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A joint initiative of Ludwig-Maximilians-Universität and the Ifo Institute for Economic Research
VOLUME 4, NO. 4
Forum
WINTER
2003
Focus
JAPAN
IN
CRISIS
Hirohiko Okumura
Yutaka Imai
Robert Dekle
Adam S. Posen
Hanns Günther Hilpert
Pro and Contra
EU SOCIAL UNION?
Guiseppe Bertola
Hans-Werner Sinn
Spotlights
EXCHANGE RATES
CAPITAL FLOWS
FOREIGN EXCHANGE RESERVES
WES
WORLD ECONOMIC SURVEY
Trends
STATISTICS UPDATE
CESifo Forum ISSN 1615-245X
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Editor: Heidemarie C. Sherman, Ph.D., e-mail [email protected]
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www.cesifo.de
Forum
Volume 4, Number 4
Winter 2003
_____________________________________________________________________________________
Focus
JAPAN IN CRISIS
Economic Crisis and Economic Policies in Japan since the 1990s
Hirohiko Okumura
Japan’s Growth Challenge
Yutaka Imai
Japan’s Deteriorating Fiscal Situation
Robert Dekle
Did Monetary Laxity in Japan Cause the Bubble?
Adam S. Posen
Japan: Is the Crisis Over?
Hanns Günther Hilpert
3
12
16
21
27
Pro and Contra
A SOCIAL UNIOIN FOR THE EU?
Pro: An EU-Level Social Policy
Guiseppe Bertola
Contra: Europe Does Not Need a Social Union
Hans-Werner Sinn
35
36
Spotlights
Exchange Rates and Capital Flows Reverse Direction
Sharp Rise in Private Capital Flows to Emerging Market Economies
Enormous Growth of Foreign Exchange Reserves in Asia
37
38
39
WES
World Economic Survey
40
Trends
Statistics Update
47
Focus
JAPAN
IN
CRISIS
economy has been the lack of consistency in policies. The economy therefore fell into a state of
“dynamic inconsistency,” in which economic agents
could not believe that the government and policy
makers would adopt consistent policy-making attitudes in the future. It is said that asset prices (as of
2003) may not yet have hit bottom 14 years after
the beginning of their steep fall. One reason for
this state, which was not even experienced during
the Great Depression in the 1930s (where, for
example, US stock prices represented by the Dow
Jones 30 industrial index dropped from a peak of
381 on Sept. 3, 1929, to a bottom of 41 on July 8,
1932, after roughly three years), is that the margin
of fall from the initial peak was not so large as that
in the United States during the Great Depression.
Another reason may be that the uncertainty of
future revenue and discount rates that should be
reflected in asset prices has increased very much
under the inconsistent implementation of policies.
Similarly, when economic systems as represented
by pension, financial, and budgetary systems
become highly unsound and their future cannot be
predicted, economic activities of consumers and
enterprises are less responsive to economic stimulation policies than before.
ECONOMIC CRISIS AND
ECONOMIC POLICIES IN
JAPAN SINCE THE 1990S
HIROHIKO OKUMURA*
I
n the 1990s, the Japanese economy experienced a
deep decline, following 40 years of growth. The
deterioration of performance became so serious not
only because the rate of economic growth was low
but also because the soundness of the economic systems supporting the lives of the Japanese citizens
deteriorated with no endogenous mechanism for
reform. The latter include the pension system, the
financial system, and the budgetary system whose
increasing uncertainty created great concern among
the Japanese citizens about their future lives.
In this paper, we will examine the relationships
between the deterioration of performance and economic policies. The period under consideration coincided with the collapse of the bubble economy, which
occurred in the latter half of the 1980s. It was an exceptional period in which policy makers found it difficult
to predict the conduct of economic agents. Therefore,
for an analysis of the relationships between the deterioration of performance and economic policies it is
important to look at the relationship between (1) the
changes in conduct of economic agents and the reform
of the economic structure, and (2) the economic performance and the effectiveness of economic policies,
particularly the conduct of each economic entity
under the influence of enhanced uncertainty.
Inconsistency of
monetsry and fiscal
policies over time
This dynamic inconsistency of economic policies
was observed in both fiscal and monetary policies,
as well as in financial management policies. In fiscal policy, for example, while the government
enforced tax increases and public expenditure cuts
by promoting policies of rehabilitating the economy through budgetary reconstruction in 1996 and
1997, they adopted policies of suspending budgetary reconstruction and economic expansion
through tax reduction and increasing public expenditures in 1998, a complete change. Thereafter, in
2001, the government again suspended the fiscal
policies to stimulate the economy while the market
was still dull and stock prices continued to fall.
“Dynamic inconsistency” in economic policies
Inconsistent policy development
The largest problem since the 1990s in developing
economic policies after the collapse of the bubble
In financial investment and loan programs, the
government loudly proclaimed that public financial institutions were unnecessary and should be
reduced in number and subsequently initiated
* Gakushuin University.
3
CESifo Forum 4/2003
Focus
early resolution of the problems. In later developments, asset prices dropped continuously because
economic policies to promote economic growth
consistent with a recovery of asset prices were not
implemented, and in 1996, it became necessary to
inject public funds in the amount of 685 billion yen
to the housing loan corporations. Upon massive
criticism, the government and the monetary
authority were later content to stand by while large
security companies and large city banks collapsed.
However, their policy reversed again from 1998
through 2003, when they again found it necessary
to inject huge amounts of public funds (about
35 trillion yen) to relieve the financial systems.
their transfer to private hands (1996 to 1997). In
1998, however, it reversed policy and largely
expanded the credit limit and guaranty limit of
public financial institutions as countermeasures
against “reluctant credits” of private financial institutions. Toward the Japan Development Bank, in
particular, the government suddenly changed its
attitude and began extending credit to small and
medium-sized enterprises by exceeding the conventional range of credits for plant and equipment
of large enterprises and further requesting to make
loans for long-term working funds including measures for fund management, such as smoothing the
refunding of bonds. This new policy is equivalent to
assigning the role of last resort for long-term
finance to the Japan Development Bank, just like
the Bank of Japan is playing the role of the last
resort for short-term finance. This was quite contrary to the assertion of reducing the role of the
Japan Development Bank, which had been made
immediately before this change in policy.
No consistent
policies for growth
From the collapse of the bubble economy to the
spring of 1995, monetary policy was characterized by
a high real rate of interest accompanied by low
growth of the money supply. Thus, in the autumn of
1994, the government raised the money market rate
(call rate). From the autumn of 1995, however, the
government switched to an ultra-low interest rate
policy which was maintained while the economy
indicated recovery at annual real rates of growth of
3 percent and 4.4 percent for two consecutive years
(fiscal 1995 and 96). During that period, monetary
policy and fiscal policy became inconsistent because
fiscal policy changed direction to slow the expansion
as described above. With business conditions again
falling into the doldrums, the Bank of Japan was driven into the zero interest policy from 1999.
Also in line with the Koizumi Cabinet policy of
emphasizing structural reform, this policy is repeated. As a result, while the government asserted its
desire to reduce the role of public financial institutions, it actually further expanded the functions of
the Development Bank of Japan (the new name of
the Japan Development Bank after merging with
other government financial institutions) so that it
can play a role in revitalising the Japanese economy.
These policy developments clearly suggest that,
immediately after the collapse of the bubble economy, policy makers had no intent to raise the growth
rate as much as possible but were rather governed
by the idea that a low growth rate was either allowable or inevitable. Under these circumstances the
attitude toward economic growth swayed significantly, and policies to emphasize economic growth
became dominant during 1997 and 1998, when the
economy suffered a negative growth.
Inconsistent policies for achieving financial system
soundness
In financial administration, measures for injecting
public funds to protect against bad assets of financial institutions and to achieve soundness of financial systems were changed frequently. The
“Comprehensive Economic Countermeasures”
issued by the ministerial conference on August 28,
1992 called for implementing measures to secure
the stability of the financial systems. Four measures were to cope with the issue of bad assets of
financial institutions: (1) measures to give liquidity
to pledged real estate, (2) tax procedures based on
the practical situation, (3) establishment of a system to publish the amount of bad assets held by
financial institutions, and (4) early establishment
of methods to deal with issues like the housing
loan corporations and non-banks. At that time,
however, there was no intention to fully make public the problems of the banks in order to achieve an
CESifo Forum 4/2003
Relationship between economic growth and
economic systems
Economic growth as the prerequisite for
conventional economic systems
The most important point concerning the “dynamic inconsistency” of economic policies discussed in
the previous section is the relationship between
4
Focus
dropped below the target. Thus, problems expanded while the economic systems were left alone until
they fell into unsoundness.
economic growth and the soundness of economic
systems. Any economic system, including pension,
budgetary, and financial systems, is closely related
to economic growth. The reason is that, while the
yield on investment assets and the growth of the
standard wage of employees in the pension system
will vary according to the growth of the economy,
so too will the growth of tax revenue in the budgetary system, and the price of equities and real
estate held by financial institutions in the financial
system. The soundness of loans of financial institutions depends on the soundness of debtors, which is
deeply related to the growth of the economy.
In other words, the government and officials in
charge of policy making were buying time until the
problems would be resolved by giving the illusion
that the economic systems were sound.
Economic systems becoming unsound with
confusion over policies
At the beginning of the 1990s, prompt policies to
expand demand should have been implemented
without creating an illusion in economic systems.
Efforts to reform the economic systems should
have been made at an earlier stage even in the
absence of an expanding economy. In that case
people would have realized that a welfare society
for the aged cannot be built with a low growth rate
and thus would have changed their life styles. In
reality, however, with no such policies, the Japanese
economy gradually evolved into a state of economic decline, depressed by an unsound economic system, particularly in the latter half of the 1990s. For
example, as the pension system collapsed and an
extreme increase in government debt was
revealed, people became increasingly uneasy about
life in the future. Their desire to spend became
weaker. This was confirmed by the results of the
Opinion Survey on Lifestyle and Financial
Behavior of the Bank of Japan in March 2000
which showed that 41.7 percent of all households
decreased their expenditures compared to the previous year. (Only 6.3 percent of the households
increased their living expenditures.) Three reasons
cited by these households were: (1) anxiety about
the future job or income (60.4 percent), (2) anxiety
about the decrease of payments from a pension or
social insurance (52.5 percent), and (3) anxiety
about increases in taxes and social security contributions (36.7 percent).
In Japan, the economic growth rate used as the prerequisite in designing these economic systems is
not made explicit, but a real economic growth rate
of 3 percent or more seems to have been tacitly
assumed in recent years. It was considered to be
almost equal to the potential growth rate of the
Japanese economy at that time. It was also considered the medium-term growth rate that was
expected by private enterprises until the beginning
of 1993. Furthermore, it was also the target growth
rate for the government’s medium-term economic
plan.1
In contrast, the real rate of economic growth averaged only 1.6 percent from fiscal 1991 to 1997. In
particular, the growth rate during the fiscal period
of 1992 to 1995 was not only less than the potential
growth rate but quite a bit less than the target
growth established by the government each year.
During that period, the government continued
operation of various economic systems without
changing their conventional designs. Eventually,
business conditions became poor and the economic systems became unsound (i.e., underfunding in
the pension system, increase in the public debt
(including latent debt), increase in non-performing
loans of financial institutions, etc.). But the policymakers continued to operate these systems in a
conventional manner on the supposition that the
economy would expand steadily according to its
potential. However, without policies to stimulate
the economy, the actual growth rate continuously
Unrealistic growth
assumptions
underlying systems
operation
Under these circumstances, a prolonged period of
unresolved financial system issues prevented the
financial institutions from developing positive
investment and financing strategies. The recovery
of investment activities of enterprises, particularly
medium and small-sized enterprises, was made difficult, and brought about lack-luster stock prices.
Given such developments, it is difficult to stimulate
business conditions only by implementing policies
to increase demand. Therefore, policies that stress
1
The medium-term economic growth rate predicted by private
enterprises was surveyed by the Economic Planning Agency.
(“Survey of the conduct of enterprises”). As a practical example of
medium-term economic planning established by the government,
the 5-year plan of 1987 predicted an average real economic growth
rate of about 3.75 percent for the period from fiscal 1988 to 1992;
the 5-year plan of 1992 predicted an average real economic growth
rate of about 3.5 percent for the five-year period from fiscal 1992
to 1996; and the “economic and social plan for structural reform” of
1995 predicted an average real economic growth rate of about
3 percent for the five-year period from fiscal 1996 to 2000.
5
CESifo Forum 4/2003
Focus
ernment then reduced the income tax for the
first time after the collapse of bubble economy.
(3) Though business conditions improved in the fiscal years 1995 and 1996, they deteriorated again
in and after the fiscal year 1997. Some causes
mentioned for this dip were the failure of major
financial institutions, economic crises in Asia,
and increased prudence in lending attitudes of
financial institutions due to restrictions by the
BIS regulation. Policy makers also began to
emphasize, for the first time, how factors such as
the increase in uncertainty about the future
bring about risk-avoiding actions, which will
hinder the recovery of business conditions.5
the aspect of supply, structural reform, and deregulation gradually came to be emphasized.
During the collapse of Japan’s bubble economy, economic conduct of each economic entity differed
from ordinary conduct. Generally speaking, the policy planning authority was unable to develop appropriate policies under such conditions due to four
factors: (1) time lag for recognition, (2) errors in
judgment, (3) time lag for changing and implementing policies, and (4) inconsistency of the policies.
With the help of official documents of the
Economic Planning Agency and the Bank of Japan
we can show how Japanese policy makers assessed
the economic situation during the period after the
collapse of the bubble economy from 1990 to 1997
and how their assessments were based on erroneous diagnoses.
Three factors
prevented appropriate policies
It is important to note here that seven years had
passed since the collapse of the bubble economy
before Japan came to recognize strongly that (1)
there are large influences of financial factors on
the real economy and (2) uncertainty and psychological factors of economic agents are necessary
for understanding human activities in the market
economy.
(1) From 1990 to mid 1992, when asset prices began
to fall, they considered the state of affairs as an
ordinary phase of the business cycle. They
stressed the fact that steady increases in corporate profits and economic expansion without
inflation were continuing in the real economy.
They had already noticed that something was
unusual in the financial sector during the bubble economy in the later half of the 1980s and
did not stress the rise in asset prices due to the
bubble economy or its influence on the real
economy.2 In early 1993, they judged that there
would be a recovery during the second half of
1993, though they began to stress the adverse
effects of the drop of asset prices. By deeming
it a business cycle, they assumed the collapse of
the bubble economy itself would end in 1993.3
(2) When business conditions did not recover in
the first half of 1995, the Bank of Japan was driven to lower the official discount rate to
0.5 percent. Factors cited for the unexpected
economic lull were the yen overvaluation, the
Hanshin-Awaji Earthquake, and the rise of the
East Asian economies. At the same time, the
problems with balance sheets were cited as an
after-effect of the bubble economy.4 The gov-
The implementation of a tax reduction was delayed
until fiscal 1994 and a continuous interest rate
reduction was delayed until the beginning of 1995.
Inconsistency of monetary and fiscal policies
occurred but inconsistency was also conspicuous
between policies concerning business conditions
and policies concerning economic systems.
Thus, being faced with the collapse of conventional
economic systems, the arguments for structural
reform came to the fore while the arguments for
economic growth receded. As a result, at least as a
short-term target, the movement to pursue reconstruction of economic systems through a contractionary policy instead of an expansionary policy
was enhanced. However, the policy to release the
strain of financial institutions as well as business,
government, and the United States as debtors by
maintaining an ultra-low interest rate for an
extended period of time seems to be contradictory.
In the 1990s, Japan was the richest economy in the
world from a macroeconomic viewpoint, as it had
surplus labor and abundant funds to make it the
largest creditor nation in the world. Furthermore, it
was clear that the working population would begin
to decline in 2000 and the total population would
2
“Economic White Paper of Japan” compiled by the Economic
Planning Agency, 1992 issue. “Monthly Report of the Bank of
Japan” published by the Bank of Japan, June 1992 issue.
3 “Economic White Paper of Japan” compiled by the Economic
Planning Agency, 1994 issue. “Economic White Paper of Japan”
compiled by the Economic Planning Agency, 1998 issue.
“Monthly Report of the Bank of Japan” published by the Bank of
Japan, June 1998 issue.
4 “Economic White Paper of Japan” compiled by the Economic
Planning Agency, 1995 issue. “Monthly Report of the Bank of
Japan” published by the Bank of Japan, June 1995 issue.
CESifo Forum 4/2003
5
“Economic White Paper of Japan” compiled by the Economic
Planning Agency, 1998 issue.
“Monthly Report of the Bank of Japan” published by the Bank of
Japan, June 1998 issue.
6
Focus
increased in Japan while decreasing in the United
States. When the yen tends to depreciate continuously against the US dollar, investors inside and
outside Japan move their capital from Japan to the
United States, against a background of a gap in
interest rates between the two countries. In other
words, when capital moves out of Japan due to the
ultra-low interest rates there, US bond prices rise
due to the purchase by foreign investors or expected purchases (lowering of long-term interest rates).
Stock prices will also rise more easily. In this case,
economic activity accelerates in the United States
due to the lowered long-term interest rates and
higher stock prices and the demand for money
increases. If policies to maintain a constant money
supply are adopted, the trend of US dollar appreciation against the yen will continue. Japanese
investors can obtain a high return on investments in
dollar-denominated financial assets due to both US
dollar appreciation against the yen and increase in
prices of financial assets. They are therefore further
induced to invest in dollar-denominated financial
assets. At the same time, similar effects can also be
obtained from transactions where foreign investors
obtain yen-denominated funds in Japan at a lower
interest rate and then employ such funds in dollardenominated financial assets either inside or outside the United States.6
peak in 2007. The population is expected to
decrease by about 7 million by the year 2025 and by
about 30 million by 2050. Also, a new aged society,
including 32 million people over the age of 65, will
become a reality in the near future. Thus, when the
Japanese economy is positioned in a historical setting, it can be concluded that an expansionary policy rather than a contractionary policy should have
been adopted in the second half of the 1990s. It was
necessary to redesign the economic systems while
converting potential growth into actual growth.
Domestic economic policies and their influence
on foreign countries
Extraordinary development of policies in Japan
and influences on foreign countries
Adoption of the above mentioned economic
polices and a continuously unstable economy in
Japan (the largest creditor country in the world)
gave rise to a vicious circle, first influencing the
economies of foreign countries, particularly the
United States (the largest debtor country) which in
turn affected Japan.
For example, the ultra-low interest rate policy of
Japan affects not only the exchange rate leading to
a strong dollar and a weak yen but also the interest
rate of the United States. It also affects the stock
prices in the United States directly and indirectly.
In other words, we should consider that the model
of the small open economy is not applicable to the
actual relationship between Japan and the United
States at this point in time. This may also be supported by the fact that even the US Federal
Reserve cannot judge which interest rate is appropriate when there are extraordinary movements in
the financial markets or the real economy.
