not seek to open trade relations with the Western countries on their own. Japan’s first contact with Western countries was anything but smooth. The exploitative colonial approach of the European traders and their persistent efforts to convert the Japanese to Catholicism led to much hostility among the Japanese. 1 Unfair trading practices by the Europeans led the Japanese to expel the Portuguese, Spanish, and Dutch traders. Thus in 1639, Japan closed the borders to Western nations. Japan’s next official contact with the West occurred in 1851, more than two hundred years later, when the American Commodore Matthew Perry, authorized by US President Millard Fillmore, entered the Bay of Tokyo with four ships. Perry’s aim was to open trade relations with Japan, and he tried to accomplish this by bearing gifts for the emperor and other officials along with threats from the fire power of his ships. Trade relations were imposed upon the Japanese on March 31, 1854, when Commodore Perry returned to Tokyo with a larger squadron of ships. The Japanese, albeit angered and humiliated, reluctantly signed the Kanagawa Treaty. 2 This treaty gave the US steamships access to two Japanese coaling ports. In addition, the Japanese government agreed to assist stranded US ships and American seamen (whalers) at risk in Japanese waters. An official commercial treaty, the Harris Treaty, was signed by the United States and Japan a few years later in 1858. Although Japan was forced to accept trade relations practically at gunpoint, opening its economy turned out to be exceptionally beneficial. 3 Japan was able to access advanced technology for all sectors of the economy including the military. As a result, Japan was gradually transformed into the most powerful economic and military power in the Pacific. Japan has undergone several stages of industrialization since the opening of its economy. However, much of its industrial base and infrastructure was destroyed during WWII, a period when Japan was at war against the Allied Forces. After WWII, the US assisted Japan in rebuilding its economy. The post-WWII phenomenal growth in the Japanese economy was interrupted by a period of chronic stagnation and deflation, known as the “Lost Decades”. Set against this background, this study has several objectives. First, it provided a comprehensive review of the economic causes of the Lost Decades as well as the major policy responses, with a focus on the stimulation plans of former Prime Minister Shinzō Abe. Second, an ARDL model was estimated to study 1 Milestones 1830-1860 – Office of the Historian. Retrieved from https://history.state.gov/milestones/1830-1860/opening-to-japan. 2 https://www.archives.gov/exhibits/featured-documents/treaty-of-kanagawa 3 Such benefits do not of course reflect cultural preferences derived from isolationism. ZESTOS, JIANG, SIMONS Macroeconomic Relations in Japan 421 www.RofEA.org the long run relationship among important macroeconomic variables; a variety of Granger causality tests were then performed to investigate the nexus among them. Finally, this paper critically assessed the success of Abenomics based on the estimated econometric model. Since public debt had a rather small impact on real GDP, the massive public debt in Japan should not be identified as the sole cause for the lost decades. Nevertheless, the Japanese government should be cautious in mounting public debt on the road to reform. The rest of the paper is organized as follow. Section 2 discusses the major historical events and policy changes related to the Lost Decades. Section 3 reviews extant economic studies, both theoretical and empirical, that addressed the policy responses. Section 4 explains the employed methodology and data. Section 5 contains the empirical results and policy discussion. Section 6 concludes. 