The Current State of the Japanese Economy and Remedies*

Naoyuki Yoshino Abstract Professor of Economics Japan has reached the limits of conventional macroeconomic poli- Keio University 2–15–45 Mita Minato-ku cies. Lowering interest rates will not stimulate the economy be- Tokyo 108–8345 cause widespread excess capacity has made private investment in- Japan [email protected] sensitive to interest rate changes. Increasing government expenditure in the usual way will have small effects because it will Eisuke Sakakibara take the form of unproductive investment in the rural areas. Cut- Professor Keio University ting taxes will not increase consumption because workers are Tokyo, Japan concerned about job security and future pension and medical Former Vice Minister of benefits. Expanding the monetary base will not induce banks to Finance for International Affairs, Japan increase investment loans because the proportion of nonperforming loans in their portfolios is growing because of the pro- longed economic stagnation. In order for sustained economic recovery to occur in Japan, the government must change the makeup and regional allocation of public investments, resolve the problem of nonperforming loans in the banking system, improve the corporate governance and operations of the banks, and strengthen the international competitiveness of domestically oriented companies in the agriculture, construction, and service industries.

1. Introduction

It is often argued that Japan needs to implement aggres- sive structural reforms to achieve a sustainable and robust economic recovery. The line of argument typically begins by observing that Japan’s absolute productivity is very low and stagnant and that many Japanese industries, such as domestic manufacturing and services (e.g., food pro- cessing, real estate, and distribution), are either tightly reg-

* This is a revised version of a paper presented for the Asian Eco- nomic Panel meeting held in Cambridge, Massachusetts, 26–27 April 2001.

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ulated or highly subsidized. Drastic deregulation and reduction of subsidies are usually recommended to stimulate these sectors. Alternatively, analysts advocate improving consumer and business conªdence by reducing the budget deªcit and strengthening the balance sheet of the private sector.

These assertions and strategies appear to be plausible but they are often not sup- ported by empirical data. Some case studies have been conducted at a microeco- nomic level (Sakakibara 2000), but few analyses have been framed in a macroeconomic context that addresses the effectiveness of ªscal or monetary policies. Paul Krugman’s macroeconomic analysis suggests that the Japanese economy is caught in a liquidity trap that renders monetary policy ineffective. In this paper we present empirical evidence to argue that a major reason for the ineffectiveness of recent Jap- anese monetary policy is not the liquidity trap, but the interest insensitivity of investment during a recession. In addition, we claim that the effectiveness of Japanese ªscal policy has dramatically declined as a result of politically motivated regional misallocation of public investment. One indication of this misallocation is that the public-investment multiplier has decreased sharply from around 2.5 to about 1 in recent years (Yoshino, Kaji, and Kameda 1998).

Several factors account for why the Japanese economy has remained in recession for more than 10 years. Banks still dominate Japanese ªnancial markets: they receive approximately 60 percent of total individual savings. Because of the continuous pressure exerted by nonperforming loans (NPLs) on banks’ balance sheets, bank lending has continued to decline signiªcantly, despite a loose monetary policy. Al- though banks have traditionally been quite conservative, the degree of risk aversion on the part of banks has apparently increased since the banking crisis, and this trend has pushed the IS curve to the left. Thus, although there has been some positive shift of the IS curve to the right as a result of an increase in public works, the decline in bank credit has continued to exert a downward pressure on private investment. Furthermore, many manufacturing industries have moved their production overseas (this includes relocation to other Asian countries), which has reduced Japanese domestic production. Finally, domestically oriented industries, such as the agricultural, construction, service, and banking sectors, are not competitive internationally.

The following remedies would be likely to lead to a recovery of the Japanese economy:

1. The construction of infrastructure should be focused much more on productive regions.

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2. The usual ex ante overestimation by public ofªcials of the usage of infrastructure, such as the number of passengers that will use an airport or the number of cars that will travel over a bridge or road, should be brought under control. The methods used for such estimations, as well as the government’s response to the results of these estimations, should be disclosed to the public. 3. Politicians should abandon the Keynesian ªscal policy of the last 10 years, which has more than doubled the ratio of government debt to GDP in 10 years (from 60 percent in 1991 to 140 percent in 2002). A large proportion of government bonds are held by banks and the post ofªce. Because banks do not want to increase their NPLs, they prefer to hold government bonds, which crowd out loans to the private sector. 4. Domestically oriented sectors such as construction, services, and banking must work hard to make themselves internationally competitive and should prepare themselves to conduct their business overseas if necessary. In short, they should pursue strategies similar to those adopted by the strong Japanese manufacturing industries during Japan’s high-growth period.