Nevertheless, we can suppose that the attitude of
the financial authority of Japan during the collapse
of the bubble economy complied with the model of
the small open economy in the short run.
International
repercussions
Instability of exchange rate and policy-induced
international expansion of finance
We have already experienced cases in which the
exchange rate changes (on a short-term basis) as a
result of capital movements. In the first half of the
1990s, for example, when US fiscal policy aimed at
expanding the economy, monetary policy left the
rising interest rate alone. During the same period,
both the fiscal and monetary policies of Japan were
operated to maintain neutral business conditions.
Capital was transferred from Japan to the United
States, resulting in a large US dollar appreciation
against the yen. (During that time, changes in the
system, such as deregulation on portfolio investments in foreign countries by Japanese institutional investors, was also a factor resulting in fluctuations in the exchange rate.)
From fiscal year 1997 to the first half of fiscal year
1998, Japanese fiscal policy shifted toward contraction, while monetary policy was maintaining an
ultra-low interest rate. During the same approximate time, neutral monetary and fiscal policies
were pursued in the United States. As a result, capital moved from Japan to the United States, the yen
depreciated against the US dollar, and net exports
Thus, differences in policy mix of monetary and fiscal policies between Japan and the United States is
often closely related to the fluctuation of the
6
“Borrowing Asia’s Troubles,” New York Times, December 28,
1977.
7
CESifo Forum 4/2003
Focus
exchange rate. In other words, unusual fluctuations
of exchange rates are often caused by the unusual
economic policies of either Japan or the United
States. In the case of monetary policy, for example,
when the real interest rate is compared with the
actual state of economy, it can be seen that the
interest rate in the United States in the first half of
the 1980s was abnormally high. The interest rates
in the United States from 1991 to 1993 and the
interest rates in Japan in the latter half of the 1990s
were abnormally low.
This movement became evident from mid-1990.
From 1996 and through 1997, for example, the
annual inflow reached approximately 600 billion
dollars, and the outflow reached approximately
$350 billion. In 2000, the inflow was $932 billion,
and the outflow was $521 billion.
(1) The economic policies of Japan as a creditor
country and the international intermediation of
the United States as a debtor country, together
with a huge amount of fund shifts from personal deposits to mutual funds (approximately $600
billion in 1992 to 1997) were among the main
causes of the extraordinarily steep rise of US
stock prices (the aggregate market value of
stock increased 2.7 times, or about $8 trillion
from 1993 to 1998 and increased another
$6.2 trillion from 1998 to 1999) and also eventually gave rise to a boom of the real economy
inside and outside the United States. However,
this boom had the intrinsic potential to cause
the Asian economic crisis in the autumn of 1997,
and a subsequent world economic disturbance.
This shows that, if countries adopt their unique
policies by asserting the independence of policies
under the floating exchange rate system, the
exchange rate will exhibit unstable fluctuations.
Cooperation in policies among leading countries is
essential for the stability of the exchange market.
“In setting national policies, the international
implications and interactions of those policies
should receive an appropriately high priority.”7
The United States
as international
fund intermediator
In view of this, economic policies implemented by
Japan and the United States in the 1990s are seen
to have disturbed the short-term movement of the
exchange market. The yen rate against the US dollar fluctuated violently from approximately
160 yen per dollar in 1990 to approximately 80 yen
in 1995 and to 147 yen in 1998, making the management of Japanese enterprises quite difficult.
Japanese foreign reserves reached 204 billion dollars by the end of 1995 as a result of large interventions of purchasing dollars and selling yen in
the process of yen overvaluation in the fiscal years
of 1994 and 95 (foreign reserves increased by
approximately 100 billion dollars in two years). To
cope with the yen depreciation in the latter half of
the 1990s, there should have been interventions in
the first stage in spite of side effects. However, the
Government of Japan did not dare to implement
such intervention, possibly because they wanted to
give some consideration to the United States.
In other words, the three abnormalities, i.e. (1) shift of
funds from deposits to mutual funds by the household
sector in the United States, (2) the large scale international fund mediation by the United States, and (3)
the ultra-low interest rate of Japan as a creditor country) are interrelated, and none of them was sustainable. The subsequent phenomena of a simultaneous
drop in world stock prices and the disturbance of
exchange markets can be said to be a consequence of
these abnormal economic policies. The confusion that
occurred in the Asian region after 1997 must be
understood in the framework of overall world finance
and economics. Japanese economic policies provided
a very large influence in that context.8
Break-out of the “finance trap” and public-sector
finance reform
To resuscitate the Japanese economy, the systematic relevance between the real economy, privatesector-related financial intermediation, and publicsector-related financial intermediation must be
analyzed methodically since private and publicsector finance coexist in Japan. Japan must thus
adopt a properly unified policy.
With the increase in the exchange rate of the US
dollar and the rise in returns on dollar-denominated financial assets, to which Japanese economic
policy related closely, the United States performed
the role of international intermediation or funds.
They took in huge amounts of funds from foreign
countries and put them to use again in foreign
countries.
8 The central bank of Germany also performed a similar analysis of
the relations between international fund mediation/excess liquidity
and the economic crisis in Asia (Deutsche Bundesbank (1998),
“Die Verschuldungskrise ostasiatischer Schwellenlander,” Deutsche Bundesbank Geschaftsbericht 1997.) pp. 116 to 123.
7
Group of Ten, “The Functioning of the International Monetary
System”, 1985.
CESifo Forum 4/2003
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Focus
The market economy and public-sector finance
control. This adversely influences the healthy
growth of a market economy.
In a market economy, why is the government
involved in financial intermediation? Uncertainty
and financial instability are inherent in the market
economy. The future is always uncertain for financial
entities. When uncertainty grows, financial intermediation by private economic entities tends to
increase the costs, as it overestimates the risks of
borrower and lender. For this reason, financial intermediation by public-sector finance that satisfies specific conditions may ease the burden on the people.
Government participation in the market economy
therefore has a desirable aspect as business cycles
and financial crises are unavoidable. Uncertainty in
the market economy should be considered a different criterion from risk, and public-sector finance
should only be employed in areas containing greater
uncertainty. In this case, uncertainty defines a situation in which there is either a drastic change of economic structure or instability resulting from loss of
balance in the economic conditions. Examples of the
former include an abrupt change of industrial structure, innovations in techniques, changes in regulations, and geographical changes in natural resource
distributions. An exceptional deterioration of the
economy can be an example of the latter.
First, on both the financial and real-economy sides,
putting more weight on the government sector and
reducing the role of the private sector lowers the
efficiency of resource utilization. Obviously, there
would not be any problem if people chose this state
responsibly. As noted above, however, public-sector finance is becoming more unmanageable due to
a lack of consistent, clear information on costs and
benefits, and the question of who bears responsibility for them.
Second, the inflow of huge sums of money into public-sector finance channels exceeds the level of the
original purpose, which is (1) being funded by governmental financial institutions and (2) for public-sector projects. In its current state, the funding inflow is
diverted from its true purpose and is directed toward
funding portfolio investments in national and local
bonds. The purchase of national and local bonds by
public-sector finance is not a responsible action carried out based on risk-return considerations. A large
influx of funds causes prices of national and local
bonds to rise sharply and a long-term interest rates to
fall. Consequently, long-term interest rates become
very low, the interest curve is flattened, and the price
mechanism is artificially distorted.
In public-sector finance, funds are collected from
postal savings, postal life insurance and public pensions. These funds are spent on (1) financing by
governmental financial institutions, (2) financing
governmental institutions for public projects, and
(3) purchasing national and local bonds. The presence of public-sector finance in terms of size and
business scope is much larger than optimum.
Analyzing the background of this dissociation
reveals four problems in the government.
Harmful effects
of public sector
finance
Third, the supply of risk money from the households,
the ultimate lenders, becomes inadequate. The major
routes open to a flow of funds from the ultimate
lender to the ultimate borrower, are deposits and
loans through the private sector, postal savings, postal
insurance, and public pensions. Capital market routes
have been markedly few in Japan. Present conditions
and the high presence of public-sector finance are
closely related. From the viewpoint of a household,
the market is not adequately prepared to diversify
risk. Until 1998, regulation of comparison information
was applied to financial assets, and information related to portfolio selection itself was not fully available.
Funding high-risk, high-return projects thus becomes
extremely difficult. How can such a situation continue
for over 15 years after the start of deregulation of
interest rates on deposits? How do the development
of a capital market and the supply of risk money
transform into an empty slogan? One cause could be
that policy-making authorities do not recognize the
financial structure as a means of reducing the information and transaction costs in economic affairs and
of promoting the accumulation of capital and techni-
(1) The entities that collect funds and the entities
that use those funds do not communicate, and
thus they do not act together.
(2) There is no clearly responsible authority.
(3) There is no information available about cost
and return, and performance on financial intermediation is unclear.
(4) There are no controllers to recognize and direct
public-sector finance.
Harmful influence of excessive public-sector
finance on the market economy
The actual scale and function of public-sector
finance are far from ideal and are getting out of
9
CESifo Forum 4/2003
Focus
cal innovations. The authorities also fail to recognize
that the growth of the economy depends on the structure of finance. Americans and Europeans understand that the prosperity of the 1990’s was attained
using the capital market as a catalyst, but that thought
has not reached the authorities in Japan. For example,
in some reports such as the White Paper on the economy, one central government agency pointed out that
the problem of the Japanese economy is that the
household single-mindedly prefers deposits-and-savings over providing risk money. Another central
agency has declared that several hundred trillions of
yen collected from the households are only applied to
clearly low-risk financial assets. It is unreasonable to
expect any consistent policies under these conditions.
Necessary reform
of public sector
finance
Generally, the state of finance influences economic development by promoting technological
change. As finance affects the real economy, the
result depends on information and transaction
costs, the unbundling and transaction of risks, distribution of resources, supervision of borrowers,
and utilization of savings. The capital market that
supports economic development must carry out
responsible investment based on risk and return.
The flow of funds in Japan, which inclines heavily
toward public-sector finance, is just the opposite.
Furthermore, public-sector finance significantly
influences the behavior of private financial institutions. Public-sector finance no only intrudes in the
realm of private-sector finance in terms of
deposits, insurance policies, housing loans, etc. but
the activities of public-sector finance also flatten
the yield curves, making it difficult for private
financial institutions to make long-term loans. In
other words, because public-sector finance continues to purchase large volumes of government and
municipal bonds regardless of the price, thereby
helping to lower long-term rates of interest, such
yield curves will prevent private financial institutions from obtaining a sufficient profit margin
between short-term procurement of funds and
long-term lending, and makes it difficult for them
to assume the risk of long-term loans. As a result, a
vicious circle repeats itself, in which business conditions flag while new bad assets are produced,
financial conditions of private financial institutions
do not improve, and household funds again flow
into public financial institutions.
Fourth, excessive public-sector finance introduces a
lax attitude of politics and policy-making authorities toward the budget deficit. Given the unconditional purchasing of national government debt by
the public sector without any consideration of risk
versus return, that sector cannot consider the prices
(interest rates) of national government debt instruments as the standard for resource allocation.
Politicians and bureaucrats concerned with policy
decisions, however, view the low interest rate of
national government debt as an indication that people are supporting a policy of deficit finance.
Harmful influence of excessive public-sector
finance on policy management
Hypertrophic public-sector finance also negatively
affects policy management because it impairs the policy implementation mechanism. For example, the existence of such public-sector finance decreases the
effectiveness of expansionary monetary policy after
the collapse of the bubble economy or in a financial
crisis. In such circumstances, the household sector
shifts funds from private-sector finance to public-sector finance. In fiscal years 1991 to 1999, a little more
than 50 percent of the rise in financial-assets was
turned over to public-sector finance. Public-sector
finance applies half of these funds to portfolio investment and circulates funds to national and local government bonds that they believe are safe and certain.
In this way, even if a central bank adopts a super-low
interest-rate policy and implements quantitative easing, the credit channel through which a loan from private-sector financial institutions passes is not expanded. Furthermore, these activities do not favorably
influence risk-asset prices, such as stock prices, and
therefore the credit expansion effect that is triggered
by a boost of asset prices does not work.
CESifo Forum 4/2003
In addition, if structural reform is attempted, the
presence of hypertrophic public-sector finance
prevents internal conversion of the economic systems and thus reduces the effect of policies. This is
because, in one channel, fund operation of households constitutes a main cause of the bias to indirect finance instead of direct finance and, in the
other channel, large investment in public bonds
results in a huge budget deficit, while an increasing
government debt prevents the decline of the standard of living of households.
A practical solution to the public-sector finance
problem
In summary, Japan failed to create the channel for
funding via the capital market, but it allowed an
unusual flow of funds that infringes on the market-
10
Focus
Calomiris, Charles W. (1993), Financial Factors in the Great
Depression, Journal of Economic Perspectives, Vol. 7, No. 2, Spring.
economy principle by expanding public-sector
finance. Japan became increasingly entangled in its
own net and eventually fell into the “trap of
finance.” The top priority of the Japanese economy
should now be to break out of this trap. There is no
time to wait for the system reform called publiccorporatization or privatization of postal savings
and postal insurance. All that is required is the
replacement of the portfolio management system
by public-sector finance (that, as mentioned above,
reaches several hundred trillion yen) by a responsible management system based on public disclosure of performance, personnel evaluation, and a
risk-return analysis.
Fazzari, Steven (1992),“Keynesian Theories of Investment and
Finance: Neo, Post, and New” in Fazzari, Steven and Papadimitriou,
Dimitri B. eds. Financial Conditions and Macroeconomic Performance: Essays in Honor of Hyman P. Minsky, Chapter 8 M. E. Sharpe.
Friedman, Benjamin M.(1988), Lessons on Monetary Policy from
the 1980s, Journal of Economic Perspectives, Vol. 2, Number 3,
Summer.
Galbraith, John Kenneth.(1990), A Short History of Financial
Euphoria; Financial Genius is Before the Fall, Whittle Direct Books.
Garcia, G.&Saal, M.(1996), “Internal Governance, Market
Discipline and Regulatory Restraint : International Evidence”, Federal Reserve Bank of Chicago, 32nd Annual Conference on Bank
Structure and Competition.
Haberler, Gottfried.(1980), “The Great Depression of the 1930s
Can It Happen Again?” The Business Cycle and Public Policy,
1920–80, A Compendium of Papers Submitted to the Joint Economic Committee, Congress of the United States, November 28.
Keynes, John Maynard(1936), The General Theory of Employment,
Interest and Money, Macmillan & Co., Ltd.
Fortunately, stock prices have fallen a little less than
30 percent from the year-end peak in 1989. Since
stocks are held for a long time, this is even less than
the historical trend covering 200 years in the U.S. and
40 years in Japan. Annual real returns of 7 to 8 percent are to be expected if stocks are held for a long
time. Equity investment by public-sector finance
may cause difficulties for the corporate governance
of a private enterprise, when an individual stock is
chosen. However, Exchange Traded Funds (ETF),
which enable dealing in all Japanese stocks at any
time and for a low commission, has been available
since the summer of 2001, and it also eliminates the
need of choosing an individual stock. If portfolio
management by public-sector finance is developed
into a responsible system, there will be a strong shift
of public funds from governmental bonds to stocks,
with a comparatively high price of bonds under a
record-low interest rate. Ignited by this, an individual
fund may be both directly and indirectly shifted from
the deposits and savings of zero interest into stocks.
A healthy stock price may thus return to a level at
which the vicious circle of the Japanese economy
may be broken.
Keynes, John Maynard(1937), “The General Theory of Employment”, Quarterly Journal of Economics,Vol. 51 February.
Kindleberger, Charles P.(1978), Manias, Panics, and Crashes:A History of Financial Crises, Basic Books, Inc.
Minsky, Hyman P.(1971),“Financial Instability Revisited: The
Economics of Disaster” Board of Governors of the Federal Reserve
System, Reappraisal of the Federal Reserve Discount Mechanism.
Minsky, Hyman P. (1975), John Maynard Keynes, Columbia
University Press.
Okumura Hirohiko(1999), “Gendai Nihon Keizairon-Baburu
Keizai No Hassei To Hokai” (Japanese Economy – The Occurrence
and Corruption of the Bubble Economy in Japan after 1987), Toyo
Keizai Shinposha.
Rabin Matthew (1998), “Psychology and Economics” Journal of
Economic Literature, Vol. 36, March.
Rabin Matthew (2002), “A Perspective on Psychology and Economics” European Economic Review 46. May.
Rhoades, Stephen A.(1977), “Structure-Performance Studies in
Banking: A Summary and Evaluation” Board of Governors of the
Federal Reserve System. Staff Economic Studies No. 92.
Salant, Walter S.(1980), “How Has the World Economy Changed
Since 1929?”, The Business Cycle and Public Policy, 1920–80, A
Compendium of Papers Submitted to the Joint Economic Committee, Congress of the United States, November 28.
Taylor, Lance and O’Connell, Stephen A.(1985), “ A Minsky Crisis”
The Quarterly Journal of Economics, Vol. 100, Supplement.
Tobin, James.(1969), “A General Equilibrium Approach to Monetary Theory”, Journal of Money, Credit, and Banking 1, February.
Tobin, J.(1984), “On the Efficiency of the Financial System”, Lloyds
BankReview, July.
Tobin, James.(1989), “ Review of Stabilizing an Unstable Economy”, Journal of Economic Literature 27, March.
References
Akerlof, George A.(2002),“Behavioral Macroeconomics and
Macroeconomic Behavior”. American Economic Review, Vol. 92,
June.
Bank for International Settlements,(1993), 63rd Annual Report.
Bank for International Settlements,(1998), 68th Annual Report.
Bateman,Bradley W.(1997), Keynes’s Uncertain Revolution. The
University of Michigan Press.
Bellofiore Riccardo and Ferri Piero ed.(2001), Financial Fragility
and Investment in the Capitalist Economy, The Economic Legacy of
Hyman Minsky,Volume II, Edward Elgar.
Bellofiore Riccardo and Ferri Piero ed.(2001), Financial Keynesianism and Market Instability, The Economic Legacy of Hyman
Minsky, VolumeI, Edward Elgar.
11
CESifo Forum 4/2003
Focus
manufacturing sectors is likely to be made outside
Japan. At the same time, a large part of non-manufacturing sectors is still holding excess capital
stock. In these circumstances, the pace of economic expansion is bound to slow, from the end of next
year, according to most forecasters. Moreover,
dependent on exports, the current recovery is vulnerable to the exchange rate appreciation and
deterioration in the external environment.
JAPAN’S GROWTH CHALLENGE
YUTAKA IMAI*
T
Continued weakness
of business and
residential
investment
o anybody’s eyes, the Japanese economic situation is improving. Output has been growing
since the beginning of 2002, the unemployment
rate has started to fall, and a large amount of bad
loans has been removed from bank balance sheets.
