The Japanese economy has pulled out of a steep dive that started after the tax increases in the spring of 1997 and bottomed at the end of 1998 amid fears of global deflation and, in Japan, rising budget deficits and an emerging liquidity trap. But despite the self-congratulation by some analysts on "early" calls this past spring for a Japanese recovery, the Japanese economy could slip back into negative growth and deflation over the coming months. That slip would prompt an easing of monetary policy, faster money growth, and inflation targeting that would help move Japan onto a sustainable growth path.

The Recovery That Stalled

The Japanese economic "recovery" of 1999 is better described as an escape from disaster than as a bottoming out and prelude to growth. During December 1998, Japan experienced the unmistakable symptoms of a flight into cash that could have degenerated into an accelerating deflation. The yen strengthened as private money flows abroad ceased. Long-term interest rates surged from 70 basis points in October to over 200 basis points by year-end. The upward move was propelled by a surge in bond supply and a simultaneous reduction in bond demand that reflected a rush into cash. Stock prices dropped sharply, as did Japanese money growth--which went virtually to zero on a year-over-year basis during December, after having reached a 10 percent year-over-year growth rate in November.

Since the unfolding of this frightening scenario at the end of 1998, Japan’s economy, with the help of extraordinary monetary and fiscal policy measures, has pulled back from a deflationary abyss. The sense of relief that accompanied this step back from disaster has produced a 35 percent rebound in the Japanese stock market, from year-end lows of around 13,500 in the Nikkei Index to a range of 17,500 to 18,000 over the past several months. Such a "recovery" is typical of the pattern of the Japanese economy and the reaction of its government over the past decade. The Japanese government has at its disposal the means to avert disaster and has used them aggressively and repeatedly since 1993. But the government simultaneously persists in a disconcerting tendency to ignore fundamental economic problems while treating the symptoms. Although part of the increase in the stock market reflects the start of restructuring and cost cutting by major Japanese multinationals, much of the upward move can probably be characterized as a "relief" rally based on the aggressive measures implemented by the Japanese government to avert disaster.

But the rally in the Japanese stock market has stalled, with stock prices in mid-October at levels that were reached last June. The stall is symptomatic of a pause for breath by investors, who are awaiting the answer to a straightforward question: Now that the Japanese economy has moved away from the brink of spiraling deflation, can Japan resume sustainable growth? The flows into the Japanese stock market during the first half of 1999 suggest, interestingly, that investors outside Japan are more optimistic about Japan’s ability to achieve sustained growth than are investors inside Japan. As the Japanese stock market has rallied, foreign investors have been buying stocks while Japanese investors have been selling. At the low of the Japanese stock market early in the year, foreign demand to own Japanese stocks exceeded the desire of the Japanese to sell equity positions. So the stock market rose by 35 percent between January and June of 1999. Since then, there has been largely a standoff: foreign buying has just about matched Japanese selling in the stock market, and has left the Nikkei Index in a range between 17,000 and 18,000.

A close look at the policy measures that averted disaster and at some underlying realities reflected in the Japanese economic statistics over the first half of this year and into the fall suggests that Japanese investors are right to be skeptical about the ability of the Japanese economy to remain on a sustainable growth path.

The Fight against Deflation

The intensity of the deflationary pressure that appeared in Japan at the end of 1998 can be judged by the exceptional scale of the monetary and fiscal policy measures taken to offset that pressure and by the subsequent modest results those measures achieved. A massive fiscal stimulus was executed during the second half of 1998, and extraordinary monetary policy measures were taken early in 1999.

The fiscal stimulus measures came in two stages: about ¥16 trillion in the late summer of 1998, followed by another ¥24 trillion at the end of 1998. The combined total of these measures--worth over $400 billion--is the equivalent of nearly 10 percent of Japanese GDP. Although the actual net stimulus was probably 60 percent of that, fiscal stimulus applied over a six-month period at a level equivalent to 6 percent of GDP is extraordinary. It would be equivalent to a $600 billion stimulus package in the United States administered over a six-month period. Currently, the Congress is arguing about whether to add somewhere between $10 billion and $20 billion to the budget deficit over the coming year--at a time when the U.S. budget surplus is about $125 billion per year.

The fiscal stimulus story in Japan is not yet over. As the surge effect from the huge stimulus of last year begins to wear off, the Japanese government is concerned that the patient will suffer withdrawal symptoms. It is therefore assembling another supplemental stimulus package, to be implemented early next year, that will probably equal somewhere around ¥15 trillion, with a net addition to total stimulus of about half that amount because of double counting and a tendency to carry over the effect of past stimulus packages into current stimulus packages. However measured, the supplemental budget will add between ¥5 trillion and ¥7 trillion to the net new issuance of government bonds in Japan that is now running at a rate close to 10 percent of GDP.

