Japan's Economic Problems: Diagnosis and Prescriptions

Takahiro MIYAO (Professor, GLOCOM)

Presented at the OECD Forum 2002 session titled "The Japanese Economy: The Way Forward" on May 13, 2002

These days we often see a long list of problems about the Japanese economy, but it is important to distinguish among (1) short-term problems such as economic recession and business slump, (2) medium-term problems such as asset deflation, non-performing loans and public debt, and (3) long-term problems such as loss of competitiveness and vitality.

It takes about 2-3 years for a short-term problem to develop, change and hopefully be cured, and these short-term problems often involve "flow" variables such as GDP, exports and profits. On the other hand, the time span of medium-term problems is 5-10 years, mainly concerning "stock" variables such as real estate and financial assets. Long-term problems have a time span of 15-20 years, involving "institutional" variables such as governance and market structure.

Correct Diagnosis of Japan's Illness

Japan's "illness" can be diagnosed as follows: Short-term problems are now being taken care of, essentially by the U.S. recovery, which should lead to Japan's export-led recovery in the near future. However, medium-term problems are quite serious with no sign of easing, as stock prices are stagnant and land prices continue to fall. Long-term problems are not being solved either, due to slow and belated institutional reforms.

Here the question is: What is the most serious problem of all? In my opinion, the answer is "medium-term asset deflation." The seriousness of asset deflation in Japan can easily be seen by the fact that the total value of land has declined from about $13 trillion in 1991 to about $5 trillion now, whereas total stock value has decreased from about $3 trillion in 1990 to less than $1 trillion. This means that a total of $10 trillion has vanished in the asset markets over the last ten years, and that is more than twice as much as Japan's GDP.

Needless to say, asset deflation of this magnitude has serious implications, as it has caused balance-sheet problems for corporations, banks and homeowners with mortgage loans. In the short term, consumption and investment tend to be stagnant, because consumers and corporations are anxious to repay their debts to their banks to avoid possible bankruptcies, and not much money can be spent on consumption or investment. Long-term implications are equally serious. Due to asset deflation and the resultant balance-sheet problem, individuals as well as organizations such as corporations and financial institutions can no longer take risks and are losing vitality as a result. Even worse, individuals as well as institutions tend to show strong resistance to reforms, as they cannot afford to lose in new competition that would be intensified by such reforms.

Effective Policy Prescriptions

The Japanese government has adopted a series of policy measures in an attempt to deal with the problems explained above. However, most of those measures have proved to be wrong, counterproductive or ineffective at best. In particular, short-term stimulus policies such as public spending have been wrong measures in the sense that those "flow" measures have failed to stimulate the real economy, while aggravating the government's budget deficit. The direct disposition of non-performing loans, which are widely believed to be the most effective measure, has turned out to be counterproductive, because such a measure tends to increase the number of bankruptcies and unemployment, worsening a deflationary spiral and creating new non-performing loans. Long-term structural reform measures have so far been ineffective in turning the economy around, as frustration has been building and the popularity of the reformist government has been declining over time.

Then what is the effective measure? We must attack the cause, not the effect. That means that we need to solve the medium-term key problem by adopting anti-asset deflation measures. The purpose is to stimulate the real estate and stock markets, because their stagnation has been identified as the main cause of Japan's economic problems.

Here are key measures, targeting the real estate and stock markets. First, real estate and securities taxes should be reduced to stimulate the asset markets and the economy as a whole. Second, the American-style home mortgage interest income deduction system should be introduced in order to slow down the pace of repayment of home mortgages and increase consumption by homeowners. Third, the Bank of Japan ought to adopt asset inflation targeting monetary policy by setting a goal of mild increases in real estate and stock prices.

It will take about a year or two to adopt and implement effective anti-asset deflation measures, which should initiate the recovery of real estate and stock prices. Then it will take another couple of years until the economy is fully recovered. In other words, the medium-term problem should be solved within the next 4-5 years, and then all our resources can be devoted to the solution of longer-term problems. This is the only way for us to avoid another "lost decade" for the Japanese economy.