Thus, the Japanese economy is not in crisis by any
reasonable standard. Yet, the on-going economic
recovery is not solid-based, deflation persists, and
the risk of future crisis continues to be non-negligible. To put the economy on a firmer growth path
and minimise the risk of future crisis Japan must
meet two daunting challenges. One is to revitalise
the economy by reallocating public spending
towards activities that favour future growth, remobilising resources that are locked into moribund
companies, and instilling competitive forces
throughout the economy. Another is to manage the
reversal of the expansionary macroeconomic policies pursued since the early 1990s which resulted in
the level of government debt that is 150 percent of
GDP as well as in a massive increase in the stock of
base money.
A key aspect of the on-going recovery is continued
weakness of fixed investment other than that in a
limited number of manufacturing sectors. Public
investment keeps falling at an average annual rate
of some 5 percent because of a tight purse.
Residential construction, too, continues to fall,
reflecting underlying demographic changes, though
the pace of decline is being attenuated by very low
long-term interest rates and lower land prices.
Business fixed investment outside the booming
manufacturing sectors remains sluggish, as the
labour-intensive production base is shifting
abroad, particularly to the rest of Asia, and the
non-manufacturing sectors on balance are still suffering from a conundrum of excessive capacity,
over-indebtedness, lack of entrepreneurship and
too much regulation.
Another key aspect of the current recovery is continuing deflation. Deflation weighs on debtors by
preventing real interest rates to become negative –
because of zero-bound nominal interest rates and
by raising the real value of liabilities. Concerns
have often been raised about the possibility of the
Japanese economy entering a spiral of falling output and prices through the mechanism of debt
deflation. Such risk could materialise if Japan is hit
by a big negative shock.
The nature of the current economic recovery
Over the last seven quarters, the Japanese economy grew at an average annual rate of some 2.5 percent, well above the potential growth rate of just
over 1 percent so that the output gap has been
shrinking. But the base of the economic recovery
has been narrow, driven by business fixed investment and exports in certain manufacturing sectors
producing cars and IT-related consumer electronics such as digital cameras and plasma TVs and
their parts, and raw materials. Investment in these
sectors cannot be expected to continue to grow at
the very high pace seen so far, and that in other
One should not, however, lose sight of the fact that
the current deflation is rather mild and steady. It
can be seen as a (mechanical) reflection of relative
price changes on overall price indices, rather than
a generalised fall in all prices. The weight of items
with falling prices in the consumer price index
(CPI) is now about 60 percent. Furthermore, analy-
* Graduate School of Economics, Osaka University.
CESifo Forum 4/2003
12
Focus
future growth. In the budgetary sphere there has
been some progress in this regard since the adoption of a top-down approach by the current government. Spending on public works has been cut and
its composition changed in favour of urban infrastructure yielding higher social returns. At the same
time, budget allocation to R&D, education and
social protection has been increased. The scope for
further reallocation of public spending appears to
be large in view of the still very high share of public investment in GDP by international comparison.
sis reported in the last OECD Survey of Japan has
shown that about one third of the CPI deflation
since 1998 can be explained by demand-side factors, and the rest by supply-side factors such as
greater import penetration and deregulation. The
importance of domestic supply-side factors in
explaining deflation is consistent with the fact that
real GDP and the GDP deflator have moved in the
opposite direction, because if demand factors dominated, then both should move in the same direction. It should also be noted that deflation is
greater when measured by the GDP deflator than
by the CPI because of a rather sharp fall in the
investment deflator, which is likely to be exaggerated by the particular method used to derive this
deflator.
In the private sector a trend decline in the rate of
return on capital is symptomatic of the problem of
resource misallocation. With a certain number of
exceptions, Japanese companies have failed to
adapt to, or seize the opportunities opened up by, a
change in environment in which they operate, be it
globalisation, development of new technologies or
evolving changes in the pattern of demand. To a
large extent the determining factor has been the
strength of competitive forces facing the companies. Those facing international competition have
had no choice but to respond to new challenges, or
else disappear. In contrast, those mostly operating
in domestic markets and not exposed to severe
competitive pressures have not done serious
restructuring but have been kept alive by lenient
bank attitudes. Resources are thus stuck in such
moribund companies that are behind the non-performing loans. Progress has been made in remobilising these resources along with the writing off of
bad loans from bank balance sheets, but much
remains to be done. On this diagnosis, instilling
competitive forces throughout the economy is
essential to its revitalisation and requires policies
of deregulation/privatisation, promotion of inward
foreign direct investment and fight against anticompetition practices.
Finally, the current recovery is taking place against
the backdrop of improving but still fragile balance
sheets of banks. In part, improvement has reflected
the rebound in stock markets since last April.
Banks benefited from capital gains from higher
share prices, which more than compensated for
capital losses resulting from the correction in bond
prices in September. But it has also reflected some
genuine efforts by banks to rationalise their operations, more strictly assess asset quality and write
off bad loans, though prodded by the Financial
Services Agency, the financial regulator. Despite
such efforts, at some 7 percent, the ratio of nonperforming loans to total loans in major banks
remains high and their capital base weak because it
relies excessively on deferred-tax assets. The situation is on balance worse in regional banks and
smaller banking institutions, though it varies much
across individual houses. The scheduled re-introduction of a 10 million yen limit on the protection
of ordinary savings accounts in April 2005, in the
face of continuing banking sector fragility, could
result in bank failure. And, this is the proximate
reason why the Japanese authorities are preparing
a law that would allow public fund injection in a
preventive manner.
Failure to adept to
changed economic
environment
Deregulation has much advanced in Japan since the
mid-1980s, though it has been largely limited to
economic regulation, and its extent varies across
different areas. Where it went further, such as in
telecommunications and retail distribution, it has
resulted in both a large fall in prices and strong
expansion of service volumes. A more recent initiative of urban deregulation, along with lower land
prices and increased supply of land in city centres
resulting from corporate restructuring, has allowed
urban redevelopment on a massive scale, which has
helped attenuate the decline in construction activity. Much progress is necessary in putting in place an
Revitalisation of the economy
The underlying problem of the Japanese economy
is a misallocation of resources both in public and
private sectors. To put the economy on to a higher
and more solid growth path it is necessary to reallocate its resources away from activities that preserve inefficiency towards those that contribute to
13
CESifo Forum 4/2003
Focus
appropriate regulatory framework in network sectors, a framework that would ensure impartial and
independent regulation. Much scope also remains
in deregulating public utilities, agriculture, education and social welfare services, but efforts in most
of these areas have met strong resistance from
respective ministries and vested interest groups. As
a way of combating the opposition, the government
introduced last spring special structural reform
zones which are free of specific regulation requested by local authorities. This initiative made a
promising start and could have a substantial impact
on nation-wide regulation with the accumulation of
successful experience.
Deregulation and
privatisation, but
too little inward
FDI
sional competence. A new law is under preparation, notably to raise sanctions and introduce a
leniency programme. This, together with the
whistleblower protection just enacted, would help
counter widespread anti-competitive practice
often linked to trade associations.
Managing the macroeconomic policy re-direction
Over the decade to 2001, the Japanese economy
grew by 14.5 percent cumulatively. It seems quite
likely, however, that without the support of fiscal
policy the Japanese economy would have recorded
no growth at best in the 1990s. The change in the
structural deficit of the general government as a
share of GDP (a broad measure of fiscal stimulus)
over the same decade corresponds to about two
thirds of this cumulative growth of real GDP, and
once the multiplier effect is taken into account, the
contribution of fiscal policy could arguably be 100
percent. This also suggests that repeated fiscal
stimulus failed to spark off a self-sustained growth
of the economy. At the same time, this left a legacy
of large deficits, rapidly growing public debt and
misallocated public spending, notably towards
unproductive public works.
Japan has also privatised quite a few public corporations, and reform including privatisation of
remaining public corporations is on the policy
agenda of the current government. Public corporations deprive private companies of profit opportunities and/or raise the cost of intermediate inputs.
Postal savings and postal life insurance are examples of the former, and the notoriously inefficient
Japan Highway Corporation is an example of the
latter. Privatisation of the Postal Corporation and
the Japan Highway Corporation is the top priority
of the Koizumi government, though the relevant
ministries and vested interest groups are attempting to shape the implementation process to suite
their needs. Reform of the Highway Corporation
must be carried out in ways which would lead to a
reduction of the high costs of transportation, an
obstacle to expansion of domestic markets.
The contribution of monetary policy over this period is much harder to evaluate, since monetary conditions are also influenced by exchange rate developments which are difficult to control. Short-term
interest rates continued to fall, but with disinflation and deflation, real rates remained between
1 and 2 percent, while the real effective exchange
rate of the yen showed a significant swing. Overall,
monetary conditions have fluctuated with the
movement of the exchange rate but with no obvious trend. On this basis, one could conclude that
monetary policy was on balance neutral over the
decade to 2001. It should be noted, however, that
the Bank of Japan (BOJ) has adopted a new policy
approach of quantitative easing under zero policy
rate since March 2001, after the historical decision
in February 1999 to set the policy rate at zero and
a controversial reversal in August 2000 to raise it to
0.25 percent.
Introducing foreign competition in the form of
direct investment has a large potential in fostering
dynamism in domestic markets, as demonstrated
by the omni-presence of multinational fast food
chains and the dramatic turnaround of Nissan by
Renault. But the level of foreign direct investment
in Japan remains miniscule at about one percent of
GDP. While there is no formal obstacle to the entry
of foreign capital, poor quality of regulation and
weak enforcement of competition policy in certain
respects are often cited as major impediments.
There is considerable room for strengthening the
role of the Fair Trade Commission (FTC) as a competition fighter. Sanctions are currently too low to
discourage the violation of law; human resources
of the FTC are insufficient for the desired task
both in quantity and quality; and the selection of
the commissioners is not always based on profes-
CESifo Forum 4/2003
The new policy of quantitative easing has been
pursued through open-market purchases of securities of longer maturity, notably the 10-year
Japanese government bonds. At the same time, the
BOJ announced that it would continue this new
14
Focus
policy until deflation ends and the risk of relapsing
into deflation is virtually eliminated. This resulted
in a significant decrease in long-term interest rates
as well as the drying out of short-term money markets. The former can be seen as a sort of financial
bubble which could exacerbate the eventual fall in
bond prices. The latter has resulted in the need of
the private sector to hold increased liquidity balances because it cannot rely on the call market, a
need which has been accommodated by the BOJ in
the name of target for current account balances
held at the BOJ.
policy of quantitative easing even after prices
begin to rise, and that it will change its policy only
when the risk of relapsing back into deflation
becomes infinitestimal. For otherwise long-term
interest rates, which are a function of expected
future short-term rates, would rise, impeding the
economic upswing. The BOJ announced in
October a clarification of specific criteria by which
the appropriateness of changing policy is assessed.
But this still leaves the timing of an actual policy
reversal uncertain.
Furthermore, if policy were to change, the required
magnitude of tightening would also remain uncertain. The longer the policy of quantitative easing is
maintained, the greater the amount of liquidity
injected into the economy. Given the currently
very low velocity of circulation of base money, it
might become difficult to control inflation once
prices start to rise. A radical tightening of policy
might then become necessary. As markets speculate on both the timing and the size of policy tightening, the risk of financial turbulence may
increase.
Reversing the policy stance will become necessary
sooner or later and raises difficult issues on both fiscal and monetary fronts, though their nature differs
across policies. On the fiscal side, the policy reversal
should start as soon as possible. Indeed, the stance
for next year is likely to be tightened slightly in the
absence of a supplementary budget for the current
fiscal year, a plausible assumption given the lack of a
call for one typical in a recessionary situation. But
the magnitude of fiscal consolidation that would be
required to merely stabilise the ratio of public debt
to GDP at, say, 180 percent by 2010 is huge (about 10
percent of GDP on a set of reasonable assumptions
about output growth and real interest rate). At the
same time, spending pressures stemming from the
ageing of the population and the realisation of contingent liabilities associated with bank restructuring
and loan guarantees will be strong. There is therefore
no escaping from implementing some combination
of cutting discretionary spending, designing a more
parsimonious social security system and raising taxes
and social contributions, none of which is popular.
While it is desirable to put in place a credible medium-term consolidation programme which spells out
concrete measures to achieve a goal, this would be
politically difficult since any government that does
this would become vulnerable to attack by opposition parties and risks losing the future election. The
actual pace of fiscal consolidation is hence likely to
be determined by a gradual and sequential implementation of relevant reform as well as by the path
of nominal income growth. But the resulting pace of
consolidation may be seen as insufficient to ensure
public finance sustainability. In that event, the risk
premium on government bonds may rise, and this
would make fiscal consolidation more difficult.
Policy reversal will
be difficult
Prospects
Pulling different threads together, the road ahead
for the Japanese economy seems to be rough even
in the absence of large negative shocks coming
from abroad. Macroeconomic policy reversal could
entail financial turbulence if not pursued skillfully
and with vigour. Fiscal policy should make consolidation a top priority, while focussing on altering
spending allocation in favour of future growth. But
such efforts are politically constrained so that
progress in both regards may not satisfy the markets. Monetary policy is faced with a delicate task
of convincing the markets that there would be no
premature tightening, while minimising the extent
of tightening required when the risk of falling back
to deflation becomes virtually zero. In these circumstances the best insurance policy is to accelerate reform efforts so that growth becomes stronger
and more solidly based. The competition-enhancing nature of reform would also help to attenuate
eventual inflationary pressures and hence reduce
the required amount of monetary tightening.
On the monetary side, the issue is more complicated since the Bank of Japan must convince the market participants that it will unfailingly stick to the
15
CESifo Forum 4/2003
Focus
investment has been rising (Table 1). These recent
trends in government saving and investment were
caused by the recession, and also by structural
changes. The recession and the decline in the rate
of economic growth lowered tax revenues.
Structural changes worsening government saving
include tax reforms that lowered tax elasticities
and tax revenues, and the aging of the population,
which raised social security and healthcare expenditures. The deterioration of government finances
led to sharp increases in outstanding government
bonds, raising concerns about fiscal sustainability
and calls for fiscal reform.
JAPAN’S DETERIORATING
FISCAL SITUATION
ROBERT DEKLE*
B
ecause of a very weak economy, which lowered
tax revenues and raised government spending,
Japan’s fiscal balance has deteriorated rapidly. The
budget, in surplus until 1992, turned negative in 1993,
and the deficits continued to worsen, reaching
almost 11 percent of GDP in 1998. The government
debt-GDP ratio increased by almost 50 percent from
1991 to 1997, and by another 40 percent in the four
years after that. By 2000, Japan had the largest ratio
among Organization for Economic Co-operation
and Development (OECD) member countries.
Huge increase in
debt-GDP ratio
Recent government saving
Tax revenues declined because of the recent
recessionary environment. In addition, government consumption increased. Owing to the low
cyclical variability of Japanese unemployment
and social welfare benefits, however, government
consumption increases during the recession were
capped. Government saving can be divided into
the ”full-employment” and ”cyclical” components. We estimate that during the period
1991–99, Japan’s ”full-employment” government
saving was about 2.6 percent, slightly higher than
actual government saving of 2.0 percent, leaving
the ”cyclical” component of government saving at
Japan’s fiscal situation continues to look grim,
especially given the demographic situation.
Population aging is expected to slow economic
growth and raise future government health care
and social security expenditures. Projections of the
country’s population and the percentage of the
total population that is elderly are plotted in the
figure below. The population over sixty-five has
grown rapidly and now stands at about 15 percent.
By 2020, its percentage is expected to approach 25 percent,
and by 2050, 33 percent.
These rates of aging are much
higher than for example, in the
United States, where only about
15 percent of the population will
be over sixty-five by 2025.
Japan’s recent fiscal position
Recently, government saving
has been declining and public
* Department of Economics, USC, Los
Angeles, CA.
CESifo Forum 4/2003
16
Focus
First, during the 1990s, the central government assigned roughly two-thirds of the increased
public works spending to local
governments (without providing
Private Government
Private
Public
Net export
saving
savinga
investmentb investment
surplus
a commensurate increase in
1955–73
13.5
9.5
17.3
7.3
– 1.5
funding). The capacity, however,
1974–79
26.3
3.1
20.7
9.2
– 0.6
of local governments to expand
1980–90
26.0
4.5
20.7
7.4
2.4
1991–95
26.0
5.2
21.5
7.7
1.9
public investment was affected
1996–99
28.4
1.6
20.3
8.0
1.8
by their poor financial situation,
a
Includes net social security surplus. – b Includes plant and equipment,
and the continued rise in public
housing, and inventory investment.
investment has increasingly
Source: Ecnomic and Social Research Institute, Annual Report on the
been financed through local
National Accounts, 1999 and 2001 editions.
bond issues. The amount of outstanding local government
– 0.6 percent.1 Thus, much of the recent decline in
bonds increased from 12 percent of GDP in 1990 to
Japanese government saving was not because of
22 percent of GDP in 1997. Many local governments
”automatic stabilizers,” but because of structural
surpassed the legally allowed threshold of bonds
factors, such as tax reductions.
outstanding, and were put under bond issuance
restrictions by the central government. Second,
Government saving has declined since the early to
some of the public investment funds provided by the
mid-1990s, with tax reductions supporting aggrestimulus packages remained unused because of
gate demand in the face of an unprecedented ecopoor project implementation.
nomic downturn. Particularly in 1998, when the
economy slipped into recession, the government
Recent government debt and liabilities
passed tax cut measures that led to a substantial
decline in government saving in the following year.
The late 1990s decline in government saving and
Marginal income and capital gains tax rates and
rise in public investment led to sharp increases in
health insurance premia were cut, exemptions for
government debt. Table 2 depicts the fiscal balancegift taxes were raised, and tax deductions for home
GDP ratio, and several debt to GDP ratios. The fismortgage holders were introduced. The governcal balance-GDP ratio is lower than the difference
ment also lowered corporate tax rates from 50 perbetween the government saving-GDP ratio and the
cent to 40 percent.
public investment-GDP ratio by about 2 percent,
Table 1
Japanese Private and Government Saving, Investment, and Net Exports
(in percent of GDP)
Sharp decline in
public saving, only
moderate increase
in public investment
mainly because of the inclusion of net government
land purchases in the fiscal balance. During the
1990s, the government bought significant amounts
of land from the private sector to prop up land
prices. The fiscal surplus declined continuously in
the 1990s, reaching about minus 10 percent in 1998.
Correspondingly, the ratio of debt to GDP has risen
sharply. By international standards, Japan’s gross
debt-GDP ratio in 1999 was the highest among the
G-7 countries – Italy’s was 115 percent, and the
United States’ was 62 percent.
Recent public investment
Between 1990 and now, the Japanese government
passed ten stimulus packages, in an attempt to
jump-start the stalling economy. The most important component of the government stimulus packages were public works, which are included in public investment. However, as shown in Table 1, the
actual increases in public investment in the late
1990s were rather moderate, compared to the
prominent – and headline grabbing – role of public
works in the stimulus packages.
Because of the partly funded nature of the
Japanese pension system, as well as the government’s major role in financial intermediation, the
Japanese government holds significant assets,
keeping net debt to GDP at a moderate level, and
lower than in other G-7 countries. However, since
the assets of the social security system are more
than offset by future pension obligations, they
should be excluded when assessing Japan’s debt
There are two reasons why actual public works fell
short of the levels announced in stimulus packages.
