New Paradigm in Macroeconomics

“an ambitious attempt to shape the terms of the economic debate over Japan’s decade-long post-bubble economic stagnation.” William Grimes, Boston University

“What a wonderful read! ... Werner develops a simple and elegant model based on empirical observations but sufficiently abstract, and one that stands up to empirical testing impressively well. The potential implications are huge. His findings have become influential with those interested in the real world of (Japanese) finance.” Dirk Bezemer, Imperial College, University of London

“Werner has done an excellent job of showing the difficulties and conundrums faced by neoclassical theory when confronted with Japan’s recent (and older) performance ... Werner’s analysis of banking and credit-, in particular, offers new insights into the enigmas of Japanese capitalism. This is a book that will be read by many more than Japan specialists.” Costas Lapavitsas, SOAS, University of London Also by Richard Werner:

PRINCES OF THE YEN, JAPAN’S CENTRAL BANKERS AND THE TRANSFORMATION OF THE ECONOMY New Paradigm in Macroeconomics Solving the Riddle of Japanese Macroeconomic Performance

Richard A. Werner © Richard A. Werner 2005 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published in 2005 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 978-1-4039-2074-4 ISBN 978-0-230-50607-7 (eBook) DOI 10.1057/9780230506077

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Werner, Richard, 1967– New paradigm in macroeconomics : solving the riddle of Japanese macroeconomic performance / Richard A. Werner. p. cm. Includes bibliographical references and index. ISBN 978- 1–4039–2073–7 (cloth)—ISBN 978- 1–4039–2074–5 (paper) 1. Japan – Economic conditions – 1989– 2. Neoclassical school of economics. 3. Macroeconomics. I. Title.

HC462.95. W47 2004 339Ј.0952—dc22 2004058396

10987654321 14 13 12 11 10 09 08 07 06 05 Contents

Acknowledgements vii List of Tables and Figures ix List of Abbreviations and Acronyms xii

Part I Introduction 1

Prologue: Searching for a New Kind of Economics 3 1 Japanese Economic Performance During the 1990s 29

Part II Enigmas: Challenges to the Traditional Paradigm 35

2 The Enigma of the Ineffectiveness of Fiscal Policy in the 1990s 37 3 The Enigma of the Ineffectiveness of Interest Rate Policy in the 1990s 49 4 The Enigma of Japan’s Long Recession 78 5 The Enigma of the Ineffectiveness of Structural Policy 91 6 The Enigma of Economic Growth 103 7 The Enigma of the Velocity Decline 114 8 The Enigma of Japanese Asset Prices 134 9 The Enigma of Japanese Capital Flows in the 1980s 139 10 The Enigma of Japanese Bank Lending 143 11 The Enigma of Banking and its Recurring Crises 149

Part III Explanations: Applying the New Paradigm 155

12 Solving the Enigma of Banking and Money 161

13 Credit, Money and the Economy 181 14 Explaining the Velocity Decline 201

15 The Determinants of Growth 207

v vi Contents

16 The Cause of the Asset Price Bubbles and Banking Crises 226 17 The Determinants of Japanese Capital Flows in the 1980s 238 18 Why Fiscal Policy Could Not Work 246 19 Monetary Policy in the 1990s and How to Create a Recovery 261 20 Monetary Policy in the 1980s: How Bank Credit was Determined 267

Part IV The Goal of Macroeconomic Policy 295

21 Banking Reform 297 22 The Goal of Fiscal, Structural and Monetary Policy 307 23 A New Kind of Economics 321 24 A New Vision of Macroeconomic Policy 336

Notes 342 Bibliography 381 Index of Authors 411 Index of Subjects 414 Acknowledgements

