Download How to get growth in Japan

Central Banking, vol. XIII, no. 2, November 2002, pp. 48-54
How to get growth in Japan
Creating a full-blown recovery has been straight-forward all along, argues
Richard A. Werner
The Bank of Japan’s September policy initiative to announce the potential purchase of
certain stocks from commercial banks has once again cast the spotlight on the Japanese
economic malaise. The Bank of Japan has since made clear that its initiative was not to
be understood as further monetary easing or anti-deflationary policy. Instead, it claimed
that it wished to help banks deal with their bad debts. We will see that this claim is not
convincing, for if the Bank of Japan had really been concerned with alleviating the bad
debt situation, there would have been far more effective ways to do so. Instead, it
appears the recent announcement is little more than a product of the bureaucratic
infighting and tactical games that have been played in Tokyo for many years. Thanks to
its maneuver, the Bank of Japan succeeded in its goal to have Mr Hakuo Yanagisawa
removed as the head of the Financial Services Authority and to get key Bank of Japan
alumni, such as Takeshi Kimura, appointed to the commission supervising the FSA’s
handling of banks.
For the economy, these moves are at best a Pyrrhic victory: while the Bank of Japan’s
political position has been strengthened further, there is no evidence that its economic
policies have become any more oriented towards stimulating demand, creating a
recovery and reducing unemployment than they had been over the past decade. To the
contrary, the new pro-BoJ regime at the FSA seems bent on implementing the central
bank’s longstanding plan to increase corporate bankruptcies (banks will receive tax
money in return for foreclosing on borrowers). This is why the nomination of Mr
Kimura sent Tokyo’s equity market to a 19-year low. Few economists would argue that
raising bankruptcies and increasing unemployment is an appropriate policy for Japan
right now. But what policies are suitable? And why have they not been taken?
Back to Basics
To answer these questions, we must start with the fundamental relationship between
money and the economy. There are many versions of it – some only true under special
circumstances – and it is therefore useful to return to the original definition of the
equation of exchange. It states that the amount of money changing hands to pay for
transactions during a given time period must equal the nominal value of these
transactions.i For economic growth to take place, by definition the value of economic
transactions during one time period must exceed that of the previous period of
comparison - in other words, there must be a net increase in economic transactions
during one time period. Thus an increase in the value of transactions (and hence
economic growth) can only take place if there has been an increase in the amount of
money used to conduct these transactions.
What is Money?
The next step consists of identifying measurable data to represent these identities,
namely the change in the net amount of nominal money used for all transactions, as well
as data for all those transactions. It may help, as illustrative exercise, to initially
consider a simpler financial system that does not have a central bank (such as the United
States until 1913). As in any modern financial system, most transactions are paid by
paper money, or else non-cash transfers through the banking system. Since we are
interested in the increase in the net amount of money used, we need to measure the
increase in purchasing power used for transactions during the observation period. The
net amount of paper money issued by the banking system and net bank transfers within
the banking system can only increase when banks extend new loans. We thus know that
the change in the amount of money used for transactions is equal to the net increase in
credit in the banking system (bank credit creation). ii A central bank usurps the
monopoly on the issuance of legal tender. However, it does not diminish the power of
commercial banks to create credit. Thus the correct definition of the money used for
transactions is the change in the quantity of credit.
Some Uncontroversial Results
Already at this stage we can come to some uncontroversial conclusions: it is true that
the decline in the value of economic transactions during the 1990s in Japan had to be
accompanied by a decline in net credit creation. For the value of transactions to increase,
and hence economic activity to pick up, there must also be an increase in the amount of
credit created by central bank and banks.
The Disaggregation of Credit
I have pointed out that if we wish to link this equation of exchange to GDP, both the
increase or decrease in the net amount of money changing hands and the change in the
value of transactions need to be divided into those that are part of the GDP definition
(what can be called credit used for ‘real transactions’) and those that are not (credit used
for ‘financial transactions’), such as real estate transactions.iii Thus we can say that the
rise (fall) in the amount of credit used for GDP-based transactions is equal to the rise
(fall) in nominal GDP.iv Meanwhile, asset prices are determined by credit creation used
for financial transactions.