1
We estimate the “full-employment” government saving by
regressing government saving on the output gap and a constant. We
interpret the estimated value of the constant; which is the government saving rate when the output gap is equal to zero – as “fullemployment” government saving.
17
CESifo Forum 4/2003
Focus
Table 2
Overview of Government Finances
(all figures in percent of GDP)
a
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Fiscal balance
Government Saving
of which:
Social security surplus
Healthcare
Other surplus
1.9
7.2
1.8
7.2
0.8
6.7
– 2.4
4.7
– 2.8
4.2
– 4.1
2.9
– 4.9
2.6
– 3.7
2.6
– 10,7
1.2
– 7,0
0.0
1.3
– 3.6
9.5
1.7
– 3.5
9.0
1.6
– 3.7
8.8
1.4
– 3.8
7.1
1.2
– 3.9
7.0
1.2
– 4.1
5.9
1.1
– 4.2
5.6
1.2
– 4.1
5.5
0,8
– 4.2
4.6
0.4
– 4.3
3.9
Gross debt
Net debt Ab
Net Debt Bc
65.1
7.3
35.4
64.7
6.4
35.5
67.6
12.3
42.9
72.7
10.1
42.8
78.4
12.1
46.6
85.4
16.9
52.5
91.8
21.6
57.7
97.5
27.9
64.6
108.5
38.0
75.9
120.5
44.4
84.9
a
b
Government Saving plus Net Land Purchases and Net Gift and Inheritance Taxes minus Public Investment. –
Including social security system assets. – c Excluding social security system assets.
Source: Economic and Social Research Institute, Annual Report on the National Accounts, 2001 editions.
situation. As a result, Japan’s net debt excluding
social security net assets, at 85 percent, is significantly higher than in the United States, at 60 percent, and in Germany, at 53 percent.
Unfunded liabilities
increase the
government’s net
obligations
Investment and Loan Program (FILP) loans generate less revenue than budgeted, which may imply
significant contingent liabilities of the government.
For example, much of the substantial debt – 3 percent of GDP – of the now privatized Japan
National Railways is owed to FILP. Since most of
this debt will never be repaid, this debt will eventually have to be covered from the government
budget. Other public corporations with large accumulated FILP debt include the Japan Highway
Corporation (4 percent of GDP) and the Housing
and Urban Development Corporation (2.5 percent
of GDP).
The government’s true net obligations may be substantially higher than the net debt figures because
of unfunded liabilities. There are three main
sources of unfunded liabilities. The first source is
the future costs of government social security and
health schemes. Estimates of future unfunded
social security costs depend on demographic, economic growth, and interest rate assumptions and
range widely. In Japan, there are several social
security schemes, but the main scheme – the
Employees’ Pension Scheme – derives one-third of
its (benefit) payouts from government subsidies,
and two-thirds of its payouts from payroll taxes
(contributions). Muhleisen (2000) estimates the
present value of net unfunded liabilities at 60 percent of GDP. With regards to government health
benefits, on average, government subsidies cover
about one-third of total public health insurance
benefits (2 percent of GDP), with the rest covered
by health insurance contributions and co-payments. Given that the elderly are exempt from
health insurance contributions and pay only small
co-payments, the future aging of the population is
expected to significantly raise the proportion of
health benefits covered by government subsidies.
The third source of unfunded liabilities is the
explicit and implicit government guarantees of private sector lending. Explicit guarantees are extended by FILP and other government entities to
encourage lending by private financial institutions.
Examples are guarantees of bank deposits by the
Deposit Insurance Corporation and guarantees of
lending by credit cooperatives to small- and medium-sized enterprises. Although, these guarantees
do not entail fresh government lending, should the
guaranteed loans not be repaid, the government
must cover the loans from the budget. The total
amount of outstanding government-guaranteed
bonds and loans amounted to about 10 percent of
GDP in 2000. Although historically, only about
1 percent of government-guaranteed loans are
never repaid, if the Japanese economy worsens, the
percentage of unpaid loans could soar (Bayoumi,
1998).
The second source of unfunded liabilities is potential losses on government assets. A portion of the
government’s assets represents soft loans that may
not be repaid. Many large public or joint publicprivate infrastructure projects financed from Fiscal
CESifo Forum 4/2003
In addition to the explicitly guaranteed government loans and bonds, there are the implicitly guar-
18
Focus
nominal coupon rate, inflation will lower the real
return on bonds, and the real interest rate. From
the equation above, we can see that the fall in the
real interest rate will lower the required adjustment in the primary deficit.
anteed government loans. Historically, the
Japanese government has shown willingness to
cover the irrecoverable problem loans of private
financial institutions. For example, in 1998, the government authorized 60 trillion yen (12 percent of
GDP) in public funding to cover the irrecoverable
loans of private banks.2 This willingness represents
implicit guarantees, and these guarantees are contingent liabilities of the government. In 2000, outstanding loans minus the capital and liquid assets
of financial institutions was about 200 percent of
GDP. If, as some bank analysts estimate, 10 percent
of the loans are irrecoverable, then the cost to the
government of these implicit guarantees could be
as high as 20 percent of GDP.
Recent fiscal reform measures
To restrain increases in the debt-GDP ratio, the
government has proposed several fiscal reform
measures in the 1990s. However, most of the measures were postponed or abandoned, as the government sought to stimulate demand in light of the
very weak domestic economy. Specifically, in 1997,
the government enacted the Fiscal Structural
Reform Law. The goal of the 1997 Law was to eliminate fiscal deficits by 2003.
Fiscal sustainability
The sharp increase in Japanese government debt in
the 1990s has raised questions about the sustainability of this debt, and much policy work has been
done in this area. Clearly, at current Japanese government fiscal deficit levels, the government debt
will keep on growing. For, given growth and interest rate assumptions, the fiscal surplus exclusive of
net debt interest payments, or the primary fiscal surplus, necessary to stabilize the debt-GDP ratio is:
The main instruments in the 1997 Law were cuts in
government consumption and investment, rather
than tax increases. Public investment spending was
to be cut by 7 percent in 1998, with zero nominal
growth until 2001; and energy, education, and overseas development assistance were to be cut by
10 percent in 1998, with annual reductions until
2001 (Ishi, 2000, p. 149). However, with the severe
recession of 1997, fiscal consolidation was put on
hold, and a wide-range of pump-priming measures
were introduced. In particular, rather than declining, public investment for 1998 was increased by
over 10 percent.
b = (r – gr) * d ,
(1 + gr)
where b is the primary surplus-GDP ratio, r is the
long-run real interest rate, gr is the long-run real
growth rate of GDP, and d is the debt-GDP ratio.
For example, assume that r and gr are 0.06 and
0.012. To stabilize the debt-GDP ratio at the current net debt-GDP ratio of 0.85, the government
will have to run a primary fiscal surplus-GDP ratio
of almost 5 percent. Given the current cyclicallyadjusted primary fiscal deficit-GDP ratio of about
4 percent, to keep the debt-GDP ratio at the current level, the required increase in the primary balance would be 9 percent of GDP.
Progress in healthcare and social
security reform
Areas where the 1997 Law made progress were in
healthcare and social security reform, which are
important, given the aging of the population. In 1997,
the contribution rate and co-payments by patients for
the government health insurance schemes were
increased sharply (Ishi, 2000). In particular, patients
aged 70 and above are required to pay a fixed proportion (10 percent) of their medical costs. The government also capped prescription drug prices, which
are very high in Japan. In 2000, a pension reform bill
based on the 1997 Law passed the legislature. The bill
contained provisions to cut lifetime pension benefits
by about 20 percent. Specifically, pension benefits for
new retirees were cut by 5 percent; the age of pension
eligibility will be gradually (from 2013) raised from 60
to 65; and pension benefits will be subject to an earnings test. Analysts have estimated that the 2000 pension reforms will reduce government unfunded social
security liabilities from the current 60 percent of
GDP to 30 percent of GDP (IMF, 2000).
It would be very difficult for the government to
achieve this adjustment in the primary balance
through fiscal reform in the near future. Thus, some
analysts have argued that the government may
attempt to lower the real value of the debt through
inflation. Since Japanese government bonds pay a
2 The total of public funds actually spent – and included in government consumption – in 2000 was about 8 trillion yen (0.16 percent
of GDP).
19
CESifo Forum 4/2003
Focus
GDP growth rate of slightly in excess of 3 percent
can imply falling debt-to-GDP ratios. The analysis
there has assumed that real growth averages just
1.2 percent per year. This assumes total factor productivity (TFP) growth of 2.0 percent per year.
TFP growth of 2.0 percent is actually an assumption on the high side, as it is equal to Japan’s average TFP growth between 1970 and 1990, and Japan
has not been as innovative as it was then. What
lowers GDP growth from 2.0 percent to 1.0 percent
is the dramatic annual decline in the labor force
caused by the aging of the population.
Looking forward, the government is planning on
implementing further budget cuts, once the economy fully recovers. Recently, a political commitment
has been made to cap government deficit bond
issues at 30 trillion yen (0.6 percent of GDP) in
2002. Although “deficit” bonds reflect only a portion of total government borrowing, this bond
issuance ceiling should help lower future fiscal
deficits.
Without significant
fiscal reforms,
prospects are grim
As stipulated in the 1997 Law, public investment is
due for further cuts. Criticism has been directed at
the economic value of the public works projects, as
well as contracting procedures. To address the efficiency issues, new cost-benefit guidelines for
review of public works projects were announced.
Contracting procedures have also been reformed.
Public works projects are scheduled to be cut
severely, although whether the cuts will actually
materialize is unclear. Moreover, the government
intends to change the form of public works from
the traditional type of construction projects to
broader social infrastructure investment; for environment and energy-related projects, telecommunications networks, scientific research, nursing
homes, and the like.
Thus, one way to increase GDP growth is to raise
the labor supply. Possibilities include removing the
impediments that restrict the movement of labor
between firms and encouraging women from participating to a greater extent. Another possibility
that has received scant attention until now is to
promote immigration into Japan.
References
Bayoumi, Tamin (1998), “The Japanese Fiscal System and Fiscal
Transparency,” in Aghevli, B. et. al. (Ed.), Structural Change in
Japan, Washington, D.C.: International Monetary Fund.
IMF (2000), World Economic Outlook, Washington, D.C., International Monetary Fund.
With regards to healthcare, contribution rates and
co-payments, especially by the elderly, are planned
to be increased further. The government’s stated
goal is to restrict the growth of medical costs of the
elderly to no more than the rate of inflation. The
age of eligibility for special elderly medical care
will eventually be raised from 70 to 75. Further cuts
are also planned in social security; for example,
there are suggestions that average benefits should
further be reduced by about 40 percent, to avoid
large increases in future contribution rates.
Ishi, Hiromitsu (2000), Making Fiscal Policy in Japan, Oxford:
Oxford University Press.
Muhleisen, Martin (2000). “Sustainable Fiscal Policies for an Aging
Population.” In Selected Issues, Japan. Washington, D.C.: International Monetary Fund.
Concluding comments
The prospects for improvements in the Japanese
fiscal situation are grim unless the government carries out significant fiscal reform. Japanese citizens
should brace themselves for painful adjustments in
the near future, in the form of lower public services
and higher taxes.
A resumption of strong growth in real GDP would
reduce the need for spending and tax adjustments.
For example, from our fiscal sustainabiliy analysis
above, if real interest rates are 3 percent, a real
CESifo Forum 4/2003
20
Focus
price booms and even busts are not uncommon,
Japan’s Great Recession is, and it was not the bubble and its bursting that produced this outcome.
The loud concern expressed in influential parts of
both the press and the official sector with regards
to the implications of the US asset price boom (for
example, in editorials of The Economist and the
Financial Times), however, seems to say that the
destiny of any bubble economy is an extended
recession.
DID MONETARY LAXITY IN
JAPAN CAUSE THE BUBBLE?
ADAM S. POSEN*
J
apan’s extended economic stagnation since its stock
market peaked on December 29, 1989, has prompted a series of investigations, recommendations, and
self-examinations, both in Japan and abroad. For monetary policy, two aspects of the situation have attracted
particular attention. One is the ability or inability of a
central bank to successfully raise the price level and
inflation expectations when the nominal interest rate is
at zero and the banking system is reluctant to lend.The
other is the appropriate response of a central bank to
an asset price bubble: whether the central bank can or
should try to “prick” such a bubble when it is expanding. This article will consider the latter set of issues as
raised by the Japanese bubble.1
Some noted German commentators (e.g., Horst
Siebert) have argued that the Bundesbank’s resistance to international pressures for overstimulus in
the mid-1980s was what saved Germany from
Japan’s fate. More recently, Otmar Issing of the
European Central Bank has suggested that a part
of the reason for having monetary growth targets is
to notice and resist overexpansions of credit. All
these participants in the discussion would lay the
responsibility for this destiny of recession at the
failure of the central banks involved to take action
against the rise of bubbles.
Can a central bank prevent a bubble?
These concerns and comments, while understandable, are not supported by study of the Japanese
case. Monetary policy clearly was (and remains) a
contributing factor to Japan’s stagnation, but it was
not disregard of asset prices on their way up which
produced this outcome. Spirited academic debates
about whether central banks should directly target
asset prices, either as part of an inflation-targeting
framework or not, need a different case on which
to hook their analyses. As I will argue, the Bank of
Japan (BOJ) should have been able to tighten policy more quickly in the late 1980s without any particular reference to asset price movements – and in
any event, monetary policy might well have been
unable to stop those movements. Negative developments in the Japanese economy after the bubble
were hardly driven by the fall in asset values, but
rather by other problems in the Japanese economy
(including overly tight monetary policy itself).
Comparative analysis broadly of other recent cases
of asset price booms supports my conclusion that a
primary concern for monetary policy should be
The topic is of more than retrospective or theoretical
concern. In recent years the American and European
equity markets have had just about an identical boom,
and so far a slightly milder bust, to that of the Japanese
market – and the Japanese and American real estate
markets both followed similar paths at about a twoyear lag to stocks. These are hardly the only examples.
A series of applied research studies done at international financial institutions have shown that there
have been a great number of asset price booms and
busts, if not definitively bubbles, and these are often
associated with negative economic outcomes.
The main point to be made here is that it takes
more than a bubble to become Japan. While asset
* Senior Fellow, Institute for International Economics (US).
1 A more detailed analysis, including consideration of the related
issues of what are the effects of a bubble bursting, how a central
bank should respond, and what promotes restructuring, on which
this article is based can be found in Adam S. Posen, “It Takes More
Than A Bubble To Become Japan,” in Monetary Policy and Asset
Prices, Anthony Richards, ed., Reserve Bank of Australia, 2003.
21
Not every bubble
ends in a prolonged
recession
CESifo Forum 4/2003
Focus
up by a blunt instrument that usually affects all
prices in the economy. And it has to do so in such a
way that the relative price shift either does not
raise expectations of a countervailing shift in monetary policy in the near future (which relies on
strange notions of what the imputed future income
from increasing land and stock prices will generate), or is expected to only be affected by monetary
policy on the upside but not on the downside
(which there is no reason to believe, if liquidity is
the source of the relative price shift in the first
place). Either way, this has to take place when we
know both analytically and empirically that the
relationship between a policy of low interest rates
or high money growth and equity or real estate
prices is actually indeterminate over time.2
how to encourage restructuring in the aftermath of
a boom, not the boom itself.
As noted, the belief is widespread that excessive
laxity of Japanese monetary policy in 1986 to 1989
caused the bubble in Japanese equity and real
estate prices. Bank of Japan officials for the last
13 years have bemoaned this fact, vowing not to
repeat the mistake. Outside observers of a more
monetarist bent have largely agreed with this lesson, thanking their central bankers for being able to
resist pressures for undue ease. And both academics and market pundits have chimed in as well,
attributing the bubble to BOJ inaction. For some,
the message is a reaffirmation of the importance of
central bank independence, since the BOJ is
thought to have succumbed to pressure from the
Ministry of Finance (MOF) for ease, and in this
view the MOF itself was easing due to pressure
from the US government. For others, the lesson is
that central banks should take asset prices into
account explicitly when setting policy. Either way,
according to this common view, the bubble arose, or
at least grew large, because of excessive liquidity.
The Japanese
bubble has been
blamed on monetary
policy
Of course, one can resolve this logical tension by
positing that the investors have unrealistic expectations about monetary policy. Some BOJ research
has done so, for example, by characterizing with
some justification Japanese investors in the bubble
years as believing unduly in low interest rates over
a decade or longer horizon. Then, however, it is the
expectations of investors, which are driving the
asset price process, not the actions of monetary policy. In that case, any monetary policy short of starving the economy of credit could give rise to a boom,
and a boom can arise even without excessive ease.
This claim that monetary policy caused Japan’s bubble, however, should not be taken for granted. We
need to decide whether excessive monetary ease was
a sufficient condition for the Japanese bubble (“if
there is a sustained monetary ease, then a bubble
occurs”), a necessary condition for the Japanese bubble (“if a bubble occurs, then there must have been
prior monetary ease”), or both. The theoretical foundation for such claims turns out to be little more
than one of coincident timing – in Japan in the second half of the 1980s, money supply was growing,
velocity was declining, and no increase showed up in
wholesale or consumer prices, so the contemporaneous growth in real estate and equity prices must have
been the result of this liquidity increase. Yet, this is a
rather tenuous link to make. As Japan itself has
demonstrated in the last few years, one can have all
these conditions present (expanding money supply,
declining velocity, no effect on the price level) and
still see no increasing trend in asset prices. Without
some forward-looking expectations on the part of investors that returns will be rising relative to base
interest rates, that profits will be growing, there will
be no buying of real estate or equities.
Monetary ease and asset price inflation
Before evaluating with respect to the Japanese
case the merits of this claim versus the more common assumption that monetary laxity causes
booms, it is worth pointing out that neither claim
has been established with respect to bubbles or
asset price booms in general. If this supposed
causal link between monetary laxity and the
Japanese bubble is not as apparent in other known
cases of asset price booms, then there clearly is
more at work in the Japanese case than just monetary ease. To examine this question, we take a list of
asset price booms in the OECD economies and
match them up with a new dataset created to offer
simple indicators of loose monetary conditions.3
2
For example, Michael Hutchison pointed out using Japanese data
that a drop in interest rates today might drive up housing prices in
the short-term by making them more affordable, but in the medium-term tends to drive prices down because it portends a monetary
tightening or slower growth. Aggregate supply factors tend to dominate monetary factors as consistent determinants of land prices.
3 The list of asset price booms is taken from Michael Bordo and
Olivier Jeanne (2002). “Monetary Policy and Asset Prices: Does
‘Benign Neglect’ Make Sense?,” International Finance, 5 (2): 139–164.
