BRUSSELS — Viewed from Europe, there are some signs that the Japanese economy might be starting to emerge from its 10-year slumber, but it remains essential that Tokyo focus on far-reaching structural reforms and antideflation measures rather than short-term policy lurches if the economy is to avoid another tailspin.
Some of the most recent reports on the economy have been encouraging — for example the spring “tankan” report from the central bank showed the key diffusion index of business confidence was unchanged from December after declining over the previous four quarters. Economists also cite the recent inventory adjustment and the rise in stock prices as reasons to be more confident than at any time in recent memory.
But European observers and officials believe there is a danger that a shallow recovery could mask the pivotal problem that the economy faces — deflation.
Falling prices negatively affect consumers, and personal consumption accounts for 60 percent of GDP. To restart growth, consumers must be convinced prices will rise.
The same is true of manufacturers buying supplies. A small dose of inflation would also ease loan repayments — higher savings returns could be used to repay debts, while higher prices would boost asset prices, thus improving banks’ balance sheets.
The case for inflation
Prof. Ron Dore of the London School of Economics sees only one way out: boosting consumer spending via the creation of inflation. The opportunity to create virtual price rises is via the spring wage talks, Dore says.
Other means of raising prices have proved futile. The government needs to coerce the private sector into boosting wages across the board by at least 4 percent, thus creating inflation and giving confidence to consumers. Companies would also then be willing to invest in new ventures as they could envisage better returns. “Such a coordinated wage rise has never happened in post-war history, but then neither has such a prolonged period of deflation,” he says.
Many officials outside Tokyo now agree the key to resolving the slump has to be tackling the bad-loan situation — not by seeing deflation as the result of the problem, but as its cause.
Deflation produces adverse effects for banks via declining economic variables on the flow side, such as in the nominal size of the economy and in aggregate corporate profits; and via a decline in economic variables on the stock side, such as through asset deflation.
Each additional percentage point of annual deflation generates new bad loans in Japan totaling 5.6 trillion yen, according to a report from IBJ.
Taking this as the starting point, officials from the major European governments and the EU’s executive arm, the Commission, believe what is required is a multifaceted approach.
Foremost, reflate the economy to improve the resolution environment. Then provide a new government capital injection to shore up viable operators and force consolidation, while improving accounting standards for the future.
Injections are still required because the banks have almost exhausted their legal reserves to cover existing credit costs and lack the resources for costs related to more NPL writeoffs, especially after the hit to their stock holdings from the April introduction of mark-to-market accounting rules.
If these resources can be released, it would be like adding oil to a rusting engine. Unemployment would invariably be a side effect, but the blow could be cushioned by higher welfare payments.
In terms of monetary policy, there is already a tremendous amount of liquidity in the overnight window of the Bank of Japan — an estimated 10 trillion yen to 15 trillion yen daily. Under normal circumstances, that would be used by the BOJ to lend on. But because of the lack of viable lending opportunities for banks that are worried their own capital positions, monetary transmission has broken down. And that brings you bank to the banks again.
Taken in isolation, most observers feel inflation targeting won’t work. If inflation can’t be created by a weaker yen and unprecedented liquidity injections, there’s no reason to believe an explicit BOJ target of, for example, 2 percent of CPI, would work. Likewise, Keynesian-style pump-priming has run its course. The IMF advocates a neutral fiscal policy in the near term.
The most logical solution is Ricardian: by reducing the deficit, expectations of future tax rises will diminish, thus helping consumption.
Willem Buiter, the chief economist at the European Bank for Reconstruction and Development and a former member of the Bank of England’s Monetary Policy Committee, feels there is also more need for patience with some traditional economic prescriptions. Specifically, he would prescribe a weaker yen, and a larger monetization of the public debt — in effect printing more money — alongside tax cuts.
“If the proper monetary and budgetary policies are pursued and banks are restructured, then I’m sure deflation and stagnation can become things of the past,” he says, adding Japan would then be in a position to consolidate at annual growth rates of 1 to 2 percent.
Major or minor change?
A leading Japan watcher, Prof. Jean-Pierre Lehmann from the International Institute for Management Development in Switzerland, believes tinkering with yen depreciation and fiscal and monetary policy might buy Tokyo some time, though it would not address the country’s fundamental malaise.
“Japan needs a sea-change in its attitudes in every respect, most crucially starting with governance,” he says. Prime Minister Junichiro Koizumi is “drowning” and is “incapable in terms of his personal leadership and his reforms.”
Lehmann sees two possible scenarios given the current course of events: either a continued slow decline of Japan to the point where it becomes a midranking global player with midranking aspirations, or a major economic collapse and a social implosion.
“It could be a run on the banks that triggers this off — the problem is no one will say just how perilous the bad-loan situation is,” he says. “I don’t see any scenario of renewal or recovery.”
He pointed to fundamental weaknesses in Japan’s political system — it has been run by the Liberal Democratic Party for all but the smallest window since the post-war constitution was written. So, in a sense the only policy options are coming from different factions of a party still dominated by septuagenarians and octogenarians.
Lehmann also sees fundamental weaknesses in the education system: Japan’s students are not embracing globalization, unlike their Chinese counterparts. They don’t have the wherewithal — especially the technical and linguistic skills — to compete globally.
Of course, not all observers are as fatalistic.
Dore from the LSE says seismic political change is not the answer. Japan’s unique system of political patronage and corporate governance served it well during the boom years of the 1970s and 1980s, so there is no reason why it won’t work now.
There are selective areas where public spending could be better employed as an economic “multiplier” — for example in education and rebuilding hospitals, noting there is still a “lot of fat” in public corporations. Civil servants should also be better empowered, in particular to appear in front of Diet committees to explain legislative proposals.
The matter of ‘capacity’
EU officials were impressed by Koizumi’s holistic approach to reform when he came to Brussels for a summit last December. Indeed, across the EU capitals, Koizumi can claim outside support because he is essentially “the only game in town,” according to European Commission officials.
“Our feeling — and this is one perhaps shared by the U.S. — is that it is far more constructive to give public backing to current economic recovery policies, and not overdo the sense of gloom,” a well-placed EU official says. “You’ve got to have perspective on the Japan problem. Many of the statistics seem alarming, but overall, the country is still very wealthy.
“Yes there are serious problems and great risks, but you have to see the problem in its totality — and Japan has the basis for great strength,” the official said.
Traditionally, the EU policy toward Japan has focused heavily on problems of market access for EU firms. But times have changed: the market has opened up considerably, investment has grown, Japan’s economy has stagnated, and the emphasis is more on helping to nurture reform and recovery.
The people around Koizumi are aware of what needs to be done. “But where we have a bit more doubt is on the delivery to date — and one of the problems here seems to be institutional capacity,” adds another EU official.
An example of this is the well-meaning move to break down the power of the Finance Ministry and elevate the Cabinet office. As a result, decision-making is now divided among several fiefdoms and fiscal policy could be muddied.
Meantime, Japan’s need to reorient its overall strategic positioning with its key neighbors — China and Korea — is another reason to speed up economic restructuring, according to Brussels.
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