Hotel Okura Executive Luncheon Meeting
The Japanese Economy: Problems, Solutions and Realities by Richard Jerram
Dr. Richard Jerram is Chief Economist at ING Baring Securities (Japan) Ltd.
The following is excerpted from a speech Dr. Jerram gave at the Hotel Okura Executive Luncheon Meeting on March 23, 2001.
The tendency to refer to the 1990s as a "lost decade" is a source of great complacency. Such a phrase implies it is possible to go back and try again. However, the destruction of the health of public finances, with a doubling of public sector indebtedness that has given Japan the highest debt in the OECD, means that it is worse than a "lost decade." Future generations will pay for the errors of the bubble and the procrastination of the 1990s.
The past decade should have taught us to be wary about predictions of radical policy shifts in Japan. It should also have shown that the health of the world economy, let alone regional security, is not dependent on growth in Japan. The "lost decade" has coincided neatly with the longest U.S. post-war expansion, and Asia appears to be benefiting from the breakdown of the preferential keiretsu system as this has led to an increase in import penetration.
Another issue is whether Japan's experience in the 1990s shows what the United States has in store. Admittedly it does show that when a bubble bursts you need an aggressive policy response to try to prevent and/or resolve a crisis, because it is not unusual for bubbles to cause financial system distress. But this is hardly a revelation. A more competent policy response is a key reason why the United States is unlikely to repeat the Japanese experience.
Identifying the suitable solution depends on the correct diagnosis of the problems. These can be split into three broad categories: structural, cyclical, and bubble-related. The structural problems are legion and well-documented, including over-regulation, a lack of competition, misallocation of resources, an inefficient tax system, and inflexible labor markets. A more sophisticated structural argument is that demographic problems produce an excessive intention to save, and the result is weak demand.
An alternative view of the past decade is that the main problems have been cyclical, based on inadequate or ineffective attempts to stimulate growth. The BOJ did not cut interest rates, for example, until July 1991--some 18 months after the bubble had burst. Moreover, even with zero interest rates, monetary policy is still too tight. Similarly, there is huge misunderstanding of the amount of fiscal stimulus that has been delivered--last year the country spent less on public investment than at any time since 1992.
The third view of Japan's problems is that they are a legacy from the late 1980s bubble. As asset prices collapsed, this put huge strains on the balance sheets of the corporate sector in general, and on those of banks in particular. As a result, investment is damaged, forbearance means too many weak companies survive and debt deflation continues to erode real estate prices.
One combined effect of the three problems is deflation, which in turn exacerbates the problems. Another is increased pessimism over the long-term growth prospects, which is similar to a negative wealth effect.
As the past decade shows, postponement of solutions is possible. Avoidance, however, is not. Although structural problems need addressing, the immediate problems are mainly cyclical and bubble related. It follows that the solution is financial system reform, accompanied by fiscal and monetary stimulus to cushion the blow.
The first step is to clean up the mess left by the bubble. This means ending regulatory forbearance and closing or merging failing financial institutions. Reducing the excess capacity that results in too much competition and stifles profitability is necessary for reform, as is providing proper incentives that will encourage management to focus on returns rather than survival.
An equally important and difficult part of financial system reform is the disposal of bad debts by the banks. The loans need to be removed from balance sheets, through securitization and sale, bankruptcy of the borrower, or debt forgiveness. In many cases the latter route is the least attractive because of the inability to control the accompanying restructuring. Similarly, the government needs to dispose of assets it inherits from failed institutions.
Financial markets are currently focused on the bad debt resolution plan being promoted by Hakuo Yanagisawa, minister for financial services. While the plan is promising, it does not add up in three areas. First, the banks are insufficiently capitalized to write off their problem loans in full. Second, banks are reluctant to dispose of bad debts, which limits corporate restructuring. Third, more stimulus than just going to zero interest rates would be needed to offset the deflationary effects. The first two problems can be resolved by a more aggressive regulatory stance, which leaves the problem that the plan would cause a recession.
To prevent recession, a determined monetary and fiscal stimulus would be needed. Even with rates at zero, there is room for monetary stimulus. Quantitative easing probably has little effect, but deliberate yen depreciation, a backdated price level target, and a money-funded tax cut look particularly attractive. Foreign reaction will limit the extent of yen decline, but 150yen/US$ looks like a good place to start. An income tax cut funded by printing banknotes is particularly effective, because the public does not need to anticipate an offsetting tax increase at a later date, as banknotes are like perpetual maturity, zero coupon bonds. In any case tax cuts are needed and if there is aggressive corporate restructuring, then cutting the consumption tax to zero, with the promise of an annual 1% rise for the next decade is a possibility. This should be accompanied by proper tax and spending reform.
The availability of viable policy options is an immense source of encouragement, only deflated by the failures of the past decade. Rather than just assuming that sensible people will do sensible things, it is useful to consider the three main barriers to policy-making.
Entrenched vested interests are a key obstacle in Japan's producer-oriented system. The concentrated power of relatively small lobbies, most evident in the construction and agricultural sectors, has been a barrier to progress. More generally, collaboration between politicians, bureaucracy, and the corporate sector acts to sustain the status quo.
A second barrier is the lack of accountability for errors of the past, and a reluctance to take responsibility for the solution. Many of the people who are responsible for shaping Japan's current economic situation are still in positions of authority, both in government and in the banks themselves. Very few have gone to jail, even though bubbles and fraud come hand in hand.
The third barrier is that life is still too comfortable; people are not yet convinced that the pain of doing nothing is greater than pain of change. This is because the two most direct effects of the bubble are declining household wealth through falling real estate prices and higher future taxes and/or reduced public services. Neither effect is particularly high profile, which is why the public is not rioting in the streets.
Cleaning up the financial system mess is going to be very unpleasant for many people, at least in the short-term. Because it is unavoidable in the end, and sensible to do it as soon as possible, a determined government should be trying to remove these barriers.
Unfortunately, to abuse H.L. Mencken's dictum, "nobody ever lost money underestimating the resolve of Japanese politicians." Another half-hearted set of measures that averts crisis without representing a genuine solution remains the highest probability. One day we will all be surprised, but at the moment the market is awarding points for progress, not for promises.