The Vicious Cycle
This framework has been corroborated by the events of Japan in the 1980s and 1990s:
As we all know by now, the main cause of the recession of the 1990s was the excessive
bank lending for speculative purposes of the 1980s, which first drove up asset prices
(more purchasing power was created and used for real estate and financial transactions,
thus pushing up asset prices). However, this credit could only yield returns (capital
gains) while credit creation continued to push up asset prices. Thus it was clear that any
slow-down in credit for financial transactions would lower asset prices, create
bankruptcies and hence trigger bad debts in the banking system.v As soon as bad debts
occurred, banks became more risk-averse, thus reducing lending. This initially lowered
asset prices further and hence reduced bank lending to speculators. Since this expanded
the bad debt problem, banks began to reduce lending also to companies with
non-speculative investment projects. With credit creation for GDP-transactions, such as
loans to small firms, falling, nominal GDP had to fall. Small firms with sensible
projects, which continued to demand bank credit, became credit rationed, as banks
would not lend to them due to their high risk aversion. With falling GDP, corporate sales,
revenues and profits also had to decline, thus creating further bankruptcies, and hence
bad debts, leading to heighten risk aversion among banks and hence a further fall in
lending.
The Size of the Bad Debt Problem
How large is the bad debt problem? The estimates are getting larger by the day. This is
not surprising, for if the right policies are not taken (and they have not been for a
decade), the private sector and the banks will not be able to extricate themselves from
the vicious cycle of falling bank lending, growing bankruptcies, rising bad debts and
hence falling bank lending. In theory, the process could continue until 100% of all bank
loans have turned into bad debts, in which case the bad debt problem will have reached
about Y500 trn (about 100% of GDP). This teaches us that it is necessary to distinguish
between bad debts that are due to the weak economy, and those that are due to the
excessive lending of the bubble era. If we use the latter as the appropriate definition of
the bad debt problem, then we can calculate the aggregate amount of bad debts by
assuming that all net new loans to the three ‘bubble sectors’ (real estate, construction,
non-bank financial institutions) extended between 1985 and 1992 had to turn into bad
debts. This figure amounts to not much more than Y80trn. That, indeed, is precisely the
aggregate amount of bad debts that have by now been written off by the banks. In other
words, the core bad debt problem has been dealt with. All remaining bad debts are the
result of the long recession. To end it by breaking out of the vicious cycle is the task of
the authorities. If they fulfill their duty, then the secondary bad debts will largely
become performing again.
Policies that Could Not Work
The policies that could not possibly work to stimulate the economy were fiscal policy,
interest reductions, expansion of high powered money and increases in arbitrary deposit
aggregates: The credit crunch and consequent lack of new purchasing power in the
economy shrank the national income pie. In this situation, interest rate reductions
remained without effect, since the quantity of credit creation does not increase. Fiscal
policy also does not work, since it increases the government share of an unchanged or
shrinking national income pie – thus crowding out private demand.vi Boosting high
powered money also does not help, since monetary transmission through bank lending
had stopped. Further, increases in deposit aggregates are not necessarily linked to
increased economic activity, since they can be due to autonomous shifts of private
sector savings into or out of their arbitrary definition domain.
Increasing Central Bank Credit Creation
The policy that has been necessary and sufficient to increase nominal GDP and close the
yawning output gap is an increase in credit creation. This can be done (and, could have
been done for over a decade) through two avenues, namely through increased central
bank credit creation and increased bank credit creation. As to the former, the Bank of
Japan often claims that it cannot inject more money into the economy, because there is
no demand for it. The truth is, to the contrary, that the biggest demand for money in the
world is located in Japan: the government continues to demand record amounts of
money and many small firms remain cash-strapped and would like to borrow. We notice
that the Bank of Japan did little to supply funds to these areas, even though lending to
the government is a key function of a central bank and lending to companies through the
purchase or rediscounting of bills of exchange is standard procedure for central banks,
including the Bank of Japan.
