Beware Policy Overreactions: Managing Changing Macroeconomic Conditions in Japan and the United States
Speech to Keizai Koho Center
Think Tankers' Symposium
© Peterson Institute for International Economics
As the year 2001 begins, growth is unexpectedly slowing in both the United States and Japan, the two countries' stock markets are declining, and a new Presidential administration is poised to take office in the United States. This is a good time to take stock of the current macroeconomic policy stance in both countries. Are the currently planned policies correct for the changing economic circumstances the economies face? Are there other options that should be pursued? Beyond the domestic policies of each country, are there common macroeconomic problems and policies to be addressed jointly by the Japanese and American governments? In this essay, I argue that both Japanese and US policymakers face a common challenge, despite their widely differing economic circumstances: the two governments must stay the course of their present policies without overreacting to new short-term bad news. This warning not only applies to their domestic fiscal and monetary policies, but also to their prioritization of regional integration versus multilateral liberalization efforts.
1. Summary of the assessment and the argument
In Japan, the slow growth and mixed signals of the economy at present are exactly what one would expect for an advanced economy undergoing significant, but not radical, restructuring-this is what structural reform looks like, for, as many of us warned, reform is a drag on growth in the short term as the economy adjusts. Japan's potential growth rate is actually rising at present, largely due to changes in the financial sector. This implies that the completion of the financial reforms (conditional recapitalization and/or nationalization, strict supervision, writing off bad loans, selling cross-shareholdings) in the remainder of the Japanese banking system would be of enormous benefit. It also indicates that aggressively expansionary monetary policy, through setting of an inflation target and active purchases of JGBs and dollars or euros, would be beneficial without any risk of inflation.
The problem is that as Japanese potential rises, unemployment will temporarily increase and stocks will temporarily fall with restructuring, and deflationary monetary policy will compound these effects. Had the Government of Japan completed the unavoidable banking reform when the fiscal stimulus was effective in 1998-99, one could have been confident that Japan would remain on course for recovery. Now that another two years of bad loans and government debt have been allowed to accumulate-and, just as importantly, another two years of apparent government inaction and Bank of Japan-caused deflation have further eroded confidence-it is unclear whether the markets can avoid panicking over any new seemingly bad news. This does not mean there is a new policy option to pursue-the combination of creation of inflation and depreciation of the yen, completion of financial reform, and very slow but steady reduction of the public sector deficit are still the right combination 2. It just means that the odds of such a program incurring some serious macroeconomic volatility in the near term, and perhaps the risk of capital flight coming to pass, are much higher than they would have been.
For the United States, the current slowdown is turning out to be worse than most people expected as recently as a few months ago. The downturn is a good reminder that our "New Economy" did not repeal the laws of economics-large stock market declines do drag consumption down, oil price rises and supply bottlenecks do hurt growth, and at some level of unemployment, inflation begins to rise. What did happen to the US economy in the 1990s was two limited but important things: there was a rise in annual productivity growth on the order of 1 percent, and there was an absence of macroeconomic policy mistakes. Combined, they meant the recovery could run a long time without the Federal Reserve cutting it off. They also mean that the stock market probably was a bubble, at least in tech stocks, that has burst. What the much softer landing in the United States than in Japan demonstrates is how financial regulation/supervision and monetary policy, rather than the stock market itself, determine the impact of a bubble.
What this means for policy is that there is no reason for the US government to fear a slowdown in growth to 2 percent or even a little less for a year. A recession is a normal part of life. The Fed's normal easing response, and the automatic stabilizers built into our tax and welfare system, should be sufficient to limit the downward momentum. The incoming administration's proposed large regressive tax cut, and especially the repeated justification of it with reference to the slowing US economy, is irresponsible. Discretionary fiscal policy is only to be used when growth has been very slow for a prolonged period, and when you have reason to believe that monetary policy is less effective than usual-in other words, in Japan in the mid-1990s. For the United States to try to fine tune American growth rather than to continue paying down the public debt would be a mistake. The weaknesses of the US economy continue to be long-term and structural: vulnerability to energy prices due to inefficiently low taxes; undersupply of skilled labor due to educational deficiencies; political tension due to inequitable medical care; and ongoing underinvestment in public infrastructure. Macroeconomic policy, however, can be largely satisfied with the status quo-a whipsawing of the exchange rate, with the dollar depreciating against the euro and appreciating against the yen, as is now occurring, would be about right. A yen depreciation will help prevent capital flight from the United States.
