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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 A quarterly journal on European issues Publisher and distributor: Ifo Institute for Economic Research e.V. Poschingerstr. 5, D-81679 Munich, Germany Telephone ++49 89 9224-0, Telefax ++49 89 9224-1461, e-mail [email protected] Annual subscription rate: n50.00 Editor: Heidemarie C. Sherman, Ph.D., e-mail [email protected] Reproduction permitted only if source is stated and copy is sent to the Ifo Institute 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 8 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. 47 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 Institute for Economic Research ORDER FORM If you wish to subsribe to CESifo Forum, please fill in the order form and return to the Press and Publications Department of the Ifo Institute. Please enter ...... subscription(s) to CESifo Forum Annual subscription price: EUR 50.00 plus postage (Members of the Ifo Institute: EUR 37.50 plus postage) Do not send payment. We shall bill you. Subscriber’s name and address: Surname .................................................................................... Forename ................................................................................... Dept./Title ................................................................................... 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