Japan Needs Stimulative Fiscal Policy
Richard Koo (Chief Economist, Nomura Research Institute)
Contrary to popular belief, the root cause of Japanese economic weakness during the last decade has much more to do with balance sheet problems at the corporate level than with the lack of structural reform within the overall economy. In Japan, asset prices began to collapse from the first business day of the 1990s with the bursting of the "bubble". So far, 1,200 trillion yen in wealth has been lost. This figure is almost three times as large as Japan's gross domestic product in 1989, the peak of bubble, and as a proportion of GDP is twice the loss experienced in the United States during the Great Depression of the 1930s.
Faced with this asset price collapse, Japanese companies, which used to borrow and invest equivalent of 10% of GDP back in 1990, not only stopped borrowing money to invest, are now paying back debt to the tune of 20 trillion yen a year or 4% of GDP in order to repair their balance sheets. This means a loss of 14 percent of GDP from the income stream compared to ten years ago.
While the corporate sector is doing the right and responsible thing by trying to repair their balance sheets, the household sector is still saving as before. With the corporate sector no longer borrowing, this means the entire household savings is turning into the deflationary gap. In this sense, Japan is facing the "fallacy of composition," a situation in which the overall result proves wrong even if everyone does the right thing.
Historically speaking, an economy that has fallen into this plight has invariably plunged into a great depression, the recovery from which has taken massive amounts of time and fiscal expenditure. Since the government cannot tell corporations NOT to repair their balance sheets, the only way to avoid such a depression is for the government to create demand by adopting stimulative fiscal policy to fill the above deflationary gap.
Japan managed to stay away from depression by preventing a flood of 1,200 trillion yen with an embankment (=fiscal stimulus) of 140 trillion yen. The same 140 trillion yen also allowed the Japanese businesses to sharply lower both their debt levels and their break-even point during the same period. By any measure, this is a major achievement.
Nevertheless, as the decline in asset prices has been so large, it will take a little more time in that direction before businessmen will stop worrying about their balance sheets. And the bond market has been supporting the fiscal stimulus all along by giving the Japanese government bond the lowest yield in the history of mankind.
However, the Koizumi government which do not understand any of this has given its priority to structural reform and the disposition of bad loans while putting brakes on fiscal spending. These are the same policies President Hoover pursued 70 years ago which plunged US deeper and deeper into depression. The so-called "30 trillion yen cap" on the issuance of government bonds, for example, has completely immobilized the fiscal policy, which is the only tool which could lead to the true recovery of the Japanese economy.
The other tool, the monetary policy does not work in a balance sheet recession because corporations are no longer maximizing profits, they are minimizing debt. That was the case in the US during the 30s, that that is the case in Japan today. Furthermore, the shift in corporate behavior mentioned at the outset started when Japan still had inflation, not deflation, and is continuing even with zero interest rates, suggesting that companies are not responding to monetary signals at all.
If the excess of household savings over corporate borrowing happens to be less than 30 trillion yen, then there should be no problem. Actually, however, it is more than that amount. As a result, bankruptcies have increased and bad loans have mushroomed, 47 percent up from last year. If the government continues to emphasize the fiscal reform and disposition of bad loans in the midst of balance sheet recession, the economy would further deteriorate and the amount of bad loans, together with the budget deficit, might well increase rather than decrease.
In fact the insufficient fiscal stimulus has already led to the budget deficit of over 30 trillion yen due to the decline in tax revenue. Even though Reformists insisted that abolition of the 30 trillion yen cap would have led to downgrading of Japan's government bonds, two-notch downgrading happened earlier this year, although the cap was maintained. That is because the main reason for such downgrading is the deterioration of the economy itself.
The policies of Prime Minister Koizumi and Economics Minister Takenaka are perfectly reasonable, even noble, in an ordinary recession. But in a balance sheet recession, they are devastating. Even though there are signs that Mr. Koizumi is beginning to make a U-turn on his policies, he better complete his turn fast before the economy falls deeper into recession.
Richard Koo, "Nihon kai ga hajimaru," Voice, August, 2002