Even as the huge fiscal stimulus was being administered to the Japanese economy, the Bank of Japan responded to the deflationary crisis of late 1998 and the sharp run-up in bond yields by pushing interest rates in the overnight market from 25 basis points down to zero. In effect, the Bank of Japan is offering Japan’s banking system zero-interest-rate loans to use for whatever purpose they wish. Even with these extraordinary terms, nearly two-thirds of the funds that the Bank of Japan forces into the overnight money market are left unused by Japan’s commercial banks. They spill instead into the hands of money brokers, who make some marginal use of the funds. Japanese banks are using zero-interest-rate loans from the Bank of Japan to finance purchases of short-term government securities with a yield of 4 basis points (0.04 percent) to 20 basis points. The unwillingness and/or inability of Japanese banks and other investors to find alternative investments to these government securities with minuscule yields is the most compelling evidence of a lack of investment opportunities in Japan.

The Bank of Japan also managed to push the growth rate of Japan’s monetary base up to nearly 6 percent by May. But overall money growth has failed to accelerate, because the banking system, which converts money-base growth into overall money growth, is not making any new loans, while it simply buys more and more short- term government securities. Since May, the growth rate of the monetary base has drifted back down to an annual rate of around 4 percent, and overall money growth still languishes at a rate close to 3 percent.

The impact on the Japanese economy from the recent fiscal and monetary measures was similar to the results achieved during 1995 and 1996 after a series of extraordinary fiscal stimulus measures. But a close look at the numbers suggests that the impact of these latest aggressive measures on the economy was quite modest. A close look at the data also reveals some questionable national income accounting practices by the Japanese government.

Why Deflation Persists

During the first quarter of 1999, Japan reported an annualized growth rate of 8.1 percent. Over half that growth was attributable to the increase in government spending, as would be expected following the huge stimulus programs of late 1998. The government also reported that personal consumption rose at a 3.1 percent annual rate during the first quarter of 1999. But much of that growth resulted from a reported deflation rate of 2.2 percent on personal consumption. The deflation rate pushed up the measure of "real" consumption growth, because the consumption deflation increases the current yen value of consumption.

In short, a combination of questionable seasonal adjustment of the national income data, questionable use of deflators, and surging government spending on public works created the appearance of strong economic growth in the first quarter for Japan. During the second quarter, reported growth decelerated to a 0.9 percent annual rate, but an adjustment for deflation—at a 1.4 percent annual rate—pushed the value of growth in the second quarter (measured in current yen) down to a negative 0.5 percent annual rate.

After the largest peacetime fiscal stimulus ever reported by a G7 government, and zero interest rates, the Japanese economy registered deflation at a 1.4 percent annual rate during the second quarter of 1999. Deflation persists in Japan in the face of massive monetary and fiscal stimulus for a number of reasons. First, the fiscal stimulus was injected so rapidly that, when it leveled off, comparisons with the previous quarter suggested a drop in activity, which means that the fiscal stimulus measures failed to produce any substantial increase in private sector growth. Beyond that, there is considerable excess capacity in Japan, so investment spending continues to be very weak. After a brief annual growth rate of 2 percent during the first quarter, capital investment in Japan returned to a negative 2.5 percent annual growth rate during the second quarter of 1999. Since the second quarter of 1997, seven out of nine quarters have seen capital investment fall in Japan. The only other positive quarter of growth was the third quarter of 1997, at a modest 0.9 percent annual rate.

In addition to the excess capacity in Japan, personal consumption in Japan is weak, partly because unemployment is rising as firms lay off labor in an effort to cut costs in a deflationary environment. Personal consumption did rise at a 3 percent annual rate during the first quarter of 1999, but, as we have seen, that was largely because an assumed 2.2 percent deflator applied to the consumption figure pushed up the reported "real" figure. Much of the 2 percent growth rate of consumption reported in the second quarter of 1999 was attributable to imputed consumption tied to higher outlays on housing, and those housing outlays were largely a result of the subsidies for home purchases that were part of the government stimulus packages.

The government has resorted to other measures than overt spending to stimulate the Japanese economy. Between October 1998 and the spring of 1999, it implemented over ¥20 trillion (above $200 billion) of loan guarantees. Essentially, the government underwrote the extension of loans (principally to small and medium-sized businesses) that banks refused to extend. The loan extensions served largely to subsidize the continuation of nonviable small and medium-sized businesses, some of which will eventually fail and thereby force the government to assume the bad debts incurred under the loan guarantee program.