2 A Bubble Interrupts Expansion: Policy Responses Following a period of rapid growth, a major bubble formed in Japan’s real estate and stock markets, causing asset prices to skyrocket in the late 1980s. In 1989, the Nikkei stock market index surpassed 38,000, a record high. In 1991, however, the inevitable happened and the bubble burst. What followed was an unprecedented period of chronic stagnation and deflation branded as the “Lost Decades.” A number of factors had contributed to the formation of the Japanese asset bubble. Ultra-expansionary monetary policy kept interest rates exceptionally low for a very long time. Several corporations reported high profits based on capital gains, enabling them to borrow at incredibly low interest rates and employ these funds for speculative investments. In addition, relatively high household savings were used to increase demand for equity and real estate assets. Such monetary innovations were called “Zaitech” 4 which translates in English to “financial engineering”, Zestos (2016) 5 Prior to the formation of the asset bubble, the Japanese economy was internationally competitive in several industries, including electronics, machinery, and automobiles. This success resulted from the transformation of the traditional Japanese economy into a modern one, dominated by large corporations organized and strategically positioned for global competition. Japanese corporations recruited and trained many employees who became faithful and remained with the same companies for a lifetime. The tradition of lifetime employment prevailed in Japan for over a century and it was the outcome of cooperation between business management, labor, and the Japanese government. Furthermore, the Japanese government guided corporations to compete internationally. The Ministry of International Trade and Industry (MITI) was created in 1949 to coordinate trade policy along with other government 4 See, for example, J. Colombo (2012). 5 A term very familiar in the US from the US Subprime Mortgage Crisis of 2007-2009. Review of Economic Analysis 14 (2022) 419-440 422 www.RofEA.org agencies. A successful export sector allowed Japan to purchase high quality capital and technology-intensive imports that played a favorable role in the growth of the economy. In the late 1990s, Japan nevertheless experienced a major asset bubble. Consequently, the Bank of Japan (BOJ) 6 began raising interest rates, causing the Japanese economy to enter a prolonged period of deflation and stagnation (Hoshi and Kashyap, 2010). The BOJ was criticized for not being more aggressive or announcing a target inflation rate. As a response to the stagnation-deflation problem, both the BOJ and the Japanese Treasury contributed to the massive increase in government bonds. Such a massive increase in public debt led to a zero bound interest rate, a phenomenon that had never been explored by other major central banks (Nakano and Okabe, 2012). Many economists, including Leigh (2010), Grabowiecki and Dabrowski (2017), and Krugman (1998), were convinced that a liquidity trap was responsible for the low, below trend economic growth. The crisis created many problems, including high unemployment among the young and middle-aged which contributed to a higher income inequality. Lost government revenues due to stagnation affected the ability of the government to assist the aging population. Government efforts to cope with the crisis required increasing public deficits that gradually raised the public debt-to-GDP ratio to an unprecedented level. The question arises: how could, after more than 20 years of stagnation and unprecedented increases in the public debt-to-GDP ratio, interest rates on government bonds did not rise? Such an increase would have been explained by rising default risk premia necessary to finance the public debt 7 . The fact that Japan’s public debt has not wreaked havoc is attributed to many factors; one such factor is a relatively high private saving rate compared to other developed countries. In addition, approximately 92% of the Japanese public debt is domestically owned. There is evidence of home bias among Japanese investors. Furthermore, because of the European Sovereign Debt Crisis, many international investors who preferred to invest in a safehaven country, began purchasing short-term Japanese government bonds. As the Eurocrisis has waned, nonetheless, the purchase of government bonds by international investors has declined but investors still purchased yen for carry trade. However, several unique factors characterize the Japanese economy. For example, although the real Japanese GDP growth rate was substantially reduced for many years, the Japanese economy still ranks the fourth in the world in terms of purchasing power parity (PPP) rates. Consequently, the Japanese enjoy high standard of living. 8 Furthermore, Japan is the largest creditor in the world. Despite such success, the Japanese government had been applying 6 This is the name of the Central Bank of Japan. 