I am grateful for the generous advice and support I received during the lengthy gestation period of this book. I have received much advice from my thesis advisers at Oxford, Dr Jenny Corbett and Dr Tim Jenkinson, as well as Mr Nicholas Dimsdale. In addition, I have benefited greatly over the years from many comments by academics and professional economists that are too numerous to mention. Nevertheless, I would like to thank those who provided particularly valuable advice or support during various stages of the research, namely Prof. Robert Z. Aliber, Prof. Jonathan Batten, Dr Joerg Bibow, Prof. Craig Freedman, Prof. Charles A. E. Goodhart, Dr James Gordon, Prof. Harald Hagemann, Prof. Harukiyo Hasegawa, Prof. Walter Hatch, Prof. Declan Hayes, Prof. Glenn Hook, Dr Tobias Hoschka, Dr Tim Jenkinson, Prof. Nobumitsu Kagami, Prof. Keimei Kaizuka, Dr C. H. Kwan, Prof. Paul McNelis, Dr Mark Metzler, Dr Bori Minakovic, Prof. Grayham Mizon, Prof. Stephen Nickell, Prof. Yukio Noguchi, Dr Marcus Noland, Prof. Hirohiko Okumura, Prof. Hugh Patrick, Prof. Hank Pruden, Prof. Ghon Rhee, Prof. Ryuzo Sato, Dr Christopher Scott, Prof. Sir Nicholas Stern, Prof. Joseph E. Stiglitz, Prof. Steve Thomas, Prof. Kazusuke Tsujimura, Dr Peter Warburton and Prof. Kozo Yamamura. I owe a special thanks to those who have taken it upon themselves to read the entire typescript, namely Hideo Fujiki and Suminori Sakurai of the PHP Research Institute in , T. J. C. Cooke, Dr Frank McGroarty, Dr Costas Lapavitsas and especially Dr Dirk Bezemer. Charles Goodhart has also kindly read the book and provided support and much stimulus for improvement, for which I am very grateful. I am also indebted to the many discussants of the relevant papers that I presented at international conferences, especially those most closely resembling chapters in this volume, namely at the 1993 Royal Economic Society Annual Conference, University of York, the 34th Annual Conference of the Money, Macro and Finance Research Group (MMF, 2002) at Warwick University and the 36th Annual Conference of the Money, Macro and Finance Research Group (MMF, 2004) at the Cass Business School. The international conferences in Europe, Japan and the Asia-Pacific region at which parts of this book were presented – and improved thanks to stimulating comments from participants – are unfortunately too numerous to mention. I am also grateful to the anonymous referees of those papers that have been published. The views expressed in this book are, however, mine. I am also grateful for the research support received during various stages of this research project by the , the Citicorp Foundation, the Commission for the European Union, the ESRC, the Japan Development Bank, the Japan Foundation, the Japanese Ministry of Education, the Krupp

vii viii Acknowledgements

Foundation, the Ministry of Finance’s Institute for Monetary and Fiscal Studies, the Nomura Research Institute and the Profit Research Center Ltd. The highly supportive environment of Linacre College, the former Institute of Economics and Statistics at Oxford, the , as well as the collegiate support at , Tokyo and the University of Southampton have also furthered the completion of this work. I would like to thank my editor Amanda Hamilton and her efficient team at Palgrave Macmillan for her professional guidance and enthusiasm for this project. I also would like to thank the publishers of previous versions of parts of this book, usually in the form of articles, for permission to reproduce parts, usually in much modified form, especially Blackwell Publishers Ltd, the East Asian Economic Association, Duncker und Humblot and M. E. Sharpe. Many of the graphics and all of the econometric calculations were produced with the user-friendly PC-Win and PC-Give Version 10.0 software, or its predecessors since Version 7. Over the years, many research assistants have contributed to this study, foremost among them Yoko Minami and Jenny Alf, whose excellent work deserves particular mention. I have also benefited from the great enthusiasm shown by many of my former and current students at Sophia University and the University of Southampton and would like to thank them for their sup- port. Finally, all insights that I may have contributed I owe to the Lord, who is my Light (Psalm 27). R. A. W.

Note on the representation of personal names

The ordering of first names and surnames follows the conventions of the English language. List of Tables and Figures

Tables

1.1 Key indicators of macroeconomic performance in Japan during the 1990s 31 2.1 Fiscal stimulation packages and supplementary budgets in the 1990s 38 2.2 Contribution to nominal GDP growth in the 1990s 40 2.3 Government borrowing and debt in the 1990s 41 2.4 Interest rates in Japan during the 1990s 46 3.1 Fundraising via domestic markets, broken down by source 72 3.2 Fundraising by the domestic non-financial sector, broken down by source 73 3.3 Fundraising by the domestic non-financial sector 74 5.1 Postwar Japanese real GDP growth 93 5.2 Comparison of key economic performance indicators since 1950 96 6.1 The correlation of real interest rates and real GDP 111 6.2 The correlation of nominal interest rates and nominal GDP 111 8.1 Tangible assets as a percentage of GDP in the US and Japan in 1988 136 11.1 Common features of systemic banking crises 152 12.1 Compound interest: examples 169

14.1 Regression of VM and VR against trend 205 15.1 Parsimonious model of nominal GDP growth 220 ⌬ ⌬ 15.2 Granger-causality test between credit CR and nGDP 223 16.1 Empirical model of Japanese real estate prices 235 17.1 Parsimonious empirical model of Japanese foreign investment 244 18.1 Estimation results of private demand model 251 18.2 Linear restriction test of ineffectiveness hypothesis 252 20.1 Secondary sources on the existence of credit controls in the 1980s 274 20.2 Parsimonious model of bank lending 283 20.3 Window guidance loan growth quota versus actual loan growth, 1974–91 285 20.4 Shares of total bank lending by type of bank 289 20.5 Market share ranking by type of bank 289 20.6 Granger-causality test of SI(1,1) variables 290 20.7 Tests for structural break in 1982:Q1 291

