In August 2010 the Federal Reserve Bank of Kansas City hosted its regular symposium on monetary policy in Jackson Hole, Wyoming. Attention centered on the paper “After the Fall” by Carmen and Vincent Reinhart, presenting an analysis of how global shocks and financial crises have affected economies since the start of the twentieth century. Their study makes the following points:
•Growth rates of real per capita gross domestic product decline by about 1 percentage point during the decade after financial crises. (This means that if the US economy were growing at an annual 3% rate, a crisis would slow growth to 2% for the next 10 years.)
•Unemployment rates rise significantly above their level prior to a financial crisis during the decade following it. This is particularly true of the advanced economies, where post-crisis median unemployment rates have been about 5 percentage points higher than before the crisis.
•Real housing prices during the decade after financial crises were below their level the year before the crises in 90% of the cases observed. Median housing prices were 15% to 20% lower, and cumulative declines as large as 55% were seen.
•Private-sector borrowing expands during the decade prior to a financial crisis, with the ratio of domestic credit to GDP climbing about 38% and external indebtedness soaring. After the crisis the ratio falls, again by about 38%. This deleveraging is, however, often delayed and turns into a lengthy process lasting about seven years.
•Macroeconomic policy management after a crisis typically errs by assuming that negative shocks are temporary and seeking to return the economy to its status prior to the crisis. Banks may conceal the extent of their debts, and governments may adopt protective trade policies. Such a response only makes the crisis last longer.
US Federal Reserve Chairman Ben Bernanke was among the participants at the symposium, and his address, which followed the presentation of the Reinharts’ study, provided advance notice of the Fed’s second round of quantitative easing, or “QE2,” which was officially adopted on November 3. When Bernanke’s comments caused the yen to gain strength, Bank of Japan Governor Shirakawa Masaaki, who was also at the symposium, was hurriedly called back to Japan. To deal with the expected new round of easing in the United States, the BOJ formulated a policy of “comprehensive monetary easing,” including a new program for asset purchases, and announced it on October 5.
The Reinharts’ paper, which may be seen as the trigger of the shift to ultraeasy money by the central banks of Japan and the United States, leads to two general conclusions. First, proactive policies need to be implemented in the wake of a crisis in order to rescue economies from stagnation. Second, even if the authorities embark on aggressive monetary relaxation, the policy will have a limited impact as long as economic actors are under pressure to straighten out their balance sheets.
Japanese and American statistics confirm that slowdowns after a crisis become protracted, as the Reinharts’ study found. When we examine data on the growth rate of the working-age population’s per capita GDP, for instance, we find that in the United States it was just below 3% around 2000 but dropped almost to zero after the start of the recent global financial crisis; currently it is improving but is still only about 0.5%. The per capita GDP growth rate of Japan’s working-age population, which was above 4% shortly before its bubble economy collapsed at the start of the 1990s, dropped almost to zero and remained there until 2002. Just before the recent crisis it had recovered to almost 2.5%, but it then fell back to zero and has currently climbed only to about 0.5%.
Data on unemployment tell a similar story. Unemployment in the United States was about 5% prior to the global financial crisis. It then rose all the way to 10% and remains in that vicinity today even though the economy has been recovering. Japan’s jobless rate was 2% at the start of 1990 but then began an ascent, reaching a peak of 5.5% in 2002. By 2007 it had declined to 3.5%, but it began rising again during the latest crisis and is currently above 5%.
Debating the Value of QE2
When it introduced QE2 on November 3, the Fed revealed that it was to be a large-scale program of monetary relaxation centered on the purchase of $600 billion in long-term Treasuries, which are somewhat risky, from financial institutions. Bernanke has stated that QE2 has the potential to create from 700,000 to 1 million jobs. Among economists, however, evaluations of QE2 are divided. Theoretically, effects based on “portfolio balance” can be anticipated. Because the Fed is buying long-term Treasuries in large volumes, general investors are able to increase their purchases of equities and other financial assets, which should cause stock prices to rise. That would produce an asset effect, which would stimulate household consumption, among other results.
It is a fact that US stock prices have risen by about 10% since the QE2 announcement. According to Harvard Professor Martin Feldstein, however, a price rise of that extent will have little impact on consumption. Furthermore, households are currently rebalancing their budgets, curbing spending in the process, and that will also limit the asset effect. And as can be understood from the Reinharts’ study, QE2 may also have little effect on housing investment. Even if monetary relaxation reduces long-term interest rates, it will not automatically stimulate housing investment as long as housing prices are still in an adjustment process. To be sure, lower long-term interest rates could spur US exports by weakening the dollar, thereby contributing to an export-led expansion, but concerns have been expressed about possible negative effects for the world economy, including the formation asset and resource bubbles in China and other emerging countries.