7 See Horioka, Nomoto and Terada-Hagiwara (2014) 8 According to our calculations, in the 1960’s the Japanese GDP grew 14.4%, in the 1970’s 5.05%, in the 1990’s 4.90% and only 1.07% from 1990 to 2016. ZESTOS, JIANG, SIMONS Macroeconomic Relations in Japan 423 www.RofEA.org incorrect fiscal policy by increasing public consumption and decreasing public investment (see Akram, 2014). 2.1 Abenomics Upon his reelection in December 2012 as the Japanese Prime Minister, Shinzō Abe, along with the newly appointed governor of the BOJ, Harunciko Kuroda, announced a set of new policies to revive the Japanese economy (Guillemette and Starsky, 2015). The three policies listed below are known as “The Three Arrows” of Abenomics: 1. Accommodative Monetary Policy 2. Fiscal Policy followed by consolidation 3. Structural Reforms to induce private investment and raise economic growth The first arrow, Accommodative Monetary Policy, aimed to increase inflation to an annual target rate of 2% to overcome the chronic deflation problem. To achieve this objective, the BOJ launched the Quantitative and Qualitative Monetary Easing, commonly known as QE monetary program. The BOJ initially purchased an extraordinarily large amount of long-term government bonds, quickly doubling its total holdings. The second arrow, fiscal policy followed by consolidation, employed fiscal policy to raise real GDP growth and to reduce the public debtto-GDP ratio. The first two arrows employed monetary and fiscal policies. These two policies alone, however, would not have been sufficient to achieve the ultimate objectives of Abenomics unless complemented by the third arrow, the structural reforms. Such reforms included increasing labor force participation rate of female and older workers. In addition, an elaborate deregulation program of the economy was launched. Abenomics aimed to resolve the deep-rooted deflation-stagnation problem of the Japanese economy that emerged after the 1991 financial crisis. Deflationary expectations created by the crisis had become self-fulfilling (Bojkova, 2017). Price expectations in Japan were, for a long time, backward-looking. 9 Low energy prices were an additional obstacle for the BOJ’s efforts to reverse backward looking expectations of prices. Prices, however, started rising on November 2021. The aggressive BOJ monetary policy of QE aimed to increase inflation by establishing negative short and long-term interest rates. To achieve this objective, the BOJ also switched to purchasing long-term government bonds instead of short-term bonds. The BOJ’s aim was to flatten and even invert the yield curve. 10 Despite the massive increase in liquidity, a new 9 Governor Haruchinko Kurodova of The Bank of Japan also characterized inflationary expectations in Japan as backward looking, implying past deflation would continue in the future despite very aggressive expansionary monetary policy. 10 The US Federal Reserve also had launched such policy for this reason QE sometimes is referred to as Qualitative and Quantitative easing (QQE). Review of Economic Analysis 14 (2022) 419-440 424 www.RofEA.org consumption tax contributed to a minor recession in 2014. It is suspected that excessive liquidity did not end up in the real economy and did not boost domestic production; instead, it was simply absorbed by the financial sector (Xing, 2016). Abenomics could have been more effective if it were not preceded by an earthquake and tsunami that caused the tragic explosion (meltdown) of the Fukushima Daishi nuclear power plant on March 11, 13, and 15, 2011. 11 These natural disasters worked against Abenomics. Preliminary data regarding the performance of the Japanese economy during the launch of Abenomics indicated mixed results. The inflation rate never reached its target of 2%. There was, nevertheless, a modest increase in output (Hausman and Wieland, 2015). A reduction in unemployment from 4.2% in 2013 to 3% in October 2016 took place without a substantial increase in nominal or real wages. 12 Recent unfavorable international economic developments, such as Brexit, exchange rate volatility, the breakdown of multilateral international trade negotiations, trade wars, and the Pandemic, have worked against Abenomics. 