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 nonper- forming loans in their portfolios is growing because of the pro- longed economic stagnation. In order for sustained economic re- covery 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. Asian Economic Papers 1:2 © 2002 the Center for International Development at Harvard University and the Massachusetts Institute of Technology Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/15353510260187436 by guest on 24 September 2021 Current State of the Japanese Economy 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 macroeco- nomic 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 in- vestment 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 over- seas (this includes relocation to other Asian countries), which has reduced Japanese domestic production. Finally, domestically oriented industries, such as the agri- cultural, construction, service, and banking sectors, are not competitive interna- tionally. 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. 111 Asian Economic Papers Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/15353510260187436 by guest on 24 September 2021 Current State of the Japanese Economy 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 pri- vate 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 con- cerned 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. 112 Asian Economic Papers Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/15353510260187436 by guest on 24 September 2021 Current State of the Japanese Economy 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)].