Mr. Chairman and Members of the Budget Committee,
Thank you for this opportunity to offer my views on the current state of the Japanese economy and banking system and their implications for the global economy. A more extended treatment of these issues is contained in a paper entitled: "The Asian Crisis Is Not A Currency Crisis" (AEI Economic Outlook, May 1998), attached to this summary.
Japan’s economy is weak, probably having entered a recession at the end of 1997. A combination of a tax increase (equivalent to 2.5 percent of GDP or 10 trillion yen) and other economic depressants were put in place during the second quarter of 1997. These consisted of a 2-percentage point increase in the value-added tax, a doubling of household co-payments for government-sponsored medical insurance, and increased contributions to government pension funds.
It will be especially meaningful to the members of this committee to realize that a tax increase equivalent to 2.5 percent of GDP would amount to $200 billion in the United States today. Little wonder that the Japanese economy that had depended heavily on fiscal stimulus for growth since 1992 should collapse under the weight of such a tax increase. Add to this ill-timed sharp tightening of fiscal policy and attendant increases in household co-payments for government health and pension programs, the collapse of economies in ASEAN and North East Asia, to which Japan is a significant supplier of exports, and you have a powerful negative impact on the Japanese economy that created a drastic slowdown.
Broadly, Japan’s problem has been tied to excess capacity since the early part of this decade when overinvestment caused its stock market to collapse early in 1990. Japan is a high saving country with relatively few domestic investment opportunities, given the high level of costs and regulation in its domestic sector. Government policies have, until recently, tended to force Japan’s savers to invest at home, thereby driving the rate of return on investment inside Japan to a low level. As a result of the sharp downturn in the economy after the stock market collapse, Japanese investment began to flow to other parts of Asia, especially including China, South Korea, Indonesia, and many of the countries currently experiencing severe difficulties with excess capacity.
In short, Japan and the rest of Asia have been feeding each other’s excess capacity problems for nearly a decade and the sharp downturn in the Asian economies, including Japan, is a symptom of the continuation of this trend. The currency collapses represent a market response to the existence of too much productive capacity. Cheaper currencies increase foreign demand for domestically produced goods while reducing domestic demand for foreign goods. Unfortunately, everyone in the region cannot successfully increase demand for their product by devaluing and so there has been a tendency for the currencies of Asia to depreciate sharply against other major currencies like the Dollar and the Deutsche mark.
The collapse of Japan’s property market and stock markets after 1990 resulted in severe losses for Japan’s banks. Weak banks have been kept afloat and the losses have mounted, recently being exacerbated by the slowdown in other Asian countries outside of Japan where Japanese banks have invested over $270 billion dollars. As a result of sharply lower equity and land prices and bad performance by companies borrowing from Japanese banks, Japan’s banking system has lost about a fifth of its total assets or somewhere between 100 trillion yen to 130 trillion yen, the equivalent of nearly $1 trillion. Consequently, Japan’s banks are shrinking their balance sheets and therefore are unable to help small and medium-sized Japanese companies that do not have access to capital markets.
Having employed a series of fiscal stimulus packages to try to pump up the economy, Japan’s fiscal picture has deteriorated sharply to a point where its gross debt to GDP ratio is about 90 percent and its deficit to GDP ratio is approaching 7 percent including its prefectural governments that work closely with the Federal Government on fiscal affairs. Both measures are far worse than those faced by the United States at the height of its budget crisis in 1985. Japan’s fiscal position has deteriorated to a point where the most recently announced fiscal stimulus package of 16 trillion yen has been negatively received by markets. The confidence level of Japan’s consumers is such that they are unlikely to spend tax cuts while additional public works spending, on top of the large amount that has already been conducted over the last six years, is largely wasted. The deterioration of Japan’s fiscal picture has prompted Moody’s to put it on what amounts to a credit-downgrade watch.
All of these negative developments have created the danger of more serious deflation in Japan by eroding confidence of households and businesses and prompting a rush into cash. Prices are already actually falling in Japan, but have not yet reached the dangerous stage of a self-reinforcing deflation that accelerates as consumers, fearful of the future and expecting lower prices, go on a total buying strike. Japan needs to avoid the possibility of a deflationary crisis that would exacerbate the Asian crisis and thereby threaten the growth of the world economy.
