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Japanese Economic Recovery and the Macroeconomic Policy Mix

This paper reviews the macroeconomic policy mix in Japan over the past 15 years as it grappled with slow economic growth and deflation in the economy. It argues that the repeated recessions and the enormous difficulties in economic recovery are not unrelated to the macroeconomic policies adopted by Japan. Countercyclical economic policies have largely been a let-down. Given the near liquidity trap situation in the economy and the doctrinaire methods of Japanese monetary authorities, not much could be expected from monetary policy. Expansionary fiscal policy could have provided the necessary demand push if only the fiscal stimulus had been large enough and the nature of public expenditure such as to induce a significantly high multiplier effect in the economy. This obviously was not the case. In the past few years, fiscal policy has been clearly contractionary despite the continuing demand deficit in the economy.

Japanese Economic Recovery and the Macroeconomic Policy Mix

This paper reviews the macroeconomic policy mix in Japan over the past 15 years as it grappled with slow economic growth and deflation in the economy. It argues that the repeated recessions and the enormous difficulties in economic recovery are not unrelated to the macroeconomic policies adopted by Japan. Countercyclical economic policies have largely been a let-down. Given the near liquidity trap situation in the economy and the doctrinaire methods of Japanese monetary authorities, not much could be expected from monetary policy. Expansionary fiscal policy could have provided the necessary demand push if only the fiscal stimulus had been large enough and the nature of public expenditure such as to induce a significantly high multiplier effect in the economy. This obviously was not the case. In the past few years, fiscal policy has been clearly contractionary despite the continuing demand deficit in the economy.


I Context

he anaemic growth of the Japanese economy over the past 15 years has overshadowed the spectacular achievements of Japan during the post-second world war period. The scene of the economic miracle in the 1970s and 1980s has been caught in a steep downward spiral of slow growth and deflation since 1990. Compared with annual rates of growth of 4.1 per cent experienced during 1970-90, the Japanese growth slumped to 1.6 per cent during 1990-2001 and 1.5 per cent during 2001-05.1 The decline which began with the bursting of the asset bubble in 1990 and slump in stock markets and real estate markets, brought with it massive downward adjustments in investment and consumption demand and increased joblessness across the economy. Deflation – a phenomenon that had almost disappeared from modern economic experience – became a chronic problem. Initially, asset prices including land prices began to decline; this was followed by the decline in prices of corporate goods as business investment plummeted; and thereon commodity prices fell continuously. Between 1998 and 2005, there was a near continuous fall in overall price levels in the economy.

In 1990, Japan held a position of considerable strength in the world economy: Twelve of the world’s 15 largest financial institutions were Japanese, as were six of the top 10 industrial firms. After a decade, none of the world’s top 15 banks, and only one of the 10 biggest industrial firms (Toyota), was Japanese. The market value of Japanese financial firms, many of which used to operate globally, halved over the last decade while the US and European financial firms observed a near 10-fold increase in market value. With a very high savings rate, Japan had traditionally been a capital exporting nation. In 2004, for the first time, inward FDI in Japan outstripped its outward FDI. The Japanese investment boom in the US during 1984-89 had seen the Japanese acquire over 500 US companies – including high profile deals such as Sony-Columbia or BridgestoneFirestone.2 Today, the US multinational giants are rapidly buying up Japanese firms: Merrill Lynch’s 1998 acquisition of Yamaichi Securities; Salomon Smith Barney’s tie-up with Nikko Securities; GE’s acquisitions in life insurance, consumer lending, and commercial leasing are a few examples.

Following as it does after 15 long years of slow economic growth with four cycles of recession, and a considerable erosion of economic muscle in the world economy, the real economic growth of 3.2 per cent in fiscal year (FY) 2005 has rekindled hopes of a possible turnaround on the cards3 (see Figure 1). Resonating this optimism Bank of Japan, Quarterly Bulletin (February 2006) notes, “business fixed investment is growing steadily in a wide range of industries, as corporate profits remain high and business sentiment has been showing a gradual improvement. As for the household sector, after a prolonged period of difficulty due to firms’ efforts to reduce excess labour and personnel expenses, household income has been rising moderately”. The Short-Term Economic Survey of Enterprises in Japan (Tankan, March 2006) indicates that firms are perceiving the strongest capacity constraints in terms of capital stock and employment in more than a decade. Though wages are yet to pick up, expansion in employment has helped revive private consumption – the weakest component of aggregate demand in the recent years. The outlook for prices brings the silver lining: for the first time, since 1998, the consumer price index (CPI) has registered a positive year-on-year growth in the last two quarters of 2005.4 Deflation in CPI that had continued unabated even as real economic growth showed an uptrend since the end of 2002 is finally showing signs of easing.5 Bank of Japan forecasts of about 0.6 per cent growth of the CPI in 2006 and another 0.8 per cent in 2007 reflects that the bank is hopeful that the current recovery in prices would mark an end to the protracted deflation in the economy.

II Great Depression in Perspective

Several observers have compared the Japanese deflation to the Great Depression of the early 1930s, when there was a massive contraction in real output, unemployment and the prices declined. Against the background of the high and enduring growth performance of the previous several decades in Japan, the decline in output, employment and prices have indeed been severe. Even

Figure 1: Growth of GDP and GDP Deflator in Japan,FY 1995-FY 2005

(in per cent) -3 -2 -1 0 1 2 3 1995 19 96 1997 1998 1999 20 00 2001 2002 2003 2 004 200 5 Nominal GDP GDP Deflator Real GDP

Source: BoJ, Financial and Economic Statistics Monthlyand BoJ, Outlook for Economic Activity and Prices(April 2006)

so, the magnitudes are nowhere comparable to the enormous declines witnessed during the Depression. During the major contraction phase of the Depression, between 1929 and 1933, prices fell at a rate of nearly 10 per cent per year. Whereas even in the worst years, 2001 and 2002, the consumer price index (excluding fresh food) fell by one per cent in Japan (Table 1). Since the onset of the current deflationary episode – the price level has registered a cumulative decline of between 2 and 9 per cent depending on the price index.6 Real output in the US during 1929 to 1933, fell nearly 30 per cent and the unemployment rate rose from about 3 per cent to nearly 25 per cent. Whereas in Japan the growth of real output has been positive in most of the years and the output gap measuring the difference between the actual and the potential output was in the range of 1-3 per cent (annual). The unemployment rate in Japan rose from around 2 per cent in 1990 where it had stayed for close to two decades to peak at a little over 5 per cent by the year 2002. The Japanese depression is, thus, much milder in intensity when compared to the 1930s depression.