TransPacific economic relations have already suffered from an overreaction to the fallout from US-Japan interactions during the Asian financial crisis. The Japanese government, frustrated with what it sees as the American high-handed approach towards it and the rest of Asia in 1997-99, as well as with the decline in reverence for the Japanese economic "model", has of late pushed hard for the development of Asian financial cooperation and institutions. The incoming American administration, unnecessarily and overly concerned about negative spillovers from economic disagreements onto the US-Japan security relationship, has misinterpreted the American calls for changes in Japanese macroeconomic policies during the crisis as bilateral bullying. This has motivated a pre-emptive announcement that bilateral trade tensions will be kept under control, and Japan should be able to pursue its own reforms at its own pace-it has also contributed to a planned shift in US international economic policy focus to Latin America.
The shame of all this is that the critical alliance for advancing the agenda of multilateral liberalization and institution building, that between the United States and Japan, has been distracted and even disabled (only temporarily, I hope). Regional, one might fear bloc building, initiatives have taken precedence over multilateral efforts; avoidance of tension has replaced constructive mutual challenging of each others' macroeconomic and structural policies to live up to potential. The U.S. and Japan must stand together to make the emerging markets safe for foreign direct investment without national preference, to reform the International Monetary Fund and the World Bank (including increasing Japan's voice at Europe's expense, and garnering US funding more easily), and to relaunch a multilateral trade round that does put agriculture on the table. If the necessary tensions of the last few years result in the Free Trade Area of the Americas and an Asian Monetary Fund taking the place on our two nations' agendas formerly held by supra-regional efforts, we will all be the poorer.
In the remainder of this essay, I fill out the details on the first set of points for the Japanese economy as background material for discussion.
2. The Japanese Economy in 2001-Avoiding Panic Until Potential is Realized
Weakly positive growth, conflicting indicators between favorable corporate developments and softening consumer demand, some sectoral price declines associated with specific liberalizations, volatile and high average unemployment numbers, tightening credit standards and extensive sales of equity-this describes the economic scene in Japan today. This is also what structural reform looks like. Structural reform subjects previously protected sectors to competition and encourages the reallocation of capital and labor between sectors. During this period of reallocation, unemployment and bankruptcies rise, and stock valuations and wages fall, especially in (but not limited to) the sectors undergoing decline. That is why reform in an advanced economy is, in the short term, a drag on growth.
The exception is that owners of those factors of production (mobile financial capital, technical skills), which can be quickly moved to the expanding sectors, can be forward-looking and see their returns rise. This is why, for example, capex has risen in Japan in the last year, especially in information technology. At the same time, this is why banks are not doing very well and are selling their cross-shareholdings: until they liquidate their outstanding bad investments and/or write off their bad loans, they cannot reallocate their investment capital. Workers with firm-specific skills related to long tenure in formerly (or still) protected industries are losing value, while workers with the willingness to move and the capability to learn new skills are seeing stable or rising wages.
While the picture appears to be mixed and uncertain for many of the firms and workers involved, the overall picture of the Japanese economy at the moment is one of marked improvement. In Japan, the efficiency in the allocation of labor and especially of capital has gone up of late, and technological progress from the "New Economy" has begun to be felt. The primary motivating factor supporting this change has been the financial sector reforms undertaken since the Obuchi government's financial reform legislation of October 1998. As can be seen in the aggregate evidence of a credit crunch, as well as in the increasing frequency of specific instances where major Japanese banks refuse to roll over loans to bankrupt borrowers-such as in the cases of Sogo Corp. and Chiyoda Mutual Life Insurance Co.-lending standards have risen since the major banks were recapitalized by 1 April 1999.