For monetary policy to be the source of a bubble,
the relative price of one part of the economy (here
financial and real estate assets) has to be pumped
CESifo Forum 4/2003
22
Focus
often put forward without question in the discussions of the Japanese bubble. Perhaps this confusion is because those speaking about Japan actually subscribe to the idea of sustained monetary ease
as a necessary, not a sufficient, condition for a
boom to occur – if there is an asset price boom,
then there must have been prior ease. In other
words, on this hypothesis, while there can be periods of ease which do not result in bubbles, there
are no bubbles that did not result from monetary
ease. This relates closely to the idea of central
banks “pricking” asset price bubbles, that interest
rate increases somehow remove the loose credit
conditions on which the bubble is predicated.
Looking at 15 countries (including Japan) over the
periode 1970 to 2000 for industrial share prices and
1970 to 1998 for residential property prices, we
have a list of 18 booms in property prices and 24 in
share prices. For our purposes, this generates a list
of booms independent of our markers of monetary
ease and, in the next section, of deflation.
Identifying periods of monetary ease would appear
to be much harder. For the purposes of examining
the link between monetary ease and booms, however, a simple approach seems justified. In the discussion of monetary policy with respect to perceived bubbles, particularly but not just with
regard to Japan, there is usually the sense that it
took significant sustained ease to cause the bubble
– booms do not seem to pop up frequently enough
to be associated with minor mistakes of overly easy
monetary policy.
Utilizing the same list of booms and periods of monetary ease, we consider two possibilities – that ease
must have preceded the start of the boom or that at
a minimum there must have been ease during the
boom. Neither elicits much support from the data –
for property and share price booms, fewer than onethird of them were either preceded by or accompanied by sustained ease in credit growth; none of the
share price booms were preceded or accompanied
by sustained ease on these criteria. The results are
therefore far from supportive of monetary laxity as
either a necessary or a sufficient condition for asset
price booms, at least with regards to the advanced
OECD economies since 1970.
So for our investigations we utilize two broadly
applicable measures of monetary ease: first,
whether the central bank’s real overnight or instrument interest rate is less than 1 percent for a sustained period; second, whether growth in a credit
aggregate greatly exceeds the aggregate’s average
growth rate for a sustained period. We create a list
of these periods for the same 15 OECD countries
over the same time-period as in the sample of
booms, and find 38 periods of monetary ease by the
M3 criterion and 11 periods of monetary ease by
the real interest rate criterion. We see whether
asset price booms occurred within 36 months of the
end of one of these periods of monetary ease.
The evidence does
not support the
notion that monetary
ease is a necessary
and sufficient
condition for a
bubble
Did political pressure cause too much ease?
The direct association often drawn between the
Bank of Japan’s monetary policy stance in the late
1980s and the Japanese bubble therefore bears closer scrutiny. In short, there is more to the story than
just that the BOJ did not raise rates in time. The
(Japanese) textbook version of the story is that international pressure upon Japan from the United States
led to too much ease from the BOJ, and that ease led
to the bubble. Japan had come out of the second oil
shock, carefully closing its public deficits and managing money for price stability. At the time, protectionist pressures were mounting in the US Congress due
to the large US trade deficits and the rise of the
Reagan-Volcker dollar. First in the Plaza Accord of
September 22, 1985 and then (after additional bilateral pressures from the US government) in the
Louvre Agreement of February 20, 1987, the Japanese government agreed to stimulate domestic
growth and help manage an appreciation of the yen
against the dollar.
So what is the response to the question, “if ease,
then boom?” The results do not support the popular image of sustained monetary ease being a sufficient condition for a boom. Of 38 periods of ease
identified by the M3 criterion, only 12 resulted in
share price booms and 12 in property booms (the
lists are not identical); of 11 periods of sustained
ease by the interest rate criterion, no booms followed within 36 months. In any event, the absence
of any booms in response to low real interest rates
would seem to put the focus on credit market conditions more narrowly, but even by that criterion,
fewer than one-in-three periods of significantly
above average credit expansion are followed by
booms.
The idea that monetary ease alone is a sufficient
condition for asset price booms might appear to be
something of a straw man, though it is one that is
23
CESifo Forum 4/2003
Focus
obvious international pressure, the idea that such
low rates would be sustainable without any effect
on inflation or medium-term growth would have
been discounted. The fault for the asset price
increases seems to lie in the unrealistic expectations of participants in a bubble, not in Japanese
monetary ease.
Under direction from the MOF, the BOJ began to
make interest rate cuts in January 1986, starting
with an overnight rate of 5 percent. By the time of
the last cut three years later, the BOJ had cut its
overnight rate to 1 percent. Meanwhile, the MOF
did not wish to imperil its hard won budgetary consolidation by engaging in expansionary fiscal policy, so the burden of stimulus fell totally on the
BOJ. The yen appreciated from a low of ¥240 per
dollar to ¥125 per dollar, inducing the short-lived
Endaka (high-yen) recession of 1985 to 1986. The
Heisei boom, that we think of as the bubble years,
began shortly thereafter. No obvious increases in
the CPI or WPI arose for the remainder of the
decade, and most private sector forecasts were for
continued low inflation (Ahearne et al. 2002). The
‘Black Monday’ US stock market crash of October
1987 provided another reason for the BOJ to keep
interest rates low. In this version of the story, the
issue is whether the BOJ could have raised interest
rates some time in 1988 and in so doing could have
pricked the bubble.
Let us turn the question around: should the BOJ
have believed in the macroeconomics of the
Heisei-boom in the second half of the 1980s? Or
should they have been in a position to discount this
story? The debate among monetary economists
over this period usually is cast as whether or not a
central bank can read asset prices any better than
financial markets and can assess the evaluation of
equities. As the Japanese case of the late 1980s
illustrates, this debate is misfocused. Whatever the
state of asset prices, central banks have to assess
the potential growth rate of the economy they
oversee, and this macroeconomic assessment can
be done largely independently of any specific relative prices in the economy. For Japan in 1987 to
1991, output was 2 percent a year above trend, and
1988 showed the highest growth rate (7 percent)
seen since the mid-1970s.
What transformed monetary ease into asset price
inflation
Did investors
have unrealistic
expectations?
Meanwhile, just looking at overall market averages,
the stock and bond prices implied either 15 or more
years of low interest rates or a massive drop in the
risk premium. Could a significant drop in the risk
premium be held credible for aging Japanese savers,
given well-known demographic trends and savings
behavior? Alternatively, how could interest rates be
expected to stay low indefinitely if the boom’s
euphoria was based on a real increase in the potential rate of output – and therefore of the economy’s
natural rate of interest – over the long run? The
apparent surge in Japanese labor productivity in the
late 1980s was something to be suspicious about.
Given limited deregulation before the 1990s, the
end of catch-up growth, and the absence of any new
technological revolution, what would justify a neardoubling of productivity growth from its around
3 percent average of 1979 to 1987? What precedent
was there for a 2 percent jump in trend productivity
anywhere except emerging markets making the
great leap as Japan already had in the 1950s?
Yet, none of this explains why there should have
been a bubble in Japanese equity and real estate
markets. Something had to transform the easy
monetary policy into asset price appreciation
rather than either more general price pressures or
sustainable growth. Again, the sole argument for
blaming monetary policy seems to be one of timing. Even that, however, does not hold up well.
Land prices were already rising before the Plaza
Accord, let alone the full force of the BOJ’s rate
cuts: one common index shows a 12.7 percent
increase in FY1984 and a 28.9 percent increase in
FY1985. And the run-up in stocks began even
when the Endaka experience was fresh in people’s
minds, but the only policy commitment of the BOJ,
not by choice, was supposedly to keep the yen on
an upward trend.
If the decision to cut rates in 1986 to 1989 was truly
a political decision in response to US pressures on
the MOF, and MOF pressures on the BOJ – as
reported upon in the press and clearly grumbled
about by BOJ officials – why was the BOJ’s frustrated case for tighter policy not persuasive to the
bond markets? Surely, if it were clear that the BOJ
were violating its normal policy priorities due to
CESifo Forum 4/2003
In short, the BOJ could have decided to tighten policy in the 1980s without any reference to asset
prices beyond the most general evaluation of interest rate expectations. It was not lack of explicit
24
Focus
by regulation, and their franchise value was declining, yet they retained the same large amount of
loanable funds due to deposit insurance. The
‘Convoy’ system of financial supervision, which
equated banking system stability with no closure of
banks, kept overcapacity in the system, leading to
low profits and undercapitalization, increasing the
desire to take risks with taxpayer insured deposits.
attention to rises in asset prices that led monetary
policy astray. No expectations based on a reasonable evaluation of monetary policy could have supported these macroeconomic assumptions embodied in the overall asset market. Recent work by
Kenneth Kuttner and myself establishes that for
any of a wide range of potential output estimates
– using real-time available information and varying
in method but never explicitly including asset prices – the BOJ would have normally been expected to
raise rates some time in 1987 to 1988.4 Of course,
even if interest rates had been increased, it is not
evident that alone would have ‘popped’ the bubble.
As a result, Japanese banks made a huge shift into
lending to small and medium-size enterprises
(SMEs), increasing that share of their loan portfolios from 42 percent in 1983 to 57 percent in 1989,
while their loan portfolios expanded by more than
half. The banks nearly doubled their overall lending in selected sectors favorable to the SMEs.
Companies hold substantial real estate in Japan,
and used this as collateral of rising worth to borrow more; households also took advantage of rising home prices and declining lending standards
(mortgage limits rose from 65 percent of home
value on average to 100 percent on the assumption
that land prices would go up). Two additional indicators of this lending/real estate boom arising out
of the partial deregulation/ongoing deposits
dynamic were the increase in Japanese banks lending directly to firms in the real estate sector, from
6 percent of total lending in 1983 to more than
12 percent in 1989, and the extreme pressure on
the long-term credit banks who were most dependent on the borrowing of major corporations.
One could try to restore the link between the
Japanese asset price bubble and monetary policy
by asserting that a firm belief in ongoing pressure
from the United States for yen appreciation in
response to the United States’s endemic trade
deficits, rather than actual faith in the potential
output measures implied, was what underlay the
belief in monetary ease and thus the boom.
Perhaps that would have been more rational than
belief in the bubble per se. As Ronald McKinnon
and Kenichi Ohno have shown, however, at least
theoretically a long-term expectation of sustained
yen appreciation will result in deflationary expectations (including of asset prices) in Japan. So there
is no way to square this circle of the bubble somehow logically resting on expectations of future
Japanese monetary policy. The bubble was based
on assumptions independent of monetary policy.
When large
corporations durned
to direct financing
banks shifted their
lending to SMEs that
held collateral of
rising value
It is easy to draw the chain of causality from
improved access to capital for both large and small
business, due to rising collateral values as well as
deregulation and shifts in lending standards, to rising expectations of profits and stock prices. And in
Japan’s system of cross-shareholdings and banks
owning significant share portfolios in borrower
firms, these effects are amplified through increases
in bank capital. Some belief in the rising value of
land does underlie this dynamic, but once that is
given, one can understand the emergence of a bubble in both stock and asset prices with no reference
to monetary ease whatsoever. For comparison,
remember that the analogous dynamic seen in the
US savings and loan industry took place in the early
and mid-1980s, hardly a time of monetary ease.
Structural causes of the bubble
We should turn instead to the obvious nonmonetary factors in the creation of the Japanese bubble.
These financial developments are both well within
the usual remit of a central bank’s surveillance, and
logical justification for why the unrealistic expectations of bubble participants were fed irrespective
of monetary policy. There is a consensus view
among economists on how partial financial deregulation in Japan in the 1980s led to a lending boom:
Japan’s banks lost their best corporate customers
after liberalization of securities markets allowed
large firms to reduce their cost of capital by seeking direct financing. The banks’ ability to move into
new lines of business was still partially constrained
So how did the BOJ monetary policy respond to
this structural source of asset price increases? The
evaluation tends to turn on whether the BOJ
should have raised rates in 1988 instead of waiting
4 Kuttner, Kenneth and Adam Posen (2003). “The Difficulty of
Discerning What’s Too Tight: Taylor Rules and Japanese Monetary
Policy,” IIE Working Paper No. 03–11, December.
25
CESifo Forum 4/2003
Focus
until 1989, and how much they should have raised
rates. This is often cast as a dispute over the sufficiency of inflation targeting as a guideline for monetary policymaking, without explicitly taking asset
prices into account. This dispute turns on the definition of a policy rule for the inflation targeting
central bank, and the information content of asset
prices for inflation and output beyond factors normally considered. As I have argued, however, the
proper perspective on potential output in Japan in
the second half of the 1980s on its own terms would
have led to rate increases in any usual forwardlooking policy rule. The issue of whether asset
prices should or should not explicitly enter the central bank’s target is moot (at least for Japan).
A policy of proper
inflation targeting
would have reversed
monetary ease
in 1988
In terms of the practice of monetary policy in the
real world, inflation targeting is not about simple
policy rules and what data enters them, it is about
communication and accountability. And it is with
regard to communication and accountability that
inflation targeting is indeed relevant for the behavior of the BOJ in the late 1980s, as well as for other
central banks facing asset price booms. The BOJ
ultimately was slow to raise rates and then raised
them high and kept them high, because around 1987
it radically increased its relative weight on inflation
versus output goals and discounted the information
from developments in the real economy.
It is ironic that the BOJ began approximating an
“inflation nutter,” in Mervyn King’s sense of the
term, in the late 1980s, in contrast to the frequently told story about the Louvre Agreement and
political pressures (not to mention Black Monday)
causing monetary laxity. Senior BOJ officials have
indicated as much by saying that it would have
been politically impossible to raise rates earlier
than when the BOJ did without evidence of inflationary pressures – precisely when information
from the potential growth side was offering that
evidence. Had the BOJ been under an inflationtargeting regime, the sole focus on inflation would
have been revealed to the public and (one hopes)
reversed; conversely, had the BOJ had an inflation
targeting communications framework to draw
upon, they could have conveyed to the public the
inflationary pressures that were evident, even if
not showing up yet in the WPI or CPI. In any
event, the monetary ease in Japan in 1987 to 1989
was not the result of the bubble not being taken
into account, just as the bubble was not the result
of the monetary ease.
CESifo Forum 4/2003
26
Focus
1992 to 2002. Apparently, the collapse of the stockmarket and land-price bubbles marked a deep and
decisive point in Japan’s post-war history (see
Figures 1 and 2). During the following post-bubble
phase, no sustaining economic boom could be
achieved despite a great number of lavish fiscal
spending packages and extensive monetary easing.
To the contrary: Economic policy could not prevent
the ascent of deflation – the first time ever since the
1930s that this monetary phenomenon has returned
to an industrial country. Furthermore, in spite of
regulatory changes and heavy capital infusions, the
Japanese banking crisis could
not be finally solved and the
amount of non-performing
loans held by Japan’s banks kept
rising. A great many of other
structural problems such as poor
corporate governance, excess
regulation, rigidities in the political system and the lacklustre
performance of a great range of
protected industries were responsible for the economic stagnation and the nearly absent
productivity growth in the
1990s. Last but not least, as a
consequence of high and rising
fiscal deficits, Japan has accrued
a gross fiscal debt of probably
150 percent of GDP at the end
of 2003. If debt accumulation
cannot be stopped, a major fiscal crisis is looming.
JAPAN: IS THE CRISIS OVER?
HANNS GÜNTHER HILPERT*
F
or Japan, the decade following the burst of the
asset-price bubble in the early 1990s has been a
virtual economic disaster. Japan, which was until the
late 1980s the fastest growing economy in the
OECD area, has become the slowest one with a
meagre average growth rate of just 1.1 percent from
Figure 1
Economic stagnation in the 1990s,
but recent recovery
However, since mid-2002 there
have been visible signs indicating a turnaround of at least the
macroeconomic situation. Real
GDP showed positive (seasonally adjusted) growth for seven
quarters in a row. The latest
data for the third quarter of
2003 showed that Japan grew
* German Institute for International and
Security Affairs, Berlin.
27
CESifo Forum 4/2003
Focus
What went wrong? Demand
shocks, structural problems,
fiscal deficits
Figure 2
Demand and supplyside problems
coincided
There are two distinct views on
the causes of Japan’s economic
stagnation. One side blames a
sequence of unfavourable macroeconomic shocks and the persistence of insufficient aggregate
demand. The other side stresses
structural or institutional impediments which both affect productivity growth and aggregate
demand. The debate goes far
beyond mere academic reasoning
and has real implications for
Japan’s economic policy making. According to the
first “demand-oriented” strand of thinking, a more
appropriate fiscal or monetary policy, in particular a
more powerful stimulus, is needed to lead to economic revival. The opposing “supply-oriented” group,
however, considers major structural reforms as the
necessary condition for overcoming the existing
growth impediments. One must object to such onesided views. The two explanations do not necessarily
contradict each other. Japan’s economic stagnation
and transformation crisis is both a demand-side and a
supply-side problem, as can be shown by the long
list of its major economic problems and growth
blockades.1
by a real 0.6 percent quarter on quarter and by
2.2 percent on an annualised basis. Japan’s economic revival is strongly supported by economic
indicators: According to the Bank of Japan’s
Tankan survey, business sentiment and the business outlook are improving, especially among the
large manufacturing firms. Investment confidence
and consumer confidence are also getting better.
Production, inventory, capital utilisation, corporate
profits and capital investment are all rising. Only
private consumption has not gained momentum
yet. Reflecting the substantial improvement in the
macroeconomic situation and in business sentiment, stock prices have recovered sharply.
• The sustained economic stagnation is obviously
caused by insufficient aggregate demand.2 The
country’s decade of stagnation started with the
collapse of the asset-price bubble (1990 to 1992)
and was continuously aggravated by a sequence
of unfortunate demand shocks: A steep yen
appreciation (1992 to 1994), an excessive fiscal
consolidation (1997), the Asian crisis (1997 to
1998) and the burst of the new economy bubble
(2001 to 2002). Alas, since 1992, Japan’s economy has been afflicted by a substantial demand
gap, which originally resulted from the sharp
decline of business investment subsequent to
the burst of the asset-price bubble. The continu-
However, Japan had already experienced two short
cyclical upturns during the 1990s. They had been driven by fiscal spending and export demand, but faded
away quickly under the assault of macroeconomic
shocks and structural problems. To be sure, the current upturn seems to be broader. It is increasingly
being driven by private domestic demand, especially
by capital investment. According to the official diffusion index, the recovery spread throughout 80 percent of all industrial sectors within the latest reported 6-month span. Nevertheless, the crucial question
remains: Will the current recovery be sustained and
become a longer lasting boom or will it fizzle out in
the same way as the short recoveries of 1996 to 97
and 2000? To reach a well-founded answer to this
question, at first a short overview of the causes and
the more relevant consequences of Japan’s long-lasting economic slump will be needed. This will be followed by an examination of the mainsprings of the
current recovery, and finally the question itself can
be addressed.
CESifo Forum 4/2003
1
For an overview on Japan’s demand-side and supply-side problems,
see: Hanns Günther Hilpert. Japans endlose Wirtschaftskrise.
Perspektiven für Japan und die Weltwirtschaft, SWP-Studie Nr.
4/2002, pp. 11–34.