Thus the Bank of Japan can always expand its own credit creation by lending to the
government and small firms. No matter what the demand for money, it can also increase
its supply, and hence boost economic activity by sharply increasing its asset purchases.
This is not all; the number of possibilities abounds. For instance, the central bank could
also directly transfer newly created money to all taxpayers (this is technically
straightforward, since the bank account numbers of tax payers are known and could take
place within minutes). A transfer of Y1m or Y2m to each tax payer would not fail to
increase net transactions (one could consider it a refund of money from the central bank,
since it failed to deliver the goods for a decade). I also fancy the idea of the BoJ buying
land and turning it into ‘BoJ parks’; this would support the real estate market, help the
banks that have collateralized much land and, most of all, improve the quality of life in
the concrete jungle of Japan’s cities.vii Unlike policies taken by the authorities over the
past decade, none of these policies burden the tax payer, crowd out private activity or
deliver negative side effects.
Increasing Bank Credit Creation
The second set of policies focuses on stimulating bank credit creation. This, in turn, can
be achieved in two ways. The first, and slower one, consists of economically efficient
measures to help the banks shed their bad debts. The second avenue consists of
government demand for bank loans, and will be discussed further below. As to the
former, the Bank of Japan’s recent announcement to purchase banks’ stock holdings is
unorthodox, but only a very indirect way of addressing the bad debt problem. Having
shown willingness to consider an unfamiliar method, the Bank of Japan should instead
have opted for one that directly solves the problem once and for all – and which has
already proven to be successful: instead of buying stocks from banks, the Bank of Japan
should have bought their bad debts at face value.viii Since the banks are connected
online with the Bank of Japan, the transaction could take place within one morning. By
buying debt for 100 that is now only worth, say, 20, Japanese banks would receive a
cash infusion that would turn them overnight into the strongest in the world. Instead of
making a loss of 80, as the Bank of Japan has argued, it would actually make a profit of
20 on this transaction, since it would simply print the money for nothing and get
something worth 20 in return.ix Most of all, this policy would not cost the taxpayer
anything: the money is created for free. Economics teaches that this is the most efficient
method to deal with the bad debt problem.
Post-1945 Precedent
This policy proposal has a proven track record and thus is hardly unprecedented: Just
after the war, in 1945, the problems of the Japanese banking system were naturally far
larger than they have been at any time in the 1990s. Close to 100% of their assets were
non-performing, consisting of forced loans to the munitions industry and compulsory
ownership of ‘Greater East Asian’ war bonds. Such debts of a country just defeated had
merely flea market value. So how did bank balance sheets improve rapidly, bank credit
soar, and economic growth accelerate so much that after a few years inflationary
pressure required monetary tightening? The Bank of Japan simply printed money and
injected it directly into the economy through asset purchases and direct lending to
corporate Japan. Secondly, it bought the banks’ bad debts at prices far above their
market value.x
How to Avoid Moral Hazard
Would Bank of Japan purchases of the bad debts create a moral hazard problem, as the
central bank claims? To avoid moral hazard, economic theory tells us that ‘those who
mess up should pay up’. As I demonstrate in recent research, the bad debt problem was
created by none other than the Bank of Japan itself.xi Hence central bank, not the
taxpayer should pay. This is also why the former FSA head Hakuo Yanagisawa was
right to reject the use of tax money to help the banks – it would create a serious moral
hazard problem. (Of course, the moral hazard of unpunished central banking mistakes
remains, which can only be addressed if the central bankers responsible for past policy
blunders are called for account and the central bank is legally rendered accountable to
democratically elected institutions).