The most striking thing about the massive monetary and fiscal stimulus applied to the Japanese economy over the past year is how little it has done to produce signs of sustainable growth. Year-over-year growth during the first quarter was 0.1 percent. It rose modestly to 0.8 percent in the second quarter, largely as a result of the comparison with the sharp contraction of the Japanese economy during the first half of 1998. Year-over-year deflation in Japan, measured by the GDP deflator, remained at negative 0.7 percent during both the first quarter and the second quarter of 1999. The deflationary tendencies in Japan have contributed to persistent yen strength which, in turn, has caused Japan’s net exports to be a drag on GDP growth. Net exports subtracted 1.2 percentage points from Japanese growth during the first quarter of 1999, and added only 0.2 percentage point during the second quarter. Meanwhile, since July, the yen has appreciated by a further 14 percent against the dollar, thereby reinforcing the deflationary tendency in Japan while conducing to a resumption of the drag on growth caused by a fall in net exports.

The Resistance to Fundamental Change

The Japanese economy’s basic problem lies with using macropolicy instruments meant only to stabilize growth from year to year instead of permitting the fundamental economic restructuring that the Japanese economy sorely needs. After the bank failures of late 1997, the government contemplated a consolidation of the banking system that would reduce the number of banks and close some; the remaining banks would be stronger and better able to prosper by having to spread business less among themselves. However, in the spring of 1998, the government elected instead to preserve most of the banks by injecting large amounts of capital (funded by the government) into the banking system to keep the weaker banks afloat. As a result, Japan has a banking system that is virtually unable to function as a financial intermediary because of excess capacity and managements that are unaccustomed to surviving in a global competitive environment without heavy subsidies from the government. While several of Japan’s larger banks have taken some steps toward restructuring, the system as a whole is still a drag on the Japanese economy.

The Bank of Japan continues to pump funds into the banking system by lending banks money at zero interest rates, but, as already noted, the system does nothing but purchase government bonds with the excess liquidity it has on hand. That, in turn, encourages the government to proceed with further stimulus packages, because it is able to borrow at sub-market interest rates to fund those packages. Unfortunately, the stimulus packages are largely directed at the weaker sectors of the Japanese economy and therefore tend to generate more and more dependence on government financial handouts. The Japanese government has built a massive lifeboat with its macrostimulative measures and must run the pumps ever more rapidly to keep the boat from sinking.

The end to the process of keeping all the old baggage in the lifeboat, while discouraging new enterprise and slowing the process of restructuring, will probably come over the next year. The government’s demands on the credit markets are becoming unsustainable. During the 1999 fiscal year, which will end next April 1, the Japanese government will have to sell a total of ¥75 trillion worth of bonds (about three-quarters of a trillion dollars’ worth), ¥37 trillion of which will be in addition to the stock of government debt that now totals about ¥500 trillion, which is over 100 percent of GDP. During the fiscal year starting in April 2000, total Japanese government bond sales will reach well over ¥85 trillion, with a ¥45 trillion addition to Japan’s massive stock of national debt.

In the past, government-bond buying programs have been used to help absorb the huge supply of Japanese government debt. Japan’s Trust Fund Bureau has recycled savings flows from Japan’s massive Postal Savings System into the purchase of government bonds. However, during the year 2000, over ¥120 trillion of deposits in the Postal Savings System will mature, and the Japanese government will be forced to offer higher interest rates to keep Japanese savers from putting their funds elsewhere, possibly even into cash if deflation is virulent enough. Meanwhile, the Trust Fund Bureau has no more capacity to purchase Japanese government bonds because its support of local Japanese government financing has forced it to sell the assets that, in the past, have cushioned it from the need to sell Japanese government bonds. Beginning this fall, the Trust Fund Bureau will become a net seller of government bonds, adding to the tremendous supply already emanating from government fiscal deficits.

The big problem with Japan’s huge bond issuance is the impediment it creates to the recovery of the economy. Should the Japanese economy start to grow, or even just stabilize at a zero inflation rate, the normal interest rate on Japanese ten-year government debt would be about 3.25 percent, based on historical data that adjusts the nominal yield on Japanese bonds for inflation rates. Currently, interest rates on ten-year Japanese government bonds are about 1.75 percent. Given the much larger stock of Japanese government debt outstanding, the equilibrium rate on ten-year government debt at zero inflation is probably close to 3.5 percent, which is typical for industrial countries. A 3.5 percent interest rate would mean a doubling of Japanese interest rates over the coming year--unless deflation returns, in which case the likelihood of the real economy’s recovering becomes even slimmer.

The government is not unaware of these serious problems. Over the coming months, it will probably guide longer-term interest rates higher in an effort to create conditions under which maturing postal savings investments will be returned to the government as reinvestment in Japanese government bonds. However, the rise in Japanese interest rates, coupled with its deflationary tendencies, has created persistent strength in the yen, which, in turn, weakens Japan’s net export sector and reinforces deflationary tendencies.