2 For an estimation of potential growth and the output gap see:
Tamin Bayoumi, “Where Are We Going? The Output Gap and
Potential Growth,” in: Tamin Bayoumi and Charles Collyns (ed.),
Post-Bubble Blues: How Japan Responded to Asset Price Collapse,
Washington D.C.: IMF, 2000, pp. 89–106.
28
Focus
construction, almost all service industries and
large parts of manufacturing is one major
growth impediment. Actually this “dual” sector
represents the majority of Japanese production
and employment. Most firms from this sector
only survive because of protective regulation,
government contracts and subsidies. Instead of
restructuring, the dual sector has expanded its
share in the 1990s. As a result, the share of the
efficient competitive export industries, which
have to bear the cost of inefficient business services, has declined.7
• As a result of the burst of the asset-price bubble, Japan has been struck by a banking crisis.8
Both in terms of absolute figures and relative to
GDP, the Japanese banking crisis is exceeding
all recent banking crises in other industrialized
countries. According to the latest report of the
Financial Supervisory Agency (FSA), non-performing loans held by the major banks amounted to around 35.3 trillion yen at the end of
March 2003, which is equal to about 7.1 percent
of Japan’s GDP. However, the real problem is
not the losses incurred, but the apparent institutional failures in financial regulation and the
spread of moral hazard within the finance industry. For example, it has come to light that risk
management by the banks has either been lacking or underdeveloped, that corruption in the
finance industry and in government is not rare,
that the supervisory authorities have been complacent even in the case of blatant law infringements, and that regulation has generally been
rather discretionary and non-transparent.
Furthermore, the banks’ bad loans are mirrored
in companies’ bad debts. By far too many technically insolvent companies are being kept alive
ing decline of investment reflects both cyclical
and structural elements, the latter apparently
being the dominant driving force. The investment share in GDP has fallen from 20 percent in
1990 to 15 percent at present.3 Today, Japan still
has excess capacities. According to the latest
calculations of the Mitsubishi Research Institute, the output gap was still 5,2 percent in the
second quarter of 2003.4
• As a result of the output gap and also pushed by
exogenous factors like an increasing inflow of
cheap imports and technology-driven price
decreases, the Japanese economy entered a state of
deflation. Since 1991 real estate prices have fallen
by an annual average of 5 percent, wholesale prices
by 1 percent. In 1995 the GDP deflator turned negative and since 1999 the consumer price index has
been falling by an annual average of about 1 percent. Although deflation is still mild in Japan, it is
entrenched by now. Cheap imports from China
continuously fuel further price decreases. Private
households and business firms are currently postponing consumption and investment in the expectation that prices will fall further.
• Japan’s economic growth is not only affected by
a deflationary gap, but also by a low and falling
rate of total factor productivity (TFP).5 Miscellaneous structural and economic impediments
prevented a successful transition from the former mainly investment-driven growth to the
required productivity-led growth. These impediments include an unfavourable demographic
structure, an underdeveloped venture capital
market and poor innovation management, as
well as a conservative industrial policy, which
favours incumbent inefficient sectors by means
of regulation and subsidies.6
• Generally, the backwardness of the majority of
Japan’s domestic industries such as agriculture,
Regulation failures
and moral hazard
problems beset the
banking industry
6
For this interpretation see: Hayami and Ogasawara, Changes in
the Sources of Modern Economic Growth: Japan Compared with
the United States, pp. 12–16, 28; Jonathan Eaton and Samuel
Kortum, “Engines of growth: Domestic and foreign sources of
innovation,” Japan and the World Economy, 9 (1997) 2, pp. 235–259;
David E. Weinstein, “Historical, Structural and Macroeconomic
Perspectives on the Japanese Economic Crisis,” in: M. Blomström,
B. Ganges, S. La Croix (eds.): Japan’s New Economy, Oxford:
Oxford University Press 2001, pp. 35–44; Hiroki Kawai and Shujiro
Urata, “The Cost of Regulation in the Japanese Service Sector”, in:
Mordechai E. Kreinin, Michael G. Plummer, Shigeyuki Abe (eds.),
Asia-Pacific Economic Linkages, Amsterdam: Pergamon, 1999;
Scarpetta, Bassanini, Pilat, Schreyer, Economic Growth in the
OECD Area: Recent Trends at the Aggregate and Sectoral Level.
7 See: Richard Katz, Japanese Phoenix. The Long Road To Economic Revival, Armonk 2003, pp. 40–58; McKinsey Global
Institute, Why the Japanese Economy is not Growing: Micro
Barriers to Productivity Growth, Washington. D.C.: McKinsey July
2000.
8 For more details on Japan’s banking problem, see: C. Fred
Bergsten, Takatoshi Ito, Marcus Noland, No More Bashing.
Building a New Japan-United States Economic Relationship,
Washington D.C.: Institute for International Economics, pp. 69–85;
Thomas Cargill, Michael Hutchinson, Takatoshi Ito, The Political
Economy of Japanese Monetary Policy, Cambridge, MA: MIT
Press.
3 See: Taizo Motonishi and Hiroshi Yoshikawa, “Causes of the Long
Stagnation of Japan during the 1990s: Financial or Real?” Journal
of the Japanese and International Economies 13 (1999), pp. 181–200;
Ramana Ramaswamy and Christel Rendu, “Identifying the Shocks:
Japan’s Economic Performance in the 1990‘s,” in: Tamin Bayoumi
and Charles Collyns (eds.), Post-Bubble Blues: How Japan
Responded to Asset price Collapse, Washington D.C.: IMF, 2000, pp.
45–88; Günter Weinert, “What Went Wrong in Japan. A DecadeLong Slump,” Vierteljahreshefte zur Wirtschaftsforschung, 70 (2001)
4, pp. 463–466.
4 See:
http://www.mri.co.jp/REPORT/ECONOMY/2003/er030803.pdf.
5 See: Fumio Hayashi and Edward C. Prescott, “The 1990s in Japan:
A Lost Decade,” Review of Economic Dynamics 5 (2002),
pp. 206–235; Yujiro Hayami and Junichi Ogasawara, “Changes in
the Sources of Modern Economic Growth: Japan Compared with
the United States,” Journal of the Japanese and International
Economies 13 (1999), pp. 12–16; Stefano Scarpetta, Andrea
Bassanini, Dirk Pilat and Paul Schreyer, “Economic Growth in the
OECD Area: Recent Trends at the Aggregate and Sectoral Level,”
OECD Working Paper No. 248, Paris: OECD 2000; Hiroshi
Yoshikawa, “Technical progress and the growth of the Japanese
economy,” 16 (2000), 1, pp. 34–45.
29
CESifo Forum 4/2003
Focus
Economic policy
proved ineffective
because of poor
political governance
It cannot be surprising that Japanese economic
policy has been heavily criticised both by academics and the media because of its great many mistakes and its poor results By at times contradictory arguments, government policy was blamed for
misjudging the actual economic conditions, for
aggravating the situation by outright policy mistakes, for lacking honesty in the analysis of the
underlying economic and structural problems and
for protracting the necessary remedies, and for acting too weakly against powerful vested interest
groups. For the most part these charges cannot be
denied. It is revealing, for example, that critics have
convincingly shown that the fiscal stimulus exerted
in the 1990s was insufficient10, that the monetary
policy to fight deflation proved to be much too
restrictive11, and that the structural reforms were
inadequate.12 One may wonder why Japanese economic policy proved to be so ineffective. Three reasons may explain the policy failures:13
by the joint complacency of government authorities and financial institutions. For much too
long, banks were made to trust in the so-called
“convoy system”, which stipulated that while no
bank could fail, all banks would be liable for one
bank’s losses. In spite of capital infusions by the
authorities and the increasing provisioning and
write-off of bad loans by the banks, the amount
of non-performing loans (NPL) increased from
1998 to 2002. It only slightly decreased during
2003.
• A disastrous consequence of the decade-long
economic stagnation and the expansionary fiscal policy has been the steep rise in Japan’s public debt, amounting to almost 150 percent of
GDP in gross terms at the end of 2003. This is
the highest ratio of all OECD countries.
Admittedly, in net terms the public debt is substantially lower, and virtually all debt is denominated in Japanese yen and is owed to Japanese
creditors. But there is also a large amount of
hidden debt on Japan’s public books, and the
rate of debt accumulation has increased substantially since 1998. It must be feared that the
public debt will get out of control once nominal
interest rates start rising.9
1. Japan’s economic policy has failed to take
coherent action towards reforms because the
aims and the content of reform are yet to be theoretically and politically determined. With the
collapse of high economic growth and with the
resulting demise of the Japanese-style economic
model – both formerly regarded as the basis of
Japan’s post-war consensus society – an intellectual void has opened up. Although the need for
reform is generally agreed on, Japan’s political
and business elite has not yet agreed on a final
vision for Japan’s post-industrial society. However, as long as there is no basic reform concept,
all current economic and political reforms will
proceed without vigour and without a sense of
direction.
2. The political governance system, based on the
cosy relationship between politicians, bureaucrats and business, is a major roadblock against
structural reform. When vested interests are at
stake, this “iron triangle” is wielding stronger
political power than the elected executive
Japanese economic policy: The crisis, vested
interests, and looking for direction
The steep decline of economic growth and the length
of the period of economic stagnation raise the question of the role and responsibility of government
policy in countering the various negative trends. In
fact, throughout the 1990s and until the present, various demand-side and supply-side policy approaches
have been tried, ranging from aggressive fiscal and
monetary expansion to structural reform. From 1992
to 1998 eight fiscal stimulus packages were launched,
totalling more than ¥100 trillion of officially
announced expenses. To suppress deflationary
trends, monetary policy became increasingly expansionary, and since mid 2001, the Bank of Japan has
been officially operating a zero-interest-rate policy.
There were also different supply-side measures in
order to stimulate investment and remove growth
impediments, for example industrial deregulation,
privatisation and restructuring of state enterprises,
continuous efforts to clear up the banking crisis, as
well as measures to attract foreign direct investment.
9
CESifo Forum 4/2003
10 See: Adam Posen, Restoring Japan’s Economic Growth,
Washington D.C.: Institute for International Economics, 1998.
11 See for example: Bennett T. McCallum, “Japanese Monetary
Policy,” Shadow Open Market Committee, 30.4.2001
(htto://www.somc.rochester.edu/Apr01/McCallumApr01.pdf);
Meltzer (2001), Monetary Transmission at Low Inflation: Some
Clues from Japan, pp. 13–34; John B. Taylor, “Low Inflation,
Deflation, and Policies for Future Price Stability,” in: Monetary and
Economic Studies 19 (2001) Special Edition February 2001,
pp. 35–52.
12 See: Katz (2003), pp. 193–297; Edward J. Lincoln, Arthritic Japan,
Washington D.C.: Brookings Institution Press, 2001, pp. 94–152.
13 For the following reasoning see: Hanns Günther Hilpert and
Helmut Laumer, “Japans steiniger Weg ins 21. Jahrhundert,” ifo
Schnelldienst 51 (1998) 21, S. 11–25.
For more details see: Hilpert (2002), pp. 24–29 and 45–47.
30
Focus
ment and seniority-based wages and salaries, violations of law and regulations as well as frequent
cases of internal corruption.14 With the economic
slump continuing and the deflation proceeding, it
became increasingly apparent that consolidating
one’s operations would not suffice to attain a
meaningful transformation of the dysfunctional
corporate system. Rather, companies had to limit
the demands of “exploitative” employees, management, business partners and regulatory authorities,
and subordinate their stakeholders’ interests to the
primary goal of raising the profitability of assets
and equity. But the legal environment also had to
adapt. This challenge has been increasingly taken
up both by business and government. In particular
the large manufacturing companies have been
restructuring by carrying out internal corporate
reforms, by downsizing and by cost cutting. As a
result profits of non-financial firms on the Tokyo
Stock Exchange are now 30 percent higher than at
the peak of the bubble.15 According to a corporate
survey by the Ministry of Finance, debt/equity
ratios have fallen substantially from 219 percent in
1995 to 155 percent in 2002.16 The government has
also done much to create a more transparent,
accountable and efficient business environment.
The commercial code and the bankruptcy law have
been reformed, accounting and auditing rules have
been changed, shareholder rights have been
strengthened, and payments into corporate pension plans have been made portable. Without
doubt, Japan’s currently increasing capital spending as well as the stock market rally owe a lot to the
improved profit situation of Japan’s large manufacturing companies. However, two important
reservations must be added:17
branch, but is not accountable to Parliament or
to the electorate. Although some political
reforms to overcome the old system have been
carried out, vested interests are still well
entrenched. It will take considerable time for a
new system to become effective.
3. In Japan’s current political and economic environment, there seems to be a disastrous dilemma
between Keynesian expansionary policy and
structural reform policy. On the one hand, a rigorous structural policy writing off bad loans and
closing down companies loaded with bad debt
would trigger rising unemployment. National
income, production and employment would fall
further and Japan’s deflationary gap would
widen. On the other hand, Keynesian demand
stimulation would politically restrain the progress
of reform. Anti-reform forces from government,
administration and business would argue that
structural reforms had to be postponed in order
not to endanger the economic recovery. For
exactly this reason they rather supported either
fiscal or monetary expansionary policy.
The mainsprings of the current recovery
The extent of Japan’s economic and structural
problems shows clearly that only an appropriate
mix of demand-side and supply-side policy measures can be successful. Stimulating demand and
restoring economic activity are necessary but not
sufficient to overcome the stagnation. For a sustained recovery more than an economic upswing
will be needed. The existing structural growth
impediments have to be overcome as well.
Otherwise the current recovery will falter in the
same way as the short upturns of 1997 to 1998 and
of 2000. A closer look at the mainsprings of the
current economic recovery may clarify which structural improvements have been achieved, which
economic policy changes have occurred so far.
Restructuring by
large corporations
has resulted in rising
profits and lower
debt/equity ratio
1. Although the financial situation of the corporate sector has improved somewhat, it is far
from satisfactory. Across the board, debt-equity
ratios are still high, return on assets is still low in
Japan when compared to the situation in other
major economies. In other words, excess capacities are still in place and industrial restructuring
has only come halfway.
2. To date, progress has been uneven across industries and across firms, reflecting once more the
Is Corporate Restructuring Proceeding?
The past decade of macroeconomic crisis and stagnation gave also rise to a fundamental microeconomic crisis in Japan’s industrial structure and corporate governance system. The salient features of
the corporate governance crisis were continuous
operating losses, a highly leveraged balance sheet,
a meltdown of shareholder value, unprecedented
breaks of the implicit promises of lifelong employ-
14 See: Martin Schulz, “The Reform of (Corporate) Governance in
Japan,“ Vierteljahreshefte zur Wirtschaftsforschung, 70 (2001) 4,
S. 530–32.
15 For this ratio see: The Economist, 10.9.2003, Japan’s rock bottom.
16 See: Ministry of Finance, Financial Statements Statistics by Industry. 2003.
17 For details see: T. Baig, D. Iakova, K. Kang, T. Konori, S. Kim,
Japan: Selected Issues, Washington D.C.: IMF 2003, pp. 3–15.
31
CESifo Forum 4/2003
Focus
inflationary expectations. But besides influencing
the market participants psychologically, the BoJ’s
more important monetary goal may have been to
influence the relative prices of financial assets.
dual structure of Japan’s economy. The restructuring successes are limited to the larger manufacturing companies. Many smaller companies
and most companies in construction, real estate,
retail trade, mining and agriculture are still
showing highly leveraged balance sheets and
rather low profits. The latter companies can only
survive because of low nominal interest rates.
The persistence of such weak borrowers stresses
the need for further industrial restructuring and
the exit of nonviable firms.
• By expanding the money supply via additional
purchases of JGBs, the BoJ not only successfully pushed down interest rates in the JGB primary market, but also generally reduced interest
rates in the corporate bond market from
3.5 percent to 1.5 percent.
• By buying stocks and non-performing-loans
from the banks’ portfolios, the BoJ stimulated
and promoted Japan’s post-March 2003 stock
market rally.
• By heavy intervention in the foreign exchange
markets, the BoJ slowed down the yen appreciation against the US dollar considerably.18
• By actively lending to the small and mediumsized firms that suffer from the banks’ balance
sheet consolidation and credit rationing, it
improved the firms’ financing and investment
conditions.
Has monetary policy become more expansionary?
Zero-interest-rate
policy and quantitative easing to be
continued
CESifo Forum 4/2003
For a long time, the Bank of Japan (BoJ) has been
under considerable pressure to fight deflation and
to stimulate economic growth by pursuing a more
expansionary monetary policy. It has especially
been urged to set explicit inflationary targets.
Former BoJ Governor Masaru Hayami objected to
his vociferous critics from academia, the IMF and
the Japanese government, saying that the BoJ had
already done everything possible by pursuing a
zero-interest-rate policy since September 2001,
with the official discount rate set at 0.1 percent and
the overnight call rate at 0.002 percent, later at
0.001 percent. In spite of zero interest rates, however, monetary transmission would disappear in
the dysfunctional banking sector. It was concluded,
therefore, that the consolidation of Japan’s financial institutions and the enforcement of structural
reforms should come first. A further expansion of
the money supply could become inflationary and
thus create new structural defects. These reservations notwithstanding, in September 2002
Governor Hayami introduced an important policy
modification by starting the so-called quantitative
easing. Beyond mere liquidity expansion, the monetary base was to be increased by purchases of
large quantities of Japanese government bonds
(JGB) and company equities. These purchases
were also to improve the balance sheets of the
weak banking sector. When the new BoJ Governor
Toshihiko Fukui assumed office in March 2003, he
announced that he would continue the zero-interest-rate policy and the quantitative easing not only
until prices will have stabilised, but even afterwards. In other words, from now on the BoJ will be
committed to monetary expansion until well after
deflation changes into inflation. Although the BoJ
does not set an explicit inflation target, implicitly it
has pledged to sustain its monetary expansion.
Supposedly this pledge has been made to create
The strategy seems to have succeeded. The reduced
long-term interest rates, the higher share prices
and the BoJ’s loan extension to small and mediumsized firms are effectively reducing the refinancing
costs for business and private construction, stimulating investment. Furthermore, business sentiments are improving. With regard to the ailing
banking sector, however, the BoJ’s expansionary
monetary strategy looks risky.
Will the bad loan problem be solved at last?
The bail-out of Resona Bank, the country’s fifth
largest, in May 2003 sent strong signals to Japan’s
financial markets. The government made it clear,
that it will not hesitate to nationalise a bank that is
not capable of disposing of bad loans and of raising
profitability. But the generous terms of the Resona
rescue also showed that the nationalisation of a
bank is not necessarily to the detriment of the
bank’s depositors, its borrowers and not even its
shareholders. Furthermore, this action presented
an effective strategy for solving the banking crisis.
On the one hand, the banks are forced by the FSA
to write off their non-performing loans, to identify
their problem loans and problem borrowers, to
18 If compared to the appreciation of the euro against the USdollar
in the light of the non-intervention policy of the European Central
Bank.