Of course, this rise in standards has not been imposed on all borrowers, especially in the all-too-often protected construction industry, but that it holds even for some is an improvement over the near-universal loan rollover practice of the mid-1990s. Coupled with intermittently improved supervision from the Financial Supervision Agency and tighter, more transparent accounting practices, this means that about 50 percent of all corporate finance in Japan is being allocated more efficiently than in the past. Returns on capital in Japan are rising as a result.
Not only are companies that have failed or that have simply overinvested in unproductive activities being limited in their ability to waste further assets, new companies and activities are being supported by Japanese banks. This can be seen in the development of the OTC stock markets (like MOTHERS and JASDAQ), the increasing role of venture capital and inward foreign direct investment, and the rising investment of Japanese business in ICT (including software). So taken as a whole, the average quality of Japanese investment is improving by a substitution of higher-return projects for wasteful efforts.
Furthermore, with 45 percent of the 160 trillion yen ($1.5 trillion) in Postal Savings Time Deposits coming due in 2000-01 being moved into private-sector investments, there is a beneficial reallocation of capital into more productive sectors. It is true that the other half of Japanese corporate finance and the bulk of Japanese savings continue to be squandered by either smaller Japanese banks allowed to continue rolling over bad loans, making the total grow, or by the Fiscal Investment and Loan Program (FILP) on wasteful rural public works projects. Nevertheless, for much of Japan's financial system, the change has clearly been for the better in the efficiency of capital allocation.
Other reforms have taken place in recent years. The Japanese retail sector, which remains less than 60 percent as productive as the American system, has had some increasing competition introduced. After an unjustifiably long struggle, the Japanese Ministry of Posts and Telecommunications has reduced some of NTT's access charges, and despite its ongoing protection of NTT, some alternative carriers (particularly wireless ones) have emerged. Gasoline prices, a cash cow long protected by the Ministry of International Trade and Industry (MITI), have also been significantly deregulated of late, as seen in the limited net price rises at the Japanese consumers' pumps, despite the rise in world oil prices. It is undeniable that vast sectors of the Japanese economy, notably in services and nontradables, are beset by inefficiency as a result of domestic protection and lack of competition. Yet it is equally undeniable that some important sectors of the economy have begun to offer more competitive pricing-as seen in the BOJ's ability to legitimately point to some instances of "good" deflation.
Meanwhile, the Japanese economy is proving slightly more adaptable than some observers have wanted to give it credit for. Investment in information and communications technology has been growing ever faster in Japan in the past six years. Although this is not comparable to the ICT investment boom in the United States, there has unquestionably been a rise in the share of investment that is productive, and it may have spillover benefits, as opposed to the overhang of depreciating old-fashioned capital. The former replaces the latter without replicating it, so the returns are higher even if the total undifferentiated capital stock rises.
On the labor side, despite a temporary rise in mismatch between the unemployed and available vacancies-which is itself an indication that the newer industries requiring different skills are rising while employment in the older industries is contracting, an efficiency gain-labor supply has begun to increase. The retirement age has risen in practice, and it will rise again as old age pension reform proceeds. Young Japanese women's willingness to stay in the labor force has increased a small but noticeable amount, along with their job tenure and availability, meaning an underused resource is finally being tapped. As on the economy' financial side, the changes in the efficiency with which labor and goods are used, and in technology, are all in a positive direction, no matter how vast the areas for further potential reform and improvement remain.