The Goal of Central Bank Policy
If the solutions are clear, why has the Bank of Japan not been more cooperative? The
economic principle of ‘revealed preference’ indicates that for the past decade the Bank
of Japan has not been willing to create a recovery. This is surprising. To solve the puzzle
and find out why they have been averse to creating recoveries, we can only ask the
decision-makers themselves. Spokesman Kunio Okina said in 1999 that a recovery
would “relieve pain”. And less pain “may induce a further delay in the progress of
structural adjustment. When the economy recovers, non-performing loans could become
collectable, excess inventories could be sold, and excess equipment could become
operational”.xii That needed to be avoided, he argued. His view seems representative of
the Bank. Governor Hayami explained in 2000: “When the economy recovers… it
might well be the case that efforts for structural reform might be neglected due to a
sense of security”.xiii The Bank of Japan is a long-standing and declared enemy of the
post-war Japanese economic system. The central bankers have repeatedly told us that
what they really want is structural reform. And their calculation has been that a recovery
would slow or prevent such reform.
What the Government Can Do
If the central bank is unwilling to fulfill its mandate of price stability by stimulating
demand to fight deflation, the government needs to act on its own. What can be done
immediately by the government to boost bank lending and hence stimulate economic
growth effectively, even without the cooperation of the central bank, is a method I
suggested many years ago:xiv The government simply needs to stop the issuance of
government bonds and fund its public sector borrowing requirement directly through
borrowing from banks via simple loan contracts.
This proposal has recently been endorsed in a modified form by others, such as Tim
Congdon, who argue that the government should issue short-term financing bills instead
of government bonds.xv However, such an implementation may not be effective, since
the decision of whether or how much to purchase of these bills would remain up to the
banks. Because there is no guarantee that the banks will always buy all bills, some
crowding out of private sector activity due to government funding would most likely
persist. It is therefore clearly preferable - and also simpler in its implementation - for the
government to sign loan contracts with the banks to fund its public sector borrowing
requirement, thus guaranteeing complete monetisation. Doing so would immediately
boost bank lending by between 6 to 10%. No matter what the persuasion of an
economist, most agree that increasing bank lending would be positive for the economy.
Indeed, my proposal would create vigorous nominal GDP growth within about 9 months
and would set Japan on a sustainable path of growth without deflation or inflation. This
could be achieved, even if the Bank of Japan continued its policy of non-cooperation
with the government. Indeed, the sudden hint by the Japanese Ministry of Finance on 13
September that it might adopt such a policy could well have been what jerked the Bank
of Japan into action, thus announcing its latest, mainly political initiative.
This article draws on recent monthly Japan Liquidity Watch and Global Liquidity Watch reports by
the Profit Research Center Ltd., Tokyo, and the author’s forthcoming book Princes of the Yen, whose
Japanese edition became a No. 1 bestseller.
Richard A. Werner is chief strategist at Profit Research Center Ltd., Tokyo, and lectures
monetary economics and finance at Tokyo’s Sophia University.
The verbal description of this version is based on Richard A. Werner (2002),
The ‘Enigma’ of Japanese Policy Ineffectiveness in the 1990s, Paper
presented at the Money Macro Finance Annual Conference, Warwick University,
September 2002, forthcoming in The Japanese Economy, vol. 30.
ii Bank deposits would not be an accurate measure of ‘money’ M in the equation
of exchange, since that refers to the money changing hands to pay for
transactions during a given time period. By contrast, deposits measure the
amount of money not in circulation at any moment in time. Further, there
is no clear definition of deposit aggregates, since they measure a sub-set
of private sector savings – thus the profusion of M-aggregates. Credit
figures have the additional advantage of greater information value
concerning the use money is put to, which is necessary for the disaggregation
suggested below.
