More on Asset Deflation in Japan

Takahiro MIYAO (Professor, GLOCOM)

This commentary is based on the author's original article which appeared in the "Japan-U.S. Discussion Fourm" (http://lists.nbr.org/japanforum) on May 8, 2003: posted here with the author's permission.

In response to various comments on my argument about asset deflation in Japan, I would like to answer the following three questions.

1) What caused the collapse of asset values?

In my view, misguided policies in the early 1990s lead to the complete collapse of asset values in Japan. I don't deny the existence of a "bubble" in the stock and land markets in Japan in the late 1980s, but the adjustment of the bubble in the market could only partially explain such a big drop in asset values in the early 1990s. Mostly the "big push" downward by the Bank of Japan and the Ministry of Finance, which both targeted and attacked the stock and land markets deliberately in a very unconventional way such as credit controls for real estate. In contrast, the stock and real estate markets have not collapsed, but mildly been adjusted after the bursting of the IT bubble, mainly because U.S. policy makers are wise enough to learn from Japan's policy mistakes.

2) Are asset markets driven by crowd psychology? If so, overshooting or undershooting in the market would be a short-term phenomenon, but is hardly sustainable for a decade.

Let me try to offer a better explanation than crowd psychology for a strong propensity to overshoot ("bull") as well as to undershoot ("bear") in asset markets. Normally, one tends to think that there might be a "normal" rate of return for an asset and the normal value of the asset should be obtained by rationally discounting the future stream of "normal" rates of return. Then, a natural conclusion may be that any deviation of such normal asset values would be a "bubble." As an economist who has studied asset markets for more than 3 decades, I must say that such an argument is false. In fact, there exist multiple equilibria in an asset market, typically two equilibria, say a bull market equilibrium and a bear market equilibrium, each of which has its asset value and the corresponding rate of return. This is because a high asset price tends to stimulate the economy and push up the rate of return to justify the high asset value as a result, just like the U.S. economy in the late 1990s, whereas a low asset price tends to depress the rate of turn, again, to justify the low asset value in the market. Then the most plausible interpretation of what happened in the early 1990s in Japan was that the policy makers gave a tremendous blow to the asset markets so that the markets were forced to move from the "bull market" equilibrium to the "bear market" equilibrium. Once the economy is trapped in the "bear market" equilibrium, it is quite difficult to get out of the vicious circle, just as a less developed economy is trapped in the Nurkuse-type vicious circle of underdevelopment. You need a "big push" to move back from the bear market to the bull market, and that is why I am proposing a rather unconventional set of policies to boost asset markets. By the way, asset reflation policy (or asset inflation targeting policy) is less radical and less unconventional than general reflation policy (or general inflation targeting policy), since the former only targets asset prices, and not all prices as in the case of the latter policy.

3) Is it the case that Japan's economic woes can only be cured by painful restructuring and reform and not by asset reflation policies?

I would like to point out that asset reflation policies are perfectly consistent with restructuring and reform, and in fact are likely to facilitate desirable reforms. Whether the economy is good or bad (whether asset markets are high or low) superior companies (or individuals) will beat inferior companies (or individuals) anyway in the market, but reform policies can facilitate the market outcome. Asset reflation policy itself would not particularly favor inferior companies (or individuals), and might well favor superior companies as has happend in the U.S. economy. In this connection, let me quote from Richard Koo's article "Preemptive Strike to Deal with Balance-Sheet Recession" (Dec. 25, 2002, GLOCOM Platform)

http://www.glocom.org/opinions/essays/200212_koo_preemptive/
Currently, the Japanese economy is inflicted with two illnesses, one is "pneumonia" and the other is "diabetes," so to speak. It is needless to say that we should put our priority on the treatment of "pneumonia" to save the patient's life first and then deal with "diabetes" later. While the Koizumi government is trying to treat diabetes, that is, "structural problems including the problem of non-performing loans," there seems to be no recognition on the part of the government that the Japanese economy is dying of pneumonia, that is, "balance-sheet recession," which should be regarded as the fundamental cause for the current economic stagnation (Richard Koo)

As Richard Koo suggests, asset reflation (targeting) policy is to treat "pneumonia," whereas restructuring and reform policies are to deal with "diabetes." Good doctors can diagnose and treat both in the right order, but bad doctors tend to misdiagnose illnesses and kill the patient.