2. A brief history of the Japanese economy

The following four important reforms to the Japanese economy were undertaken right after World War II. They were implemented without causing social unrest and created the basis for the success of the Japanese economy after 1955.

1. Land reform. The land of large-scale farmers was distributed to small farmers. 2. Education reform. Basic education was compulsory for all children. 3. Wage reform. A minimum wage rate for workers was set up. 4. Abolition of large conglomerates. Large conglomerates (zaibatsu) were abolished.

Table 1 displays some basic economic performance data for Japan from 1955 to 2000. The Japanese economy grew very rapidly from 1956 to 1970. The average real growth rate was about 10 percent [column (6)] until the Japanese economy was hit by the Nixon shock1 in 1971. The exchange rate had been pegged to the U.S. dollar until 1970 at 360 yen/dollar, and the Nixon shock forced the yen to appreciate against the U.S. dollar. The Japanese government and the central bank were concerned that the drop in Japan’s exports resulting from the yen’s appreciation would cause a contraction of the Japanese economy. Expansionary ªscal policy and a loose

1 The term “Nixon shock” is commonly used in Japan to describe President Nixon’s pressures on U.S. trading partners to reduce the chronic balance of payments deªcits of the United States. The 1971 measures included an across-the-board tariff on imports and the suspension of the convertibility of gold to U.S. dollars.

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Table 1. Basic economic indicators of Japan (5) (1) (2) (4) Growth (6) (7) Growth rate Growth rate (3) Growth rate of Growth Exchange Fiscal of the WPI of the CPI Growth rate rate of nominal rate of rate year (1990 = 100) (1990 100) of HPM M2 CD GNP real GDP ($US/yen) 1955 — — — — — — 360 1956 — 5.1 0.94 — 12.1 6.4 360 1957 — 6.31 8.62 — 14.5 7.5 360 1958 2.33 0 11.62 — 7.0 7.3 360 1959 0.23 5.94 3.82 — 17.2 11.2 360 1960 1.14 6.9 11.89 22.91 19.9 12.2 360 1961 1.69 8.47 16.31 17.11 20.9 11.7 360 1962 2.17 2.97 22.87 24.60 10.6 7.5 360 1963 0 6.86 16.37 20.61 17.4 10.4 360 1964 0.22 5.74 17.25 15.72 15.8 9.5 360 1965 1.29 4.47 15.61 18.49 11.1 6.2 360 1966 2.98 5.81 12.46 15.74 17.6 11.0 360 1967 1.86 5.49 13.98 14.93 17.0 11.0 360 1968 0.81 4.93 16.40 15.41 18.3 12.4 360 1969 3.02 5.74 16.18 18.20 18.4 12.0 360 1970 2.15 6.91 17.99 18.00 15.8 8.2 360 1971 0.76 5.98 18.58 24.04 10.2 5.0 335 1972 4.05 5.38 15.95 23.18 16.6 9.1 297 1973 21.67 15.92 18.17 26.53 20.9 5.1 274 1974 20.09 20.93 26.92 22.69 18.4 0.5 293 1975 2.28 10.2 20.25 11.92 10.2 4.0 290 1976 6.07 9.59 13.59 13.10 12.4 3.8 292 1977 1.99 6.94 11.08 15.11 11.0 4.5 257 1978 0.57 3.81 9.11 11.38 9.9 5.4 201 1979 8.76 4.76 9.81 11.75 8.0 5.1 230 1980 12.50 7.52 11.65 11.85 8.9 2.6 217 1981 0.20 4.1 7.01 8.90 6.2 2.8 220 1982 0.30 2.55 3.99 9.20 4.9 3.2 235 1983 0.70 1.92 6.85 7.40 4.6 2.4 232 1984 0.30 2.11 5.40 7.80 6.9 4.0 251 1985 1.70 1.95 4.08 8.40 6.6 4.2 201 1986 5.20 0 6.12 8.70 4.5 3.2 160 1987 1.70 0.46 7.40 10.40 5.0 5.1 122 1988 0.60 0.79 10.31 11.20 7.1 6.3 126 1989 2.70 2.81 10.77 9.90 7.5 4.9 143 1990 1.30 3.17 11.09 11.70 8.1 5.5 136 1991 0.40 2.9 1.94 3.60 5.3 2.5 125 1992 1.00 1.5 2.24 0.60 1.8 0.4 125 1993 1.80 1.2 3.66 1.10 0.9 0.4 112 1994 1.40 0.5 4.85 2.10 1.0 1.1 99 1995 1.00 0.3 5.28 3.00 2.0 2.5 103 1996 1.50 0.4 9.03 3.30 2.6 3.4 116 1997 1.00 2.0 8.20 3.10 1.0 0.2 130 1998 2.10 0.2 9.20 4.00 1.1 0.6 115 1999 1.00 0.5 6.00 3.60 0.2 1.4 102 2000 0 0.5 7.40 2.10 0.5 0.9 114

monetary policy were implemented, and the growth rate of the money supply went up 24 percent in 1971 and continued to be high until 1974 [column (4)].

