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November 11, 2002

Japan's Economy at a Major Turning Point

Ronald Dore (Professor, University of London)

Two weeks in Japan, two weeks of reading the Japanese press, and the faith of any Japanophile would be shaken. First there is what passes for foreign policy. There is nothing new in the on-going triangular contest between the Washington poodles, the nationalists – those like the Mayor of Tokyo, interested only in belligerent self-assertion -- and the independent-foreign-policy pragmatists. But in the last weeks the pragmatists seem spectacularly to have lost out to the other two. Their achievement in bringing about Koizumi's visit to Pyongyang, producing what seemed like a major success – North Korea's coming clean on the abduction allegations – gradually turned sour. They were elbowed aside as the Government yielded to a media-stoked wave of vociferous anti-North Korean sentiment. A clear promise to let the five surviving abductees visiting Japan go back to North Korea was reversed. Never mind that pacta servanda sunt business when certified members of the axis of evil are concerned. Subsequently the follow-up talks in Malaysia about the formal resumption of relations were turned for the media's benefit into a futile display of tough-guy posturing.

And then there's the economy. The clichι story of the Western press – peddled once again by the Economist this week – is quite straightforward. Japan's "lost decade" is the result of policy mismanagement after the bursting of the land and stock price bubble. What is needed is "Reform" -- a Thatcherite revolution such as brought prosperity to Britain, the quondam sick man of Europe. The agenda is clear: deregulation, privatisation, the break-up of industry cartels, reassertion of managerial control, ruthlessly profit-oriented managers, flexible labour markets. In Koizumi, Japan at last has a Prime Minister whose dedication to Reform is beyond question. His achievements have been small – so far. But that is thanks to sabotage by the Resistance Forces – the old guard in his party whose sole and unprincipled concern is to protect vested interests -- particularly those of the moribund construction and retail industries from whom they get corrupt money and organised votes.

The trouble with that diagnosis is not that it panders to Western stereotypes of Japanese feebleness of mind and will, but that Mr. Koizumi and his followers actually believe it. The actual content of the reform agenda he has spatch-cocked together hardly seems like bold supply-side surgery . The privatisation of a few public corporations, notably the highways and – eventually – the post office savings bank, and a shift of public investment from rural to urban areas. But increasingly in recent months "reform" has meant cleaning up the banks' balance sheets by getting rid of their non-performing loans, some of them dating back to the bursting of the bubble, but mostly the product of the stagnation of the last five years.

Here, Mr. Koizumi's penchant for a display of jaw-jutting determination comes into its own. He recently demonstrated the firmness of his resolve, by giving Takenaka, the American-trained economist brought from the university to become Minister of Economic Affairs, the additional portfolio of managing the finance industry.

Finally, finally, the Reformists said, with a sound neo-classical economist in charge, something will be done. But few had expected anything quite as drastic as Takenaka proposed. There was nothing new about one part of the recipe: a promise to accelerate the process of getting the debts off bank balance sheets by forcing debtor companies ("the zombies" in clichι story parlance) into bankruptcy or Chapter-Eleven type reconstruction. The promise had been made many times before. And the arguments and counter-arguments were entirely familiar. Sceptics argued that the bankruptcies and fresh unemployment will give an extra deflationary kick to the economy and create more new bad debts than the banks get rid of. The "moment of truth" school that the zombie companies with real assets are already laying off workers to pay down their debts: better to write off their debts, their shareholders and their present managers and start afresh under new managers with their real assets. As for the hopeless firms in shrinking industries, liquidate them and "free up resources" to create (eventually!) new and better jobs in the expanding sector of the economy.