The differences in magnitude notwithstanding, the experiences of the 1930s depression and the countercyclical policy mechanisms that it established do provide a useful yardstick by which to view the Japanese macropolicy response to deteriorating economic conditions during the post-bubble era. The depression and the following years of recovery were instrumental in breaking with the orthodoxy of economic thought and giving a new orientation to macroeconomic policy that accorded government intervention a central role in combating depression. The Keynesian revolution established the criticality of public expenditure financed through deficit spending as the necessary means to boost effective demand during economic slump. The ineffectiveness of monetary policy when interest rates were already low and prices were declining, as was the case in Japan, was spelt out in no uncertain terms. Commenting on the flawed implications of the quantity theory of money for depression economies, Keynes (1933) wrote,

The other set of fallacies, of which I fear the influence, arises out

of a crude economic doctrine commonly known as the Quantity

Theory of Money. Rising output and rising incomes will suffer

a set-back sooner or later if the quantity of money is rigidly fixed.

Some people seem to infer from this that output and income can

be raised by increasing the quantity of money. But this is like

trying to get fat by buying a larger belt. In the US today your belt

is plenty big enough for your belly. It is a most misleading thing

to stress the quantity of money, which is only a limiting factor,

rather than the volume of expenditure, which is the operative factor.

There was also a clear edict for financial policies. Keynes had a strong suspicion on the role of stock markets in determining private investment and predicted that “when the capital development of a country becomes a by-product of the activities of a casino the job is likely to be ill-done”.7 Regulation on finance and banking and subordination of financial interests were strongly emphasised for real economic development.

To what extent have these policy directions that were instrumental in post-war economic management and revival of the major economies of the world been observed in Japan? How does the Japanese experience fare when analysed through this lens?

The present paper reviews the macroeconomic policy mix of the Japanese economy during the post-bubble era specifically in reference to the three crucial areas of fiscal policy, monetary policy and financial policy. In critically analysing these policies our attempt is to find out in what ways these policies have (or have not) contributed to the process of economic recovery. The outline of the paper is as follows. The next two sections (Sections III and IV) discuss the Japanese financial policy, fiscal policy and monetary policy shifts in the past 15 years. We argue that the financial sector has undergone a radical shift towards neoliberal market driven objectives and structures, so that the unique relationship between bank and industry, so characteristic of Japanese banking has been completely eroded. The new characteristics of banking including large-scale foreign acquisition of Japanese financial institutions and consolidation of existing Japanese banks as a defensive strategy has undermined any possibility of bank-led demand expansion contributing to economic recovery. The fiscal-monetary policy mix suggests an overall conservative monetarist format within which Keynesian pump priming has been accommodated somewhat uneasily. And lately, even the meagre fiscal push has been reversed. Section V takes a closer look at the Bank of Japan monetary policy and the controversies and dissatisfaction surrounding its role in economic recovery. The disappointment primarily springs from the failure to prevent deflation and effect a rise in the price level through monetary policy management. We argue that the attack on monetary authorities is misplaced since the present situation in Japan is one of monetary policy ineffectiveness rather than the alleged monetary policy inactivity. It would ultimately require a shove in aggregate demand to bring the economy back towards full employment. Such a push finally came from export demand and gradually spread to business investment (Section VI).

Table 1: Main Macroeconomic Indicators for the JapaneseEconomy: FY 1990 – FY 2005

Year on Year Growth Un-Inflation Corporate Total (in Percentage) employment Based Bankruptcies Market FY Industrial Credit Rate on CPI Cases Amount of Value of

Production to (Per (Per Liabilities 1st Section Private Cent) Cent) (100 mn of Tokyo Sector Yen) Stock

Exchange (100 mn Yen)

1989 5909087
1990 5.0 11.6 2.1 3.3 6468 19958 3651548
1991 -0.7 6.9 2.1 2.8 10723 81847 3659387
1992 -6.0 3.4 2.2 1.6 14069 76014 2810056
1993 -3.6 2.5 2.6 1.2 14564 68476 3135633
1994 3.1 -2.9 2.9 0.4 14061 56294 3421409
1995 2.1 0.1 3.2 -0.1 15108 92411 3502375
1996 3.3 1.3 3.3 0.4 14834 81228 3363851
1997 1.1 0.2 3.5 2.0 16464 140446 2739079
1998 -6.8 -0.6 4.3 0.2 18988 137483 2677835
1999 2.6 -0.7 4.7 -0.5 15352 136214 4424433
2000 4.3 -1.6 4.7 -0.5 18769 238850 3527846
2001 -9.1 -1.8 5.2 -1.0 19164 165196 2906685
2002 2.8 -3.9 5.4 -0.6 19087 137824 2429391
2003 3.5 -4.8 5.1 -0.2 16255 115818 3092900
2004 4.1 -3.6 4.6 -0.1 13679 78176 3535582
2005* 1.8 4.3 -0.1 12998 67034 5220681

Note: * Estimates.

Sources: (i) Ministry of Economy, Trade and Industry; (ii) BoJ, Financial and Economic Statistics Monthlyand (iii) BOJ, Monetary Survey, Longterm Time-series Data.