13 2.2 Exchange Rate Developments Under the Bretton Woods fixed exchange rate system, the nominal exchange rate in 1971 was set at 308 yen per dollar. When Japan joined the floating exchange rate system in 1973, the yen appreciated substantially to 270 yen per dollar. In the 1985 Plaza Accord, the US, Germany, France, and Japan agreed to intervene in the foreign exchange markets by coordinating economic policies to prevent further dollar appreciation. The dynamics of real exchange rate in Japan is depicted in Figure 1 of Section 4.2. Following the Plaza Accord, the yen rapidly appreciated until 1988. After a couple of years of depreciation until 1990, the yen appreciated again until 1995. A stronger yen had a negative impact on the international competitiveness of Japan, since the country’s export prices increased substantially. A nominal yen appreciation reduced the Japanese price level, thus leading to deflation. Starting in 1995, the real yen began a long depreciation path, following a volatile upward trend. Long subintervals of substantial oscillations took place, indicating that the yen exchange rate was unstable. For example, during the period from 2007 to 2015, the yen completed a half cycle consisting of both appreciation and depreciation. From 2007 to 2012, a period during which the US Subprime Mortgage crisis began and spread to Europe, the yen appreciated. Such yen appreciation was explained because investors reduced demand for dollars and euros. 11 Patrick (2014) and a few other authors expressed admiration for the extraordinary resilience of the Japanese people which prevailed and led to fast economic recovery despite the massive destruction including the killing of 20,000 people. 12 Japan is similar to the rest of the world regarding suppressing labor costs to enable national firms become internationally competitive, thus, trade union membership declined along with labor income as a percentage of GDP. 13 A few events nevertheless fall outside our sample period, but Abenomics is still applicable ZESTOS, JIANG, SIMONS Macroeconomic Relations in Japan 425 www.RofEA.org Currency speculators and other financial investors during this period sought a safe haven and thus invested in yen. This led to the appreciation of the Japanese currency. When the US Subprime Mortgage crisis and the Eurocrisis were mostly subdued by 2012, the demand for yen declined and the Japanese currency began depreciating again until 2015. A cheaper yen was expected to have restored the Japanese international competitiveness, especially in relation to the South East Asian countries that had seriously challenged the Japanese exports sector. In addition, monetary and fiscal policy under Abenomics, starting in 2013, reduced both short and long-term interest rates, driving them to zero-lower bound and even negative. Low interest rates discouraged investment in Japan, as a result, the yen depreciated. A yen depreciation, however, only mildly improved the Japanese trade balance. 3 Literature Review 3.1 Causes of the “Lost Japanese Decades” Several explanations are provided for the prolonged stagnation-deflation period of Japan. Almost all studies begin with the late 1980s and early 1990s financial crisis which peaked in 1991. Many studies attribute the origin of the crisis to the formation of a bubble created by an excessive increase in money supply and liberal credit policies that induced a large demand for financial and real estate assets (discussed in Section 2). Eventually, the bubble burst. Although bubble crises are not uncommon among countries, the prolonged stagnation-deflation of Japan is rare and unique. The yen appreciation after the Plaza Agreement in 1985 is considered a major factor of the prolonged deflation-stagnation problem. Two alternative hypotheses provide explanations of the crisis; these are classified either as supply-side or demand-side theories. The supply-side theories mainly focus on the decrease of labor productivity and the declining labor force due to an aging population. Demand-side theories focus on the real yen appreciation effects on the real economy after the Plaza Agreement. These theories also analyze the monetary and fiscal policy responses by the BOJ and the Japanese government respectively, to cope with the crisis which created a liquidity trap. 14 The ultra-expansionary monetary policy triggered a liquidity trap that rendered monetary policy impotent. Furthermore, deficit spending led to the mounting public debt problem. A high public debt-to-GDP ratio required large interest payments which hindered economic development 15 . 