So much so familiar, but the surprise was in Takenaka's proposals for change in the bank capital calculation rules. These are the rules under which the banks are deemed to meet, or fail to meet, the "own capital equals at least 8% of liabilities" criterion which Japan, under the Basle Convention, has promised the Bank of International Settlements that all its internationally trading banks will fulfill. Hitherto they have been allowed to count as capital prospective refunds of previous years' taxes which would be returned if writing off bad debts made them the sort of losses that would bring their capital adequacy in question. American rules are more restrictive than Japanese, and Takenaka proposed that within a couple of years Japanese regulations should be brought into line with the American. This would predictably bring the weaker banks below the 8% level. If they still wanted to be international, the next part of the package would kick in: they would have to accept an injection of public money, and that would be generously given -- on condition that the top management boards responsible would all resign with no golden handshakes.

An unusually blunt and public expression of fury from the banks, and from the "Resistance Forces", forced Takenaka into grudging retreat, though how far remains unsettled. But what makes those in the vital and efficient parts of the economy despair is the way in which all the public discussion and all the policy effort is concentrated on the banks and their (until the economy recovers uncurable) non-performing loans. What gets only minor attention is the central problem: low or negative growth and the deflationary spiral that contributes to it. Japan is like a cancer patient whose doctors all insist that they can't think about the cancer until they have cured him of the flu.

Koizumi is said not to understand economics and his performance in the chair of his central Economic and Industrial Council amply confirms that reputation. What he does understand is the electoral advantage of photo-opportunities with George W. Bush on his ranch. Decisive action to restore health to the Japanese financial system – to remove all danger of a Japanese banking crisis threatening the world financial system , as Koizumi himself said recently --will make him popular in Washington. That much is made clear by the public pronouncements of such luminaries as Glen Hubbard, the Chairman of Bush's Council of Economic Advisors – a friend of Takenaka with whom he shares an unreconstructed adherence to supply-side Reaganomics. (Recently displayed by Hubbard in a Financial Times article deprecating defeatist talk about a renewed American recession and reasserting his faith in America's productivity miracle.) Hubbard is a frequent visitor to Tokyo where he gives news conferences focussing entirely on the evils of the non-performing loans. His views are echoed by the chorus of American bank economists resident in Tokyo, led by Robert Feldman of Morgan Stanley.

It is all a classic exemplification of cultural hegemony theory. As Takenaka's emphasis on bringing Japan's bank accounting standards in line with America's suggests, improving the international reputation of Japan's banking system is what policy is all about, not improving the functioning of the banks in the Japanese economy. To be sure, the advocates of a blood-on-the-floor clean-up of bad loans claim that only if the banks are restored to health will they regain the confidence to indulge in adventurous lending. But all the evidence suggests that it this is nonsense. It is a lack of willing borrowers, not willing lenders that explains why the volume of bank lending is steadily falling, and why the Bank of Japan can pump a 20 percent increase into base money and produce only a 3 percent increase in money supply. Who wants to borrow money for new investment, when deflation increases your real debt burden by two percent a year, and product market forecasts are dampened by the prospect of an overall fall in real GNP? No wonder Japanese banks have nothing better to do with their cash than send it to the United States and help to prop up the dollar. The uncharitable suggest that Mr. Hubbard's friendly concerned advice is largely motivated by the need to keep up that flow as America's trade deficit tops the 4 percent of GNP mark.

Meanwhile, the deflationary pressures dampening enterprise and depressing animal spirits seemingly get worse. Perhaps Koizumi will begin to take them seriously when he perceives that Americans, too, are beginning to talk about a deflationary threat to the American economy. A much quoted report by economists at the Federal Reserve this summer[1] broke sharply with Wall Street and Washington's clichι story of Japan's lost decade. Japanese policy in the immediate post-bubble years was not all that bad. Monetary policy conformed to the equations which the collective wisdom of central bankers consider best practice; the fiscal deficits and government spending packages may have proved inadequate, but the situation would have become much worse without them. But still, with deflationary pressures from demand contraction, enhanced competition and cheap Chinese imports, the economy turned from dwindling inflation to deflation in mid-decade, and since the bank crisis of 1997, the downward spiral of prices, accelerated by demand contraction from unemployment and wage cuts, has shifted inexorably from goods to services. Beware America, they say, it could happen to us. The same forebodings grow in Europe, especially in Germany where the arrival of the euro and low-cost competition from the rest of Europe has brought inflation down to the one percent mark. The stability pact, which limits counter-cyclical fiscal boosts to three percent of GNP, grows increasingly unpopular. The President of the European Commission has publicly, if unguardedly, called it stupid.