Indeed, as the analysis in this paper shows, the Japanese state has wholly abandoned demand management and the specific counter-cyclical policy prescriptions that emerged forcefully from the experience of the Great Depression and the Keynesian revolution in economic theory. In the 1990s, domestic demand conditions were allowed to stagnate while Japan looked elsewhere (towards exports) to provide demand impetus to its producers. Simultaneously, there was a realignment of Japan’s financial sector to obey market principles and integration into the world economy through inward capital flows. These two trends – the rise of financial interest (domestic and international) and the evident demise of demand management – are not unrelated. Demand management requires the existence of a nation state as the agency of intervention, whereas globalisation of finance by restricting the state’s capacity to intervene undermines that coherence.8

III Financial Sector Changes: 1980s and 1990s

By the beginning of the 1990s the Japanese economy had already made substantial departures from the carefully laid economic structures of the post-war years for corporate sector and financial sector management. In the post-war years, the Japanese economy had created a banking structure, distinctly different from the Anglo-Saxon model of financial intermediation, where “a bank not only provided loans to a firm, but also held its stock. Typically, a firm developed a relationship with a particular bank and relied on its steady support in funding over the long-term. In return, the firm used the bank for major transactions from which the banks earned fees and profits” [Chandrasekhar and Ghosh 2002]. Government regulation played a crucial role in ensuring depositor protection so that the savings of the household sector formed an assured fund base for the banks. Further, regulations prevented the use of bank funds for speculative purposes and insisted on their deployment in productive investments in industry. In return banks were in a position to use the resulting leverage to ensure that their funds were profitably employed and properly managed.

The bedrock of the government-bank-depositor-firm relationship was diluted during the 1980s through a series of policy measures aimed at liberalising the economy. The government eased regulations on banks by allowing them greater freedom to select avenues for investment of bank deposits. Thus, banks could diversify into overseas operations, lending against real estate and stock market investments, a liberty which they used fully. In addition, the appreciation of yen following the Plaza Accord in the second half of the 1980s, rendered overseas investments attractive even as the competitiveness of Japanese exports suffered, so that Japanese banks expanded their business activities overseas. Within Japan, the main domestic borrowers for Japanese banks changed from big businesses, who were now increasingly relying on equity finance, to medium and small businesses, especially in the field of real estate agencies and construction companies and non-banks such as specialised housing finance companies. Wood (1992) estimates that property, directly or indirectly, supported as much as 80 per cent of the total loans of Japanese banks. Simultaneously, banks also increased their exposure to the stock market. Between 1985-89, the total market price of shares of listed companies swelled by more than three times, and the units of shares listed increased by 21 per cent. Of the total stock of listed shares in 1989, financial institutions held a whopping 42.3 per cent, business firms 24.8 per cent, and individuals 22.6 per cent [Itoh 2001]. A bubble, largely a result of speculative trading of financial assets and real estate using easily available credit and cheap equity finance by big corporations, medium and small firms and financial institutions, was in the offing.

When the speculative bubble burst, as was inevitable, asset prices fell sharply and stock prices fell ahead of land prices. At the end of 1989, the total market value of the first section of the Tokyo Stock Exchange was 591 trillion yen, but three years later at the end of 1992, it had dropped by more than 50 per cent to 281 trillion yen. Between 1990 and 1993, there was a near 50 per cent drop in land price [Statistical Handbook of Japan 2003]. Asset price-deflation marked the beginning of a long and precipitous decline of the financial system with a massive contraction in bank credit, huge pile-up of bad debt with losses up to 17 per cent of GDP in dealing with non-performing loans, large-scale failures of both smaller cooperative type financial institutions and larger banks leading to the dissolution of 110 deposit-taking institutions under the deposit insurance system by the year 2000 [Nakaso 2001].

Further Liberalisation of the Financial Sector

The policy response to the problems of the financial sector was to push forth strongly with further liberalisation of the financial system along with improved supervision and new style regulation. The official explanation for the problems of the banking sector blamed the crisis on “the gap between competitive pressures in the financial markets and a convoy style of banking supervision and regulation that in effect ensured the viability of the weakest banks.9This gap had become unsustainable. The crisis was accentuated by the formation and bursting of the bubble.”10 Thus, rather than locate the cause of the crisis in the policy of financial liberalisation that was well underway since the 1980s, Japan pledged to fully align the financial system on competitive market principles. In addition, restructuring of the corporate sector and development of more liquid capital markets were actively planned to weaken the close ties between bank and industry.

Financial system reform, “the Japanese Big Bang,” commenced in November 1996 under the three principles of “free, fair and global”. As a first step, the Foreign Exchange Law was changed to totally liberalise cross-border transactions in April 1998. The Financial System Reform Law along with revisions to the Banking Law, the Securities and Exchange Law, and the Insurance Business Law were enforced in December 1998. These amendments facilitated further liberalisation by revising regulations on the business scope and organisational format of financial institutions, easing entry barriers to the financial industry, and, deregulation of products and services. Alongside, the Financial Supervisory Agency was created to strengthen bank supervision and prudential standards. Financial Supervisory Agency metamorphosed to Financial Services Agency in the year 2000. With this change, the Financial Services Agency took over the entire planning of the financial system from the ministry of finance.

Radical Changes in the Structure of Banking

The other major set of financial reforms was in the ownership structure of banks. This encompassed two major initiatives: crossshareholdings between banks and firms that had already weakened were further diluted, and the rules governing FDI in banking were liberalised.

In the post-war years, cross-shareholding arrangements (firmfirm, bank-firm, bank-bank) operated as tacit mutual pacts designed to insulate the management of both sides from any market threat or hostile takeover. Further, it served the following functions: (a) efficiency of capital derived from delegating the function of monitoring to the main bank as the implicit agent of the other creditors called the signal function; (b) the main bank assistance to firms in financial distress called the rescue function; and (c) an active role in corporate governance [Sheard 1989, 1994]. With the liberalisation of banking operations in the 1980s the close relation between banks and firms, particularly large firms, had weakened considerably. The bursting of the asset bubble and the consequent uncertainty surrounding their partner’s weaknesses dealt a further blow to this arrangement. Firms with relatively small capital or firms belonging to industries flung in recession continued their dependence on banks, whereas banks in the new competitive environment obliged to meet the capital adequacy standards preferred to retreat from cross-shareholding vis-à-vis such firms. Finally, the policy changes zealously facilitated the demise of the cross-holding arrangement. The Financial Services Agency in June 2001 proposed that a bank’s shareholdings be less than the value of its capital holdings in a company, and asked banks to divest all excess shares estimated to be more than 10 trillion yen over a three-year period.11

According to Nippon Life Insurance Research Institute estimates, cited in Hideaki and Fumiaki (2005), the stable shareholder ratio – defined as the ratio of shares owned by commercial banks, insurance companies, and other non-financial firms to total issued shares of listed non-financial firms, calculated on a value basis – was 45 per cent in the early 1990s, but only 27.1 per cent in 2002. While the cross-shareholding ratio between corporations decreased only slightly, the ratio of shares held by financial institutions dropped significantly. The ratio of shares held by banks alone dropped from 15.7 per cent in 1990 to 7.7 in 2002.

