Banking Sector: Roots of Recession In Japan

Eventually, the Under-Secretary of the Treasury, Larry Summers, felt compelled during the summer to take the unprecedented step of making an outright criticism of the way the Japanese economy was being run. Reluctantly supporting the U.S. policy of supporting the declining yen and unhappy about the tentative nature of proposed economic and financial reforms, he bluntly declared that the yen would fall further unless meaningful steps were taken to redirect and reform the economy, especially the banking sector. Stanley Fischer, the deputy director of the International Monetary Fund was equally vocal in his criticisms, especially of the financial sector, saying "Japan's weak financial system has hampered the recovery of the economy for most of this decade".

These comments are themselves enough to draw attention to the plight of Japan. Coming from such influential figures, they illustrate the magnitude and seriousness of the problems facing the economy. The comments are also useful in that they treat some of the key issues of current problems. In this regard, Clinton's comments are particularly perspicacious because they contain the general observation that the procedures, arrangements and policies that served Japan well in the past may be now inhibiting recovery and contributing to the prospect of reduced growth after any recovery. This will be one of the main themes of this essay, as will the problems faced by the banking sector in Japan. Summers and Fischer have both identified the emasculated condition of the Japanese banking and financial sector of being of particular concern, which has outstanding delinquent loans of over ¥100 trillion according to some private sector estimates, equivalent in size to the whole Chinese economy. Rubin's concern over the macroeconomic state of Japan is well founded, since Japan appears to be in the throes of an extremely severe recession and appears to be immersed in a canonical Keynesian liquidity trap and a Fisherian debt deflation scenario.

These issues will also be discussed in this essay, which attempts to provide an explanation of current problems, in terms of their cause and course. Japan faces major changes to its economic and financial systems, and from this are likely to proceed widespread and permanent alterations to the political and social fabric of Japanese society. Already, during the course of the current slump, the Liberal Democratic Party (LDP) experienced an interruption to the rule it had experienced virtually unchallenged since the end of World War II. The causes, consequences and significance of the changes in the economic and financial sphere are analysed, and the review begins with a brief description of the Japanese asset price bubble of the late 1980s, but the emphasis in the essay is on contemporary responses to contemporary problems.

The essay therefore proceeds in the following manner: the asset price bubble is discussed with reference to the activities of the banks during this period. This involves a lengthy discussion of the industrial structure of Japan, where banks play an extremely influential role. The industrial structure is one of the many aspects of the Japanese economy which is faced with widespread change and thus is of interest in its own right. Theoretical analyses of financial sector problems and their implications for the macroeconomy are then discussed. A brief review of the macroeconomic condition is then presented, and this section shows how the problems faced by the banks are an extremely important factor in explaining the present state of Japan, but the discussion also shows how fiscal and monetary policies have introduced problems of their own as well as compounding the problems faced by the banking sector. Recent attempts to solve the banking crisis and assess their success in the light of events since the introduction of reforms will then be described. Current problems and the corresponding policy responses that face the economy as a whole conclude the essay.

The bubble has had important ramifications on the present state of the banks, whose condition is undoubtedly at the root of so much of Japans current malaise. The bubble economy may be said to have begun with the Plaza Accord of 1985, designed to reduce the burgeoning current account deficits of the U.S. The agreement resulted in a doubling of the value of the yen, which represented a sharp shock to an economy that had hitherto enjoyed export based economic growth. The immediate result was that the economy fell briefly into recession to usher in the period of endaka or ‘high yen crisis'. The Bank of Japan responded by cutting interest rates, so that by February 1987 official discount rates had reached a post-war low of 2.5% and the endaka was overcome. As soon as the economy had reverted to this more solid growth trajectory, the Bank of Japan was reluctant to raise interest rates to pre-endaka levels because of the subsequent Louvre Accord, which stipulated that the signatories try to keep exchange rates ‘around current levels'. The stock market crash of October 1987 also raised fears that a premature tightening of monetary policy could have disastrous effects on the financial system.

The bubble started because of the enormous amount of liquidity available to borrowers implicit in such low interest rates. The structure of the ensuing bubble basically revolved around the practice of using the rising value of property as collateral for speculative borrowing. Much of this speculation was directed towards equity and property markets, thus intensifying the process of borrowing and speculation. Valuations in these markets reached staggering levels; at the height of the bubble Japanese real estate represented one third of all wealth in the world and the capitalized value of the stock market stood at 42% of world stock market value. In theory, Japan could have bought Canada or Australia simply by selling the land underneath the Imperial Palace or the whole of the U.S. by selling off downtown Tokyo. To understand the condition of the banks and their activities during the bubble, a lengthy analysis into the structure of industry and banking is necessary, which is of importance in its own right as it allows insight into some of the most significant features of the Japanese economy.