Greg Mankiw, another Harvard professor, is a supporter of QE2, which he believes can head off the Japanese-style deflation and stagnation that began in the 1990s. He also observes, though, that the Fed is making its portfolio riskier. If future interest rate movements lead to portfolio losses, the Fed might need an injection of government funds, which could undermine its political independence. Another cause for concern is moral hazard, since the decision to adopt QE2 could lead the way to QE3 and QE4.
Returning balance sheets to a healthy state is, as the Reinharts’ study observes, a structural issue that cannot be solved by monetary policy. If the United States continues on a course of ultraeasy money, a weakening dollar and low interest rates could set off a flow of funds out of the country. Moreover, if so-called carry traders enter the picture, borrowing low-yield dollars and investing them in high-yield currencies, overseas asset and resource prices could rise. Among the critics of QE2, some even say that by destabilizing the dollar, a key currency, and undermining the discipline it imposes on commercial and financial relations, it could create a situation akin to the unraveling of the Bretton Woods system in 1971. The result could be faster global inflation and greater financial market volatility. With the money supply expanding, prices of general goods, not just assets, could move sharply upward. That would totally transform the situation that has prevailed over the past 30 years, during which hikes in general prices have been held in check by steadiness in the growth of the money suppy.
Global Ripples from Monetary Policy
The November meeting in Seoul of the Group of Twenty ran aground on a split in opinion between industrial and emerging countries. The tussle between the United States and China was particularly prominent. In response to a call from Washington for revaluation of the yuan, Beijing appealed for a more moderate American monetary policy, arguing that the Fed’s ultraeasy money was weakening the dollar and producing asset inflation in China. China’s position is that as a result of quantitative easing among the developed countries, the emerging markets are experiencing a huge inflow of funds. In lashing out at Washington, though, Beijing is also hoping to avoid making the yuan more flexible. By no means can US monetary relaxation be seen as the sole cause of China’s rising asset prices.
Beijing has effectively pegged the yuan to the dollar; this provides a means of limiting the exchange rate risks on the nation’s stock of dollar and other foreign-currency assets. The situation is not unlike that of the period leading into the Asian currency and financial crisis of 1997. But Asia’s emerging countries now have a much larger economic scale than they did at the time of the 1997 crisis, and they exert far more influence on prices in today’s globalized commodity markets. Much attention has focused on the increase in the price of oil, but in fact a wide range of resources including grains and nonferrous metals have become more costly. The index of commodity prices has rebounded by a multiple of 2.4 from the low point it reached after the global financial crisis hit, and it is now higher than it was in 2007. Higher international commodity prices worsen the terms of trade for importing countries. They engender income transfers that lower real income in importing countries and restrain domestic consumption.
BOJ Governor Shirakawa has also expressed apprenhension about disequilibria produced by the global ripple effects of financial policies. By and large, however, the central banks of the developed countries have focused only on the merits of monetary relaxation, taking little note of how their policies sow seeds of new financial imbalances elsewhere, including bubbles in emerging countries and resource markets. There is a strong likelihood that Japan’s past policy of quantitative easing, which was in effect until March 2006, abetted the asset inflation in Western countries, which were also receiving large fund inflows from other Asian countries.
More attention needs to be paid to the strong effects an easy-money policy in one industrial country can have on others. Earlier I observed that the yen came under upward pressure following Fed Chairman Bernanke’s August 2010 reference to the QE2 option in his speech at the Jackson Hole symposium, and this pushed Japan’s central bank in the direction of further relaxation. The proposition that the effects of a monetary policy can be walled off by means of adjustments in foreign exchange markets is nothing more than a desktop argument. The fact is that the policy decided on by the United States has a pronounced impact on the policies adopted by other developed countries, and by emerging countries, as well.
Ramifications of a Declining Labor Supply
Industrial production in Japan contracted by 35% between the oubreak of the global financial crisis in 2008 and early 2009. While production has subsequently rebounded, as of the end of 2010 it was still about 13% below the level prior to the crisis. The government’s “eco-car” subsidies for buyers of fuel-efficient vehicles and “eco-point” program for purchases of energy-efficient home appliances motivated consumers to push their spending plans forward, and consumption in and after the fourth quarter of 2010 may be sluggish as a result. Government policies like these can create unnecessary swings in the business cycle.