As it were, cross-shareholding and the main bank system had worked to hold foreign investors at bay. Cross-shareholding promoted long-term transactional relationship between the partners making it difficult for foreign investors to break into Japanese network. Thus one of the principal dissatisfactions with this arrangement, and plea for its dilution had come from external interests.12 These external financial interests ultimately triumphed in Japan with the liberalisation of foreign direct investment rules in the finance and insurance sector. Until 1991, the government limited FDI through formal measures such as the Foreign Exchange and Foreign Trade Control Law, which required “prior notification” for investment in any sector. This was amended to “ex post facto” notification except in certain restricted sectors. Specifically, regulations in industries such as financial services, retailing, and telecommunications were largely eliminated.

The next few years saw a surge in FDI flows into Japan (see Figure 2). Inward FDI in Japan rose from 405 billion yen in 1990 to 687 billion yen in 1997 and further to 4,027 billion yen in 2004, recording a ten times increase in 14 years. In terms of sectoral distribution, finance and insurance attracted the most amount of FDI – both in terms of the number of cases and their value – with its share in total inward FDI peaking to 73 per cent in 2004. What’s been the nature of this FDI?

(a) An overwhelming proportion of FDI in Japan, particularly in the finance and insurance sector, has taken place through mergers and acquisitions transactions. A rough estimate puts the share of M and A activities at over 80 per cent of total FDI since 1997, whereas greenfield investments were minimal.13 For global corporations eyeing opportunities in mature markets, it is easier, more economical, and faster to acquire companies with existing plants, distribution systems, suppliers, employees, and customers than to develop this piecemeal at substantially greater cost over a longer period of time.

  • (b) The US has been the single-largest investor in finance and insurance sector, with an average share of 48 per cent investment in the sector between 1998 and 2004 (see Figure 2). The concentration in terms of country of origin essentially reflects the dominance of US investment banks in the acquisition of Japanese financial institutions and insurance companies. A handful of investment banks like Goldman Sachs, Morgan Stanley, Ripplewood Holdings, among others, by buying up Japan’s financial assets at less than 10 per cent of their face value have made huge profits from buying and selling. These present typical examples of what is known as vulture investing, wherein large investors try to grab distressed or undervalued assets on the cheap, install new management teams to turn the companies around – often by selling assets and laying off workers – and resell what’s left of the original entity to a third party at a premium price.
  • (c) Rather than recognise the predatory nature of such foreign investments, a lot of the mergers and acquisitions have been posed as “rescue acquisitions” as the investing firms were supposed to have acquired stakes in financially troubled institutions14 [see US-Japan Business Council 2005]. This is admittedly a strange connotation, for the Japanese government had pumped in millions of yen in rescuing several of these financial institutions before they were picked up by foreign investors at almost rock-bottom prices. And, as expected the turnaround in their fortunes came in no time.
  • The rising presence of foreign investment in banking means that the regulatory and monetary authorities have lesser control. The regulator’s inability to practise moral suasion when dealing with an entity more focused on the expected returns from transactions and less sensitive to domestic goals set by the state has already been witnessed in Japan. The New York-based Ripplewood Holdings – having won much acclaim for turning around the fortunes of Long-term Credit Bank of Japan, after the government temporarily nationalised the bank and cleaned up its bad debt

    – refused to join other creditors in bailing out Sogo department stores, triggering bankruptcy for the chain. In 2004, Citibank was in news for selling inappropriate financial products in Japan. Financial Services Agency had to ask Citibank to suspend some of its operations and close down a few of its branches for providing financial services not allowed under the banking law.

    Even more dangerous, however, is the inability of the authorities to prevent capital flight by the foreign banks in the face of real or imagined crisis in the domestic economy. The ensuing instability across the financial system could then have a selffulfilling effect causing severe damage to the economy, as the recent Argentine example illustrated.15

    Response of Domestic Banks

    With the entry of foreign investment in banking, Japan’s large banks have engaged in a series of defensive mergers, accompanied by government assistance in unloading bad debt. A decade into the post-bubble adjustments, virtually all large Japanese banks have merged.16 These “bigger is better” mergers did not resolve the problems of the financial sector: gains in microeconomic efficiency were minimal, and these banks’ inability to lend compromised any possible economic recovery [Dymski 2002].17

    Table 1 indicates that bank lending to the private sector declined continuously over the past seven years in Japan. While many observers attribute the declining credit to a demand-constrained situation – as borrowers were unwillingly to take on debt due to continuing deflation and recession in the economy – the supplyside inducement may have been equally strong, as is observed in a large number of cases of economies undergoing structural

    Figure 2: Inward FDI in Japan the recent rally in the stock market is being looked upon to revive demand conditions by raising the value of assets held by individuals and firms. The latest Quarterly Bulletin of the Bank of Japan (February 2006) notes that, “the increases in receipts of

    consumption”. With this, the story of Japanese depression and

    100 90 80 70 60 50 40 30 20 10 0 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Percentage100 million yen

    recovery has come full circle. The very agency – the bursting

    of the asset bubble – that had led to the collapse of the Japanese

    economy in the early 1990s and the prolonged stagnation thereon

    is being pursued to pull the economy back into the growth path.


    It is noteworthy that the rally in stock prices has been wholly due to the unprecedented foreign investor interest in Japanese stocks even as net purchases of stocks by the Japanese people

    – both firms and individuals – remain overwhelmingly negative (see Figure 3). No wonder, the greatest endorsement for reforms in the Japanese financial system has come from international investors, and institutions which represent their interests.