The ªrst oil crisis hit Japan in 1973, when the growth rate of the money supply was very high. The result was an unprecedented, high inºation rate in 1973 and 1974 [table 1, columns (1) and (2)]. Both the wholesale price index (WPI) and the consumer price index (CPI) increased by approximately 20 percent in each of those years. At the same time, the contractionary supply-side effects of the sharp oil price

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(8) Nikkei 225 (9) (10) (13) Stock Land price Interbank (11) (12) Household Average index (six rate (call Discount Unemployment savings rate (yen) large cities) rate; %) rate (%) rate (%) (%) 390.68 0.63 6.77 6.78 2.60 11.9 519.84 0.80 7.44 7.31 2.20 12.9 522.95 1.00 11.39 8.32 1.90 12.6 618.58 1.23 9.04 7.57 2.20 12.3 890.17 1.55 8.38 7.06 2.00 13.7 1,247.61 2.35 8.31 7.01 1.50 14.5 1,547.08 3.73 8.46 7.01 1.40 15.9 1,417.05 4.65 8.64 7.01 1.30 15.6 1,385.10 5.48 7.56 5.89 1.20 14.9 1,252.95 6.25 10.07 6.49 1.10 15.4 1,268.07 6.53 6.33 5.56 1.30 15.8 1,472.09 6.73 5.87 5.48 1.30 15.0 1,379.59 7.20 6.85 5.77 1.20 14.1 1,662.69 8.03 7.79 5.97 1.10 16.9 2,099.38 9.33 7.95 6.08 1.10 17.1 2,147.56 10.98 8.02 6.09 1.20 17.7 2,569.34 12.50 5.87 5.23 1.30 17.8 4,304.36 14.96 4.74 4.37 1.30 18.2 4,591.43 19.46 8.88 6.94 1.30 20.4 4,177.54 20.22 12.74 9.00 1.50 23.2 4,374.51 19.00 9.23 7.36 1.90 22.8 4,759.95 19.33 6.93 6.47 2.00 23.2 5,061.21 19.83 5.14 4.59 2.10 21.8 5,775.63 20.78 4.28 3.5 2.20 20.8 6,420.81 23.08 7.04 5.50 2.00 18.2 6,999.03 25.58 10.76 8.1 2.10 17.9 7,599.12 27.50 6.96 6.02 2.20 18.4 7,531.08 29.03 6.94 5.5 2.50 16.7 9,322.97 30.40 6.28 5.32 2.70 16.1 11,060.72 32.43 9.06 5.00 2.70 15.8 12,934.89 35.56 4.56 4.89 2.60 15.6 18,032.35 43.00 4.28 3.27 2.80 15.6 24,194.71 56.32 3.39 2.5 2.80 13.8 28,865.17 69.00 4.13 2.5 2.40 13.0 34,967.53 87.99 4.38 3.53 2.20 12.9 26,872.30 103.31 6.66 5.69 2.10 12.1 23,350.00 96.41 8.34 5.31 2.10 13.2 17,188.86 79.03 5.56 3.29 2.20 13.1 19,640.87 67.13 3.91 2.11 2.50 13.4 19,508.51 59.25 2.44 1.75 2.90 13.3 19,868.15 51.51 2.28 1.0 3.20 13.7 19,361.35 46.57 0.44 0.5 3.40 13.4 15,258.74 43.72 0.47 0.5 3.40 12.7 13,842.17 41.22 0.32 0.5 4.10 13.2 18,934.34 37.79 0.05 0.5 4.70 13.7 13,785.69 35.10 0.2 0.5 4.70 —

Note: WPI ϭ wholesale price index. CPI ϭ consumer price index. HPM ϭ high-powered money.

increase caused real GDP to shrink half a percent in 1974. The growth rates of high- powered money and the money supply in 1974 were 26.9 percent and 22.6 percent, respectively, despite the high inºation rates, because the central bank sought to off- set the fall in output [columns (3) and (4)]. After the ªrst oil crisis, various measures were implemented to save energy, and expansionary ªscal policies were undertaken.