32
Focus
assess accurately their equity
Figure 3
capital, and finally to improve
their profits. Owing to the
FSA’s stricter supervision, the
accounting of the banks is more
rigorously checked, effectively
stopping such former practices
as understating the amount of
core capital or assessing unrealistically high the tax-deferred
assets as part of the core capital. On the other hand, if banks
like Resona cannot improve
their situation and bankruptcy
is looming, the authorities will
step in and nationalise the
institution. Obviously, there are
banks in Japan which are too big to fail – to the
comfort of depositors, borrowers and shareholders.
excess capacities in the banking sector.19 In the
current environment, however, there exist two
structural impediments to the necessary (and
unavoidable) capacity reduction. First, with the
government implicitly guaranteeing the continued existence of the larger banks, a capacity
reduction by the exit of one of the bigger players cannot take place. Second, with nominal
interest rates so low, it is difficult for banks to
raise core profitability. Thus the income value of
retail banking has decreased and the process of
consolidation has been slowed down.
2. In spite of the long duration of Japan’s banking
crisis, the major problem of the non-performing
borrowers, which lies behind the non-performing loans problem, has not been earnestly
addressed yet. Japan’s big banks are heavily
exposed to so-called “zombie-companies”,
which have little or no prospect of ever becoming viable again and survive only because of
protective regulation, government loan guarantees and their uncomfortably close bank relationship. The elimination of such non-viable
borrowers is not only hindered by government
protection but is also delayed by the low nominal interest rates. With interest rates so low,
even “zombie-companies” can still service their
debt despite little cash-flow and despite being
technically insolvent.20
For the time being, the new strategy seems to be
working very well. During the past fiscal year, the
amount of non-performing loans held by the major
banks decreased substantially for the first time
since 1996 (see Figure 3). Admittedly, the amount
of non-performing loans remains high, the banks’
capital base is still small and is highly exposed to
the volatile stock market. But banks are stepping
up their restructuring, and the official roadmap for
the rehabilitation of the financial sector, which
prescribes the reduction of non-performing loans
to a ratio of 3 to 4 percent of a bank’s total loan
assets, is looking increasingly realistic. Apparently,
the financial environment has brightened for the
banking sector. The economic recovery and the
rebound of the stock and the bond markets have
improved banks’ profitability. In particular the various governmental support operations, that is
(1) the implicit guarantee of the continued existence of the major banks, (2) the purchase of company shares and non-performing loans from the
banks’ portfolios, (3) the stimulation of the bond
and stock markets by massive purchases, (4) the
propping up of the stock market by official restrictions on stock futures or by unofficial verbal intervention, have paid off at last.
Obviously the current strategy has ameliorated the
worst effects of the financial crisis. But the strategy
applied has also inherent flaws and severe systemic
risks. There are three critical points:
Stricter supervision
by the FSA has
shown results
but government
guarantees make
for moral hazard
problems
19
A comparison of the banking industries of Japan and the United
States shows that the Japanese banking sector would need to shrink
its lending volume by 20 percent. This would necessitate closing
around every third Japanese bank. For the calculations see: Takeo
Hoshi and Anil Kashyap, “The Japanese Banking Crisis: Where did
it come from and how will it end?” NBER Macroeconomics
Annual 1999, pp. 40–43.
20 See: IMF, Japan: Financial System Stability Assessment,
Washington D.C. 2003; Katz 2003, pp. 88–91.
1. Although the banking crisis has already lasted
more than ten years, there are still substantial
33
CESifo Forum 4/2003
Focus
deflation and the banking crisis are adding even
new risks and distortions. First, the generally discretionary supervisory policy in the financial sector, in particular the implicit government guarantee for the larger banks, creates severe moral hazard problems. Second, the monetary expansionary
policy with the Bank of Japan purchasing government bonds, stock market shares and foreign
exchange on such a massive scale, is unprecedented. The strategy is apparently working well as long
as deflation is entrenched and nominal interest
rates are low. But with a successful turning around
of inflationary expectations of the private sector, a
major private and public debt problem will turn up.
Once nominal interest rates start rising again,
repayment or refinancing one’s debt will become
increasingly difficult. Both the corporate sector
and the state will face a severe consolidation crisis.
In dealing with the public debt problem, the
Japanese government will either have to push
through broader and higher taxation or inflate the
domestic currency – all public debt is denominated
in Japanese Yen – or declare default.
3. The combined actions of the BoJ and the FSA
mark a return to the former convoy system,
incurring severe moral hazard problems. Thanks
to government guarantees, the banks no longer
have to fear bankruptcy risks but they only have
to subject themselves to a rather discretionary
and discriminatory supervision. The banks’ loan
risks are socialised. Thus a higher quality of
credit analysis and higher standards of lending
prudence cannot be expected, especially as long
as Japan’s major problem borrowers are safeguarded by protective regulation and also by
(implicit and explicit) government guarantees.
Owing to the massive purchases of bonds and
company shares by the BoJ, the bond rally and
the stock market rally seem to be exaggerated.
Conclusions
Many structural
problems remain
unsolved
Economic indicators clearly show that Japan’s current economic recovery is for real. Three powerful
business and policy trends are driving the upswing.
First, the successful restructuring by some major
manufacturing companies, second, an unconventional expansionary monetary policy which is
bypassing the dysfunctional banks and is targeting
directly the relative prices of financial assets, and
third, a more powerful approach to rehabilitating
the banking sector. Admittedly, deflation has not
been overcome yet and it will take several years for
a final solution of the banking crisis. But the situation on the price front and in the financial arena is
improving rather than deteriorating further.
However, Japan’s other structural problems persist. Restructuring of the weaker part of Japan’s
domestic industries has not seriously started yet.
For example, there are still many technically insolvent large companies, mostly in the construction,
real estate and the domestic trade sectors, which
are only kept alive by debt waivers, low nominal
interest rates or even generous government contracts. Generally, as long as excess capacities in
Japan’s economy are not reduced, the macroeconomic output gap will endure and Japan’s private
domestic demand will not recover. Furthermore, as
a consequence of the remaining structural deficiencies, productivity growth will not recover and
Japan’s long-term potential growth will remain
low.
If Japan’s unresolved structural problems were not
enough, the current economic policies to overcome
CESifo Forum 4/2003
34
Pro and Contra
A
SOCIAL UNION FOR THE
EU?
entities can stifle economic development, as in
Italy’s Mezzogiorno and Germany’s eastern länder. But harmonization does not imply uniformity,
and a European layer of social policies cannot be
avoided. Citizens’ social concerns must be
addressed at the same level where economic interactions take place, for choices made at lower levels
too easily heed resentment against economic integration as a source of unfair competition and
reduction of already inadequate protection.
PRO: AN EU-LEVEL SOCIAL
POLICY
GIUSEPPE BERTOLA*
By Hans-Werner Sinn’s own Selection Principle,
governments should address problems that markets cannot solve efficiently. And if that criterion is
fulfilled then, just because those problems are not
well addressed by competitive interactions, competition among governments is not a good thing.
Such a layer cannot be done without. It already
exists, albeit in the limited and imperfect shape of
EU agricultural, regional, and structural funds, and
of a relatively small but intrusive body of regulation
in the social field. Both are motivated by concern
about the possible adverse effects of economic integration on distribution and on the governments’ willingness and ability to address them. That concern is
politically strong in Europe and it is not surprising to
hear it expressed in the same treaties that extol the
virtues of economic integration.
The EU’s ever closer integration of factor and product markets implies that uncoordinated national policies simply cannot achieve the redistribution they
deem desirable in light of financial market imperfections and political cohesion objectives. Directly or
indirectly, via migration and capital mobility or via
market interactions, tax bases react elastically to taxation and benefits are effectively paid to members of
jurisdictions other than those legislating them.
What is missing, and needed, is a translation of that
desire into a clear system of rules and adequate
financial resources addressing the relevant tradeoffs coherently. EU-level financial and regulatory
interference with national social policy is far from
negligible, but its opacity and complexity fail to
generate goodwill: quite the opposite, each national
government only sees incentives to retrieve funds
that are not perceived to address common concerns
at the European level. Redistribution should occur
transparently across national borders, to the poor
from the rich, who should understand that this use
of resources can be motivated, rather than by solidarity, by the need to ensure that nobody feels left
out of the efficiency gains accruing to the rich from
trade and specialization opportunities.
If markets imperfectly address the relevant issues,
relying on competition among also imperfect policymaking systems is unlikely to yield better outcomes
than a well-informed policymaking framework that
addresses the relevant tradeoffs coherently. To preserve both redistribution and economic integration,
elements of social policy must be centralised or coordinated. In an integrated European economy, decision-making power in the social field must not be
exclusively national, for this would either make
social policy ineffective or, more realistically, let calls
for protection from foreign social dumping strengthen old and new barriers to trade and factor mobility.
Of course, the pitfalls of centralized policies must
be avoided. Misguided application of homogenous
rules and tax systems to heterogeneous economic
* Università di Torino.
If you want to comment on this topic or react to the opinion expressed here, please visit the CESifo
Internet Forum on our web site: www.cesifo.de
35
CESifo Forum 4/2003
Pro and Contra
low-productivity to the high-productivity regions
where the probability of finding a job is higher, but
this migration would not bring about the usual welfare gains which result from migration driven by
competitive wages. To prevent mass migration, the
richer countries would be forced to pay huge fiscal
transfers to the poorer countries similar to those that
flow from west to east Germany.
CONTRA: EUROPE DOES NOT
NEED A SOCIAL UNION
HANS-WERNER SINN
Europe does not need a social union. Why? Because a
social union would replicate the problems east
Germany faced after unification. Germany introduced
a monetary union, a political union and a social union,
and the social union turned out to be a disaster. It
pushed wages way above the market clearing level,
because the welfare state paid high replacement
incomes such as unemployment benefits, social assistance and early retirement pensions, and people were
unwilling to work for wages below, or equal to, those
replacement incomes. Mass unemployment resulted.
The defenders of a social union argue that open borders and free migration make it difficult, if not impossible, to preserve the welfare state, because independently acting welfare states will erode under systems
competition. Welfare states will try to treat rich capital owners better than their competitors do in order to
increase their tax bases via capital imports, and they
will treat the poor less generously than their competitors do in order to avoid becoming targets of welfare
migration. Thereby they will be caught in a downward
spiral that leads to a gradual reduction of taxes and
social benefits even though all would prefer maintaining their benefit levels if there were no migration.
The welfare state is not a problem if it remains moderate, i.e. if the wage floor that it implies is not binding. That this condition is met can be assumed for
rapidly growing economies whose wages rise faster
than the welfare state can react. However, shrinking
economies with declining wages have their problems,
because the entitlement wage levels reflected by the
welfare benefits stem from better times. Similarly,
poor economies whose replacement incomes are codetermined by the rich ones cannot prosper.
This argument is correct in principle. The huge divergence in productivity and income levels across
Europe is far too high, however, to conclude that a
social union with harmonised benefits is the right way
to prevent the erosion of welfare systems. The price in
terms of mass unemployment in the less-productive
regions of Europe would be excessive.
There is a better way to preserve European welfare
states in an integrated Europe. It consists of two elements that were proposed in the first report of the
European Economic Advisory group at CESifo1 The
first element is the payment of wage subsidies
instead of wage replacement incomes. That would
make the welfare state a partner rather than a competitor of the private sector. It would make wages
flexible and prevent unemployment. The second is
the selectively delayed integration of migrants. In
Germany, the annual net fiscal benefit enjoyed by
the average migrant who had been in the country for
less than ten years was 2.600 euro in 1997. The selectively delayed integration would exempt migrants
during some transition period from some of the tax
financed benefits of the welfare state and make the
net fiscal benefit zero. As a consequence, free migration would be efficient and the European welfare
states could be maintained without harmonisation.
This would be Europe’s problem if a social union were
implemented. The political consensus on the harmonised level of replacement incomes would, in all
likelihood, be too high for the poorer countries in the
South and the East, because the richer countries of the
North would not be willing to reduce their social standards. There are Spanish, Portuguese and Greek areas
where wages are only a quarter of west German wages,
and in the new Eastern European member countries,
wages average hardly more than a sixth. A rapid deindustrialisation or at least a halt to further industrialisation in these areas would result from social harmonisation measures and their implied wage equalisation.
Today, west German social assistance paid to a family
with two children is 1500 euro, which is more than
three times the 450 euro that the typical Polish industrial worker earns. There would not be two, but twenty
Mezzogiorni in Europe if European welfare levels
were harmonised at the west German level.
Migration would exacerbate the situation. There
would be mass emigration of unemployed from the
CESifo Forum 4/2003
1
“Welfare to Work“, Report on the European Economy 2002,
CESifo 2002.
36
Spotlights
pinned a rapid increase in investment and an
exceptional rise in US equity prices. The prospects
of higher returns in the United States had attracted large portfolio flows, especially into equities
and corporate bonds, as well as foreign direct
investment flows. These capital inflows had fuelled
a sizeable appreciation of the dollar which in turn
weakened the current account balance.
EXCHANGE RATES AND
CAPITAL FLOWS REVERSE
DIRECTION
After a long period of strength, from the mid-1990s
to its peak at the end of January 2002, the US dollar has been weakening. In nominal effective terms,
it depreciated by over 10 percent between January
2002 and November 2003. The adjustment of the
dollar was especially significant against the euro
which appreciated 35 percent, reaching all-time
highs of over $1.20 by the end of November 2003.
The euro gained about 15 percent in nominal effective terms over the period. The dollar also weakened against the yen, albeit to a lesser extent. In
contrast, the yen continued to decline against the
euro, from ¥117.12 in January 2002 to ¥128.
By contrast, in the first half of 2002, both the direction and the composition of capital flows changed,
as confidence in the US financial markets deteriorated. In addition, restrictive changes in US trade
policy were interpreted as suggesting increasing
official concern about the US current account
deficit. In 2002, the deficit reached 5 percent of
GDP and net foreign liabilities exceeded 20 percent of US GDP for the first time. Private portfolio
and FDI flows from the euro area to the United
States became negative, on a net basis. Moreover,
international investors shifted still further away
from portfolio equity and FDI into safer assets. The
share of the US deficit financed
by official dollar reserves, mostly held by Asian countries, rose
considerably.
During the period of dollar strength, high actual
and expected productivity growth had under-
Interest-rate differentials have
re-emerged as an important
determinant of capital movements and hence exchange rate
changes. Having the highest
interest rates among the three
major economies, the euro area
has been the prime destination
of these yield-driven capital
flows, underpinning the euro’s
appreciation.
H.C.S.
37
CESifo Forum 4/2003
Spotlights
against a backdrop of stronger macroeconomic conditions should be supportive of a further increase in
flows. The Asia/Pacific region’s portfolio equity
inflows are expected to jump to more than $11 billion in 2003, from $2.6 billion last year. In 2004 net
portfolio equity flows to the region are expected to
reach $13.3 billion. China and Korea are likely to
account for $10 billion of these flows.
SHARP RISE IN PRIVATE
CAPITAL FLOWS TO EMERGING
MARKET ECONOMIES
The stock markets of the industrialized countries
have bounced back. The S&P index of the United
States, for example, increased by 35 percent from its
low on October 9, 2002. But this is nothing compared
to what has happened in the stock markets of emerging market countries. From the same date they have
jumped by 60 percent, driven partly by investors from
the industrialized countries. Despite losses sustained
in the Asian crisis of 1997, these investors are back,
believing that the emerging markets are more stable
today, economically and politically, and that the
returns are just too good to pass up.
Direct Investment to bottom out this year
Although direct investment is likely to fall to $103 billion this year, the lowest level since 1996, these flows
still represent nearly two-thirds of total net private
capital flows to emerging markets. The trough expected in FDI this year is attributable in part to weak
growth trends in the world economy since 2001 and the
lingering effects of the bursting of the technology and
IT bubble. A decline in mergers and acquisition activity has also dampened direct investment as has a reduction in privatization of state-owned enterprises. An
expected pick-up in emerging market growth in 2004
should help provide a boost to direct investment again.
In 2002, private net capital flows to emerging markets were less than half their mid-1990s peak. But
they have been rising. This year, they are expected
to increase to $162 billion from last year’s level of
$121 billion, a ten-year low. In 2004 private net
capital flows to emerging markets are projected at
$185.7 billion (Chart).
Progressive recovery of net private credit flows
The willingness of investors to purchase emerging
market bonds has increased sharply this year, reflecting a search for yield outside mature markets where
equity prices remained weak early in the year and
accommodative monetary policy pushed down bond
yields. Net financing from non-bank private creditors,
primarily in the form of bond purchases, is expected to
double in 2003 from last year’s $16 billion. A further
increase is expected in 2004. The capacity of emerging
markets to absorb more debt will continue to improve
as the ratios of overall external debt and debt service
to exports fall further from their peak in the late 1990s.
Turnaround in net inflows of portfolio investment
Emerging market net portfolio equity investment is
expected to shift this year to net inflows of more
than $13 billion from last year’s net outflow of about
$1 billion. The Asia/Pacific region will account for
nearly two-thirds of the turnaround in flows, as asset
prices continue to rebound. In 2004, net portfolio
equity inflows are projected to approach $17 billion.
Prospects for improved corporate profitability
Commercial Bank Lending
turning positive again
Net commercial bank lending
in 2003 will be positive again
for only the second time in six
years. It is projected to exceed
$13 billion, mostly flowing to
emerging Europe, following net
repayments of $5.7 billion in
2002. In 2004, net lending by
commercial banks to emerging
market countries could fall
below $10.5 billion, as net lending to Asia is expected to fall.
H.C.S.
CESifo Forum 4/2003
38
Spotlights
ENORMOUS GROWTH
FOREIGN EXCHANGE
RESERVES IN ASIA
increases in the current account rather than capital
flows.
OF
From a multilateral perspective, the current
account surpluses in many emerging market countries are the largest counterpart to the US current
account deficit. In 2002, the current account surplus for emerging economies in Asia was $133 billion, larger than that of Japan ($113 billion) or the
euro area ($72 billion). Neither the euro area nor
Japan appear particularly well placed to generate
faster growth of domestic demand in the short run.
Thus, an eventual narrowing of the US current
account deficit from its current (unsustainable)
level will most likely require the emerging
economies in Asia to share in the adjustment.
Global foreign exchange reserves have risen
sharply over the past decade, with the build-up
accelerating over time and the bulk of the increase
occurring in emerging markets. According to the
Bank for International Settlements, reserves
almost doubled from 4.1 percent of world GDP in
1990 to 7.8 percent in 2002, and rapid reserve accumulation continued in 2003. The share of emerging
market countries rose from 37 percent in 1990 to
61 percent in 2002, with emerging markets in Asia
accounting for much of the increase.
However, during the recent period of US dollar
weakness, the relative price adjustments have in
fact fallen mostly on the euro area, whereas in
emerging economies in Asia, the rapid reserve
build-up and stability of exchange rates against the
US dollar have meant that real
exchange rates have actually
depreciated.