    IV Anti-deflationary Policies: Fiscal Stimulus and Monetary Easing

    The fiscal situation during the second-half of the 1980s in Japan would have pleased any central banker and for the Bank of Japan, trying to enforce monetary discipline and price stability, it was particularly satisfying. Japan had, since the 1980 budget maintained the goal of reducing and eliminating the issuance of special deficit-financing bonds, through restraint on the expenditure side. Partly as a result of the bubble economy and the increase in tax revenues in the latter-half of the 1980s, Japan finally succeeded in formulating the 1990 Budget without issuing special deficitfinancing bonds for the first time in 16 years. Government bond issues, which amounted to more than one-third of total expenditures in 1979 gradually declined in the 1980s and recorded a low of 9.5 per cent of total expenditures in 1991.

    The restraint on public expenditure and issue of government bonds, however, had to be soon abandoned as recession set in and the need for a strong fiscal stimulus was recognised. The tax-ratio declined from 13.4 per cent in 1990 to around 9 per cent in the recent years due to the depressed conditions in the economy and the tax cuts announced by the government (see Figure 4). Once again, the issue of special deficit financing bonds was stepped up and reached unprecedented levels after the Asian financial crisis and collapse of domestic financial institutions. Public money was used for public works in social infrastructure projects and injections into the banking system against nonperforming loans of the failing financial institutions.

    The substantial increase in bond-issue hiked the public debt-GDP ratio. The public sector’s gross liabilities in March 2003 stood at 161 per cent of GDP, up from around 60 per cent of GDP in 1990. Yet the contribution of public expenditure to national product went up by a small 3 percentage points. A significant share of the additional bond issue went into covering the revenue declines from the tax breaks that the government announced. The latter was to stimulate private consumption expenditure and also private investment. Normally, the multiplier effect of tax relief in a depression economy would be much less than direct expansion of public spending. The difference is particularly sharp for the Japanese economy. In the context of the Comprehensive Economic Measures of April 1998, which combined major tax cuts with social infrastructure investment to the tune of 16 trillion yen, the ministry of foreign affairs calculations show that the income multiplier for a tax cut is 0.46

    i il

    Share of Finance and Insurance in Total Inward FDI


    Share of US in Inward FDI in Finance and Insurance


    Inward and FDI (100 million yen) Source:Ministry of Finance, FDI data

    reforms in banking. In the stylised case, the new regulatory requirements on banks such as provisioning norms for bad debt and capital standards create tendency towards asset switching: away from traditional lending to fee-based income, investments in government securities and loans based on standardised balance sheets, as the latter carry lesser credit risk. Essentially, banks’ reactions to hitting regulatory constraints on their capital ratios are likely to vary according to the stage of the business cycle and the bank’s own financial situation. Raising new capital or boosting retained earnings may be easier in booms whereas cutting back loans may be more cost effective in economic troughs. Similarly, raising capital is easier for strong banks compared to weak banks which may cut back on loans. Further, the tendency towards asset-switching becomes more potent when domestic banks are suddenly exposed to competition from overseas financial institutions. With the latter known to focus on select activities and cherry-pick the best customers, domestic banks are left with customers of lesser quality, which creates further incentives to reduce loan exposures. Dymski (2004) notes the consequences of these strategic adaptations in the credit markets: “Banks operating differently from the elite multinational banks must adapt or lose customers and profits; but in adapting they sacrifice some of the unique characteristics that have made them well-suited engines of industrial growth”.18

    Could the prolonged slump in the Japanese economy spanning a decade and a half have been prevented or at least shortened, if the old financial structures and policies were in place? Could the Japanese financial have played a more proactive role in economic recovery? As per our reading of the trends, the answer is yes.

    The old system had given the Japanese banks “deep pockets” to extend credit to industry that could help tide over economic crisis involving crisis of private business confidence. Crossshareholding arrangements ensured that the banks rescued crossshareholder firms in distress, even as monitoring mechanisms could prevent unsound investment decisions. State control on bank and industry could ensure that the actions of the private players were not inimical to the broad objectives of development. Moreover, the exclusion of international financial flows and subordination of domestic financial system to the needs of the real economy via appropriate regulations meant that the likelihood of financial crisis triggering a downward spiral in the economy was eliminated.

    Instead, the Japanese banks were turned into liabilities for the economy sucking in public money without contributing to economic recovery, and ultimately several of them were dispensed cheaply to foreign investors. Stock markets grew in might and came to occupy a central role in the economy. So much so that

    Figure 3: Stock Trading by Type of Investors: Net Purchases*

    100000 80000 60000 40000 20000

    0 -20000 -40000 -60000 -80000

    (in 100 million yen)




    Corporations Note: * Ist section of Tokyo Stock Exchange. Source: BoJ, Financial and Economic Statistics Monthly.

    whereas for public investment it is 1.46. It would have made more economic sense if the Japanese state were to directly spend the money rather than provide tax relief.

    There are two other angles from which the fiscal stance might be considered conservative. Firstly, given the massive size of the economy, a much greater shove in demand was required than was forthcoming through public consumption or public investment expenditure. As seen from Figure 4, the contribution of public expenditure to the national product went up only by a small percentage. Secondly, the overall rise in public spending could nowhere compare with the huge contraction of private demand (see Table 2 for the contribution of private and public demand to aggregate spending).

    Moreover, since 2000 there has been a decline in the contribution of public expenditure to GDP. The reversal is part of the package of fiscal reform legislation that was passed in 1997 [Fiscal Structural Reform Act 1997] but had to be kept in abeyance due to the continuing stagnation and the need for public funds to stabilise the financial system. Lately the balance has tilted clearly in favour of fiscal reforms. Public investment has continuously declined since the quarter October-December 1999. The decline accelerated to double digits in 2003. Development Bank of Japan (2003) figures show that the public investment now accounts for only 5 per cent of GDP and is expected to decline further given the “continuation of structural reforms and financial difficulties”.

    In respect to monetary policy, Japan has consciously followed a monetary easing policy for several years now, especially after the Asian crisis. The Bank of Japan had tightened monetary policy around mid-1989 with a view to contain inflationary expectations and maintain price stability. It raised the discount rate to more than 6 per cent (August 1990) which was higher than the level prevailing at the time of Plaza Accord. The ministry of finance also introduced restrictive laws and regulations for land transactions. These changes possibly triggered the bursting of the bubble. After June 1991, monetary policy was eased gradually though the Bank of Japan at that time was still pledged to the anti-inflationary objective. By September 1995, the official discount rates had been reduced to 0.5 per cent, the lowest level in Bank of Japan’s history.