Therefore, we must raise our assessment of Japanese potential growth. Putting a precise number on the increase in Japanese potential growth in recent years, however, is difficult. The two standard econometric techniques for making such an estimate have generated results that are biased downward (for understandable reasons).3 The cash value of the additional capital moving from public sector and old firms to private sector and new technologies, the increase in labor supply from changing patterns of female and older workers, and the rises in productivity of capital and labor that will result from better allocation with greater discipline (and less protection) will be able to be ascertained only in retrospect a few years from now. It is fortunate that we can be certain at present that all the major changes in Japanese potential have been in a positive direction, meaning that they have been increasing the sustainable growth rate.
In short, most estimates agree that Japanese potential growth was about 1.75 percent to 2 percent, annual rate, in 1996. This is a useful starting point, before both multiyear deflation and financial fragility biased the purely econometric estimates downward, and before the important structural reforms, especially in the finance sector, which raised the returns on capital and the share of ICT investment, took place. Then it would seem logical that potential growth has now risen at least to somewhere from 2.5 percent to 2.75 percent-the financial sector reforms that improved the allocation of (and returns to) 50 percent of Japanese corporate finance being worth a few tenths of a percent of GDP a year, the productivity-enhancing effects of capital deepening through ICT investment being worth another few tenths, and the limited but real deregulation in energy, telecom, and retail being worth at least a tenth each.4
With rising potential growth, and therefore the prospect of a steady rise in incomes over the next decade in Japan (in comparison to the stagnation of the past decade), policymakers should be making a calm assessment of how to tackle the two large negative legacies of the 1990s recession: consolidation and recapitalization of the remaining banking system; rolling over the outstanding Japanese government debt while continuing to slowly reduce it. If additional structural reforms are undertaken, including the needed end of bad loan rollovers among the smaller banks, potential growth should rise even further. And rising potential growth means that the Japanese economy can grow faster for a longer time without sparking fears of inflation.
The problems of the Japanese economy should finally shrink relative to the economy-assuming that financial supervision prevents the additional accumulation of bad loans, and instead forces the banking system to start over from here. The problem is that the Japanese government and the Bank of Japan have squandered the opportunity presented in the last two years by improved macroeconomic policies. The combination of sizable, though badly designed, fiscal stimulus packages in December 1998 and April 1999 (and responsibly slow cutbacks in public investment since then), and the financial reforms package passed in October 1998 and implemented for most of the first tier banks by April 1999, put a floor under Japanese growth. Remember that in the summer of 1998, Japan was teetering on the edge of outright financial crisis, with Japanese banks being shut out of interbank markets, capital flowing out of the economy, the stock market and yen declining precipitously, and (most frighteningly) Japanese savers pulling their money out of the private banking system and putting it into cash instead. Since late 1998, we have instead seen a return to clearly positive growth with, until recently, much diminished risk of instability in Japan.
This is not to say that macroeconomic policies have achieved all that they could have. As I advocated in 1998, a three-part program was necessary to restore Japan's economic growth: large scale fiscal stimulus through structurally sound tax cuts, conditional closure and/or recapitalization of the banking system, and aggressively expansionary monetary policy anchored by a positive (initially 3 percent) inflation target. Only half of the first and of the third measures were actually implemented, because of the government's unwillingness to give up wasteful traditional public works spending or to extend discipline to the lower half of the Japanese banking system. Japanese monetary policy of course went in exactly the wrong direction, creating deflation, which has now lasted more than 40 months, instead of inflation. Still, even the fiscal and financial half-measures were sufficient to buy some growth.
And that time of growth was the time to complete the reform of the financial system, to credibly cut off future wasteful public works spending plans, and to reassure financial markets that Japanese problems were not only manageable, but were being managed. As it happens, it was also a time of recovery in most of Asia, and of ongoing rapid growth (and high net imports) in the United States. Instead, banking problems were allowed to accumulate further, the LDP-dependent construction sector continued to grow (and the public "investment" sent there had a very low multiplier, defeating some of the fiscal stimulus), the need to liquidate distressed real estate assets and reform housing regulations was ignored, and all of these reversals of what was clearly agreed to be better policy have further eroded confidence in policymakers.