Japan’s policy options are limited, but not absent. Further fiscal stimulus is largely precluded by the bad state of Japan’s finances and by a budget law passed in November of 1997 that mandates a ratio of deficits to GDP of 3 percent by the year 2003. On the monetary policy front, the Bank of Japan cut the discount rate to 50 basis points in September of 1995 as an "emergency" measure. The discount rate has been held at this low level for some time but Japan’s deflation continues to push up the real cost of borrowing.
Japan’s economy and financial system have deteriorated to a point where radical policy measures are necessary to increase the attractiveness of Japanese assets to foreign investors. One measure would be a sharp, pre-emptive devaluation of the currency to a range of 160 to 180 yen that would make Japanese banks, insurance companies, and other enterprises attractive to foreign investors in view of what would amount to a price reduction of about one third measured in dollars. Many of Japan’s companies are attractive franchises that could be transformed into highly profitable enterprises using the methods applied in the United States since the late 1980s and are currently being applied in Europe. Large capital flows into Japan could help speed needed structural changes that would make the non-traded services sector more efficient.
In the shorter run, Japan needs to assure that the self-reinforcing deflationary cycle does not take hold. This will require pushing up demand by convincing households that prices will not be lower, and in fact, will be higher in the future. The only way to do this is for the Bank of Japan to flood the system with liquidity by printing money and injecting it directly into the financial system. Technically, the Bank of Japan could aggressively purchase Japanese government bonds for cash thereby pushing long-term interest rates down further as cash in the hands of the public increases. There is no guarantee that such a sharp increase in cash holdings would be spent, but if pursued aggressively enough, with the Bank of Japan making clear its intention to push prices higher by pushing up expenditures, there is a chance that it would succeed.
Many object to this measure on the grounds that either it won’t work or it would be inflationary. If a rapid increase in the money supply in Japan does not work, that is, does not lead to an increase in expenditures, Japan is already in the grip of a serious deflationary crisis with the demand for money growing at a very rapid pace. Under those circumstances, the printed money would simply have to be spent directly by the government in order to avoid further acceleration of the deflation.
If alternatively, the result is that some modest inflation reappears in Japan, while households are encouraged to begin to spend again, the much-desired increase in domestic demand in Japan will have been achieved and an inflation rate of 1 percent will be a small price to pay. In fact, it would be a blessing if it ignited growth in Japan’s dormant domestic demand.
None of these policy alternatives sounds particularly attractive. They cannot be made so as Japan’s economic and financial systems have deteriorated to a state where there are neither easy nor attractive policy alternatives. While pushing up aggregate demand, Japan needs simultaneously to attack its banking system problem in a manner parallel to that followed by the Resolution Trust Company in the United States in the early part of this decade. Depositors must be protected, weak banks must be closed and "bad" assets must be purchased by a government corporation and then resold in better market conditions to avoid having solvency problems translate into systemic liquidity problems and to minimize the cost of closing weak institutions.
Having said all this, the immediate outlook in Japan is not encouraging. The government has resisted following the policy of closing weak institutions since one major bank was closed in November of 1997. Beyond that, the government seems intent on continuing to experiment with fiscal packages, which are demonstrably ineffective. Simulating effectiveness of fiscal packages by entering the currency markets to buy yen upon the announcement of such packages is both counterproductive and dangerous, as detailed in my attached article. It is counterproductive because strengthening the currency amounts to a tighter monetary policy, which is the last thing that Japan needs now. It is dangerous because it exacerbates the risk of a deflationary crisis in Japan.
For its part, the United States government has offered ample advice to the Japanese government on ways to end its economic and financial crises. Some of the advice, especially the recent advice to cut taxes, has in my view been less than useful since tax cuts are unlikely to be spent in a deflationary and depressed Japan. At this point, the best thing the U.S. government can do is to signal that it will stand aside and let markets determine exchange rates while encouraging Japan to follow monetary measures that would push up domestic demand. It would be far better to have a dollar/yen exchange rate at 160 with Japan beginning to recover than a dollar/yen exchange rate at 120 with Japan slipping into a dangerous deflationary cycle. This truth is made even more forceful by the emergence of an Asia-wide economic and financial crisis. The notion that the yen can’t be depreciated because that makes the situation in the rest of Asia more difficult represents serious confusion. Japan needs to reflate; a weaker currency is part of reflation and a reflating Japan-at any exchange rate-is better for Asia and the global economy than a deflating Japan.
John H. Makin is a resident scholar at AEI.