While the rapid accumulation of reserves between
1997 and 2001 was broadly in line with fundamentals, the surge in reserves in 2002 and 2003 was
excessive by any measure. It has been driven by
From both the domestic and the
multilateral perspectives, a
slowdown in reserve accumulation in emerging economies in
Asia appears desirable. Growth
there should become more
reliant on domestic demand,
accompanied by a steady reduction in current account surpluses over the medium term. One
key aspect in this would be to
allow greater exchange rate
flexibility.
H.C.S.
39
CESifo Forum 4/2003
WES
WORLD ECONOMIC SURVEY*
the projections of corporate investment and export
volume were upgraded in October compared to
the July results. However, the public deficit is seen
to be a main source of instability. In Canada the
economic climate index improved slightly, indicating that the previous economic setback is expected to be overcome.
WORLD ECONOMIC CLIMATE
HAS IMPROVED CONSIDERABLY
In October 2003 the world climate indicator surpassed its long-term average (1989 to 2002: 93.7)
and now stands at 100.2 compared to 91.3 in the
July survey. This strong improvement resulted from
both, a more favourable assessment of the current
economic situation and highly positive expectations for the coming six months (see Figure 1).
Western Europe: Economic climate improves
According to the most recent survey results, both
the assessment of the current economic situation
and the expectations for economic developments
in the next six months point to an improvement of
the economic climate in Western Europe (see
Figure 3).
World economy: Onset of a global economic
recovery
The improvement of the economic climate index
had already set in by late April, after the end of the
Saddam regime in Iraq. In July the positive trend
of economic expectations gained momentum, and
finally in the October 2003 poll, the upward movement of the indicator became clearly pronounced.
After three consecutive positive survey results and
the fact that the assessments of the current economic situation are beginning to follow the positive
economic expectations in almost all regions, the
latest survey results may be interpreted as signalling the onset of a global economic recovery.
United States: Economic
upswing takes hold
Despite the overall improvement of the economic
climate in October, the vast majority of WES
experts surveyed in this region judged the present
economic situation of their countries to be still
below the “satisfactory” level. In particular, in
Belgium, Austria, Germany, Italy, Portugal, the
Netherlands and Switzerland the assessments of the
present economic situation – though slightly more
favourable than in the previous survey – remained
in negative territory. In of all these countries, the
outlook for the first half of 2004 is very optimistic,
however.
Figure 1
In the United States as in Canada, the economic upswing gained momentum in the second
half of 2003 (see Figure 2). In
the United States the impetus
derived from private consumption, which is expected to keep
growing during coming months.
The assessment of the present
economic condition as well as
* The survey is jointly conducted by the
Ifo Institute and the Paris-based
International Chamber of Commerce
(ICC).
CESifo Forum 1/2003
40
WES
Figure 2
41
CESifo Forum 1/2003
WES
In Croatia the economy is trending up. Since the
end of 1999 the assessments of the present economic situation have steadily improved, and almost
reached the satisfactory level in the October survey. The outlook for the next six months points to
a continuation of the economic recovery. In
Bulgaria, too, WES experts expect a stabilization of
the economy at the current satisfactory level. In
Romania and Serbia and Montenegro, the present
economic performance is well below “satisfactory”, but the outlook for the coming six months is
for an improvement. A much less encouraging economic situation still prevails in Bosnia Herzegovina, where the presently depressed economy is
not expected to improve in the near future.
In the Scandinavian countries, that is in Denmark,
Finland, Norway and Sweden, and also in the
United Kingdom and Ireland, the present economic
situation was judged satisfactory. The panel’s forecast for the coming six months is for a stabilization
of the current positive state of affairs. In two
Southern European countries – in Greece and
Spain – the downturn of the economic climate
index that had set in by the end of 2000 reversed
well before reaching negative territory in line with
general economic sentiment in Europe. The only
exception to this positive trend was France, the
second largest economy of the region. Its present
economic performance worsened in October,
according to French WES experts. But the prospects for the coming six months are very positive,
which is also true for the euro area in general.
Latin America: Disparity of economic trends
The assessments of the current economic situation
of Latin American economies deteriorated slightly,
whereas near-term expectations improved somewhat (see Figure 2). Economic trends in the individual countries of the region diverged widely. In
Brazil, the panel’s responses reflect a continuation
of economic stabilization. The prospects for the
first half of 2004 are very positive. Private consumption as well as capital expenditures and
exports are expected to continue rising. During the
first nine months of the administration of
President Lula da Silva, the Brazilian economy has
demonstrated a remarkable robustness. However,
unemployment and insufficient demand remain the
main problems of the country, whereas inflation,
which was the second most important economic
problem at the beginning of 2003, seems to have
been brought under control. WES experts also
reported a moderate economic climate for Chile
and Peru. Expectations point to further stabilization at the current “satisfactory” level, with higher
forecasts for private consumption, capital expenditure and exports. To a lesser degree this also holds
true for the economic climate in El Salvador. In all
these three countries, unemployment is listed as the
major economic problem. In Argentina, the recovery process is continuing, according to the recent
survey results. Assessments of the current economic situation steadily improved during 2003, although they have not reached a satisfactory level.
The outlook indicates a continuation of this positive trend. A similar picture can be observed in
Colombia. Less favourable assessments concerning
the present economic situation were given by WES
Eastern Europe: Economic prospects point to
further growth
According to the panel, the current economic
situation in Eastern Europe remained stable in
October. On average, the forecasts for the coming
six months point to an economic stabilization in
almost all countries of the region (see Figure 2).
The economic climate index of the ten EU accession countries – Czech Republic, Cyprus, Estonia,
Hungary, Latvia, Lithuania, Malta, Poland,
Slovenia and Slovakia – averaged above the satisfactory level. Especially in the Baltic States
(Estonia, Latvia and Lithuania) the assessments of
the present economic situation remained at a highly satisfactory level, demonstrating considerable
robustness over the past two years. WES experts
are very optimistic concerning the further development of these economies. In the other prospective
new EU members, too, recent data suggest a stabilization of these economies at the current “good”
level in the next six months. The only exception is
Hungary, where WES experts are less optimistic
concerning the recovery of the economy in coming
months. A strong decline in private consumption is
forecast for the next half year. In Poland the recovery process is also proceeding rather sluggishly. To
a greater degree than in Hungary, WES experts
there expect exports to grow in coming months. In
both countries public deficits, and – probably related to this – lack of confidence in government economic policy, are regarded the most important
impediments to economic recovery.
CESifo Forum 1/2003
42
WES
Figure 3
43
CESifo Forum 1/2003
WES
Economic expectations for the next six months
point to further improvement of the overall economy, especially in business investment, private
consumption and exports.
experts in Mexico, Paraguay, Panama and Uruguay.
However, the near-term prospects are positive
there. In all these countries the private consumption as well as business investment are expected to
pick up strongly in coming months. The export sector is forecast to strengthen, too.
In India, economic growth strengthened further.
Macroeconomic stabilization and fiscal reforms,
trade liberalization, industrial deregulation and
privatization have pushed India to the forefront in
terms of business sentiments among the Asian
countries covered by WES. Improved performance
was seen across all sub-sectors: capital expenditure
and private consumption as well as exports. Thus,
the foundations for further growth in the coming
six months are seen to be good, and growth is
approaching the Chinese level. However, in Japan,
where the recovery process from the recession gained momentum in the second half of 2003. The economic expectations for the next six months point to
further improvement of the overall economy in the
country, in particular in capital investment, private
consumption and exports. China, however, retains
its central position as the driving force of growth in
the region. The economic climate remained highly
favourable in October. Apart from continued
export growth, private consumption is expected to
strengthen further.
In other countries of the region the overall economic situation is less encouraging. In Ecuador, the
current economic situation was rated very poorly
in October and is expected to worsen further in the
course of the next months. Venezuela is recovering
only sluggishly from the recent political crisis with
a protracted general strike that affected many
industrial sectors. The assessments of the current
economic situation are still very low, but for the
first time in over two years near-term expectations
entered positive territory. The worst marks concerning the overall economic climate were given by
WES experts in Bolivia, where a political crisis was
triggered by a controversy surrounding the
Bolivian petroleum industry, the second largest in
Latin America after Venezuela’s. The violent conflict is expected to ease somewhat now that Carlos
Mesa has succeeded Gonzalo Synchez de Lozada
as president. However, since lack of confidence in
government’s economic policy is ranked as the
foremost economic problem of the country, the
political and economic situations are still far from
stable.
ASEAN and the East Asian Nics are now showing
better current assessments and continued good
prospects. Thailand posted solid economic growth
of 5.2 percent in 2002. In October 2003 the economic situation was assessed to be at a highly satisfactory level and is expected to improve further in
2004. WES experts from Vietnam and Malaysia
also reported that the present economic situation
as well as economic expectations remained at a
high level, with capital expenditures, private consumption and the export sector set to grow in the
course of the next six months. Though the assessments of the current economic situation in Hong
Kong and South Korea have not yet reached a
satisfactory level, the current economic assessments and hence the overall economic climate
changed for the better, confirming the optimistic
expectations of the previous surveys. The present
economic situation in Indonesia is now judged as
satisfactory, but the outlook for the next six
months is still cautious, implying a rather sluggish
economic recovery. In Taiwan, WES experts were
satisfied with the present overall economic performance. The prospects for further development are
moderately positive.
Asia: Economic climate indicator rises
In the October survey the economic climate indicator in Asia reached the highest level compared to
its long-term average among all WES regions. The
recovery process had already begun quite strongly
in 2002. The ensuing growth was interrupted by the
geopolitical uncertainties relating to the conflict in
Iraq, by the outbreak of SARS and by the economic weakness in the West. In July and October
2003, however, the economic climate index bounced back, significantly surpassing its long-term
average. Whereas the July pick-up was mostly attributed to the optimistic forecasts for the coming six
months, the October improvement is due to both,
positive assessments of the current economic situation as well as to a positive outlook for the next six
months.
In Japan the recovery from the long recession gained momentum in the second half of 2003.
CESifo Forum 1/2003
44
WES
rates are expected to rise for the first time since the
July 2002 survey. Central-bank interest-rate increases are seen to be more likely in the United States
than in the euro area, where the majority of
experts anticipate that the European Central Bank
will leave interest rates unchanged. In the United
Kingdom and in Australia the increase in interestrates expected by the WES participants have already occurred. In Western Europe outside the euro
area, rising interest rates are expected in Denmark
and Switzerland. In Sweden the WES participants
expect interest rates will to fall slightly, and in
Norway the central back is expected to leave interest rates unchanged. In Eastern Europe most survey participants indicated that interest rates will
continue to fall. Only in the Czech Republic
Estonia, Bulgaria and Croatia are slight interestrake increases expected in coming months.
Inflation: To remain moderate
An average 2.9 percent increase in consumer prices is expected for the world economy in 2003,
which is only insignificantly higher than in July
(2.8 percent) and much lower than the estimates in
Spring 2003 (3.2 percent). Inflation in the euro area
in 2003 is seen to be under the 2 percent mark
(1.9 percent). Inflation estimates range from
1.1 percent in Germany to 3.6 percent in Ireland.
At 0.7 percent, Switzerland will have the lowest
inflation rate of Western Europe according to the
WES experts.
In the United States a slightly higher inflation rate
is expected than in the July survey (2.2 percent
after 2.0 percent). Contributing factors are in particular the economic recovery and the weakening
of the dollar vis-à-vis important currencies such as
the yen and the euro, which will lead to higher
import prices. On the whole, however, the expected
US inflation rate clearly remains below the 2.5 percent mark that the Federal Reserve would still consider acceptable. Of all the surveyed country blocs
Asia displays the highest price stability. In comparison with the July survey a marginally higher inflation rate is expected now (1.3 percent instead of
1.1 percent), due to a higher inflation prospects in
China (1.6 percent instead of only at 1.0 percent in
July). In Japan and Hong Kong a deflationary price
trend is expected to continue but to be weakening,
particularly in Japan.
In the other WES regions, short-term interest-rates
are likely to decline further, but not as strongly as
indicated in the July survey. In Latin America on
average, stable central-bank interest rates are
expected. This includes both the expectation of
central-bank interest-rate cuts in Brazil and
Uruguay as well as rising central-bank rates especially in Colombia and Venezuela. In Asia the WES
experts see little need for rate changes by the central banks. Deviating from this general trend, interest rates are expected to increase in India,
Indonesia and Thailand and also in China (for the
first time since mid-1996).
The inflation outlook for Central and Eastern
Europe remained virtually unchanged (4.2 percent
after 4.3 percent in July). The strongest price
increases by far are likely to be registered in
Romania (13.8 percent), Serbia-Montenegro
(9 percent) and the Slovak Republic (8.7 percent).
Parallel to the expected increase of short-term
interest rates, bond rates are also likely to rise with
the exception of Eastern Europe, where a further
drop in long-term rates is expected. Slightly declining bond rates are expected in Latin America and
slightly increasing rates in Asia.
In Central and Latin America, inflation continues
to slow down, with an average rate of 7.8 percent
now expected for 2003, after 9.0 percent in the July
survey. The highest inflation rate persists in
Venezuela, but it is also slowing (31.9 percent after
an expected 45.8 percent in July).
Currencies: Euro still considered overvalued
As in the July survey, the euro was again assessed
as overvalued, along with the British pound, on
average for all 91 included countries. The US dollar
and the yen were seen as undervalued. This overall
assessment also holds for Western and Eastern
Europe. In the United States, too, the exchange
rates of the euro and the British pound were considered overvalued and that of the yen as slightly
undervalued. Experts in Australia and in Russia
regarded the home currencies to be overvalued vis-
Interest rates: Trend expected to reverse
The present round of interest rate cuts has come to
an end, according to the WES panelists. In the
course of the next six months, short-term interest
45
CESifo Forum 1/2003
WES
à-vis the dollar, the euro, the British pound and the
yen. In the Asian countries, on average, the exchange rate of the dollar is considered appropriate, that
of the euro slightly overvalued and that of the yen
overvalued.
The responses to the supplementary survey question on the likely development of the US dollar
during the next six months indicate no appreciable
change in parities. This conclusion also holds for
Western Europe. In Canada and Australia a further
weakening of the US dollar is expected. In Eastern
Europe as well as in Russia and the Near East, the
WES experts see their home currencies weaken
vis-à-vis the dollar over the next six months. The
same applies to Latin America and Africa, where a
depreciation of the home currencies relative to the
dollar is expected. WES experts see a weakening
dollar predominate in China, Japan, Taiwan and
Thailand.
Medium-term growth outlook: A little more
positive
A year ago, WES experts expected average annual
growth of GDP of 2.7 percent for the next three to
five years. This forecast has now been raised to
2.9 percent. While the WES panelists in Western
Europe only expect a 2 percent average rate of
growth, expectations in the United States increased perceptibly from 2.5 percent to 3.1 percent. In
Asia the expected average growth rate increased
from 3.5 percent to 3.8 percent. In Eastern Europe
the expected growth rate remained at approximately 3.5 percent. In Latin America the growth chances are considered slightly more positive than a
year ago (2.5 percent after 2.3 percent), but in
Argentina an acceleration to 3.3 percent is foreseen. The expected growth rates in the Near East
(4.1 percent after 3.1 percent) and in Africa
(3.6 percent after 3.1 percent) continue to be relatively high.
CESifo Forum 1/2003
46
Trends
FINANCIAL CONDITIONS
IN THE EURO A REA
Short-term interest rates have remained unchanged since June of this
year, at 2.15%. Long-term rates, in contrast have been rising from their
low of 3.72% in June to 4.45% in November. Accordingly, the yield
spread has increased from 1.57% to 2.29% over the same period.
Stock prices have continued their upward trend that had started in
March/April 2003. In November, all three indices had regained their
average levels of June to August 2002.
The annual rate of growth of M3 increased to 8% in October, from 7.6%
in September. The three-month average of the annual growth rates of
M3 over the period August to October 2003 was 7.9%, compared with
8.1% in the period July to September 2003.Of the main counterparts of
M3, the annual growth rate of loans to the private sector was 5.1% in
October, compared with 5.0% in September.
This indicator of monetary conditions in the euro area has stabilised in
November, but still reflects relatively easy monetary policy. Both underlying statistics, the real short-term interest rate and the real effective
exchange rate of the euro remained unchanged.
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CESifo Forum 4/2003
Trends
EU SURVEY RESULTS
According to first estimates for the third quarter of 2003, Euro-zone and
EU15 GDP both grew by 0.4% compared to the previous quarter. In the
second quarter the growth rates were – 0.1% for the euro-zone and 0.0%
for the EU15. Compared to the third quarter of 2002, GDP grew by 0.3%
in the euro-zone and by 0.6% in the EU15, after 0.1% and 0.4% respectively in the previous quarter.
* The industrial confidence indicator is an average of responses (balances) to the
questions on production expectations, order-books and stocks (the latter with
inverted sign).
** New consumer confidence indicators, calculated as an arithmetic average of the
following questions: financial and general economic situation (over the next
12 months), unemployment expectations (over the next 12 months) and savings
(over the next 12 months). Seasonally adjusted data.
The Economic Sentiment Indicator in the EU increased by 0.6 percentage points in November, the biggest rise since its turnaround last summer. It has now reached a level of 96.5, the highest level since mid-2002.
The main factor behind the improvement was the development in the
industry sector, with construction and consumer confidence supporting
the general upward trend. The biggest improvements were registered by
Belgium, Denmark, France and the UK.
The improvement in the industrial confidence index was supported by
similar improvements in its components: Production expectations, order
books and stock of finished products all improved by 3 points. Capacity
utilisation increased significantly from 80.3 in August to 80.9 in November
2003.
Industrial confidence in the EU continued to improve and now exceeds,
for the first time since early 2001, its long-term average. It is followed by
consumer confidence which, after having stayed unchanged for three
months, increased by one point. It thus resumed its trend increase observed since March.
CESifo Forum 4/2003
48
Trends
EURO AREA INDICATORS
The economic climate in the euro area improved in October 2003 for the
fourth time in succession, standing at 85.6. The improvement was again
based on more optimistic expectations for the next six months.
Assessments of the current situation stopped did not deteriorate further,
remaining at the third quarter’s level. The economic climate was above
the euro-area average in Belgium, Austria, Finland, Greece and Spain, but
below average in France, Italy and the Netherlands.
The euro continued to appreciate against the dollar in November, averaging $1.17 (and more so in early December when it breached the $1.20
mark). In terms of purchasing power parities, it is closely approaching
the German basket.
In October, the euro-area (seasonally adjusted) unemployment rate
stood at 8.8%, unchanged compared to September. It had been 8.5% in
October 2002. The lowest rates were registered in Luxembourg (3.9%),
the Netherlands (4.0% in September), Austria (4.5%) and Ireland
(4.6%). Spain’s rate, at 11.2%, remained the highest, topping Finland’s
(8.9%), Germany’s (9.3%), and France’s (9.6%).
Euro-area inflation is estimated at 2.2% in November, following 2.0% in
October, when it had dipped from the September value. It thus continued the modest upward trend, following the low of 1.8% in May. Core
inflation increased only marginally in October.
49
CESifo Forum 4/2003
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