The second oil crisis hit Japan in 1979. As a result of energy-saving investments by Japanese companies, however, the oil shock had a much less severe impact on the

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real economy than that of the 1973–74 oil crisis. This time, monetary policy was not loosened aggressively to counteract the contractionary effects of the oil shock. The growth rate of the money supply was about 11.8 percent in both 1979 and 1980 compared with 11.4 percent in 1978. Although the Japanese yen had appreciated continuously since 1971, Japanese exports continued to grow because of the success of the manufacturing industries in improving the quality of their products and cutting production costs.

The Plaza Accord in September 1985 forced Japan to increase imports to reduce its balance of payments surplus. Loose monetary and ªscal policies were implemented. The discount rate fell to 2.5 percent in 1987 and 1988 [table 1, column (12)], and the growth rate of high-powered money was between 10 and 11 percent in the 1988–90 period. The inºation rate remained low [columns (1) and (2)], mainly as a result of the large appreciation of the yen, which lowered the yen prices on non-oil imports and kept the yen price of oil imports relatively stable. However, the Nikkei 225 Stock Average [column (8)] went up to 34,967 yen (yearly average) in 1989, which was more than three times the stock price in 1984 (11,060 yen). The land price index also increased more than three times between 1984 and 1990, from 32 to 103 [column (9)].

The period of high stock prices and high land prices in Japan was known as the “bubble economy.” Because private banks used land as collateral, the higher land prices raised the collateral value, and loans were expanded to real estate ªrms, construction companies, and non-bank ªnance companies. When large corporations started to raise funds from the capital market and from overseas, long-term credit banks (including Nippon Credit Bank and the Long-Term Credit Bank) and trust banks lost many customers, and these banks responded by increasing loans to non- traditional customers such as real estate ªrms, construction companies, and non- bank ªnance companies.

A tight monetary policy and credit regulation were introduced in 1989, raising the discount rate from 2.5 percent in 1988 to 6 percent in 1990. The amount of bank loans to real estate, construction, and non-bank ªnance companies remained at a high level. No measures were taken, however, to address the problem of overdue loans.

Although it is widely recognized that Japan’s rapid economic success was partly a result of the Japanese management system and corporate employment practices, it is less commonly recognized that Japan’s ªnancial system was also a key factor in that success. The principal features of the ªnancial system were a high level of household saving; market segmentation by function, maturity, region, and source of fund-

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ing; the predominance of indirect ªnance and the main bank system; and a wide range of government-guided mechanisms to allocate savings and investment. These government-guided mechanisms included the direct control of over 30 percent of savings deposits through the postal savings system, regulatory controls, non- market-determined interest rates [rates were determined by the Ministry of Finance (MOF)], branch licensing (by the MOF), administrative guidance (by various minis- tries), window guidance (by the Bank of Japan), and, until 1980, restrictions on capital inºows and outºows. The bursting of the bubble economy at the end of the 1980s has led even the most staunch supporters of the system to have doubts about its viability in today’s global marketplace. Recent economic data support a skeptical view: for example, in 1999 and 2000 the unemployment rate went up to about 5 percent [table 1, column (12)], and the nominal growth rate became negative [column (5)].

3. Reasons for Japan’s current stagnant economy

The sudden imposition of a tight monetary policy in 1990 pushed land and stock prices down about one-third from their peak level. The annual real growth rate of the economy was below 2 percent for most of the 1990s. The unemployment rate went up to almost 5 percent in 1999 and 2000 [table 1, column (12)] and is expected to rise much more. Paul Krugman argues that Japan is currently in a liquidity trap, a situation in which monetary policy is ineffective in lowering interest rates. Our econometric investigation, however, indicates that the problems of the Japanese economy stem from other sources. We will state our diagnosis here and then sub- stantiate it in the sections that follow.

We begin by making two observations about private investment behavior in Japan. First, land price is an important determinant of private investment, especially from 1985 to 1998, because it serves as collateral for bank loans. This is why Yoshino, Kaji, and Kameda (1998, appendix table BB) ªnd that the coefªcient of land in the investment equation has a t-value of 3.24. Second, private investment in Japan will not increase when the interest rate is lowered. Yoshino, Kaji, and Kameda ªnd that interest rate sensitivity for investment is now zero. Private investment displays this unconventional behavior because of uncertainty about the future and the excess capacity created in the late 1980s.

The post-1992 decline in land price has shifted the IS curve to the left, as shown in ªgure 1. In such circumstances, because monetary policy is ineffective, ªscal policy should be used to shift the IS curve back to the right so that the economy can re- cover. The dilemma, however, is that despite the huge increase in government investment, the IS curve has not shifted enough to the right.