While I am not yet cynical enough to suggest that it was inevitable the LDP leadership would pursue this course so long as there was growth rather than crisis, I will admit to having myself been too hopeful that the fiscal stimulus would take the form of tax cuts, and that the banking reforms overseen by Minister Yanagisawa and the FSA in the first quarter of 1999 would be extended to the rest of the system. I am disappointed in the wasting of the Japanese government's opportunity.
So now the same serious but soluble problems face Japan, and while the rise in potential growth makes them more tractable in some ways, the continued policy inaction and mistakes have revived the potential for panic in the JGB and stock markets. Moreover, now there are many more cyclical or environmental drags on the performance of the Japanese economy that were not there in 1998-99:
First, the Bank of Japan has actively promoted deflation, allowing downward momentum in the general level of prices to accumulate. 5 Note that this did not occur because of a mistaken forecast or assessment of potential by the Bank of Japan, though those understandably happened -the deflationary trend in Japan persisted and gathered steam since 1998 because of a strategy that claimed that zero inflation was the goal, and nothing more than ZIRP could be done.
Second, the blind eye turned to the ongoing moral hazard of undercapitalized, undersupervised small and regional banks, credit cooperatives, and the like, has continued to tie up capital by rolling over loans into low return, high risk projects. It has continued to exclude some potential new firms.
Third, the vast quantities of distressed real estate, largely foreclosed collateral on bank loans, left unsold has put a strong damper on household and business investment. The prices have continued to drop, and uncertainty has continued to mount, because a market needs to be created before the bottom can be reached and liquidity will return.
Fourth, the US economy is finally slowing, reducing net import demand from Japan and elsewhere, and oil prices are finally rising. For both of these it was only a matter of time before they happened, but now they have, whereas through 1999 they had not.
At some point, all the banks will have to be recapitalized and/or shut down, at some point the public debt will have to be put on a sustainable path, at some point the labor and capital tied up in distressed construction and real estate will have to be reallocated-in short, at some point there has to be a massive financial loss taken by all the Japanese citizens of today rather than pushing it onto their children, and by those who have been especially protected from losses will have to take disproportionate hits. The money is gone.
All of these losses, though sizable, are manageable since they all involve yen-denominated, domestically held assets, and Japan starts with a high level of domestic savings. Essentially a massive internal redistribution has to take place in Japan. If done in a time of growth, with improving potential making that growth sustainable, this can be done slowly and calmly. The macroeconomic policy prescription of completing financial reform, aggressively loosening monetary policy, and avoiding sharp contractions in fiscal policy remains correct, and will allow this unavoidable loss taking to happen through largely market means (beyond direct regulation of the banks themselves). There are no additional major new policies which will make the needed redistribution, although some small things could help at the margin (like passing the consolidated taxation to go with the consolidated accounting to help mergers take place, or changing the composition of how the Japanese government collects taxes). It is the steady transparent implementation of these already identified policies which is required.
But the success of this course depends upon Japanese savers, and holders of yen-denominated assets worldwide, not panicking. If the current rise in potential growth is hidden by policy uncertainty, or by deflation and continued accumulation of bad assets, savers and policymakers alike may decide to take drastic overreactions, which will overwhelm the proper economic policies and improving fundamentals. A drastic overreaction would not be the banks selling off their large equity positions in non-financial companies-that is something they should be doing even at losses. A danger sign would be all foreign and large investors shedding stocks with no one buying. A drastic overreaction would not be the average Japanese saver switching to a higher yielding, or even foreign managed, account-that is something they should be doing to get higher returns. A danger sign would be most Japanese savers repeating 1997-98's disintermediation and switching into cash, with the interbank Japan premium widening. A drastic overreaction would not be interest rates on the long-end of the JGB market rising because FILP buys less of the new debt-that is something that FILP should be doing to remove distortions and credibly impose long-term fiscal discipline. A danger sign would be the kind of very rapid upwards spike in interest rates driven by a bond market panic that we saw in January-February 1999, after the Trust Fund and Moody's announcements at that time.
