Rethinking Japan’s “Lost Decade”: Some Post-Crisis Reflections

Yoshio Okubo Vice-Chairman, Japan Securities Dealers Association (JSDA)

here are many parallels and similarities in the financial systems. Deleveraging has been prevalent aftermaths of financial crises. What distin- and seems to have increased in the last four years. Tguishes the current state of the world econo- To cope with liquidity crises and deflationary im- my four years after the global economic crisis from pacts, central banks have resorted to bold non-tra- the situations of previous crises and from Japan’s ditional policies and expanded their balance sheets “Lost Decade”? What can this imply for the world on an unheard of scale. No signs of reversing these economy in the future? policies are likely for the foreseeable future in the United States, Europe or Japan. Rather, the policy The Crisis and its Long Aftermath debate is mostly focused on whether we need an- other round of monetary expansion. The bold and Four years have passed since the outbreak of the unconventional monetary policies are affecting the global financial crisis. World financial markets foreign exchange markets and the relative com- now seem to have regained a measure of stabil- petitiveness of countries as well is creating an un- ity from its immediate aftermath thanks to swift precedented environment for policymakers. At the and forceful policy actions taken by many govern- same time, many countries have sharply increased ments and central banks working in concert. The their public debt in response to the financial crisis sense of panic has certainly subsided and the des- and from high spending and lackluster tax reve- perate pessimism has been gradually replaced by nues. Efforts to contain public sector debt are be- cautious optimism. There seems to be more con- ing made in those countries, but progress seems fidence now on the policy actions that should be slow given the need to sustain demand in addition taken, although differences still exist among poli- to the political and social difficulties that any fiscal cymakers over the speed and the magnitude with reform would entail. which they need to be implemented. The initiatives to reform the financial system to prevent future Under these circumstances, the core function of crises were launched globally, mostly in the G-20 the financial system of allocating scarce risk-tak- framework. Remarkable progress has been made ing capital for the future growth of the economy on many fronts, including in strengthening banks’ seems constrained everywhere, and the role of the capital adequacy standards and dealing with sys- financial system is overshadowed by the need for tematically important financial institutions. All of securing financing for the public sector. these developments are brightening prospects for the world economy. Implementation Challenges Rising

The current state of the world financial system, While financial crises are caused by similar under- however, is far from normal. While global eco- lying factors, the past four years revealed that there nomic growth has been helped by the buoyant are three major aspects that have made this global economic development of emerging market econ- financial crisis distinctly different from previous omies, the growth of developed economies seems financial crises. These factors will continue to pose still hampered by the suboptimal health of their significant challenges to policymakers not only at

Think Tank 20: New Challenges for the Global Economy, New Uncertainties for the G-20 54 the current juncture but also over the foreseeable A weakness in the financial system impacts the longer-term horizon. The implication of these fac- real economy, as credit becomes dangerously tight, tors will affect the way the financial system will consumer confidence plunges, and unemployment evolve and will impact the performance of the surges. The deterioration of the real economy, in world economy in the long run. turn, adversely affects the soundness of financial institutions and increases the risk of a serious vi- First, the financial system has clearly shifted from cious cycle. No country is immune to these effects. a bank-based to a market-based system. A market- The initial complacency is replaced by the loss of based financial system allows fair and flexible al- pride and humility. Governments and financial in- location of risk and returns, and efficient alloca- stitutions are responding quickly and boldly, but tion of capital and sustainable economic growth. it takes considerable time for these efforts to bear It brings about enormous benefits to the economy fruit, testing the political will of policymakers and by strengthening financial freedom and inclusion, the patience of voters. allowing entrepreneurship to flourish. At the same time, under the market-based system, the poten- The second aspect relates to the cost and responsi- tial ability of debtors to repay, regardless of wheth- bility of resolving financial crises. With the emer- er they are corporate, household or sovereign, is gence of highly integrated financial markets, it has quickly assessed by the markets and reflected in become much more complicated to assess the real market prices. This encourages prompt corrective burden borne by various stakeholders as it involves action, contributing to the stability of the financial much greater cross-border implications. When the system under normal circumstances. When a cri- financial crisis hit Japan about a decade ago, the sis hits, however, it leads to swift deterioration in Japanese government declared that Japan would the quality of the balance sheets of creditors and not be the one to trigger a global financial crisis. causes concomitant liquidity problems, particular- The crisis was largely a banking sector crisis and ly for banks. Even in the cases where borrowers are the government effectively succeeded in contain- concentrated in specific sectors or countries, the ing the impact within its own borders. The cost of impact spreads across the globe instantly through resolving it was also shared mostly within Japan’s rapid balance sheet effects and strains in liquid- borders. In the context of the current crisis, how- ity positions. Any potential vulnerabilities of the ever, it seems extremely difficult for any country to financial system are exposed much more quickly make such a declaration. The crisis in Europe is a than a decade ago, compounding the challenges to glaring example of this difficulty, not just because policymakers. of the single currency but also because of the very high degree of economic integration. The European crisis highlighted this point. In the immediate wake of the global financial crisis in The solution for today’s financial crisis requires 2008, blame was directed at the United States. Crit- a far more systematic and globally consistent ap- ics made a number of points, including reckless proach. In the aftermath of any financial crisis, the lending by mortgage companies, excessive bor- post-crisis political situation is prone to creating rowing by consumers, and inadequate oversight by an environment in which populist policy actions regulatory agencies. However, it became immedi- are appealing. Tensions arise between the desire of ately clear that the crisis exposed the weaknesses policymakers to appear tough and forceful to in- and vulnerabilities in the financial systems every- troduce drastic changes on the one hand and the where and especially in Europe, where the impact desire to be supporters of “traditional values” on turned into an unprecedented crisis of confidence. the other in the face of entrenched public expecta- The underlying fiscal imbalances and differences tions. In addition, the resolution of today’s crisis in- in internal economic fundamentals within Europe volves a far more complex international dimension. became clear. Tensions arise between the need to take a globally