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Figure 1. The ineffectiveness of monetary policy

Public investment has produced low stimulative effects on GNP because it has been distributed ineffectively. The bulk of public investment has been increasingly concentrated in the countryside, and the facts are that public investment has a much smaller impact on rural areas than on urban areas and that public investment in the agricultural sector has been much less effective than public investment in the industrial and service sectors (more details concerning this are given in section 4). The result of this increasing rural and agricultural bias in the allocation of public investment is that the multiplier of public investment has declined sharply from about 2.5 to only about 1 in recent times (Yoshino, Kaji, and Kameda 1998). This means that such public investment only increases budget deªcits; it cannot bring about a recovery of the Japanese economy.

Several other factors have contributed to the current stagnant economy:

1. The level of consumption has decreased. The fall in the propensity to consume has been mainly a result of workers’ concerns about possible layoffs. In addition, the fall of asset prices has lowered consumption, including that of the corporate sector, because of the wealth effect. 2. There is a credit crunch, because banks have been less willing to make investment loans for several reasons. Falling land prices have made private banks re- luctant to grant loans because of the anticipated fall in the value of collateral. The prudential measures introduced in 1998 for tougher bank examination, as well as the higher capital requirements, forced banks to reduce the number of loans they made. The growing proportion of NPLs in the banks’ loan portfolios has caused

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the banks to reduce their loans to build up their loss provisions. The failures of several large ªnancial institutions have also reduced the availability of loans. 3. Capital ºows have become more interest rate sensitive. The lower interest rate in Japan has encouraged outºow of ªnancial investment to the United States and other countries.

4. Effects of public investment in infrastructure on regional productivity

Figure 2 (from Yoshino and Nakahigashi 1999) reports the marginal productivity of public investment in the agricultural, industrial, and service sectors in each region of Japan. The following conclusions can be drawn:

1. For a given region, the marginal productivity of infrastructure investment in the agricultural sector is smaller than the marginal productivity of infrastructure investment in the industrial and service sectors. The marginal productivity includes both the direct production effects caused by the additional infrastructure investment and the indirect production effects from the increases in private investment and private employment stimulated by the additional infrastructure investment. 2. For 7 out of 11 regions, the service sector has the highest return to infrastructure investment. 3. The output effects of infrastructure investment in the industrial and service sectors are highest in the South Kanto region (where Tokyo is located), the Toukai region (between Tokyo and Osaka), and the Kinki region (where Osaka is located). 4. Regional variations in the marginal productivity of infrastructure investment in the service sector are relatively small, possibly because infrastructure investment in the populated areas in each region accelerates private investment and private employment in these areas.

These results suggest that infrastructure investment should be concentrated in the service and industrial sectors of the South Kanto region, the Toukai region, and the Kinki region. We see the opposite trend to this optimal allocation, however, in Japan. The results of this misallocation are seen in the decline in the returns to public and private investment over time, as reported in table 2. The marginal productivity of public capital was high during the high-growth period (1955–69) and increasingly low from 1970 onward. It is likely that the misallocation of public capital helped lower the rate of return to private capital as well, because public investments are not removing the infrastructure bottlenecks that are lowering the rate of return to private investment.

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Figure 2. Marginal productivity of infrastructure investment

Source: Yoshino and Nakahigashi (1999).

5. Government investments in various sectors and the impact on welfare

Table 3 reports regressions to explain government investment in agriculture, land conservation, and industrial infrastructure and changes in the standard of living. The explanatory variables in all cases are prefectural income per capita (Yp), size of prefecture per capita (Sp), and number of lower-house representatives per capita (Rp). Dummy 1 is the dummy variable for Tokyo, and Dummy 2 is the dummy variable for Okinawa. Government investments in agriculture, land conservation, and industrial infrastructure are strongly correlated with the number of lower-house representatives per capita in a given prefecture (i.e., more political power has led to

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Table 2. Marginal productivity of private capital and public capital Private capital Public capital 1955–59 0.8346 0.2468 1960–64 0.8685 0.3216 1965–69 0.8204 0.3610 1970–74 0.4740 0.1802 1975–79 0.3144 0.0944 1980–84 0.2813 0.0722 1985–89 0.2416 0.0621 1990–93 0.2410 0.0592

Source: Yoshino and Nakahigashi (1999).

