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October 31, 2002

Anti-Deflation Policy Needed Before Disposition of Non-Performing Loans

Miyohei SHINOHARA (Professor Emeritus, Hitotsubashi University)

No Visible Results from Structural Reform

One and a half years have already passed since the inauguration of the Koizumi administration. Although Mr. Koizumi has repeatedly said that "there is no economic recovery without structural reform," he has not achieved much in that respect. He might insist that Japan's current recession is a result of the growth recession in the U.S. economy, but that is not all.

The problem is the effort of disposing of non-performing loans as a part of the Koizumi reform. The more rigorously such an effort is made, the further the decline in stock prices and the more non-performing loans to follow. There are two kinds of structural reform. One is a kind of reform, including the disposition of non-performing loans, which is likely to facilitate deflation. The other kind is a longer-term reform including the privatization of the postal corporation and the reform of the public highway corporation. It would be correct to undertake such longer-term structural reforms, but it inevitably takes 5 to 10 years before any results are obtained. Therefore, we could not expect any impact on the current economic slump in Japan, no matter how hard Mr. Koizumi tries to push this kind of reform. The biggest problem is that Mr. Koizumi does not seem to have realized this fact.

Policies Disregarding Effective Demand

I have compared changes in stock prices and those in losses from disposing of non-performing loans for the last ten years, and found a completely reverse correlation between them. Based on this comparative study, I predicted at the beginning of this year that major banks' total losses from their disposition of non-performing loans for the fiscal year of 2001 would be around 8 trillion yen, which has turned out to be exactly on the mark. On the other hand, such total loss was supposed to be kept around 3 trillion, according to the scenario of the Financial Services Agency. In reality, however, it swelled to 8 trillion yen due to the sharp decline in stock prices, as I predicted.

While it is correct for individual firms and banks to try to clean up non-performing loans, it is bound to have macroeconomic consequences: (1) the sale or disposition of non-performing loans would lead to new supply of stocks and declines in stock prices, (2) the bankruptcies of corporations would decrease effective demand, and (3) debt forgiveness would lower profits for the corporations that forgive others' debts . Either way it would lead to a decrease in effective demand.

The approach taken by the Financial Services Agency so far has lacked this kind of macroeconomic viewpoint, and only focused on microeconomic viewpoints of individual firms. Such an approach has a bias toward the supply side as was the case in the pre-Keynes era. Although I am not a Keynesian economist, I would like to ask politicians, bureaucrats and critics to discuss various policy options by taking account of their macroeconomic effect on effective demand.

Consumption Tax Proposal

I have recently been proposing an anti-deflation policy focusing on the consumption tax, as consumption accounts for almost 60 percent of GDP. If consumption is weak, the consumption tax rate should be set to zero temporarily, for example, for about four years, and then raised to 15% from the fifth year on. That would facilitate the "intertemporal substitution" of consumption, and definitely raise the level of consumption.

There may be some other formula such as a gradual increase in the consumption tax rate after lowering it to 1%. In any case, the important point is that the consumption tax as an expenditure tax should have a more direct and powerful impact on effective demand than does the income tax.

If, furthermore, the consumption tax rate is raised to 15% after the fifth year, the tax revenue might increase to about 30 trillion yen, as compared to the current consumption tax revenue of 10 trillion yen per year. This would be like killing two birds with one stone by contributing to a reduction in the budge deficit as well. Similar formulae could be used for investment taxes and corporate taxes to stimulate effective demand now and to raise tax revenue later. The governmental tax council has so far ignored this kind of proposal, partly because they might be afraid to see a temporary drop in consumption before the consumption tax decrease is implemented. In my opinion, however, this temporary decrease should be small compared to a surge in consumption during the 4 year period, when the consumption tax rate is reduced to zero. I would like to use this policy as an important first step for the Japanese economy to return to the 2-3 percent growth path.

Structural Change in Money Supply

I would like to point out that since the beginning of the 1990s there has been a rather drastic change in the structure of money supply, which has been affecting stock prices and corporate investment. When we focus on "quasi-money" (time deposits) for general corporations, annual changes in that amount have shown greater fluctuations than those in "money supply" (cash and deposits in general).

First, in the late 1980s the annual growth rate of quasi-money for general corporations was 15-20 percent, and this rapid growth helped corporations actively invest in various assets as well as capital equipment. This growth rate was higher than the growth rate of total money supply, which was 10-13 percent.

Second, the economy stagnated in the 1990s, but money supply in general managed to maintain positive (but low) growth rates almost throughout the decade. In contrast, quasi-money for general corporations generally showed negative growth rates, ranging from zero to minus 10 percent. This may be regarded as both a cause and an effect of stagnation in the stock and land markets as well as capital investment by corporations.

Third, it should be added that quasi-money for general corporations has been dropping sharply since the beginning of 2002, more than 20 percent lower than that in the previous year. This is clearly due to corporations' concerns about implementation of the pay-off system. In view of this drastic decline in quasi-money, I strongly feel that implementation of the pay-off system should be postponed not just for a couple of years, but until confidence is established for the revival of the Japanese economy.

Some Inflation Indispensable for Economic Growth

I regard a 3-4 percent increase in consumer prices and a 4-5 percent increase in wholesale prices as indispensable for the Japanese economy to return to a healthy growth path. However, I would not argue for sustained inflation, but limit it to the period of 3 to 5 years. In other words, I am advocating a "limited-time reflation policy." Within this time period, the government should be able to increase the issuance of bonds without worrying about its fiscal bankruptcy, and the Bank of Japan should be permitted to purchase general corporate stocks without being accused of deviation from the norm.

The Financial Services Agency was previously attacking the non-performing loan problem in a piecemeal fashion, probably because of Japan's international commitment to do so, but that only aggravated the problem due to stock price declines as I have already pointed out. New Financial Services Minister Heizo Takenaka is now advocating the use of public funds to support the financial system, while facilitating the disposition of non-performing loans. This may be better than the previous approach, but I strongly feel that a limited-time reflation policy should be adopted first in order to stop the generation of new non-performing loans. A comprehensive set of macroeconomic policy measures including changes in the consumption tax to push the intertemporal substitution of consumption must be taken to establish an upward trend for stock prices. Otherwise, the injection of public funds into the banking sector would be wasted and a new growth path will never be realized.

Just focusing on the disposition of non-performing loans to be followed by the injection of public funds might not solve any problem but leave deflationary consequences in the Japanese economy. Japan has already suffered its lost decade, and the present policy stance to keep Japan's commitment to the U.S. might well make it "the lost decade and a half."

(This translation is from the original Japanese article that appeared in the October 22 issue of "Weekly Economist" published by Mainichi Shinbun.)

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