Think Tank 20: New Challenges for the Global Economy, New Uncertainties for the G-20 55 coordinated and consistent policy approach and developed countries. In countries where public the desire to address the concerns of domestic vot- funds were used to deal with the critical crisis situ- ers. It may be tempting to blame other countries ation, criticism has become particularly harsh and for domestic problems and take unilateral actions hostile toward policies to enhance the role of mar- at a time when international coordination is indis- ket mechanisms. Efficient, transparent and open pensable. While the collaborative approach is being capital markets, which have long been accepted actively pursued in the G-20, the European Union, as an indispensable engine for economic growth the Financial Stability Board and various interna- and development, are now viewed with a measure tional bodies, there are also many policy actions of skepticism. While the criticism toward market being taken or proposed that have not fully taken systems may be exaggerated in many instances, account of broader international implications. the anxieties and uncertainties are real and cannot easily be dispelled over a short span of a few years, The third aspect is that the conflict between policy particularly for the deeply affected segments of the objectives is becoming more evident and acute, population. often polarizing politics and creating gridlock and further delaying needed actions. Ideologies have Is it right then to blame the market-based system? become more important in the political arena Markets may often turn out to be irrational, but than pragmatism. The policies, which moderate no alternative systems have ever come to exist that and centrist voters think are necessary and accept- could play the role of efficiently allocating scarce able, are becoming politically unpopular because capital. Under the market based system, investors of the stronger political appeal to take extreme who make poor decisions suffer quickly and those positions. The ability to foster compromise and who take contrarian risks contribute to dampening carry forward the needed policy, which is most excess in the markets. The market based financial needed in such a moment, is undervalued in the system itself has mostly functioned effectively and age of sound bites and in the face of frustrated vot- allowed for a much quicker resolution of problems ers. This is particularly acute on the fiscal policy and resumption of normalcy than the bank-based side; any retrenchment in fiscal spending or tax system. One can argue that without the market- increase has been fiercely resisted in the name of based system, the recent problem could have been supporting the economy, regardless of the serious- much worse and the adverse impact much larger. ness of the fiscal situation. While fiscal stimulus to support the economy can play an important role It is particularly important to distinguish between under normal circumstances, the effects of fiscal the role of the market system and the abuse of the stimulus would be diminished when fiscal deficits system by market participants. Episodes of abuse are beyond a certain threshold as longer-term fis- of the markets, which often tend to surface in the cal sustainability becomes threatened and public aftermath of financial crises, exert powerful im- anxieties increase. pact on public opinions and policymakers. How- ever, the existence of the episodes of abuses itself Are the Markets to Blame? is not necessarily a sign of weakness in the system. Rather, early and effective detection of abuses is One of the most difficult challenges today is to a sign of strength of the system. These episodes embrace the merit of open and vibrant markets. could have been prevented if rules had been clearer Against the backdrop of the frustrating pace of the and enforcement had been more effective. There is economic recovery, markets have been increasingly always room for improving regulation. The initia- blamed for the problems created. Combined with tives to improve them should be taken forcefully. the perceived problems of corporate governance These improvements are in fact mostly on the side in the financial industry, public confidence in fi- of enhancing the role of markets rather than on the nancial markets seems especially eroded in many side of reducing it.