Table 3. Allocation of public infrastructure in Japan (pooled data, 47 prefectures) Land Industrial Improvement of Explanatory variables Agriculture conservation infrastructure living standards Constant 35.44 34.26 61.58 52.32 (Ϫ10.46**) ( 11.32**) ( 11.84**) (8.00**) Yp (income) 0.01 0.01 0.02 0.036 (7.21**) (13.18**) (17.99**) (25.86**) Sp (area size) 4,970 2,090 3,855 2,730 (28.47**) (13.40**) (14.39**) (8.10**) Rp (political power) 8,280 7,274 10,956 7,434 (16.88**) (16.60**) (14.55**) ( 7.85**) Dummy 1 (Tokyo) Ϫ23.21 34.27 59.81 36.85 ( 6.69**) ( 11.06**) ( 11.23**) ( 5.50**) Dummy 2 (Okinawa) 27.43 1.65 65.87 66.89 (9.26**) ( 0.62) (14.48**) (11.70**) Adj. R2 0.675 0.486 0.458 0.527

Note: Numerals in parentheses are t-values. ** indicates signiªcance at the 99.0 percent level.

more public investment). On the other hand, the improvement of living standards has a negative correlation with political power in Japanese prefectures. Political power seems to bring rents to a prefecture, but it does not improve the average standard of living in the prefecture!

We think that the preceding unexpected ªnding that rent inºows do not improve general welfare is the result of the rents’ not going to the average rural resident. Our explanation is that most of the rents from the public investments channeled by the political process go to the rural construction companies and not to the rural residents. This explanation is consistent with a recent survey that reports construction industries in rural areas to be much less depressed than those in urban areas. This survey further supports our ªnding that Japanese public investment is not correlated with productivity.

6. Nonperforming loans and the Japanese ªnancial sector

Table 4 lists the allocation of household ªnancial assets in Japan, the United States, Germany, and France. Japanese households hold an unusually high proportion of

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Table 4. Allocation of household ªnancial assets Japan United States Germany France Cash and demand deposits (%) 1975 17.8 6.7 9.2 n.a. 1986 9.6 4.7 7.6 15.8 1994 9.4 4.6 8.9 9.6 1997 12.3 1.6 8.6 8.7 Time and savings deposits (%) 1975 57.2 30.4 54.9 n.a. 1986 53 20.8 47 35.7 1994 53 16.9 35.8 21.8 1997 49.8 14.1 31.4 25.2 Insurance and pensions (%) 1975 12.8 20.9 15.6 n.a. 1986 16.3 25.1 20.4 4.4 1994 24.7 30.8 21 12.1 1997 28.2 29.9 21.8 17.3 Securities, excluding stocks (%) 1975 8.8 14.3 10.8 n.a. 1986 10.2 10.6 14.6 7 1994 6.8 16.1 21.5 5.1 1997 4.8 21.1 23 4.9 Stock (%) 1975 3.1 25.9 3.1 n.a. 1986 10.9 13.5 2.5 26.4 1994 6.2 16.2 5.5 45 1997 4.8 21.2 8.3 37.9 Mutual funds (%) 1975 — — — — 1986 — — — — 1994 2.8 7.4 7.5 — 1997 2.3 9.5 8.8 —

Note: n.a. indicates data are not available.

their ªnancial wealth in cash and bank deposits. In 1986, Japanese households held 63 percent of their wealth in this form, compared with 26 percent for households in the United States, 55 percent in Germany, and 52 percent in France. This gap wid- ened over time because Japanese households continued to hold almost the same proportion in cash and bank deposits (62 percent in 1997), whereas households in the other developed economies diversiªed out of this asset (16 percent in the United States, 40 percent in Germany, and 34 percent in France). The result is that Japanese households hold only a very small share of their ªnancial wealth in securities, stocks, and mutual funds. The 1997 share of these assets was 12 percent for Japan, 52 percent for the United States, and 40 percent for Germany.

Why do Japanese households have asset preferences that are so different from those of households in other nations? Table 5 reports a survey of the factors that Japanese households consider important when choosing ªnancial institutions. Overwhelm- ingly the most important consideration is location and convenience, which means that banks and post ofªces are favored because they are located near residences or workplaces. Furthermore, because the interest rates on small-denomination time deposits and ordinary deposits were regulated until 1993 and 1994, respectively, most Japanese selected their banks for their convenient location rather than according to the interest rate they pay.

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Table 5. Reasons why Japanese households chose speciªc ªnancial institutions Location and convenience 78.0% Nationwide branch network 24.8% Various ªnancial products are available 3.1% Rate of return is higher 2.8% Bank employees consult kindly with customers 4.5% Healthy ªnancial institution 39.3% Very friendly and kind atmosphere 7.8% TV commercial and other advertisement 1.1% No speciªc reasons 10.0%

Table 6 reports regression results on the allocation of ªnancial wealth between deposits in postal savings banks and deposits in private banks. The regressions conªrm that convenience, as proxied by the ratio of the number of branches of both types of institutions, consistently has a t-value that exceeds 11. They also conªrm that households are sensitive to differences in yields, especially the urban households in the 1990s.