14 Several references of these two broad theories are provided by Tyers (2012). Such macroeconomic models differ from the econometric study of this paper. 15 This increased income inequality (Harada, 2012). Review of Economic Analysis 14 (2022) 419-440 426 www.RofEA.org In a recent study, Nersisyan and Wray (2021) noted that while Japan has the highest public debt-to-GDP ratio in the world, the country has not been negatively affected because of its low interest rate. Furthermore, the two authors emphasized that the main reason Japan did not quickly recover from the stagnation is because its fiscal policy was not sufficiently effective during times of recessions. Thus, Japanese fiscal policy was characterized by stop-and-go steps reversing course from expansionary to contractionary prior to recoveries Fukao (2013) observed that the Japanese capital-to-GDP ratio has been increasing since the mid-1970s. Therefore, he concluded that the rise in the capital-to-GDP ratio contributed to the decline of the marginal product of capital and subsequently to a decrease in the rate of return to capital. In addition, Fukao observed not only that the accumulation of information technology was low in comparison to capital accumulation, but it was lower for Small and Medium sized Enterprises (SMEs). Although large firms had started moving production facilities abroad to avoid the yen appreciation problem and the US tariffs, low accumulation of technology had a negative impact on the SMEs efficiency. Such a phenomenon resulted in a reduction in the productivity of the SMEs, which constitute a large share of the Japanese economy and thus played a role to the stagnation-deflation problem. 16 Jiang et al. (2020) and Fokuda and Doita (2016) address the question of why the new QE policy launched by the BOJ in April 2013, which led to yen depreciation, did not trigger a significant increase in Japanese real exports and therefore to GDP. Two main reasons contributed to the slow increase in Japanese exports after the launch of the QE policy. The first pertains to the slowdown of the global economy that resulted in reduction in the external demand for Japanese exports. The second reason is the appreciation of the yen during the global financial crisis starting in 2008. Since then, Japanese corporations began moving production abroad, thus an outward bound Foreign Direct Investment (FDI) increased substantially at the expense of exports. 17 Unlike the liquidity trap explanation for the prolonged stagnation, Yoshino and TaghizadehHesary (2015) attributed the Japanese lost decades to chronic structural problems of the economy, particularly to the aging population and the unwillingness to invest in SMEs startups due to Basel international banking regulations. Such rigidities resulted in a vertical IS curve, indicating that investment is totally insensitive to interest rate changes. Therefore, a zero bound interest rate had no effect on investment and GDP. Subsequently, the authors concluded that only major structural corrections could help Japan out of the prolonged stagnation-deflation 16 German policy for SMEs is exactly the opposite to the Japanese, Germany subsidizes SMEs for many years, as they constitute the backbone of the German economy. Germany, like Japan, benefits much from its foreign sector. 17 Fokuda and Doita (2016) constructed a model that includes firms that can produce in the tradable sector in the home country or transfer production abroad. ZESTOS, JIANG, SIMONS Macroeconomic Relations in Japan 433 www.RofEA.org Table 2 Estimated Conditional Unrestricted ARDL Model Model ARDL (5,5,3,0) Sample: 1980-2016 Dependent Variable lnY Independent Variables lnM, lnER, lnPD C 7.8137*** lnYt-1 0.3129** lnYt-2 -0.0751 lnYt-3 0.1517 lnYt-4 -0.2116* lnYt-5 0.4015*** lnM t 0.2679*** lnM t-1 lnM t-2 lnM t-3 lnM t-4 lnM t-5 -0.0513 0.0645 -0.0122 0.0143 -0.0768** LnER lnER t-1 lnER t-2 lnER t-3 0.0105 -0.0119 0.0304 0.0389** lnPD -0.0867*** Break0809 -0.0199*** D.W. 2.1033 *, **, *** represent the significance levels of .10, .05, .01 respectively. Table 3 - Breusch-Godfrey Serial Correlation LM Test - χ2 Test Lags P-values 1 0.5762 2 0.2247 3 0.3687 4 0.4165 5 0.2894 Review of Economic Analysis 14 (2022) 419-440 434 www.RofEA.org Table 4. Critical Values for Bounds Test Estimated Statistics Model F-Statistic DF k=3 31.83 32 Significance Level I(0) Bound I(1) Bound 10% 2.676 3.586 5% 3.272 4.306 1% 4.614 5.966 Note: k denotes the number of independent variables in the model. According to the estimated cointegration equation, the real Japanese GDP is positively related to the real imports. This is a plausible result: an increase of real Japanese imports contributes to an increase in Japanese real exports and thus increasing GDP. This happens because imports consisted mainly of high technology capital goods. It can be predicted that when M increases by a certain percentage, Y will increase by about half of that percentage. 