    Monetary policy in the second-half of the 1990s became “ultraeasy”. Interest rates were continuously declining and by 1998 had come very close to the zero mark. In February 1999 BoJ adopted the “zero interest rate policy”. This was a combination of a near zero overnight rate and the commitment to maintain it “until deflationary concerns are over”. It was non-conventional in the sense that the interest rate was set at zero, an extreme

    Figure 4: Japanese Fiscal Action: FY1990-FY2006

    (Per cent)

    20 18 16 14 12 10 8 6 4 2 0 (in per cent) 40 35 30 25 20 15 10 5 6 (trillion yen) Notes: Initial Budget: 2006; Revised Budget: 2005. Source: Ministry of Finance, Highlights of the Budget for FY2006. 19901991199219931994199519961997199819992000200120022003200420052006 illi Expenditure/GDP (Per cent) Tax Revenue/GDP (Per cent) Government Bond Issue (trillion yen

    level, and that the near-term future policy stance was explicitly made clear.

    In March 2001, the BoJ switched from the usual approach of reduction in the target short-term interest rate to quantitative easing because by then the interest rate was very close to zero. As a result, the possible stimulus obtained through further reduction in the interest rate target was likely to be limited, the BoJ argued. Under the quantitative easing formula, the BoJ conducts open market operations to increase the money supply. The quantitative easing programme has continued with periodic intensification, till very recently (March 2006).

    V Monetary Policy and Prices

    Despite the efforts of the BoJ to maintain an (unambiguous) ultra-easy liquidity situation for most of the period, the role played by monetary policy in alleviating the Japanese crisis has been shrouded in controversy. Many commentaries on the Japanese crisis have alleged that the failure to prevent deflation is in itself an evidence of the failure of the Bank of Japan to follow an expansionary policy aggressively over a sustained period. This argument which can be traced to Friedmanite monetarism has the following logic: since an expansion in money supply by the monetary authorities, translates to a proportionate price rise through the quantity theory of money equation, given the exogenous nature of money supply it should always be possible to engineer a price rise through monetary expansion. Bank of Japan responded to this criticism by switching from targeting short-term interest rates to quantitative monetary easing policy by adopting the Bank of Japan’s current account balance as the direct target of its financial guidance policy since March 2001. As a result of this policy, the monetary base, i e, the total of Bank of Japan’s current account balance and cash in circulation has seen double digit increases but money stock has been growing at 1-2 per cent on the previous year. The money multiplier declined from 13 in the first half of 1992 to a record low of under seven in the recent period.19 In terms of the Cambridge equation, the growth in monetary base has been absorbed by the decline in money multiplier and hence, the effect of quantitative easing policy has not materialised. It is worth noting here that even the small growth of money stock of 1-2 per cent has been propped up by the growth of lending to the government, as credit to the private sector – lending and investments in industrial debentures and stocks – continue to decline.

    A more sophisticated causation running from monetary control to prices has been suggested by Paul Krugman (1998). Krugman blames the monetary authority for not being able to generate inflationary expectations, which is the only effective way to reverse the deflationary spiral. Unlike the monetarists, Krugman identifies the Japanese case with the Keynesian liquidity trap, where money supply is irrelevant at the margin since the nominal interest rates are already at near zero levels. Increase in high powered money does not spur aggregate demand through interest rate fall. The problem therefore is how to reduce interest rates in the economy. At this point, Krugman draws on the Fisher’s equation of interest rate determination to argue that the zero lower bound on nominal interest can be surpassed by generating inflation that would push down the real rate of interest.

    But this is begging the question, since the Japanese economy was already in recession with falling aggregate demand and deflation. In a deflationary state, further spending in the current period becomes unattractive and the current level price is pushed down. Only when people realise that the prices have bottomed out and would not fall further, they might begin to spend. It is here, Krugman believes, that the central bank must intervene and produce inflationary expectations through a credible commitment to inflation over a future period. Thus Krugman proposes managed inflation, “since deflation is the result of an economy ‘trying’ to get the expected inflation it needs, to avoid deflation one must provide that expected inflation by credibly promising that future price levels will be sufficiently high compared with the present”.20

    The problem with Krugman’s stylisation of the Japanese slump is that while it borrows the idea of liquidity trap from Keynes, it is then mixed with monetarist relationship so that the original conclusion of Keynes on ineffectiveness of monetary policy in an economy stuck in a liquidity trap is turned on its head. Kregel (2000) criticises Krugman on the use of the Fisher’s equation in his model and shows how the difference in the result is related to this crucial assumption. Essentially, he makes two points which are of relevance here. He emphasises the distinction between the Fisherian time preference theory and Keynesian liquidity preference theory of interest rate determination. In Fisher’s time preference approach the rate of interest is the discount of future over present income that makes their utility equal at the margin, while for Keynes liquidity preference represents the return that must be paid on illiquid assets to make investors indifferent to holding more liquid assets. Since time preference is a relation between real income today and in the future, it would be disturbed by changes in prices. And this is the sense in which Krugman uses the relationship when he talks of using the inflation to drive a wedge between nominal and real interest rate. Keynes’ objected to the Fisher’s relation because “Fisher’s argument that the money rate of interest should automatically reflect a perfectly foreseen rise or fall in the price level overlooks the impact of a rise or fall in interest rates on the capital value of existing stocks of financial assets”.

    00 01 02 03 04 Inter-bank overnight lending rate Three-month CDs Yield on 10-year government bonds Average contracted interest rate on new loans Three months moving average

    Source: Development Bank of Japan, Research Report, No 48, January 2005.