The Unhelpful Bank of Japan

The tension over the strengthening yen and its deflationary implications came to a head late in September, when the Bank of Japan refused to undertake measures such as unsterilized purchases of foreign exchange or government bonds that would, in turn, increase liquidity in the Japanese economy. The Bank of Japan essentially reiterated its commitment to zero short-term interest rates and rejected the notion of additional liquidity creation as a means to help the Japanese economy recover. Unfortunately, the Bank of Japan included in the defense of its actions an assertion that such measures wouldn’t be undertaken because they wouldn’t work anyway. Given that current measures to maintain zero interest rates aren’t working, it is unadvisable for the central bank to rule out the possible success of additional measures such as liquidity creation.

The Bank of Japan’s September 21 declaration of independence has been followed by immense pressure from G7 governments and the Japanese government to force it to increase liquidity through the purchase of Japanese government bonds or through purchases of foreign exchange. The Bank of Japan has conceded very little, suggesting only that it might consider purchasing government treasury bills rather than just keep interest rates at zero in the overnight market. That is largely a technical distinction and suggests that the Bank of Japan is continuing to target interest rates rather than print money. The Bank of Japan’s concession that it would start to purchase treasury bills in addition to holding overnight rates at zero produced little market reaction; interest rates on short-term government securities in Japan dropped only slightly, by about 2 basis points.

Much More to Do

In refusing to create more liquidity, the Bank of Japan does have one legitimate rationale. It may be protesting the government’s rapidly increasing issuance of debt to finance subsidies to the weakest sectors of the Japanese economy. As soon as the Bank of Japan commits itself to unsterilized intervention or to the purchase of government securities in a way that increases liquidity in the Japanese economy, the Ministry of Finance could, in principle, issue even larger amounts of debt, thereby jeopardizing further the solvency of the Japanese government.

Still, the persistence of deflation in Japan suggests that further monetary-easing measures are needed. The Bank of Japan has perhaps been too hasty in suggesting that such measures would not work. In research published during the past five years, Professor Allan Meltzer of the American Enterprise Institute and Carnegie Mellon University has examined two periods in the United States, one in the 1930s and one in the 1940s, when interest rates were close to zero but when accelerated growth of the monetary base helped the U.S. economy to expand. Although the number of episodes explored is small, by virtue of the fact that zero interest rates are very unusual, the two episodes that Professor Meltzer could locate for the United States imply that faster growth of the money base can help to stimulate the economy. Meltzer’s research suggests that the Bank of Japan should undertake experiments to press harder to increase growth of the money base. Beyond that, there is no reason why the Bank of Japan should not follow other central banks and announce a positive inflation target of, say, 1 to 3 percent. That would alert households and businesses in Japan (and globally) that the Bank was serious about pressing for reflation and for a sustainable recovery in Japan. It would also put an upper bound on the degree of reflation that the Bank would tolerate--and forewarn the Ministry of Finance to limit its plans for further fiscal expansion.

Given Japan’s extraordinarily difficult situation, and the importance of a Japanese economic recovery to the Asian and global economies, it is most unfortunate that the Bank of Japan has continued to refuse even to attempt measures to accelerate monetary growth. Even if the Bank relents and undertakes measures to push up growth of the Japanese money supply, and even if it succeeds in pushing for modest reflation, so that prices begin to rise at 1 or 2 percent in Japan, the economy still needs massive restructuring to move to a sustainable growth path and restore Japan to the ranks of the leading industrial economies. Indeed, removal of the large net of regulation on the Japanese domestic economy would produce enough investment opportunities to create a virtual boom in Japan.

Throughout the past decade, the behavior of the Japanese government, as reflected in its extraordinary efforts to maintain nonviable institutions, has seemed odd. Japan is a nation that has shown immense adaptability in the past. After the Meiji restoration in 1868, Japan transformed itself from an isolationist nation to an economy that was to become a major industrial power during the early twentieth century. Further, after the devastating losses of World War II, Japan transformed itself by the 1980s into the world’s model industrial economy. Overcoming those earlier challenges was far more difficult and required far more change in existing institutions than the restructuring needed by the economy today would require.

The Japanese economy will emerge eventually from this very difficult period, during which bad macroeconomic and microeconomic policies have caused serious damage to economic performance. The private sector has already begun to move ahead--and away from the government--to restructure and to create new industries that will be the basis for the reemergence of Japan as a vibrant economy. The consequences of this movement are now becoming apparent, in the form of small start-up companies and the transformation of some of Japan’s multinational corporations. But change has a long way to go, and the process would advance more quickly if the Japanese government would simply get out of the way and allow restructuring to accelerate, while the Bank of Japan presses for a modest reflation.

John H. Makin is a resident scholar at the American Enterprise Institute.