Presently, despite the government’s guarantee of monetary deposits, the fragility of ªnancial institutions has become an important concern. Three main factors have contributed to this fragility (Cargill, Hutchison, and Ito 2000):

1. The switch of many large corporations in the late 1980s from borrowing from the banks to raising funds from the capital market prompted the banks to expand greatly their loans to real estate ªrms, construction companies, and non-bank ªnancial institutions. 2. Japanese banks were competing among themselves for market share rather than focusing on proªtability, hence they did not pay much attention to the possibility of future losses. 3. Because bank managers strongly believed that land prices in Japan would never fall, they relied excessively on land as collateral when they made loans. When land prices fell by more than 50 percent in the large cities after 1989, many loans turned bad and caused many banks to fail, especially after 1995. Table 7 shows that two banks failed each year in 1992–94, with the number of failures then increasing rapidly from 3 in 1995 to 30 in 1998. Although the number of bank failures was 20 in 1999 and 2000, the cost to taxpayers was higher in these years than in 1998: 4.7 trillion yen and 5.2 trillion yen, respectively, compared with 2.7 trillion yen in 1998.

7. What is needed in Japan?

Japan’s government should change the allocation of public investments to concen- trate them in urban rather than rural regions. The distribution of public investment should be determined on the basis of how much private investment and private

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Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/15353510260187436 by guest on 24 September 2021 Current State of the Japanese Economy (adj.) 2 R 0.085 0.919 5.2 — 0.088 0.919 5.4 — 0.087 0.919 5.3 — 6 Dummy variable for regional bank X Ϫ Ϫ Ϫ Ϫ Ϫ Ϫ 0.124 0.125 15.2 0.121 14.5 15.2 5 Ϫ Dummy variable for periods of increasing interest rate X Ϫ Ϫ Ϫ Ϫ Ϫ 0.134 2.6 0.062 2.0 4 Interaction term X Ϫ Ϫ Ϫ Ϫ interest 0.039 2.3 0.005 0.2 3 Interest rate on banks’ time deposit X rate on postal savings Ϫ Ϫ Ϫ Ϫ (dummy for large cities in the 1990s). * 3 0.022 1.7 0.022 0.079 1.7 1.6 0.021 1.7 2 X Household income (100 billion yen) X Ϫ Ϫ Ϫ Ϫ Ϫ Ϫ 4 1 Explanatory variables Number of post ofªces/number of branches of banks X The interaction variable is constructed as follows: X -value 11.3 -value 11.3 -value 11.1 Table 6. Demand for postal savings inDependent comparison with private banks’ deposits,variable 1980–95 (Panel data analysis, 47 prefectures) Postal savings/ banks’ deposits Variable Regression 1 Estimated coefªcient 0.126 Note: t Regression 2 Estimated coefªcient 0.126 t Regression 3 Estimated coefªcient 0.124 t

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Table 7. Number of failed banks and amount of money spent by deposit insurance Asset purchase Debt payment Number of Grants (100 Loans (100 (100 million (100 million Year failures million yen) million yen) yen) yen) 1992 2 200 80 — — 1993 2 459 — — — 1994 2 425 — — — 1995 3 6,008 — — — 1996 6 13,160 — 900 — 1997 7 1,518 — 2,391 40 1998 30 26,822 — 26,816 — 1999 20 46,367 — 13,044 — 2000 20 51,913 — 8,501 — 2001 37 16,660 — 4,064 — 2002 43 15,765 — 5,345 — Total 172 179,322 80 61,060 40

Source: Deposit Insurance Corporation of Japan.

consumption it would induce. Public investment should not be distributed as a form of unemployment compensation. Many people say that it is impossible to keep a tight ªscal policy and reignite the Japanese economy. What is needed in Japan, however, is to keep the budget tight and to change the makeup and regional allocation of public investment.

Policies that accomplish these objectives will require changes in the political regime or structure of vested interests. The revolt of the rural electorate (who have been the net recipients of political favors) against the long-time ruling party indicates that some dramatic changes are already taking place. Because of the extreme ineffectiveness of public investment in some rural areas, the chief beneªciaries of these rural public investments are construction and construction-related companies, not the average rural resident. In fact, as the regressions in table 3 show, the political strength of the rural areas has not translated into a positive force for improvements in the living standards of rural residents.