    Figure 5: Selected Interest Rates

    (Per cent)






    This brings us to the other more practical point that Kregel emphasises in Keynes’ original argument. Even if monetary authority is able to create inflation, it would be extremely difficult to hold down interest rate (yield on bonds) at the long end of the maturity spectrum, though perhaps the monetary authority is able to control the short-term interest rate. This happens because of the liquidity preference of the investor who would reason that to offset the fall in capital value as a result of higher interest rate the rise in interest rate at the longer end must be higher. Thus it would be difficult to keep the yield curve stationary while the prices are rising. Keynes’ theory was based on first-hand observations on the behaviour of bond market, so it is not surprising that empirical evidence would support this causation, as we will see below for Japan.

    Krugman was not alone in suggesting an inflation target for the Japanese economy. Such a view was being debated in the ministry of finance and the Bank of Japan and outside. Bank of Japan monetary policy board member Nobuyuki Nakahara proposed “setting a target for base money to create inflationary expectations and get the Japanese economy out of its liquidity trap”, echoing exactly what Krugman was emphasising. Deputy vice-minister for international finance, Takatoshi Ito penned for Financial Times,“many countries have adopted inflation targeting to establish a clear objective for monetary policy and to make their (often newly) independent central banks accountable. The Bank of Japan could commit to an inflation target of, say, 1-3 per cent, to be achieved in two years”. Kenneth Roggoff of the IMF, stressed the need for a clear Bank of Japan communication strategy which would explain that (a) the BoJ intends to restore positive inflation within a reasonably short time frame and (b) the BoJ has ample capacity to restore positive inflation if it chooses to do so.21

    However, Rogoff and the others do not suggest anything beyond the quantitative easing policy to demonstrate either the intent or the ability of Bank of Japan to restore positive inflation.22

    Table 2: Contribution to Change in Real Gross Domestic Expenditures by Component

    (in per cent)

    FY Real Gross Domestic Public Private Private Residential Non-Residential Private Exports of Imports of
    Domestic Demand Demand Demand Consumption Investment Investment Inventory Goods and Goods and
    Expenditure Sum of (i) to (iv) (i) (ii) (iii) (iv) Services Services
    1995 2.4 3.1 1.2 1.9 1.3 -0.3 0.5 0.4 0.4 -1.1
    1996 2.8 2.9 0.1 2.8 1.4 0.6 0.8 0.0 0.7 -0.8
    1997 -0.1 -1.2 -0.4 -0.8 -0.6 -1.0 0.5 0.3 0.9 0.2
    1998 -1.3 -1.5 0.5 -2.0 0.2 -0.5 -1.1 -0.5 -0.4 0.6
    1999 0.6 0.5 0.6 -0.1 0.7 0.1 -0.1 -0.8 0.6 -0.6
    2000 2.8 2.7 0.1 2.6 0.5 0.0 1.0 1.0 1.0 -0.8
    2001 -0.8 -0.2 0.1 -0.4 0.7 -0.3 -0.3 -0.4 -0.8 0.3
    2002 1.1 0.4 0.0 0.4 0.8 -0.1 -0.4 0.0 1.2 -0.5
    2003 2.3 1.5 -0.1 1.6 0.5 0.0 0.9 0.2 1.1 -0.3
    2004 1.7 1.3 -0.3 1.6 1.0 0.1 0.8 -0.3 1.4 -0.9

    Source:Bank of Japan, Financial and Economic Statistics Monthly.

    Economic and Political Weekly August 12, 2006

    Imports Exports (CY quarterly basis)

    82 84 86 88 90 92 94 96 98 00 02 04

    Figure 6: Exports and Imports

    (Per cent of GDP) 16





    6 80 Source: Development Bank of Japan, Research Report, No 48, January 2005.

    Since the middle of 2003, with signs of economic recovery, long-term interest rates began to nudge upwards as Kregel in referring to Keynes’ theory had stated. Figure 5 traces selected interest rates for the Japanese economy, both at the long and the short end. Yield on 10-year government bond representative of long-term interest rate in the economy has risen to around 2 per cent. Even when the short-term rates are steered by monetary authorities to remain at low levels, yields on long-term bonds have risen. This would happen until the level of long-term interest rates becomes an explicit policy objective of the central bank. But then interest rates and not prices should be the leading indicator of monetary policy.

    VI Export Growth: The Ultimate Panacea?

    The pattern of change of gross domestic expenditure in Japan since the second half of the 1990s is presented in Table 2. As can be made out from the contribution to demand by each sector of the economy, the upswing of the Japanese economy, after the precipitous decline of gross domestic expenditure in 2001, owes largely to the growth of exports in 2002. “Led by recovery of exports, real GDP turned from a decrease of 3.3 per cent on the previous year in January-March 2002 to an increase of 1.5 per cent in July-September, the first increase in five quarters”.23 At a time when private demand in the domestic sector was extremely weak and demand push from the public sector was minimal, export demand helped prop up overall demand in the economy.

    The recovery in real private plant and equipment investment followed close on the heels of growth in exports. It started rising since July-September 2002, and since the beginning of 2003 active investment led the growth of GDP.24 By July-September 2003, plant and equipment investment had surpassed the peak recorded in the IT boom era. The following year saw substantial revival in import demand as economic recovery spread. Hence in 2004, the contribution of net exports to growth in gross domestic expenditure was more modest despite robust export growth of 12 per cent (Table 2).

    With exports playing a crucial role in restoring demand in the economy, trade dependency in Japan has grown in the recent years. Exports and imports as a percentage of GDP had declined from over 14 per cent in the early 1980s to about 9 per cent in the early 1990s following the Plaza Accord. Since the late 1990s the ratio has steadily climbed back to reach 13 per cent of GDP in April-June 2004. It is this rise in export, with accretions to demand originating from within Asia, particularly China, that Japan could turn to its advantage to engineer an export-led economic recovery.25 However, as export growth contributed to GDP growth, it simultaneously caused a rise in correlation between growth of exports and industrial production and between exports and domestic business cycles. The downside risk of over-dependence on trade and the associated vulnerability to the trading partner’s economic conditions would always be part of such a strategy.

