Revitalizing Japan: Risks and Opportunities, A Commentary by Kenneth Rogoff, Economic Counsellor and Director, Research Department, IMF

November 7, 2002

Revitalizing Japan: Risks and Opportunities
A Commentary
By Kenneth Rogoff
Economic Counsellor and Director of the Research Department
International Monetary Fund
Published in The Nihon Keizai Shimbun
November 7, 2002

The Japanese economy cannot be described as in crisis, at least not a garden-variety financial meltdown. And only the most hysterical observers see a true 1930s-style Depression as imminent. However, if not in crisis, then the Japanese economy is surely in trouble. After four decades of booming post-war growth in which Japan emerged as a giant in the world economy, its leadership position has been gradually eroding. Over the past decade, per capita income in Japan has fallen by roughly 10 percent vis-à-vis Europe, and by more relative to the United States. Absent a determined effort to tackle Japan's underlying structural problems, there is every reason to worry that the ensuing decade will be no better. Indeed, it is easy to imagine a worse ten years ahead, given the imbalances that built up in the post-bubble decade: accumulating nonperforming bank loans, the sharp rise in government debt the accelerating pace of corporate bankruptcies, the declining labor force and aging population, and the continuing deflation.

But all is not dark: there are counterbalancing forces, most notably the technology revolution. Most evidence continues to support the view that trend productivity growth is rising throughout much of the world. If the experience of past great inventions (electricity, the steam engine, railroads, etc.) is any guide, citizens of the global economy can look forward to at least another decade or two of enhanced potential growth. Unfortunately, to fulfill this enhanced potential, an economy must be sufficiently healthy and flexible. After ten years of muddling through, there is still too much deadwood in the Japanese economy today, despite the limited pruning that has already taken place. And the macroeconomic environment, with ingrained deflation and a precarious long-term fiscal position, make things all the worse. The time for action is now. There are risks to the particular policy prescription I offer below, as indeed there are risks to any course of action. But the long-term risks to continued inaction, especially to Japan's place as one of the world's global economic giants, are arguably greater. It is not simply Japan's health that's at stake, but the economic health of the Asian region and the broader world.

What Japan urgently needs is the re-establishment of confidence: of consumers, businesses and investors. For this to happen in a sustainable fashion, the macroeconomic and financial environment must again become supportive of growth. This requires restored incentives for investment and risk taking, and transparency in corporate and banking operations.

A central element of any successful strategy to revitalize the economy involves ending deflation, and ending it soon. Persistent deflation acts as a disincentive to private spending, especially in an environment of policy uncertainty and rising unemployment. It hurts investment by increasing real debt burdens of corporations and eroding profitability. Together, these factors compound deflation's psychological impact on expectations and aggravate pessimism about the country's prospects. Over the past century, no major economy has enjoyed sustained growth under persistent deflation.

That deflation persists, despite the Bank of Japan's recent efforts to increase base money, is testimony to the stubbornness of the problem. However, a central reason why quantitative easing has not had an impact thus far is that the inflation process is driven as much by expectations of future monetary policy as by present monetary conditions. As long as the public lacks confidence that the BOJ will do whatever is necessary to restore inflation, it will be difficult to reverse deeply ingrained deflationary expectations. This is why no reflation plan can succeed absent a clear BOJ communication strategy. Such a strategy 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. One reliable way to raise inflation is through more aggressive quantitative easing, provided the public understands that the BOJ will persist as necessary to attain its objective. Obviously, if the central bank were to print enough money to buy back all government debt, there would be massive inflation, with or without a weak banking sector. So surely some lesser level of quantitative easing should do the trick.

I do not pretend this is an easy undertaking, or one without risk. Indeed, it would be simplistic to think that the BOJ can just turn a dial and smoothly increase inflation from say, minus one percent to plus two percent. Given Japan's liquidity trap, and the need to rely on increases in base money to restore inflation, there is a definite risk that the inflation rate will overshoot any target, at least for a short while. Achieving, say, a 2% inflation target in a situation with ingrained deflation is like, in golf, trying to hit the ball out of a sand trap directly on to the green and in to the hole in one shot. The BOJ should not put its credibility on the line by promising to hit a narrow inflation target that it cannot realistically deliver in the short run. This concern, however, should not be overblown. Given the BOJ's strong past anti-inflation performance, and a clear communication strategy going forward, it should be possible to anchor medium term and long term inflation expectations. This would eliminate any great risk of a runaway inflation spiral.

