Japan: Game Over?


Robert Madsen of Stanford University put out a working paper for the MIT Japan Program titled "Japan:Game Over. It is Madsen's contention that all of the current debate about how Japan can dig itself out of its deflationary hole is largely irrelavant. In other words, the premise that corporate and banking reform can return Japan to the path of economic growth and avert a financial disaster is no longer valid. In other words, it is too late to prevent the unfolding of events that will led to a financial and economic crisis in Japan.


The Catch 22 of his argument is Japan's structural excess savings that has led to a chronic shortage of demand. Because the balance sheets of Japanese companies have deteriorated to the point that they can no longer afford to increase capital spending, and even if they did they would only exacerbate the existing over-supply problem, there are only three ways for Japan to maintain macroeconomic stability. (1) a massive increase in the current account, (2) fiscal deficits, and (3) corporate and financial reform. According to Madsen's analysis, even if implemented at this late stage in the problem, all three countermeasures would still lead to the same outcome--i.e., a financial collapse sometime after 2005.


Some claim that Japan's problems can be solved by devaluating the yen. But the magnitude of the adjustment required for the yen is daunting. To fill the current gap in aggregate demand, Japan's current account surplus would have to triple or quadruple, which in turn would require a huge depreciation in the exchange rate, to beyond JPY250 per dollar, a level that would have to be maintained for the next five or ten years. In reality, no country possesses the tools necessary to engineer so great a change in the value of a floating currency. For example, the BOJ's 25% expansion in the money supply in the first half of 2002 had no noticeable impact on the yen. Neither did massive intervention in the currency markets.


The second option, "muddling through with fiscal policy" to use deficit spending to absorb the excess capital and boost demand, has been tried by Japan already, simply because it was the most expedient in protecting vested interests and supporting the current LDP-based political system. Moreover, Japan's deep pool of savings that can essentially be used freely by the government has allowed the government to go deeper into debt without disturbing the financial markets. But there is no permanent immunity from market forces. The situation could become especially delicate around 2008-2010, when the government must simultaneously increase social security payments and roll over a very large block of outstanding JGBs.


The assumptions behind the structural reform argument are also flawed in that if capital expenditures fall as quickly as corporate savings, the sector's net financial position may not significantly change. Moreover, the household sector's capital surplus may not contract much. In other words, any revitalization of domestic demand may come too late to make the government's finances sustainable.


Thus the more probable scenario according to Mr. Madsen is that Japan will dither as long as possible and then pay a very high price indeed. A financial crisis would be very painful, would destabilize Japan's domestic politic, cause substantial volatility in the country's foreign and military policies and exert a strong deflationary influence over East Asia and global markets. In Japan, import-dependent industries would be decimated, bankruptcies would soar further, banks would fail and unemployment would surge.

Curing Deflation by Recapitalizing the Banks


RIETI research fellow Kobayashi has given the best case we've heard yet for recapitalizing the banks as a means of reflating Japan's economy.
He quotes the work of John Boyd of Minnesota University and Bruce Smith of Texas University who have studied the cases of 23 countries with banking crises, where a banking "crisis" was defined as a situation where banks have non-performing loans of over 5%-10% of total loans, and effectively have net negative equity.


The statistics of these cases show that when such banking crisis occur, M2 declines markedly and inflation rates decline. According to Smith "the reason that economies go into recession during banking crises is probably attributable to the marked decline in M2. Until the 1980s in Japan, the cash balances supplied by the BOJ were largely absorbed in the banking sector, but from the 1990s, the increase in cash balances largely flowed from the banks into the non-banking sector. This is an indication of the loss of trust in the bank deposits as a means of settlement. On the banks' balance sheets, the decline in cash balances was compensated for by declines in marketable securities, while loan balances showed no appreciable decline. This phenomenon agrees with Boyd's observation that in recent banking crisis, bank loans do not decline. While banks cannot be held entirely responsible for causing deflation, from a macro perspective, the loss of confidence in the settlement function of the banks can be considered as a cause of deflation.


From this line of reasoning, recapitalizing the banks is an effective means of eradicating deflation. With capital infusions, confidence in the banks' ability to perform their settlement function recovers, and more savers keep their assets in the banks, which in turn increases M2, and works to alleviate deflation in the Japanese economy. This supposedly is the same mechanism that help the US economy pull out of its deflationary spiral in 1933.


According to Boyd's analysis, for each 1% equivalent of GDP used to revitalize the banking system, M2 grows by approximately 5%. In other words, "for countries experiencing excessive non-performing loans, bolstering the capital of the banking system to improve its financial health works to increase the supply of currency and leads to inflation." Consequently, an early capital infusion for the banks is an important tool in eradicating deflation. From this standpoint, the recent efforts by the major banks to bolster their capital positions is a positive development. However, in such situations banks by themselves find it difficult to sufficiently increase their capital. From this standpoint, the government needs to use public funds to boost bank capital as early as possible, and then gradually sell off their holdings of bank equity to investors as depositor and saver trust in the banking system returns.


However, merely declaring that "additional bank capital infusions will be implemented if required" is not enough to restore depositor confidence in the banking system. Indeed, it is more likely that, as banks try to avoid capital infusions by reducing their assets, they make lending conditions tougher, thereby exacerbating the economic recession and deflation. An effective means of bolstering bank capital while at the same time eradicating deflation would be to use public funds to recapitalize the banks, and to have the BOJ purchase JGBs as a means of financing this recapitalization. This would result in improved depositor confidence in the banking system, while at the same time significantly boosting the volume of base money, resulting in a sharp increase in currency in circulation and stimulating inflation.


However, the side effect of such a policy would be a sharp increase in government debt over the short term, and would invite increased concern regarding the sustainability of government finances. Increased uncertainty over the sustainability of government finances would in turn have a negative impact on consumption and private capital expenditures. This would not simply arise due to increasing concerns about possible tax increases, but also due to a reduced level of economic activity. Moreover, the uncertainty could be countered with a clear schedule of tax increases and budgetary cuts that would minimize the impact on consumption and capital expenditures. Thus a social assistance framework, and a structural reform of budgetary expenditures including public employee personnel costs shoule be established as soon as possible. However, the precept for such actions should be fiscal stimulus aimed at bolstering the capital position of the banks.


Finally, there is the issue of the BOJ's purchase of real assets, including stocks or property. Bank capital increases have been inhibited by political and regulatory impediments, and under this environment, expansion of the base money supply by unconventional means is not an effective measure. If the BOJ were to purchase low-yielding stocks or property, they would in effect be bringing non-performing assets on their balance sheet, and would eventually need additional fiscal resources to dispose of these non-performing assets. Thus, unconventional monetary policy should not be used as a means to delay needed fiscal policies. Indeed, Boyd and Smith have found that countries that used inflation to solve their banking problems incurred recurring NPLs and banking crises.

TT's Take Mr. Kobayashi's analysis helps to clear up what has become a very muddled debate in Japan about "inflation targeting" or deflationary countermeasures. Contrary to the current consensus, he has pointed to the examples of other countries where bank recapitalizations, rather than being deflationary, actually were instrumental in returning the financial system to a more normal operating status, which in turn eradicated the problems that were causing the symptom, i.e., deflation.