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October 4, 2004

Economic Malaise -- Blame Supply-Side Policies

Gregory Clark (Vice President, Akita International University)

Toyoo Gyohten was the senior Ministry of Finance (MOF) official handling international affairs back in the early '70s, and a source of wisdom to those of us trying to understand Japan's financial maze. He now heads Japan's Institute for International Monetary Affairs. In a recent address to the Aspen Institute in Colorado he has neatly summarized the many policy mistakes behind the bubble economy of the late '80s.

[Editor's Note: The full text of Toyoo Gyohten's presentation can be found here.]

Japan then had a problem of Catch-22 dimensions. The United States was angry over Japan's persistent trade surpluses. But the rapid yen appreciation that should have cut the surpluses had also harmed the economy to the point where the fall in domestic demand had cut imports and firms were expanding exports in order to survive. Instead of falling, the trade surpluses had increased. An even angrier U.S. began to demand concrete measures to expand domestic demand.

Normally this should have been done through fiscal stimulation. But Japan's conservative policymakers opposed any increase in government debt. As Gyohten puts it, MOF's "obsession with the idea of fiscal soundness" forced Japan foolishly to rely solely on monetary stimulus. Interest rates were slashed and even as land prices began to boom the Bank of Japan (BOJ) convinced itself there was no real problem since other price indicators were stable. Like almost everyone else in Japan at the time, it believed that inflated land prices were inevitable anyway in land-scarce Japan.

According to Gyohten: "We could not prevent the birth of the bubble because we could not distinguish the real risk in the economy, because we set a wrong target for economic policy, because we chose the wrong policy instrument and because the timing of our policy implementation was wrong."

A few of us at the time tried to point out that Japan still had plenty of land available, that skewed land-tax policies plus a boom mentality were the main reason for demand outstripping supply, and that there would be "blood on the floor" when the absurd land valuations inevitably collapsed. We were thoroughly ignored.

Why the mistakes? In addition to MOF and the BOJ, Gyohten blames politicians representing various interest groups, weak government leadership and a light-headed media happy to go along with the tochi shinwa -- the myth of never-ending land-price increases. An impressive rogues gallery.

But it raises an important question. For if Tokyo could get its policies so wrong then, is there any guarantee it can do better today? The economy still suffers from chronically weak domestic demand. Policymakers still refuse the fiscal stimulus so badly needed and rely on monetary stimulus instead, even though deflation makes this largely ineffective. And together with that lightheaded media they still cling to myths -- this time the belief that reducing delinquent bank loans by pushing firms into bankruptcy will somehow revive the economy.

Underlying these mistakes is the dominance of policymakers and commentators who are dogmatically convinced that the supply-side economic policies of the Anglo-Saxon economies suffering from surplus demand and inadequate supply in the 1980s are relevant to a Japan whose current problems are the exact opposite -- surplus supply and inadequate demand. Together with the fiscal conservatives, they have dismissed as outdated the Keynesian economic policies of relying on government to fill demand gaps.

Yet even in the Anglo-Saxon economies it is debatable whether efficiency in supply is more important than demand. A favorite criticism against Keynesian policies is the alleged claim made during the U.S. Great Depression days of the 1930s -- namely that even having people dig holes and fill them in -- was better than leaving people unemployed. Few seem to realize that something like this helps sustain the U.S. and Australian economies today. The holes are household swimming pools, and they are being filled with expensive water. They add nothing to economic productivity. But they improve lifestyle, employ people and keep money circulating.

It is the explosion of lifestyle demand that sustains the Anglo-Saxon economies today, now that inflation has been largely tamed and balance-of-trade deficits can be largely ignored. Japan has not seen this explosion. For most Japanese it is work and the workplace rather than lifestyle that is important. Instead of the dangerously low level of savings found in the Anglo-Saxon economies, Japan suffers from excessive savings sucking demand from the economy. In this situation relying on demand-reduction policies when the economy is weak is an insanity on a par with those that helped create the bubble economy of the past.

Japan did not always have to suffer bad economic policies. Before the bubble it had relied on sensible Keynesian policies, using government spending to pull the economy out of slumps and cutting that spending during booms. Its only mistake was to rely on borrowing rather than taxes to finance increased spending.

In the immediate post-bubble years it reverted to these policies under Prime Minister, Kiichi Miyazawa, a student of Keynesian economics under my father, British economist Colin Clark, who himself had worked with Keynes in the 1930s. By 1996 Japan had pulled out of its post-bubble recession and its bad-loan problem was well on the way to a natural solution. All it needed then was sensible tax policies to finance future government spending without harming private demand.

Japan's problems only revived with the emergence of a new generation of U.S. influenced supply-side economists in the administrations of former Prime Minister Ryutaro Hashimoto and current Prime Minister Junichiro Koizumi.

(This article originally appeared in the September 26, 2004 issue of The Japan Times)

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