Perhaps we are at a major turning point. For the last twenty years macroeconomic policy the world over has been dominated by the need to control inflation. Will deflation come to seem the greater evil? Optimists deny any necessary connection between deflation and slow growth[2]. But they have to go back to the last quarter of the nineteenth century for an example of growth under deflation. And that was growth of a particularly painful kind, apart from the fact that that pre-globalised nineteenth century example tells one little about deflation in an economy suffering a large post-bubble debt overhang – the classic debt-deflation explanation of the 1930s slump as expounded by Irving Fisher in 1933.

But after seven years of deflation, Japanese optimists – though worried optimists – can still deny its decisive importance as a cause of recession. Koizumi came to power eighteen months ago when it seemed that the American upturn and its boost to Japanese exports might turn the recession around. His one firm promise was to limit fiscal deficits to 30 trillion. His stubborn refusal to break that promise – he has built his image on inflexible determination – is a major obstacle to hard thinking about the recession and deflation. After all, what is so bad about deflation for the majority of the population who keep their jobs and suffer only mild cuts in their bonuses? Nothing could be better than having prices come down. The connection between that and the miniscule interest on their savings, or the long-term threat of job insecurity if the economy plunges into deep recession, is not all that apparent. Those with personal cause to complain -- the newly unemployed, the homeless, the bar girls and the taxi drivers who suffer from the paring down of company expense accounts – are in a minority. Meanwhile, the ideological/ethical adherence of the Bank of Japan to sound money, and of the Ministry of Finance to sound public finances remains complete.

One might have expected better of economists, but among the minority who are prepared to pronounce on public affairs, conventional views on inflation remain dominant. It is surprising how few Japanese economists know that the 2.5% inflation target which Gordon Brown set for the Bank of England is symmetrical, shortfall (in principle, at least) as much to be corrected as overshoot. And this in spite of the fact that a much-quoted 1998 article by Paul Krugman identifying Japan's problem as a liquidity trap gave rise to much public discussion of "inflation targeting" – his recommended solution for stimulating confident animal spirits by shifting expectations. That discussion, though, has centred almost exclusively on whether, with nominal interest rates at zero and real interest rates at two percent, monetary policy can actually induce inflation. No-one seems to be discussing the quite separate question of whether, in "normal" times, targeting inflation at a steady 2.5 percent as Britain does, or at 0% as the Bank of Japan does, is better for producing a satisfactory growth rate compatible with stability of exchange rates and prices. A recent "economic policy made intelligible" best-seller, by a Tokyo University economist and leading television commentator[3] concedes that inflation has its attractions in a Japan with a huge private debt overhang and a public debt at 130 percent of GNP. He then goes on to explain why the temptation is dangerous. Inflation targets have hitherto only been used to keep inflation down, not up. Once inflation is started it can get out of control. And the political problem of overcoming opposition from the holders of financial assets would be enormous. What his political diagnosis does not mention are the cheers that should go up from the large constituency of mortgaged home owners, many of them with negative equity, or the savers who would an increase in the abysmally low interest rates on their savings – albeit partly thanks to money illusion.. Nor does he consider as politically important the unemployed and low paid whose real incomes would be raised if the recession ended and the output gap – now reckoned to be 6-7 percent – could be closed.