The following changes are required to reform the ªnancial sector: (1) greater trans- parency of the banks’ operations and decision-making procedures; (2) improvement of supervision and bank examination by the Financial Services Authority and the Bank of Japan; (3) stricter corporate governance of ªnancial institutions and corporations; (4) enhancement of competition among ªnancial institutions, for example, establishment of an easy entry and exit policy; (5) resolution of the NPLs; (6) changes in accounting standards, for example, standards pertaining to book value versus market value; (7) adoption of consolidated bookkeeping with respect to hold- ing companies and their afªliated ªnancial institutions; and (8) improvement of ªnancial risk management, such as credit risk, market risk, exchange rate risk, and liquidity risk, by ªnancial institutions and corporations.

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A full guarantee of bank deposits is mistakenly believed to be needed in Japan so that customers can make deposits without concerning themselves about the health of their ªnancial institutions. A full guarantee of all deposits, however, means that people can continue to make deposits in any kind of bank, including weak banks with low credit ratings. Banks that fail to assess credit risk responsibly tend to continue accumulating NPLs. Taxpayers’ money will have to be continuously injected to liquidate these banks and to guarantee the return of all the depositors’ funds. Since all deposits are fully guaranteed in Japan, the taxpayers are paying the cost for the “imprudence” of the depositors. If depositors are motivated to recognize problem banks much earlier, then problem banks are closed at a much earlier stage, and less public money from taxpayers will be needed to fund the bank closures. The government should at most guarantee a speciªed maximum amount of deposits (up to 10 million yen), so that although depositors are assured that they can use their ac- counts for day-to-day ªnancial needs, they will also exercise more caution in choosing the banks in which to deposit their funds.

The development of mutual funds and other ªnancial products is needed in Japan to encourage the diversiªcation of household portfolios. Because Japanese often select a bank or branch solely based on convenience, such ªnancial products (e.g., deposit services, insurance, mutual funds, stocks, and bonds) should be sold by a wide range of ªnancial institutions, including post ofªces and agricultural coop- eratives. These products do not guarantee their principal; therefore, it is important that each of these riskier ªnancial vehicles be carefully explained to prospective buyers. Without full risk disclosure, ªnancial deregulation will be politically unsus- tainable if unsuspecting customers feel deceived and dismayed by the losses caused by purchasing inherently risky ªnancial products. Former Prime Minister Hashi- moto Ryutaro initiated the “Big Bang” process of ªnancial reform in 1997 to enhance competition among ªnancial institutions in order to raise efªciency. This primary objective of the Japanese Big Bang should not be allowed to be under- mined by political backlash generated by inept management of the deregulation process.

Direct disposal of banks’ NPLs has been advocated in the emergency economic measures recently announced by the Japanese government. It is not clear, however, whether these measures are intended to enhance structural reforms of inefªcient sectors and the ªnancial system or to delay reforms again by rescuing ineffective sectors through write-offs. Japan urgently needs the reactivation of its stagnant industries, which account for 90 percent of Japanese employment, through increasing competition not only among the companies in these industries, but also among ªnancial institutions.

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As the stronger manufacturing industries shifted their production overseas, Japa- nese output gradually declined. Domestically oriented companies in the agriculture, construction, service, and ªnancial sectors have not been internationally competitive. The ªnancial sector in Japan expanded its overseas operations in the 1980s by following the strong Japanese manufacturing industries. It supplied loans overseas to Japanese manufacturing industries, without providing credit services to the countries in which the Japanese ªrms were located. As NPLs increased in Japan, most of the Japanese ªnancial institutions withdrew from their overseas operations. Con- struction industries have also relied on domestic public works and did not expand their businesses overseas. The domestically oriented construction, agriculture, and ªnancial sectors must work hard to achieve international competitiveness and earn proªts from overseas to contribute to the revitalization of the Japanese economy.

References Cargill, Thomas, Michael Hutchison, and Takatoshi Ito. 2000. Financial Policy and Central Banking in Japan. Cambridge: MIT Press.

Sakakibara, Eisuke. 2000. Why the Japanese Economy Is Not Growing: Micro Barriers to Pro- ductivity Growth. MGI report. July. Washington, D.C.: McKinsey Global Institute.

Yoshino, Naoyuki, Sahoko Kaji, and Keigo Kameda. 1998. Choice of Monetary Policy Instru- ment and the Keynesian Multiplier (in Japanese). Financial Review 45 (March). Ministry of Fi- nance of Japan.

Yoshino, Naoyuki, and Masaki Nakahigashi. 1999. Economic Effect of Public Investment (in Japanese), edited by Naoyuki Yoshino and Takanobu Nakajima, Nihon Hyo-ron Sha.

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