2002 Japan Conference: A Summary of the Papers

The Japanese economy is in a difficult situation to say the least. First, the growth rate has been low. The average growth rate was 1 percent for the last ten years hus nicknamed a lost decade. Second, deflation, that is, a negative inflation rate measured in the GDP deflator and CPI, has been going on for the last five years, and worsened in the last two years. Third, asset prices, including stock and land prices are one-third to one-quarter of the level of their 1989 peak; put differently, they are at the level of almost 20 years ago lost two decades. The nonperforming loans problem that has plagued the Japanese economy for the last ten years is yet to be resolved. Japanese banks, once regarded as mighty institutions dominating international financial markets, are struggling to survive, as their capital has been depleted by writing off nonperforming loans and unrealized losses from equity holdings. The government debt-GDP ratio has reached 140 percent, the worst among the Group of Seven, and government bonds are credit-rated below Botswana .

The traditional macroeconomic weapon has become either impossible or ineffective. The nominal short-term interest rate has been zero since 1999. Monetary policy, in terms of manipulating the nominal interest rate, cannot be strengthened because the nominal interest rate cannot be negative. Given that the inflation rate is negative, the real interest rate remains positive despite very weak aggregate demand. The situation is a liquidity trap that has been observed only in macroeconomic textbook since the 1930s. The traditional policy for overcoming a liquidity trap is fiscal policy eficit financing will raise aggregate demand and induce private-sector demands. However, after several attempts at such prime-pumping in the last ten years, private sector spending remains weak and the large debt is becoming a threat for the future. Fiscal sustainability is being questioned.

Three large banks failed in 1997 and 1998, and most of the major Japanese banks received capital injections in 1998 and 1999. The Japan premium, the higher interest rate charged to Japanese banks in the international financial market reflecting their weak financial positions, was quite high in 1997 and 1998 but returned to normal in April 1999. Several mergers and affiliations of the large banks were announced and carried out between 1999 and 2002. But, vulnerability reappeared in 2002, when a special examination by the supervisory agency found more nonperforming loans, and stock prices went down sharply in 2001 and 2002.

[* Japanese banks traditionally hold a large amount of equities on their balance sheet, partly because of long-term, cross-shareholding with borrowers. During the first half of the 1990s, even when declining stock prices were hovering at around half of the bubble peak, banks were sitting on a large amount of unrealized capital gains attributable to the low book value of equities, and they were counted toward tier II capital for the purpose of international capital adequacy standards. However, when the stock prices went down further to one-fourth of the bubble peak (the Nikkei 225 index below 10,000), unrealized gains of equity portfolio disappeared and became unrealized losses that had to be deducted from the capital adequacy ratio. *]

Faced with prolonged, weak economic conditions and a lack of traditional policy tools, several economists have floated untraditional policy tools, including inflation targeting, depreciation of the yen, cuts in fiscal spending, and nationalization of weak banks. Inflation targeting is proposed to raise the expected inflation rate, provided that the announcement of a positive inflation rate target is credible. When the expected inflation rate becomes positive, there is a chance that the real interest rate can become negative. The debate centers on whether the Bank of Japan has instruments to stop deflation. Proponents of inflation targeting argue that inflation or deflation is basically a monetary phenomenon, so that when a central bank provides enough monetary base to the economy, inflation has to occur. Not only long-term bonds but also other assets, such as listed stock mutual funds and real estate investment trusts, can be purchased as a part of open market operations. Critics, including the Bank of Japan, argue that the Bank policy has provided ample liquidity and monetary base, with increased purchase of long bonds, in the past two years without measurable effects. They also argue that purchasing stocks and real estate funds, providing unlimited liquidity, would put the Bank of Japan balance sheets at risk and create a situation that would result in uncontrollable inflation.

Another front for policy debate is the effectiveness and desirability of fiscal policy. Those who argue that fiscal policy is still potent have three rationales. Past fiscal policy, when measured correctly, shows strong effects. With monetary policy difficult, fiscal policy should be employed. Fiscal sustainability is not an immediate problem, since the interest rate is low, reflecting strong confidence among investors, and bondholders are mostly domestic investors, so there is no threat of refinancing uncertainty. Critics argue that fiscal spending has created wasteful infrastructures ridges and highways hat will produce more deficits in the future as their maintenance costs exceed revenues. Cutting back these public works will not be contractionary and instead will free resources to a more booming sector. It is indeed an unconventional view, though, that cutting back fiscal spending could be stimulative. The traditional textbooks argue that a balanced-budget multiplier is one: spending one million yen financed by a tax increase of one million yen would raise GDP by the same amount. However, in the current situation in Japan, this may not be the case. Reducing the size of wasteful public works combined with a tax cut that would stimulate private-sector research and development investment should be desirable for the economy, at least in the medium run.

Apart from the debate on public spending, some proposals on tax reform have been debated: some tax policy that would not raise deficits, when aggregated for several years, can be implemented to stimulate immediate aggregate demand. One proposal calls for the reduction of the consumption tax (VAT) rate now, say from 5 percent to 2 percent, followed by a step by step increase, say 1 percent every 6 months, reaching a level higher than the current rate, say 7 percent in several years. This will create an immediate spending boom followed by a spending rush every six months.

Resolution of nonperforming loans has become the major initiative of the Koizumi government. The market has become quite skeptical about whether Japanese banks could earn enough profits to write off nonperforming loans and increase capital. Weak banks may have to be recapitalized, again. Some banks also may have to be nationalized, if their true balance sheets are almost insolvent. Prompt corrective action needs to be implemented more than ever.

Without stopping deflation, the economy will remain weak and borrowers will continue to suffer from larger-than-expected real debts. New nonperforming loans will continue to climb. Banks will not lend and corporations will cut costs by not investing and by laying off workers. The pessimistic outlook makes consumers save rather than consume. Further deflation will result. In order to cut the links that form this deflationary chain, a policy package is needed. It is important that a package of several policies be implemented simultaneously so that a side effect of one policy will be cancelled by the other policies. Once and for all resolution of nonperforming loans may have a deflationary impact because some corporations may have to close down. Unconventional monetary policy, especially inflation targeting, may be introduced to stop deflation. Some tax measures that would stimulate the economy will reinforce monetary policy in stimulating demand.