But even if inflationists could win the argument, how exactly to turn the deflation around? The Bank of Japan's interest rate is at zero, and its attempts to increase money supply only lead to mounting cash reserves in the banks. The fiscal deficit is already running close to ten per cent of GNP and the cumulated debt exceeds even Italy's of five years ago before inflation and entry into the euro took it out of the headlines. The strength of Japan's export industries limits the extent to which the yen exchange rate will fall unaided and good neighbourliness limits the extent to which a fall can be contrived. The ageing of the population produces structural effects which make for a savings rate well in excess of Japan's investment needs. The available levers are few and feeble.

The "Resistance Forces" and others who take seriously the problem of demand deficiency and the deflation contributing to it have concentrated on conventional measures like tax cuts. But even if Koizumi eventually abandons his stubborn adherence to his pledge to cap the deficit at 30 trillion, the cuts are unlikely to be of more than marginal proportions. A few other ideas are being floated. Changes in the inheritance tax and the gift tax designed to shift cash from the non-consuming old to their more freely spending children have actually reached the planning stage, but again are cautiously marginal and not to be enacted until next year's budget. One of Japan's most imaginative economists proposes the centuries-old currency debasement remedy – a tax on cash and bank deposits to be effected by a redenomination of the yen.

And some, but not enough, debate is taking place over the advisability of printing money to raise asset prices. The Bank of Japan recently astonished everyone by going to the market to buy bank shares at the time of the latest stock market plunge. That was more a specific measure to help the banks than a sign that the Bank is really taking counter-deflation seriously, but the fact that bolstering share prices is a widely-discussed measure (and has been so intermittently ever since government funds were used in so-called Price Keeping Operations nearly a decade ago) is a mark of the centrality that the stock market has acquired – not so much in the real economy as in everyone's thinking about the economy. The volatile movements of the stock market (largely induced by foreign institutions which own 20 percent of the market and do fifty percent of the trades) make newspaper headlines two or three times a week.

But the wealth effect – the effect on consumer behaviour -- of movement in land prices (which in Japan much more than elsewhere are the major element in house prices) is probably far greater than that of stock prices. (It appears to be so even in the United States with a far higher diffusion of equity ownership than in Japan.) Land prices get far less attention in Japan because there is no Halifax to give monthly reports of house prices, and the surveys which chart the movement of land prices appear at long intervals, whereas the share index shifts every day.

So the possibility of getting out of the deflationary trap by intervention to raise the price of land on a sufficiently sustained basis to create an expectation of a continued rise does not get the public airing that it deserves. Land prices today are back where they were in the mid-1980s in nominal terms. In real terms, converted at the rate of consumer price inflation, they are back where they were in 1971. The land market is now more differentiated than it was. The more highly priced areas have fallen less than cheaper ones, presumably reflecting the way the recession has generally widened the dispersion of incomes But prices continue to fall overall, and in fact fell further in the year to last July than in the previous twelve months. How much market intervention it would take to make a decisive turnaround apparent, and how far it would help to end the recession – not only making consumers more confident but giving small businessmen better collateral to offer the banks -- remain problematic. There is a reasonable case to be made that land prices are now, finally, after the wildest extremes of the bubble, back to a level which market forces would justify, and that the reversal of the demographic trends which lay behind the forty years of mild but steady land price inflation are from now on moving in reverse. But even if an artificial resumption of that inflation were to be unsustainable in the long run, it could still be a good idea if it gave an initial priming spark to turn the deflation around and close that output gap.

But for any of this to happen, policy makers in Japan have got to acknowledge that deflation and depression are their real problems, of far greater moment than the ability of the banks to make decent profits. It was not until the rest of the world came to believe that Japan had a productivity miracle that the Japanese came to believe it themselves. Perhaps it is not until the rest of the world sees impending deflation as the real problem that the Japanese will decide that it is their problem too.

[1] Alan Aherne et al.,Preventing deflation: Lessons from Japan's experience in the 1990s, Federal Reserve Working paper, 2002-729

[2] See Sam Brittan, Financial Times, 8 November 2002

[3] Ito Motoshige, Nihon Keizai ga wakaru kiiwaado, Tokyo, Nihon Keizai Shimbun, 2002

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