    VII Conclusion

    We have reviewed the macroeconomic policy mix in Japan over the past 15 years as it grappled with slow economic growth and deflation in the economy. We have argued that the repeated recessions and the enormous difficulties in economic recovery are not unrelated to the macroeconomic policies adopted by Japan. Countercyclical economic policies have largely been a letdown. Given the near liquidity trap situation in the economy and the doctrinaire methods of Japanese monetary authorities, not much could be expected from monetary policy. Expansionary fiscal policy could have provided the necessary demand push if only the fiscal stimulus had been large enough and the nature of public expenditure such as to induce a significantly high multiplier effect in the economy. This obviously was not the case. In the past few years, fiscal policy has been clearly contractionary despite the continuing demand deficit in the economy.

    Restraint on fiscal expenditure is part of the neoliberal reform process that has wholly transformed the structure and functioning of the Japanese financial system over the last two decades into an “efficient” and internally and externally “competitive” marketbased system of the Anglo-Saxon variety. This is a major departure from the state-controlled system of financial intermediation in Japan with a cooperative and a mutually beneficial relationship across actors – the depositors, the banks, and the industries. The changed structure of the financial system played a substantive role in giving rise to the downturn in the economy, in prolonging the downturn, and in blunting the macroeconomic policy responses to the downturn. The asset price bubble in the second half of the 1980s was the result, inter alia, of reckless lending by the financial institutions confronted with the freedom to select their investment avenues freely, which now included speculative trading in the stock market and other asset markets. The consequent bursting of the asset bubble, debt deflation and prolonged slowdown in economic activity might have been moderated with a more proactive role, as was played in the past, by the Japanese banks. Instead, the Japanese banks were largely rendered powerless having lost their former financial strength and their former client base. In the new liberalised environment, banks had to, in addition, obey more stringent capital standards despite recessionary conditions in the economy. The entry of foreign investors in the financial sector, ostensibly to restructure Japanese banking and to make it more competitive, did allow the Japanese government to withdraw fiscal support, to some extent, to the troubled financial institutions, but it brought a completely new moral code of functioning for the Japanese banks, focused on expected returns from transactions and insensitive to domestic goals, which was even less conducive to bank-led demand expansion.

    Today, Japan is doggedly pursuing its ambition to rebuild the Japanese financial market into an international market comparable to the New York and London markets – ironically the very institutions Keynes had been most critical about. The recent bill on privatisation of the Japanese post – by far the most ambitious reform measure – is supposed to free huge resources for the financial markets that were otherwise channelled into Japanese government bonds. The financial markets are expected to touch new heights as a result – a future that many investors both domestic and overseas are eyeing gleefully. Meanwhile, millions of Japanese who used the post for banking and insurance, particularly in the rural areas will lose essential services that they had been accustomed to and needed, and thousands of post office workers will lose employment. Moreover, Japanese post which had given its depositors a low but assured return will now be exposed to the vagaries of financial markets.

    We will end with a question that automatically arises from the analysis presented in this paper: why has the Japanese state followed economic policies that are completely antithetical to the Keynesian logic? Why have these choices, seemed so obvious to a developed country state like the Japanese state, not circumscribed by the compulsions of most third world states? It is important to hold up to scrutiny the broader politicaleconomy dimensions of the issues examined in this paper for a fuller understanding of the national and international economic policy-making.




    [This article is the revised version of the paper written for Economic Research Foundation, New Delhi. I gratefully acknowledge comments by Jayati Ghosh on an earlier draft of this paper.]

    1 The expansion of the Japanese economy during the immediate post-warera was even more rapid. During 1946-60 and 1960-75, Japan grew atannual rates of 9.4 and 8.3 per cent.

    2 Before this, most of the Japanese investment in the US was greenfield

    investment. 3 The year refers to fiscal year, unless mentioned otherwise.4 The growth in GDP deflator in 2005 has continued to be negative at –1.2

    per cent, while the CPI has grown at 0.1 per cent in 2005. There are twomajor reasons why the GDP deflator has shown larger rates of decline

    – a phenomenon observed since the first half of the 1990s: (i) it coversa wider range of goods and services, including real estate whose pricesare falling at a significant pace; and (ii) it is computed using an “indexformula” that is known to give an opposite bias from the CPI [BoJ 2003].

    5 Following the recovery of real output and business investment, thecorporate good price index showed a steady rise. However, CPI continuedto fall till recently reflecting weak demand in the household sector.

    6 Over the seven-year period, between 1997 and 2004 the GDP deflatordropped nearly 9 per cent, the consumer price index (excluding freshfood) fell by 2.8 per cent, and wages and salaries were down by around5 per cent.

    7 Keynes (1936) pp 159. 8 For further elaboration of this point see Patnaik (1999). 9 Under the convoy system of banking regulation, the ministry of finance

    kept innovation and competition to a slow enough pace that even the

    smallest of financial institutions could survive. 10 Nakaso (2001).11 See Francis (2003).12 See the criticism raised by the US government in the Strategic Structural

    Initiative trade negotiations in this regard [Japan Economic PlanningAgency 1992].13 There were some greenfield investments by Worldcom, PSINet, andLevel 3 in Internet and data infrastructure.

    14 Merrill Lynch’s acquisition of Yamaichi Securities in 1998, GE Capital’sacquisition of Toho Life, Prudential’s acquisition of Kyoei Life are someexamples of rescue acquisitions.

    15 For a set of papers on the Argentine crisis see The implications of overseas banks acquiringcontrolling stakes in Latin American economies is discussed in Bose(2005)

    16 Japan’s four megabanks that emerged out of several rounds of mergers

    are Sumitomo Mitsui, IBJ, Mizuho and Tokyo Mitsubishi.17 Dymski (2002).18 Dymski (2004) .

    19 Development Bank of Japan (2004).

    20 Krugman (1999).

    21 Rogoff (2002).

    22 In November 2002 Rogoff commented “if the central bank were to printenough money to buy back all government debt, there would be massiveinflation, with or without a weak banking sector. So surely some lesserlevel of quantitative easing should do the trick”

    23 Development Bank of Japan Research Report (2003), p 5.

    24 Development Bank of Japan Research Report (2004).

    25 In CY 2004, China surpassed the US as Japan’s largest trading partner.Exports and imports between Japan and China, including Hong Kong,reached $ 213 billion in 2004, accounting for 20.1 per cent of Japan’stotal trade. Trade between Japan and the US was $ 197 billion, or 19 per cent of total Japanese exports and imports.


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