Hotel Okura Executive Luncheon Meeting
U.S.-Japan Economic Relations: On the Rocky Road to Recovery
Dr. Adam S. Posen is Senior Fellow, Institute for International Economics.
The following is excerpted from a speech Dr. Posen gave at the Hotel Okura Executive Luncheon Meeting on December 10, 2001.
We are heading into the most difficult time in U.S.-Japan relations in the last ten years. There is going to be a true conflict of interests, and there is no easy solution. The best answer would be if Japan, for domestic reasons, resolved its own economic problems. This is, unfortunately, not the most realistic scenario.
The situation today
The bad loan problem is much worse than anyone expected, and is pushing a sustainability constraint in the banking sector. Banks are, quite simply, accumulating losses faster than they can make them up. At the same time, Japan has endured three or four years of deflation, and the banking system has undergone only minimal reform since the early 1999 recapitalization of the largest banks. The Bank of Japan (BOJ) can stop deflation if it wants to, but it obviously chooses not to. No one outside the BOJ can fully comprehend why. By its inaction, the BOJ is not living up to its mandate, and it is inflicting extreme misery on the Japanese economy.
The vast majority of banks in Japan have been bankrupt for a long time. But they have always had the ability to roll bad loans over, and their nominal income was relatively high, even if it did not cover their losses. In 1999, for example, Japan's banks wrote off approximately 10 to 12 trillion yen in bad loans and accumulated only about 7 or 8 trillion yen in bad loans. For 2001, however, those numbers have reversed, and the banking system is now rapidly spiraling downward.
While the practice of "evergreening" bad loans has postponed crisis, there is a problem with buying time ------- it removes the natural market brake on deflation and bad loan accumulation, causing the situation to deteriorate ever more rapidly. The bad loans are still there; the money is already lost, and interest is now being paid on losses that have never been paid off, in the form of a very inefficient financial system.
Many assert that shutting banks down will impose a new shock on the economy, but the evidence suggests that this long-standing bleeding of the credit system in Japan is already hurting the economy very much. The degree to which things could worsen, were the banks to be shut down, is smaller than people expect.
Solving the problems
If the economic problems are all so obvious and simple, why have they not been fixed? Politics. The Ministry of Finance (MOF) refuses to do anything with the budget until the Financial Services Agency (FSA) cleans up the banking system and the BOJ agrees to expansionary policy. The FSA refuses to clean up the banks until the government agrees to pay for it and the BOJ agrees to expansionary policy. The BOJ refuses to loosen policy until they get a guarantee from the government on the budget and the FSA cleans up the banks. No one wants to move first.
There is a deal that could be struck to solve this waiting game, and it has two components. First, the government, including the FSA, must admit that many banks must be closed and others recapitalized. This could be done by having the government issue a special bond to recapitalize the banks. Second, the BOJ, must buy, with printed yen, this particular bond issue. This is not the same as giving a blank check on fiscal discipline to the government because the BOJ would only be buying for the specific purpose of bank recapitalization.
Such a solution would create the needed inflation. Because the money is already gone, somebody is going to have to take the loss. It is going to be the Japanese people. Inflation, because it is a tax on savings that hits everybody, is one of the best ways to pay off the debt. Many details could be added to such a plan, and there are some in the government who have been kind enough to give me a hearing on this. At this point, however, for political reasons, it is not happening.
Where we're headed
Despite the fact that the Bush administration is bending over backwards to say nice things about the Koizumi administration, there is an overwhelming feeling in Washington and in capitals around the world that Japan had an opportunity to reform the banking system and wasted it.
Amid this frustration, however, the Bush administration has been saying for many months that there is a deal on the table. If Japan cleans up its banking system, and, as a side effect of that, the yen goes down, the U.S. will do everything it can to defend Japan from protectionism. The problem with this deal is that it relies on two things that cannot be controlled: exchange markets and the U.S. Congress.
In the U.S., even with a moderate recovery, unemployment is a lagging variable. Unemployment will continue to rise well into 2002, and politicians who favor protectionist policies are likely to accuse Japan of trying to export its way out of recession again. The worst part is that such a scheme would not even work, because Japan remains a relatively closed economy, no more than 15 percent of which can be attributed to imports and exports.
Looking at the broader picture, the political problems extend well beyond U.S.-Japan relations. With the exchange rate going down, the time would be ripe for China to seek favor with the WTO and its Asian neighbors by making Japan out to be the regional villain. China could point out that they maintained their peg while Japan, which devalued its currency and got away without having to reform its banking sector during the Asian financial crisis, is once again devaluing.
The scariest aspects of this scenario are that it can happen very quickly, and it can undercut most of the multilateral economic agenda.
How likely is such a gloomy scenario? If I had to put a number on it, I would say one in three. There is a question of how skillfully opportunistic the Chinese will be. I tend to believe they are both skillful and opportunistic. If China does not take advantage of the situation, however, then there will be more elbowroom for Japan. Also, there are increasing signs that smart money is moving out of Japan. The banks are increasingly selling off their good loans because they know they cannot liquidate their bad loans.
Is there anything the U.S. can do about the situation? The Bush administration clearly understands that it is in America's long-term interest to accept a weaker yen if that is what it takes to get Japan reformed. The question is tactics ------- what provides leverage over Japan? The administration is slowly coming to the realization that no matter how many nice things they say about Koizumi, the most important contribution Japan makes to foreign policy is to be a functioning economy, and as little good as they think pressuring Japan has done in the past, doing nothing gets you even less.
I expect the Bush administration to make a turnaround; they will figure out some way of putting real leverage on Japan. The best example of this, so far, has been the IMF decision to do a financial stability assessment. The IMF team is due to come to Japan in January, and if the Bush administration plays it right, that can be the wedge that forces the issue. It will be ahead of the year-end accounting, and will probably be ahead of the foreign currency markets.
While it remains to be seen whether the Bush administration will take advantage of this situation, one thing is clear: there really is a potential crisis this time. It is for real. It will matter. And, therefore, both the U.S. and Japanese governments should take action.