26 This is the case because the elasticity of Y with respect to imports, EY.M, is 0.49. Table 5. Estimated Long Run ECM of the ARDL Model Dependent Variable lnYt Independent Variables ΔlnMt, ΔlnERt, ΔlnPDt ΔlnYt-1 -0.2664*** ΔlnYt-2 -0.3415*** ΔlnYt-3 0.1898** ΔlnYt-4 -0.4015*** ΔlnMt 0.2679*** ΔlnMt-1 0.0102 ΔlnMt-2 0.0747*** ΔlnMt-3 0.0624** ΔlnMt-4 0.0767*** ΔlnER 0.0105 ΔlnERt-1 -0.0693*** ΔlnERt-2 -0.0389*** Break0809 -0.0199*** ECt-1 -0.4207*** 26 Such an inference can be made because all the variables in this equation are expressed in terms of their natural logarithms. Therefore, the coefficients are the elasticities of Y in reference to the respective variables. ZESTOS, JIANG, SIMONS Macroeconomic Relations in Japan 435 www.RofEA.org 5.3 Granger Causality Tests within the framework of two estimated econometric models Evidence of cointegration from the Bounds Test led us investigate Granger Causality from the three right-hand side variables to lnYt. Toda and Yamamoto (1995) complement the ARDL model by showing that in a set of time series variables of differing integrating order, the standard asymptotic theory is valid if the order of integration does not exceed the length of the VAR model which is 2 in our case. Within the framework of the estimated VAR model, which is reported in Table 2A in the Appendix, we performed Granger causality tests. Prior to performing the Granger Causality tests, the estimated VAR model was tested for dynamic stability and for serial correlation. There is no evidence of serial correlation at 95% confidence level; the results of the Maximum Likelihood test for serial correlation are reported in Table 3A in the Appendix. The inverse roots of the AR characteristic polynomials remain within the unit circle, so the model is characterized by dynamic stability. Results of the Inverse Roots of the Polynomial are reported in Figure 2A also in the Appendix. Table 6 Granger Causality tests within the estimated VAR model Equation Excluded Variables 2 df P-values lnYt lnMt 5.0504 2 0.0800 lnERt 0.9178 2 0.6320 lnPDt 14.8177 2 0.0006 All 25.1975 6 0.0003 lnMt lnYt 1.1637 2 0.5588 lnERt 5.7849 2 0.0554 lnPDt 13.8579 2 0.0010 All 24.8536 6 0.0004 lnERt lnYt 24.5039 2 0.0000 lnMt 21.0530 2 0.0000 lnPDt 0.5813 2 0.7478 All 39.2529 6 0.0000 lnPDt lnYt 4.5623 2 0.1022 lnMt 3.7244 2 0.1553 lnERt 1.4864 2 0.4756 All 23.5951 6 0.0006 Review of Economic Analysis 14 (2022) 419-440 436 www.RofEA.org In Table 6 above, we report the results of the Granger Causality test. A test for each of the four endogenous variables of the VAR model was performed by employing the EViews block exogeneity test. Such tests allowed the investigation of whether the three right-hand side variables in each equation of the VAR model jointly Granger cause the left-hand side variable. These tests employed the χ2 distribution. In addition, a t-test was also performed for each righthand side variable to examine whether each of the three right-hand side variables separately Granger caused the left-hand side variable. Consequently, the Granger causality results are reported for each of the four left-hand side variables. Four different joint tests were performed, one for each of the left-hand side variables lnY, lnM, lnER and lnPD, these variables appear in the first column of Table 6. In the second column the three right-hand side variables appear for everyone of the four tests. EViews automatically performs a Granger Causality t-test for each individual right-hand side variable. The significance of each test is denoted by the p-value reported in the last column. According to the first panel of Table 6, the three right-hand side variables, lnMt, lnERt and lnPDt, jointly Granger cause lnYt at any conceivable level of significance, as the p-value is near zero. Regarding the individual t-tests, lnMt and lnPDt are statistically significant according to the reported p-values and therefore Granger cause lnYt