Restoring positive inflation is necessary for recovery and it will yield some positive growth benefit regardless of what else is done. But the growth benefit will be relatively small unless the BOJ's actions are accompanied by broad economic restructuring, especially of the banking and corporate sectors. Here is ultimately where the big gains lie, and where the most difficult issues need to be tackled. Right now, there is a vicious circle in which large unrecognized nonperforming loans make banks unwilling to lend. This hurts financial intermediation, credit and money growth, and ultimately creates new nonperforming loans even as old ones are being written off. Rolling over loans to bankrupt corporates may preserve the fiction of normality, but it is corrosive to the entire system, and creates immense uncertainties for markets. Of course, with a weak economy and deflation, financial intermediation is also shrinking because even some healthy corporates are deleveraging to strengthen their balance sheets.

Structural reforms are therefore critically needed to boost confidence and strengthen growth foundations. Direct action is urgent: loan write-offs have risen, but there are just too many questions about the true scale of the non-performing problem for there to be a consensus about the magnitude of the problems. Banks that are not viable must be encouraged to exit. If the scale of the problem is as large as some fear, it will almost certainly be necessary to inject public funds into banks with borderline solvency. This would preserve an adequate level of ongoing intermediation in the economy. But if public funds are used, they must be accompanied by strict conditionality.

Bold structural reforms are also essential in the corporate sector to strengthen viable enterprises and force the exit of insolvent firms, especially in sectors such as retail and construction. Corporate restructuring must be accelerated by giving banks stronger time-bound incentives to agree on realistic restructuring plans with viable firms and to carry out the rapid and complete disposal of the assets of nonviable ones.

The failed gradualist approach to reform and stimulatory fiscal policies have helped to increase government's net debt excluding social security from the lowest in the advanced economies the highest . Net debt excluding social security is projected to rise to over 120 percent of GDP by the end of fiscal year 2002/03, with gross debt rising to over 140 percent of GDP. The authorities must increase the credibility of the medium-term fiscal consolidation strategy by setting a medium-term debt target and broad objectives for major budget categories. This will help maintain investor confidence in an environment of high and rapidly rising debt.

Given the very weak underlying fiscal position, consolidation must be initiated within the framework of a medium-term strategy. That said, one should be cognizant of the fact that bold structural policies could engender negative short-run impact on activity. Were truly bold policies to be implemented, it would be appropriate to consider taking steps to maintain a neutral fiscal stance in the short term.

Any package that manages to engineer a successful exit from deflation in Japan, including the one I am proposing, risks a large real depreciation of the yen, at least in the short to medium run. Indeed, if theory and experience are any guides, exchange rate overshooting is likely even if the exit from deflation proceeds surprisingly smoothly. Please understand that exchange rate depreciation is a consequence of unanticipated higher inflation. It is not the one and only channel through which inflation can be engineered, as many observers wrongly seem to believe. If all the world's central banks simultaneously engineered a inflation increases of the same magnitude as Japan's, the yen would not necessarily move but Japanese inflation would still rise.

If severe yen overshooting emerges as a consequence of an ambitious attempt by Japan to restore growth, the rest of the world, especially the major industrialized countries, could help out a bit. The Federal Reserve and the ECB could support Japan, and ease the attendant risks to its trading partners, by engaging in a modest reflation. Such a policy would help curb yen exchange rate overshooting and at the same time support global demand, particularly for other Asian economies who may be particularly affected by the yen's decline. Given the present state of their economies, both the Fed and ECB should have an easing bias in their interest rate policy, anyway. Severe yen overshooting as a consequence of major restructuring in Japan would put the case for cuts over the top. In this kind of exceptional situation, the need for some measure of international monetary policy cooperation should be uncontroversial.

Fortunately, the regional impact of a temporary yen depreciation should be manageable. Compared to the 1990s, exchange rates in Asia are generally more flexible and many countries have significantly healthier reserve and external debt positions. Those countries that choose to remain on fixed rates will be able to do so, of course, but only by allowing significantly more flexibility elsewhere in their economies.

In sum, another ten years of muddling through is still an option for Japan, but it is becoming an increasingly risky and unattractive one. There are also risks to the kind of dramatic policy changes I have detailed here. I cannot deny them. The Japanese people must decide their own course going forward. But the longer Japan's core economic problems are allowed to fester, the greater the danger of a more severe growth crisis somewhere down the road.


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