Think Tank 20: New Challenges for the Global Economy, New Uncertainties for the G-20 56 Japan’s “Lost Decade” and “Déjà Vu”? of accelerating integration of financial markets, Ja- pan’s reform of accounting and auditing standards In the wake of the financial crisis, the motto world- has also been advanced in light of the ongoing of wide was to avoid Japan’s perceived mistake, the global convergence. These reform efforts were un- “Lost Decade”—the vicious deflationary trap of dertaken in earnest when banks were struggling prolonged stagnation. Four years after the global to deal with non-performing loans. A permanent financial crisis, it is worth asking ourselves if the safety-net deposit insurance system was also put in world economy has succeeded in avoiding the Jap- place, which can be activated to inject public funds anese experience and, if so, in what sense. to capitalize failing banks or nationalize them if systemic risk is detected. These reforms also cre- In the first place, it is useful to ask if and in what ated dynamism, contributing to structural changes sense the past decade was “lost.” It is true that for in the Japanese economy and corporate gover- more than a decade the nominal and real GDP nance. Cross shareholdings were unwound and in- growth was low and often in the negative in Ja- ternational investors now hold about 27 percent of pan after its financial crisis. Deflationary pressures shares issued by listed Japanese companies. Labor persisted and the stock market performance was mobility increased. During the process, foreign lackluster. Fiscal deficits ballooned. Demographic financial institutions operating in Tokyo also en- problems became acute, with a declining birth hanced their role, contributing to a deepening in rate. The Japanese yen appreciated significantly the markets and diversifying financial services. As as a result of the changes in the relative stance of a result, the Japanese financial system has become monetary policies, adversely affecting the com- more robust and Tokyo’s financial market has be- petitiveness and continuously exerting deflation- come one of the most open and vibrant markets in ary pressures. But the unemployment rate stayed the world. at a relatively low level by international standards. Many corporations are sustaining investment Why then is there this perception of the “Lost and taking international opportunities offered by Decade” in Japan? It is probably more to do with strong growth in the region. While there have been appearance than to reality. It is also related to the major setbacks from the earthquake and tsunami perception of policy stalemate that has often per- of March 2011, the manufacturing sectors have re- sisted. The process of reform and transformation covered from the damage quickly, showing resil- is long and painful. Japan has been going through ience and willingness to overcome the difficulties. major changes affecting many segments of society. It is not difficult to detect the ambivalence toward Importantly, this resilience has been supported by reform that has been created in the aftermath of many reforms that were undertaken to strengthen the crisis. The mood of the public has become wary market mechanisms and modernize the financial and less forward-looking. Political debate becomes sector, opening up the markets, encouraging com- driven less by reality but by nostalgia. petition and upholding international standards. In fact, in terms of policymaking, the “Lost De- When the global financial crisis erupted, many in cade” was not really a lost one, but rather a de- Japan felt a sense of “déjà-vu”. This may also have cade of substantial reform of Japan’s financial and reinforced anxieties and bred a degree of compla- economic systems. Since Japan launched its “Big cency. What seemed to be the weakness in Japan’s Bang” in financial reform in late 1990s, initia- financial system has proved to be much more uni- tives were launched to make Japan’s financial sys- versal this time around. The series of difficulties tem more open and competitive in international faced by the United States and European financial finance. Japan has embraced the standards and institutions seemed similar to what Japan saw a de- codes promulgated by international groups and in- cade ago. The ensuing policy responses also looked stitutions, including the Basel Committee. In light strikingly alike: aggressive injection of liquidity

Think Tank 20: New Challenges for the Global Economy, New Uncertainties for the G-20 57 into the money market by central banks and the dynamic growth of emerging markets, particularly lowering of interest rates—effectively to almost in Asia. The banking sector and the financial sec- zero interest rates—and capitalization of banks tor also need reform to better serve the economy and liquidity injection. The short-selling in stock by embracing globalization and regional economic markets was restricted, particularly for financial integration. Such reforms will continue to entail sector shares. In the days when Japan’s previous anxieties. Fortunately, however, the global reform crisis was at its height, the economy was portrayed initiatives are perfectly in line with the reforms as a unique and opaque form of capitalism and that had already been embarked on. Japan should some of these policy actions, including restrict- feel confident in continuing to pursue these goals ing short-selling, were criticized as heavy-handed proactively and forcefully. or excessively interventionist. But these are now more prevalently used to prevent market abuses. A Balanced Approach Having gone through these humbling and agoniz- ing processes on the one hand and witnessing the Financial crises require similar solutions. It is the parallels between Japan’s crisis and the subsequent complexity, scale and political situations that dif- global crisis, the Japanese public may therefore fer in each crisis. In the aftermath of the crisis, the have strengthened their ambivalence toward re- political situation may easily turn into polarization form. Difficult decisions, particularly in the area of and stalemate, particularly in open and demo- tax and social security reform to ensure fiscal sus- cratic countries. Whether the world economy has tainability, have been postponed and exacerbated succeeded in avoiding the “Lost Decade” remains problems, although the current account surplus an open question, especially if the reform entails has masked them. long-term difficulties and political stalemate be- comes persistent in many countries. The overhang Certainly, more needs to be done to make the of public sector debt makes people ambivalent and Japanese economy competitive and dynamic. This less forward-looking. What Japan’s experience can should mainly come from revitalizing market offer is not really what should be or should not forces by increasing transparency, encouraging be done in terms of policy recommendations, but risk taking and entrepreneurship by focusing on rather a sense of realism and difficulty of policy long-term investment in education and research. implementation. The solution requires political The process of reform is ongoing and is far from leaders to refrain from polarization and to stay bal- complete. The Japanese economy needs to be anced. The stalemate from political polarization is more globally oriented as well in order to reap the the real problem that can prolong the difficulties, benefits of rapid integration of world economy and which should be avoided in all cases.

Think Tank 20: New Challenges for the Global Economy, New Uncertainties for the G-20 58