Most importantly, a drastic overreaction to worry about would not be a decline in the value of the yen, encouraged by monetary policy but anchored by some public commitment to a nominal (inflation, exchange rate, money growth) target-that is something which the BOJ and the government should be encouraging. So doing would not allow Japan export its way out of recession, because Japan simply is too big and too closed for that to work, and the losses of asset price values would be too great if the currency moved that much. The point of a decline in the yen is to loosen monetary conditions in the domestic Japanese economy, signaling for a rise in inflation expectations.
The danger sign of an overreaction would be the yen moving downwards at an accelerating rate, with investors dumping the currency. Another danger sign of overreaction would be the government of Japan indicating that it did want to export its way out without resolving the banking crisis, and weakened the yen without anchoring the Japanese price level and financial values. In that case, one would see actual capital flight from Japan which would be the start of the true crisis everyone has foretold as possible, but which the half-efforts on fiscal and financial crisis in 1998-1999 prevented.
Either way, the yen will have to go down in value in the months ahead, inflation will have to increase in Japan, Japanese savers will have to take losses to pay for the banks' ongoing mistakes, and the rolling over of bad loans and retention of land assets will have to end. The question is whether the current improvements in Japan's potential growth can be taken advantage of to ease this process, or whether they will be disbelieved and overwhelmed by panic. Either way, there is only one set of macroeconomic policies available which will work, and we all know what that set consists of. The choice is therefore between:
- a responsible combination of conditional bank recapitalization, anchored monetary easing, and slow but transparent deficit reduction which could make this process orderly
- or continued delay in fixing the banking system and ongoing unsustainable deflationary monetary policy, which could make this process collapse.
The tragic aspect is that, even if the correct set of policies are finally fully pursued, they are less certain to work now than even two years ago, because previous policy inaction has squandered both needed confidence and a better economic environment. The problems of bad loans, deflation, and public debt got bigger in the meantime. Unfortunately, there are no better policy alternatives, and overreacting to the stock market or short-term interest rate swings with mistaken policies might bring on the panic that would overwhelm rising potential growth.
2 In Restoring Japan's Economic Growth (IIE, 1998; Japanese Translation, Toyo Keizai, 1999), I proposed a three part program of fiscal stimulus through tax cuts, monetary expansion anchored by an inflation target, and aggressive recapitalization and closure of the banks. The fiscal and financial proposals were partially enacted, preventing an outright crisis, and putting a floor under Japanese growth. But the counter-productive tight monetary policy and the failure to complete the financial reform explain why growth has remained weak. The fact that wasteful public construction took the lead over tax cuts also hurt a lot.
3 For an explanation of how potential output is measured, and why standard techniques incorrectly see Japanese potential as rising, see Adam Posen, "Economic Viewpoint: Recognizing Japan's Rising Potential Growth," NIRA Quarterly Review, forthcoming (Winter 2001).
4 These rough estimates of productivity gains rest on the estimates in various OECD publications and EPA and MITI white papers of what the benefits from complete deregulation in these sectors would be, halving them for the financial sector and taking less than a quarter in the other three sectors. The benefits from ICT accumulation are taken from comparison with standard estimates of U.S. benefits in the 1990s from its ICT investment, scaled down proportionately for the smaller share in Japan. Doing this assumes that returns to deregulation and ICT investment exhibit constant returns to scale. If the benefits were to exhibit diminishing returns to scale, as is usually assumed, the benefits from the deregulation, ICT investment, and capital allocation undertaken to date should be even higher.
5 See the discussions by Japanese and American monetary economists collected in Ryoichi Mikitani and Adam S. Posen, eds., The Japanese Financial Crisis and its Parallels with U.S. Experience, IIE, 2000.