iii Werner, Richard A. (1993), Towards a quantity theorem of disaggregated
credit and international capital flows, paper presented at the Royal
Economic Society Annual Conference, York, April 1993, and at the 5th Annual
PACAP Conference on Pacific-Asian Capital Markets in Kuala Lumpur, June
1993; Werner, Richard A. (1997), Towards a new monetary paradigm: A quantity
theorem of disaggregated credit, with evidence from Japan, Kredit und
Kapital, Duncker and Humblot, Berlin, vol. 30, no. 2, July
iv As is well documented, in the empirical application one usually aims for
proportionality, since data inadequacy usually renders perfect equality
in levels unattainable.
v For a warning, see Richard A. Werner (1991), The Great Yen Illusion:
Japanese capital flows and the role of land, Oxford Applied Economics
Discussion Paper Series, No. 129, December
vi Empirical research has found perfect crowding out of private demand due
to un-monetised government spending in Japan during the 1990s. See Werner
(2002), op. cit.
vii For details of such proposals, see, for instance, Richard A. Werner
(1994b), May edition, Liquidity Watch, Jardine Fleming Securities, Tokyo;
Richard A. Werner (1995a), Bank of Japan: Start the Presses!, Asian Wall
Street Journal, Tuesday, 13 June; Richard A. Werner (1996a), The BoJ
i
prolonged Japan’s recession, Asian Wall Street Journal, Thursday, 13 June;
many of my articles in the Japanese press, whose English versions have mostly
also been available at www.profitresearch.co.jp
viii See, for instance, Richard A. Werner (2001), Princes of the Yen (Japanese
edition), Tokyo
ix It is of course possible to book these transactions on the central bank’s
balance sheet in such a way that the appearance of a loss is created. However,
there is no logically compelling reason for wanting to do this, except
perhaps sectarian political reasons by someone trying to prevent such
sensible policies from being taken. As to the oft repeated claim that such
a transaction would ‘damage the reputation’ of the central bank, the central
bank’s reputation has been badly damaged by irresponsible policies taken
over the past two decades. By contrast, the majority of investors appear
well aware that policies outlined in this article would be sensible, helpful
and contribute to an improvement in the central bank’s credibility.
x Richard A. Werner (2001), Princes of the Yen (Japanese edition), Tokyo
xi Richard A. Werner (2002), Monetary policy implementation in Japan: What
they say vs. what they do, Asian Economic Journal, vol. 16, no. 2, pp. 111
- 151
xii Okina, Junio (1999), Monetary policy under zero inflation: A response
to criticisms and questions regarding monetary policy, Monetary and Economic
Studies, December 1999, Bank of Japan, Tokyo
xiii Hayami, Masaru (2000), Challenges for Japan’s Economy: The central
bank’s perspective, speech given by Masaru Hayami, governor of the Bank
of Japan, at the Keizai Club, on 22 December 2000, available at
www.boj.or.jp/en/press/koen064.htm
xiv Richard A. Werner (1994b), May edition, Liquidity Watch, Jardine Fleming
Securities, Tokyo; Richard A. Werner (1998), Two birds with one stone through
government borrowing from banks as stimulation policy, Weekly Economist,
14
July
(English
translation
has
been
available
at
www.profitresearch.co.jp); Richard A. Werner (2000), ‘Japan’s plan to
borrow from banks deserves praise’, Financial Times, 9 February; Richard
A. Werner (2001), Princes of the Yen (Japanese Edition), Tokyo, May.
xvTim Congdon (2002), What is to be done about Japan’s financial crisis?,
Central Banking, Vol. XII, No. 4, May 2002. While it appears that Congdon’s
argument is based on the importance of credit creation, as outlined in our
framework, he says that it instead hinges on the assumption that an arbitrary
subset of private sector savings (such as M2 or the like) is in a stable
relationship with economic activity, and that an increase in such savings
would result in greater economic activity. However, there is little evidence
to support this assumption, while the model presented in this article is
theoretically and empirically well supported; see for instance Werner (1997),
op. cit.; Werner (2002), op. cit.