Inflation Targeting Needed to Overcome Low Growth and Pain

Kikuo IWATA (Professor, Gakushuin University)

Evaluation of the Financial Revival Program

The financial revival program ("comprehensive measures to accelerate reforms") that the government announced recently may be appreciated as one to avoid a "hard-landing scenario" for the time being. However, it is bound to facilitate banks' credit squeeze and credit withdrawal, as it has been reported that Mizuho Corporation has decided to dispose directly of non-performing loans for approximately 150 troubled companies within next fiscal year for its own survival. Given the tightening assessment of non-performing loans and the proposed restriction on the inclusion of deferred tax assets in calculating capital adequacy ratios, banks have no choice but to reduce their credit substantially in order to increase capital adequacy ratios while avoiding managerial intervention or nationalization by the government.

If a hard-landing scenario is pursued (however slowed down this time), the number of unemployed is expected to exceed one million. Pain will be felt not only in terms of unemployment but also in terms of substantially reduced income. Even worse, the real fear of deflationary recession is just around the corner, where companies themselves as well as bank deposits, pensions and life insurance will all be in jeopardy. The so-called "safety net" would be useless in such a situation.

In Favor of 1-3% Inflation Targeting

We should stay away from the currently proposed government-led financial and industrial revitalization policy, which would worsen moral hazards and increase tax payer burden. Rather, the government and the Bank of Japan should manage the economy according to the basic principle that they provide a stable macroeconomic environment and enhance the disciplinary function of the market for financial and industrial revitalization. If economic policy is conducted this way, the Japanese economy will revive without having to endure "low growth" or suffer serious "pain."

As for macroeconomic stabilization policy, the Bank of Japan should set a target for inflation around 1-3 percent, and engage in open market operations to purchase long-term government bonds without setting an upper limit in such a way that the inflation rate will become 1% within one year and 3% in two years. Open market operations to purchase dollar-denominated foreign government bonds might also be adopted. Then deflation and asset price declines will stop and bad loans will decrease, while banks' capital adequacy ratios will increase, leading to the stabilization of the financial system without lowering growth or feeling pain.

Until such monetary policy actually takes effect, government spending should not be cut, but rather be increased in such areas as public investment in circumferential roads in the Tokyo region and other designated roads under urban planning, where private-sector investment will be induced significantly.

Voluntary Solution of Banking Problems

The government should resolve the payoff problem once and for all by creating payment (settlement) deposit accounts, where funds could only be invested in government bonds and short-term government securities while helping non-payment depositors strengthen their ability to assess and select banks themselves.

Assuming that mild inflation is realized within a year, the government might tighten assessment of assets and allow banks to incorporate differed tax assets in calculating their capital adequacy ratios by making allowances for loan losses tax exempt and refunding their tax assets to banks.

If these measures are taken under mild inflation and the market functions of supervision and selection are enhanced with proper information disclosure, then the direct disposition of non-performing loans would be accelerated by banks themselves voluntarily, while their capital adequacy ratios could be increased by new issuance of stocks. Furthermore, industrial revitalization might well be facilitated by private-sector funds for corporate revival.

(The original Japanese article appeared in the November 19, 2002 issue of "Economist" published by Mainichi Shinbun Co.)