China Surpasses Japan As No. 2 Economy China has outpaced Japan as an economic powerhouse, climbing to $5 trillion and the No. 2 spot on the list of world economies. It is second only to the United States. But while China's growth has been phenomenal, its new position as the world's second largest economy comes partly thanks to Japan's sluggishness. Japan's economy grew at an annualized rate of less than half a percent growth in the second quarter. Robert Siegel talks about that second half of the story with Adam Posen, senior fellow at the Peterson Institute for International Economics and author of the book Restoring Japan's Economic Growth.

China Surpasses Japan As No. 2 Economy

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The news that China's economy is now the world's second largest is a reminder of that country's phenomenal growth based on exports and the historic migration of millions of Chinese from the countryside to the cities. But it's also a reminder of another less impressive economic phenomenon. China's $5 trillion economy moved into second place behind our nearly $15 trillion economy because Japanese economic growth was especially slow in the second quarter and Japan dropped into third.

It's the Japanese economy we're going to hear about now from economist Adam Posen, who is senior fellow at the Peterson Institute for International Economics and author of "Restoring Japan's Economic Growth."

Hello, Adam.

Dr. ADAM POSEN (Senior Fellow, Peterson Institute for International Economics): Hello, Robert.

SIEGEL: First, we hear the occasional warning that the worst kind of recession we could imagine here would be something akin to what's happened in Japan. How bad are things in Japan?

Dr. POSEN: They're not quite as bad as people make them out to be. It's more "Friday the 13th Part IV," than "Friday the 13th Part I," but it's pretty darn bad. You've got a country that has everything going for it in terms of technology, property rights, stable government, and they still are unable to grow at a very strong rate.

The thing that people overlook is that they are still growing even though they are an aging society, and even though they have had this ongoing recession. So it's not like the Great Depression of the '30s, but it's still pretty scary when you think about a modern democratic economy with real markets breaking down that way.

SIEGEL: In the early 1990s, there were bestsellers about how the Japanese were cleaning our clocks. Some of those books were admiring, many were critical and claimed they were doing it unfairly. But there was a common assumption that Japan was on the rise. In a nutshell, what happened to that Japan of, say, the 1980s?

Dr. POSEN: Two things happened. One is it's always easier to play catch-up among countries than to be at the cutting edge. So all the way up until the mid-'80s, Japan was still doing what in a sense China is doing today, taking people out of its backward sectors, extending the market share of the economy, learning how to make the cutting-edge technologies, working its way up the ladder. And once Japan got to the mid-'80s, it was out the frontier like the U.S. or Germany or Britain, and it couldn't have the fast, fast growth the way it once did.

The second thing that happened, and this is what I've argued in my book, but now most people seem to agree, is that the Japanese officials during the early '90s, mid-'90s, were taking exactly the wrong course of policies. They were tightening policy on tax policy. They were tightening policies on monetary policy. They let the banking problems fester. They essentially accepted the decline of Japan as sort of inevitable, and that became self-fulfilling.

SIEGEL: Well, if I were a middle-class Japanese, say, schoolteacher, how different would my life be today because of the economic problems in Japan than they might have been to a similar schoolteacher 20 years ago?

Dr. POSEN: It's a really good way to put it. I think there are a couple of things that would have happened. The first is you would feel much more insecure, because it turns out that instead of getting five or 6 percent on your savings, you're getting 0.5 or 0.6 percent on your savings. So that begins to make you a little worried.

You also have a lot of fluctuations in what the government is doing. You're a schoolteacher, you want to see schools built; some years they build all kinds of schools in places that you've never even heard of in Japan, other years they cut funding, a lot of volatility in your work environment.

A third thing that would happen - and this is not just for the schoolteacher, but for all kinds of middle-class professionals in Japan - is you have this sense that the prospects for your economy are not very great, and this makes you very risk-averse. Think of the U.S. in the '70s. It's that kind of sensibility that permeated Japan.

SIEGEL: Is the Japanese economy, and Japanese society for that matter, enough like ours - allowing for many great differences - that we could with the right or wrong policy choices end up in the Japanese way?

Dr. POSEN: We could. My contention has always been that the sort of basic economic physics of, if you raise taxes in the middle of a recession, things get worse, turn out to apply just as much in Japan in 1997 as they did in the U.S. in 1937.

Similarly, the idea that if you've got savers who are getting one-tenth of what they used to get on their interest income, they may end up saving more or at least being much more risk averse because they don't know where the money is coming from. We're already seeing that sort of thing in the U.S. right now.

So, yes, there are parallels there that we should worry about. But as you indicated, Robert, a key difference is our policymakers did act much more aggressively, much more quickly.

SIEGEL: Adam Posen, thank you very much for talking with us.

Dr. POSEN: Thank you, Robert.

SIEGEL: Adam Posen is senior fellow at the Peterson Institute for International Economics. His book is "Restoring Japan's Economic Growth."

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