individually. Interestingly, the exchange rate, although not individually Granger causing lnYt, affects lnYt indirectly via its influence on the lnMt. Such indirect Granger causality is evident from the second panel in Table 6 wherein the dependent variable is lnMt. The three independent variables lnYt, lnERt and lnPDt, jointly Granger cause lnMt according to the χ2 test. As for the individual t-statistic, lnERt and lnPDt, each Granger causes lnMt . Perhaps surprisingly, InYt does not cause lnMt. The empirical results strongly indicate that the Japanese GDP is affected by the foreign sector and public debt. The high Public debt played a crucial role in prolonging the recession but has not wreaked havoc on the economy. The remaining variables, lnERt and lnPDt, are each jointly Granger-caused by the excluded three right-hand side variables. This implies that there is evidence of strong Granger causality among all the variables in the VAR model. It is evident from the empirical results of this study that imports turned out to be the most important variable Granger causing lnY. Such evidence is supported also by comparing the time plot of imports and exports in Figure 2 below. It can be seen from Figure 2 that Japan generated both trade deficits and surpluses during the 1980-2016 period. Nevertheless, the deficit years exceeded the surplus years. For a large interval of about twenty consecutive years, Japan generated only deficits. However, this cannot be characterized as a weakness; on the contrary, it should be considered a strength, as large shares of Japanese imports were capital goods and raw materials (including oil) that strengthened its ability to increase the quantity of high-quality exports (Thorbecke, 2015). It is interesting to note that Japan for many years became also an exporter of high-tech intensive capital goods to several Asian countries completing a trade cycle in the global economy. ZESTOS, JIANG, SIMONS Macroeconomic Relations in Japan 437 www.RofEA.org Fig. 2. Real Japanese Imports and Exports 6. Concluding Comments The study investigates Granger causal relations of Japanese real GDP vis-à-vis three macroeconomic variables: real imports, real exchange rate, and public debt. According to the empirical results, these variables are found to jointly Granger cause real Japanese GDP. This is an important empirical result. Although Japan was forced to open its economy to the world some 160 years ago, it presently enjoys the status of one of the most developed countries. Public debt also affected real Japanese GDP but has not wreaked havoc on the Japanese economy. Although Japan’s mounting public debt did not abruptly destabilize the economy, it is highly likely to have played a negative role to its chronic stagnation-deflation problem. Abenomics policies, launched in 2013, kept the default risk premium for the Japanese public debt exceptionally low. Nonetheless, Abenomics seems to be working despite the recent adverse domestic and international developments and the recent resignation of Prime Minister Shinzō Abe. Low and even negative interest rates along with fiscal consolidation and structural reforms are making public debt financing possible. Japan is the largest creditor country in the world and accumulated the largest international investment position. It has also evolved to be the second largest country in terms of holdings of foreign currency reserves, next only to China. As a result, Japan can keep distancing itself from financial crises and from credit events while leveling off and even reducing its public debt to GDP ratio. 0 200 400 600 800 1 000 1 200 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Imports, Exports Year Exports Imports Source: Import Export data comes from the World Bank, Billions of 2010 USD Review of Economic Analysis 14 (2022) 419-440 438 www.RofEA.org Sources of Data: Real Japanese Gross Domestic Product (Y) and Real imports (M) are measured in real 2010 Japanese currency units. The real exchange rate (ER) is expressed as the numbers of yen per US dollar, adjusted by the price levels of the two countries. The data for the three variables comes from the World Bank. The last variable, public debt (PD), is measured as the public debt to GDP ratio: PD = Public Debt/Y. Data for PD come from the Economic Database (FRED) of the Saint Louis Federal Reserve Bank. References Akram, T. 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