When we review the economy’s performance since the collapse of the speculative bubbles early in the 1990s, we can see that the recovery during the Koizumi administration early in twenty-first century was based on export growth in a weak-yen environment, accompanied by an expansion in plant and equipment investment. Nominal GDP peaked in 1997 and entered a gradual decline, but eventually it resumed its ascent and returned to the 1997 level in 2007. Consumer spending, however, has remained essentially flat since 1997.
The sluggishness of consumption, it has been posited, can be explained by shrinkage in labor’s share of the economic pie, as a result of which income growth was held back. If we measure labor’s share as the ratio of personnel expenses to the total of personnel expenses, operating profits, and depreciation expenses, we find that it has indeed gradually declined, slipping from about 73% in 1998 to under 64% in 2007. Companies, some critics charge, are holding on to unnecessarily large internal reserves. But a more important factor behind the declining ratio is change in the demographic structure. The working-age population (ages 15 to 64) has contracted each year since 1998. This shrinkage has picked up speed, and on current demographic trends, Japan’s working-age population in 2050 will be no larger than it was shortly after World War II.
During the process of the bubble economy’s deflation in the 1990s, the adjustment of balance sheets turned into a time-consuming affair. It seemed for a while during the first decade of the twenty-first century that a lasting expansion had resumed, but that was precisely when the new demographic trends, notably the downturn in the working-age population and the labor force, became sufficiently prominent to suppress economic growth. After the prolonged slump set in early in the 1990s, the authorities repeatedly attempted to stimulate business using both fiscal and monetary tools. As a result of the fiscal spending and expanded government-backed credit guarantees, however, economic resources continued to be consumed in unproductive sectors, and that depressed labor productivity and lowered companies’ anticipated profit rates. The “natural rate of interest” (the expected return on savings and investments) is said to be expressed by the growth rate of the working-age population’s per capita GDP. When the natural rate of interest moves down, monetary relaxation may be unable to produce favorable results even if it succeeds in lowering interest rates.
Two contrasting aruguments have been formulated to explain why deflation has lasted so long. One sees deflation as a currency phenomenon, and it asserts that in order to reverse deflationary expectations, the BOJ must adopt an even more aggressive policy of monetary relaxation. If people observe inflation occurring, they will be less motivated to hold assets in the form of cash, and with real interest rates moving down, they will channel funds into housing and capital investment. The second argument holds that deflation is not a currency phenomenon but a phenomenon arising from developments in the real economy. In that case, monetary relaxation will not affect it. Japan’s slump has become protracted, it holds, because corporate productivity has been depressed by regulations on business activity and rigidity in the labor market. The way to halt deflation and revive the economy is, accordingly, to pursue deregulation and enhance labor mobility. The two viewpoints also lead to different prescriptions for fiscal policy. While the members of the first camp do not, in general, see any need for fast action to reduce the red ink in the budget, the members of the second urge that public finances be quickly restored to a healthy state before the ballooning national debt causes government bond prices and interest rates to start climbing.
Neither camp, however, has developed fully persuasive remedies for deflation. We need to understand that its persistence is, to a large extent, a result of demographic factors. When the long-term potential growth rate shifts down, long-term economic targets need to be appropriately reset. The growth target we should focus on is not the overall economy’s actual growth rate but the per capita potential growth rate. Fiscal and monetary tools do not have the ability to cancel the effects of contraction in the working-age population. Ensuring the sustainability of the social security system represents the most urgent and important issue Japan must address. Because the current generation doubts the reliability of this system, people are holding back on consumption and salting money away in savings accounts. Such behavior, needless to say, undercuts demand. The government must act to illuminate and eliminate the existing imbalances in intergenerational burdens and benefits, and it should also carry deregulation further in order to get resources utilized in the economy’s growth sectors.
No Time Left for Ducking Fundamental Reform
In an interview published in the daily Nikkei on December 11, BOJ Governor Shirakawa laid stress on the basic point that the factors lying behind Japan’s long-term slump have yet to be adequately clarified. “Understanding of the fundamental causes,” he said, “is insufficient. An economy’s future growth potential is essentially determined by the growth rate of the labor force population and labor productivity. These are the two factors that must be addressed in order to come up with a solution. The decline in the labor force, however, is only going to grow in scale over the years to come.” So what can be done to lift growth expectations and shake off the deflationary stagnation? Shirakawa suggests that more women and older people be encouraged to enter the labor force, and he also advocates action on the issues confronting the real economy, such as entry into free trade agreements, tax reform, and deregulation.
