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December 2, 2002

Nationalization of Banks with Tax Cuts and Inflation Targeting

Takatoshi ITO (Professor, University of Tokyo)

Evaluation of the Anti-deflation Policy Package

The objectives of the government's comprehensive package of anti-deflation measures are threefold. The first objective is to accelerate the disposition of bad loans. The second is to stop the contraction of the real economy and get it back to a growth path. And the third is to halt price declines (deflation). These three are closely related.

Regarding the first point, I do not think a new direction for the disposition of bad loans has been presented. The disposition cannot be accelerated by a more strict assessment of bad loans, the announcement of discrepancies between their self-evaluation and official assessment, or adoption of the DCF (discounted cash flow) method to calculate corporate values, where the DCF would be infinite if the discount rate is zero. The discount rate is important. Possible progress could be made with the creation of the Industrial Revitalization Corporation, but even this could become ineffective just like the buying organization for bank-held stocks.

Second, I do not think that fiscal spending (widening the government deficit by discretionary policies) would have a significant expansionary impact on the economy under the condition of the government debt-GDP ratio exceeding 140 percent. Although a proposal is being made for investment tax relief to induce private sector investment, its total amount is probably not going to be large.

As for the third point regarding deflation, the purchase of long-term bonds by the Bank of Japan for an additional 200 billion yen or so would have little effect. In sum, the comprehensive anti-deflation policy can hardly be appreciated.

Reorganization of the Banking Sector

The causes of Japan's economic slump are (1) the deflationary spiral in the economy as a result of the delay in handling bad loans, and (2) failure to deal with bankruptcies in the initial stage of the financial crisis in 1995. What we need to do is threefold in view of the three objectives of the comprehensive anti-deflation package.

First, regarding the accelerated disposition of bad loans, it is important to reconfirm the principle of minimizing taxpayers' burden in the long run. For that purpose it may be inevitable to nationalize those banks that have insufficient capital. For those nationalized banks, assets are to be classified into three categories, (1) normal loans, (2) gray loans (for the IRC, that is, the Industrial Revitalization Corporation), and (3) bad loans (for the RCC, that is, the Resolution and Collection Corporation). The banking sector should be reorganized by selling normal loans in the market. On the other hand, the Industrial Revitalization Corporation will take care of reorganization of structurally depressed sectors with excess capacity. It is necessary to make an arrangement for the public purchase of gray loans and bad loans without forcing banks to take secondary losses.

Second, to stimulate the real economy, we need to facilitate housing investment and housing-related consumption by reforming taxes on housing in a fundamental way. However, it would be risky to increase the government's budget deficit and, therefore, some expenditures such as public investment should be cut by the same amount. Also it might be worthwhile to reduce the consumption tax rate to 3% temporarily, and raise it by 1% every six months up to 7%. This way, consumption would be accelerated every six months over the next two years.

Third, regarding deflation, the Bank of Japan must adopt the policy of inflation targeting and declare that it would take whatever means necessary to achieve its target. Obviously, the Bank of Japan should take action in accordance with their policy and declaration. For example, the purchase of ETF (Exchange-Traded Funds) should be effective as a monetary policy for the Bank of Japan.

(The original Japanese article appeared in the November 10, 2002, issue of "Economist" published by Mainichi Shinbun Co.)

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