Economic policymakers must stand ready to take timely and decisive actions when incoming information suggests that the economy is most likely to significantly deviate from the targeted course for a sustained period. And in the uncertain world in which we live, they have to deal with both upside and downside risks to the economy. In the current setting, downside risks are far greater than upside risks.

In the United States, household balance sheets have become stretched. Companies remain more generously valued relative to earnings than they were before the mid-1990s. Further falls in stock prices on top of the sustained corrections that have taken place could produce adverse wealth and confidence effects on spending by the household sector.

A major force of the current economic slowdown in the U.S. is stock adjustment in the information and communications technology sector. There are uncertainties about how long the adjustment process will continue and about the magnitude and speed of the response of this sector and the household sector to an easing of monetary policy.

In the euro zone, a sustained depreciation of the currency has contributed to a rise in headline inflation with increases in the prices of oil and other imported goods as well as hikes in food prices caused by the meat crisis. And the gap has been widening between headline inflation and underlying inflation for domestically produced goods and services.

There is a risk that increased headline inflation will raise wage pressure at a time when economic activity is weakening. This has raised a difficult question about the orientation of monetary policy by the newborn European Central Bank, which has not yet firmly established its credibility in financial markets.

In Japan, export weakness is leading to a sharp decline in industrial production and deflation persists. The recent economic downturn has intensified old structural problems: an accelerated reduction of nonperforming bank loans by liquidation and/or restructuring of bad debtors is most likely to magnify deflationary impulses; any further delay would, however, lead to greater losses in the future. In addition to the downside risks of domestic origin, the Japanese economy remains most exposed to the deflationary impulses of foreign origin.

One important external deflationary force would be a combination of further falls in U.S. stock prices and a sharp fall in the dollar.

The May 2001 edition of the International Monetary Fund World Economic Outlook discusses the global economic impacts of such a shock on the basis of two simulations with the IMF’s macroeconomic model. In a scenario where U.S. equity prices are assumed to decline by 20 percent with the dollar simultaneously falling against the euro and the yen by 20 percent and monetary policies to be eased throughout the advanced world, Japan’s as well as world output will decline by slightly more than one percentage point compared to baseline in both 2001 and 2002.

Unfortunately, there is a flaw in the simulations: Japanese short-term money-market interest rates are now close to zero and nominal rates cannot go negative as assumed in the IMF simulations. Correct simulations with a zero boundary to nominal rates would suggest that the negative output effects should be greater in Japan than shown in the IMF work.

A macroeconomic policy implication of corrected simulations would be that Japanese fiscal policy should remain flexible in the short run, at least allowing for the working of automatic stabilizers rather than rigidly limiting the maximum amount of central government bond issues to 30 trillion yen in coming fiscal years regardless of cyclical positions — a policy issue now hotly debated in the Diet.

Prime Minister Junichiro Koizumi should be commended for his efforts toward fiscal consolidation. But medium-term targets for Japanese budget-deficit cuts should be established on a cyclically adjusted basis. Too rigid a rule on fiscal policy would run the risk of further increasing the vulnerability of Japan’s already very frail economy and hence threaten the world economy as a whole.

Another difficult issue relates to the conduct of monetary and exchange-rate policies in Japan. A weaker yen could help limit the downturn in exports, support aggregate demand and eliminate deflation in Japan, whose domestic demand is likely to weaken further if the resolution of banks’ bad-loan problems is to be accelerated and supply-side reforms are to be implemented as proposed by Koizumi.

How can such a scenario be technically realized. Last March, the Bank of Japan shifted its operating target from short-term money-market rates to the level of total bank reserves. In realizing such a scenario, the bank should switch to a policy of maintaining a zero-interest rate in the money market and, at the same time, keeping the yen exchange rate at a level lower than the current rate but not lower than the purchasing power parity (which was, according to an OECD estimate, 153 yen to the dollar in 2000) by standing ready to buy foreign exchanges in unlimited amounts in the market and allowing market forces to determine the level of bank reserves. This policy should be maintained so long as it does not run the risk of igniting homemade inflation in Japan.

A recovery of the euro, at least in part the other side of the same coin as the correction of the yen exchange rate, might help reverse an important source of inflation pressure in the euro zone and provide greater room for maneuver for the European Central Bank.

Moreover, foreign exporters of primary commodities to Japan would benefit both from a rise in its exports of manufactured goods and a sustained recovery of its domestic demand triggered by an export boom. The acceleration of its final domestic demand to be realized over time, together with medium-term growth bonuses from structural reform in Japan, should in the end also help foreign exporters of manufactured goods that are competing with Japanese products in global markets. But in the short run, greater price competitiveness of Japanese exporters would put strains on foreign manufacturers in a situation where world trade is slowing down.

This raises the difficult issue of how to ensure international economic policy coordination, which ideally should be designed in a medium-term framework to maximize the global benefits of growth dynamics for interdependent economies.

Between the late 1980s and the mid-1990s, among industrial countries that suffered from balance-sheet problems, Australia, Britain, Finland, Norway and Sweden all experienced domestic demand contraction for two years or more and simultaneous sharp depreciations of their currencies. They managed to grow out of their problems through an export-led recovery triggered by increased international competitiveness.

In several of them, greater profits of export industries — banks’ important clients — together with public capital injections, strengthened their lending capacity, which in turn helped revive domestic economic activity. The three largest economies on the European continent, Germany, France and Italy, suffered from domestic demand contraction in 1993 in the aftermath of the crisis of the European Monetary System. Their subsequent economic recovery was led by sharp rises in exports.

During the first half of the 1990s, Japan, in contrast, did not experience negative growth of domestic demand amid the lingering problem of bad bank loans. The yen followed an uptrend to reach a record level beyond the 80 yen/$1 at a point in time in 1995 and has remained well above its purchasing power parity in subsequent years. Against this backdrop, Japan’s share in world exports declined steadily from a peak of 10.5 percent in 1986 to 9.2 percent in 1993 and 7.1 percent in 2000.

By subjecting the hitherto sheltered services and other sectors to global competition and encouraging them to raise their productivity and inefficient firms to exit, structural reform in Japan could over time help correct distortions caused by this abnormal currency situation.

The reform process would, however, be painful and politically difficult to implement. It could be smoothened by an export-led recovery of aggregate demand. But, given international political reality, can Japan be allowed to follow such a course without being accused of following a “beggar thy neighbor” policy?

If not, what policy option is available for Japan — which has the world’s second largest economy and is now undergoing the world’s most rapid process of population aging with projected huge increases in social expenditure — after years of fiscal stimuli that have already turned its public-sector debt position into the worst among advanced economies?

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