Obviously Shirakawa appreciates the need to add demographic factors to the conventional debate on deflation. He also recognizes the importance of strengthening the foundation for growth in strategic sectors, and in June 2010 the BOJ introduced a new lending system desiged to accomplish just that.[1. Billed as a “fund-provisioning measure to support strengthening the foundations for economic growth,” this is a lending system for projects in environmental, energy, and other growth fields funded by private financial institutions. The total amount of funds to be provided is ¥3 trillion, of which ¥1.46 trillion was allocated in the first two disbursements. The annual interest rate on the loans is 0.1%.] In setting up this system, the central bank was in effect sending a message on what ought to be done to overcome deflation, but the administration made only a dilatory response. Shirakawa himself insists that the BOJ and the administration have adequately coordinated their views and see the economy and the price situation in basically the same way, but in fact the administration’s economic policies reveal that it does not have even a rudimentary understanding of deflation despite all that Shirakawa has said about it. Furthermore, the budget the administration assembled for fiscal 2011, which begins in April, is a plan without any observable principles. One can only fear that in the political atmosphere of the budget’s deliberation in the National Diet, the administration will fail to present an outlook for fiscal policy capable of easing the people’s deep-seated distrust.
Before his appointment as governor of the Bank of Japan, Shirakawa wrote a book titled Gendai no kin’yū riron (Modern Monetary Theory) (Nihon Keizai Shimbunsha, 2008). In chapter 16 he writes, “In order to assure stable formation of interest rates on long-term government bonds, the most important needs are to manage monetary policy with the target of sustained growth in a context of price stability and, at the same time, to sustain trust in that posture of monetary policy management.” Economic textbooks state that the multiplier effect of fiscal expansion has limits, explaining that the additional fiscal spending accompanying increased issues of government bonds pushes long-term interest rates higher and restrains private investment through a crowding-out effect. When new government bonds are issued, though, the central bank can curb the climb in interest rates by means of “monetization,” or turning the bonds into legal tender by buying them from the public. This is precisely what the central banks of the developed countries have done in implemeting the latest round of monetary relaxation.
The budget prepared by the administration for fiscal 2011 amounts to ¥92.4 trillion, of which tax revenue will cover only ¥40.9 trillion. A somewhat larger portion of ¥44.3 trillion is to be financed by government bond issues, and the remaining ¥7.2 trillion will come from nontax revenue in such reserves as the Special Account for Foreign Exchange Funds. The administration brags about how it has put leadership in the hands of politicians, but in order to avoid any increase in the issue of government bonds, it had to call on the financial mandarins to secure nontax revenue. In the budgets for fiscal 2012 and thereafter, however, this source of extra funds will become unavailable. This is bad news for the spending plans of the Democratic Party of Japan. When it rode into power on a massive landslide in the August 2009 general election, the party held aloft a political manifesto containing a host of pledges, such as providing a child allowance and eliminating expressway tolls. Now it must gain the Diet’s approval of the administration’s budget, and it has no choice but to revise the manifesto, make deep cuts in what it promised to deliver, and indicate its willingness to cooperate in a major tax reform.
We are approaching the limit of the DPJ’s tactic of putting off action on fiscal reform, which has come at the price of relinquishing economic policy leadership to the Bank of Japan. While I sense that Governor Shirakawa overstepped his authority in having the BOJ establish a special lending system for strategic sectors, I am even more disappointed in the cowardliness of the administration, which made no response to Shirakawa’s message.
The graying of the Japanese population will continue to proceed at a pace unmatched by any other developed country, and this process will give rise to various difficulties. The way to cope is to implement policies that restore confidence in the social security system. The ongoing transfer of income to the country’s senior citizens is aggravating the fiscal deficit and suppressing consumption among the current generation of workers. A decade ago each elderly citizen was supported by the labor of four active workers, but now it is three workers, and a decade from now it will be only two. Japan’s social security and tax systems have not been structured to accommodate this demographic transformation. Government subsidies are being used to provide temporary stimulus to consumption, but they have only persuaded consumers to buy today what they would have bought tomorrow, setting the stage for a consumption slump. Monetary relaxation, meanwhile, lacks the power to lift the economy out of stagnation and set it on a new growth track, as I discussed earlier. We must put a stop to the bad habit of relying on expedient fiscal and monetary policies and putting off fundamental reform.
Translated from an original article in Japanese written for Japan Echo Web. [February 2011]