ix x List of Tables and Figures

Figures

1.1 Japanese nominal GDP growth between 1981 and 2003 30 1.2 The official unemployment rate in Japan 32 1.3 The official number of suicides in Japan 32 2.1 Private demand versus government demand, as defined by the National Income Accounts GDP figures 41 2.2 Nominal interest rates in the 1990s 46 3.1 Causation in the balance sheet channel 75 4.1 Japan’s trade surplus 83 4.2 Population growth in Japan 84 4.3 Growth of the official workforce 84 4.4 New university graduates 85 4.5 The outstanding stock of capital in Japan 86 4.6 Growth of the stock of capital 87 4.7 The number of new patent and trademark registrations in Japan 87 4.8 Capacity utilization as measured by the operating rate 89 4.9 Consumer price inflation, as measured by the CPI 89 5.1 Real GDP growth over the half-century from 1950 to 2000 95 5.2 The number of official cartels in Japan 100 6.1 Overnight call rates and nominal GDP growth 105 6.2 Short-term nominal interest rates and nominal GDP growth 105 6.3 Long-term nominal interest rates and nominal GDP growth 106 6.4 Long-term nominal interest rates and nominal GDP growth (time series) 107 6.5 Short-term real interest rates and real GDP growth 108 6.6 US long-term nominal interest rates and nominal GDP growth 109 6.7 US long-term nominal interest rates and nominal GDP growth (time series) 110 6.8 US long-term real interest rates and real GDP growth 110 7.1 The classical (and neoclassical) vertical aggregate supply curve 117 7.2 The upward-sloping Keynesian aggregate demand curve 120 7.3 Monetarist short-term and long-term aggregate supply curves 122 7.4 Income velocity decline in the case of M0 and M1 130 7.5 Income velocity decline in the case of M2 ϩ CD 130 8.1 Comparison of nominal GDP and consumer, stock and land prices 135 8.2 Land value/GDP ratio 136 9.1 Japanese current account, long-term capital flows and the basic balance 140 List of Tables and Figures xi

10.1 Annual growth rate of bank lending to the real estate, non-bank financial and construction industries 144 10.2 Bank lending growth and the prime lending rate 144 10.3 Bank lending growth and the prime lending rate 145 10.4 Bank lending and long-term nominal interest rates 146 10.5 Bank lending and short-term nominal interest rates 146 10.6 Bank lending and short-term real interest rates 147 11.1 The textbook representation of banks as mere intermediaries 150 12.1 The textbook representation of money multiplication 175 12.2 A more accurate representation of credit creation 177 13.1 An example of credit market disequilibrium 196 13.2 Bank of Japan credit creation and the call rate 197

14.1 Old and new velocities VM, VR and VR4 204 14.2 The old velocity VM and the new velocity VR 205 15.1 Japanese nominal GDP and credit creation used for GDP transactions 222 16.1 The vicious cycle of a credit crunch recession 230

16.2 The ratio of speculative loans to total loans (CF/C) in Japan 233 16.3 Real estate lending and commercial land prices 236 16.4 Real estate lending and nationwide land prices 236 17.1 Japanese net long-term capital outflows and banks’ real estate loans 242 18.1 Fiscal stimulation funded by bond issuance 256 18.2 Fiscal stimulation funded by bank borrowing 256 18.3 The standard Federal Reserve Note 259 18.4 The United States Note 259 20.1 Central bank credit controls (‘window guidance’) and actual bank lending three months later 284 20.2 Loan market shares of the various types of bank 288 20.3 Recursive one-step residuals (ϩ/Ϫ 2 SE) 290 20.4 Recursive one-step Chow tests 291 22.1 Bundesbank credit creation and bank lending in Germany 314 22.2 Bundesbank credit creation and economic activity 315 22.3 Recent Swiss economic performance 318 22.4 Credit creation in Switzerland 319 List of Abbreviations and Acronyms

ADL autoregressive distributed lag ARCH autoregressive conditional heteroscedasticity BIS Bank for International Settlements BoJ Bank of Japan CD certificates of deposit CP commercial paper CPI consumer price index CY calendar year ECB European Central Bank FDI foreign direct investment FILP Fiscal Investment and Loan Programme FY fiscal year GDP gross domestic product GNP gross national product HPM high powered money ( ϭ monetary base, base money, M0) IBJ Industrial Bank of Japan IMF International Monetary Fund JGBs Japanese government bonds LDP Liberal Democratic Party LTCB Long-term Credit Bank of Japan LTCBs long-term credit banks (including IBJ and Nippon Credit Bank) METI Ministry of Economy, Trade and Industry (formerly MITI) MoF Ministry of Finance NCB Nippon Credit Bank Nikkei Nihon Keizai Shinbun NPO non-profit organization ODR official discount rate OECD Organization for Economic Cooperation and Development o/n overnight PSBR public sector borrowing requirement Q1 first quarter of the calendar year s.a. seasonally adjusted u/c uncollateralized VAR vector autoregression WG window guidance WPI wholesale price index YoY year-on-year

xii