An important feature of the Japanese economy and its current slump is the three way connection between companies, other group companies and their main banks. Japanese companies rely on funds provided by banks to a far greater extent than in any comparable economy. In a survey conducted in 1992 of 110,000 companies, 90% felt that they had some sort of main bank relationship. This relationship must be considered within the network of the keiretsu, a group of companies linked by cross-shareholdings, business contracts, mutual co-operation and often a common name. Keiretsu may be horizontal (across different suppliers) or vertical (between a manufacturer and its suppliers, distributors and retailers). Since there is generally extensive cross holdings of equity, implying reciprocal ownership, the members of the keiretsu are effectively safe from hostile takeover. Garuda supplies the following example of the Mitsubishi keiretsu. In 1987, Mitsubishi Bank owned 4.6% of Mitsubishi Heavy Industries. In turn, Mitsubishi Heavy Industries owned 3.5% of the equity of the bank. As Garuda notes "Although such cross shareholdings are small on a bilateral basis, they are substantial for the group at large. In aggregate, more than 20% of all the outstanding shares of Mitsubishi group companies are held by others within the group. Still more stock is in the hands of peripheral group companies, which typically maintain weaker but still significant ties to the main bank".

In theory, this means that managers can concentrate on long term decisions, and not have to worry about dressing up earnings reports, purely for the sake of avoiding the attention of aggressively acquisitive competitors and the ire of impatient shareholders. Similarly, all keiretsu have a close relationship with a main bank, often a member of the keiretsu itself. The bank is supposed to take a long term view, allowing them to provide readily available, committed finance to develop client investment projects. In many cases, because of large equity holdings, banks often have the right to appoint directors, implying very close relationships. The bank therefore has the incentive to monitor the firm very closely, and it is especially competent to do this because of access to detailed accounts and records at the firms. This information will in some cases be known only by the firm and its bank; a problem exacerbated by the intricacies of the Japanese accountancy system. An important consequence of this system of business practice is that firms face relatively little pressure from shareholders and other investors, since the main bank is generally accepted as being the primary agency for monitoring the firm and for collecting information relating to the outcome of the firms investment decisions. This generates a type of inertia on behalf of investors, who will be reluctant to commit resources and time in acquiring difficult to obtain information. These areas became a hotbed for corruption. The difficulties of the firm were often overlooked by compliant or bribed bank and regulatory officials, anxious not to perturb the value of their own equity holdings by revealing damaging information.

Banks were able to use the rising stock prices to increase their capital and thus their lending. They did this by issuing equity warrant bonds in the London Eurobond market. This allowed the banks to borrow money by issuing bonds with very low rates of interest; attached to the bond was a warrant that allowed the owner of the bond to acquire some of the equity of the borrower. Unsurprisingly, investors eagerly snapped up these bonds, anxious to participate in the Tokyo bull run. These means, the banks were enabled to increase their Tier 1 capital.

To understand the significance of this, a discussion of an important element in bank regulation is necessary. The Basle Accord of the late 1980s constituted an attempt to ensure higher standards of capital adequacy. Japanese regulators had long held that the cross shareholdings of other keiretsu firms that were on the banks books constituted a ‘capital cushion'. After considerable international debate, these equity holdings were allowed as Tier 2 capital, provided the bank had sufficient Tier 1 capital. This contributed dramatically to the bubble, creating "an obvious nexus between the degree of constraint on Japanese bank expansion and the health of the stock market". The significance of this is illustrated by the fact that the banks have typically held 20% of the stock market, and that banks themselves constitute about 25% of the main stock market benchmark index, the Topix.

This capability of stock market movements to dramatically alter the capital of banks was not helped by the keiretsu system. Just as banks held some of the shares in other keiretsu members, the flip side of the coin, as noted above in the Mitsubishi keiretsu example, is that the companies also held equity in the bank. These companies almost never sell their stake for fear of giving offense and losing access to credit in the future, despite any difficulties the bank may be in. An example of the perversity of the keiretsu system was analysed by McKinsey management consultants and discussed by Wood. Between 1984 and 1990 Japanese banks reported an annual average profit increase of 13%, but if profits from long term shareholdings and short term stock market speculation are excluded, McKinsey calculated that the annual average increase in their underlying business was only 1%. The banks generated no extra cash by these deals and thus no profits, even though they registered large taxable gains. Under the keiretsu system, they immediately had to buy back these shares at prevailing bull market prices. By 1991 an average of 42% of the reported profits of the large banks came from these largely mythical securities gains.

Moreover, bank shares are held by fund managers because they account for 25% of the Topix. Therefore, as Wood notes, not to hold bank shares "is to make a career threatening bet against the value of the Topix". So a re-adjustment to fundamental value would have a huge downward effect on the stockmarket, on which depends the banks capital, as well as on the bank's themselves and the rest of the financial system.

The fudge inherent in the Basle Accord meant that the banks could literally create their own capital, which meant that they could extend more loans. These loans were invariably directed into the property and stock markets, which in turn boosted the collateral value of products from these markets, which in turn boosted the lending. In 1987 and 1988, loans collateralized by property accounted for more than half of the large banks incremental loan growth. This is the truly disturbing aspect of the stratospheric asset price inflation of this period. The issue is not so much that the price of land and stocks rose so quickly, but the means by which these rises were engineered by greedy banks and their compliant regulators. The manner in which these prices were achieved meant that the banks were extremely sensitive to price declines in these areas. Davis has drawn attention to a number of why reasons why banks seemed to find property speculation an attractive proposition.

Collateral is readily available in the form of the property itself; banks in Japan appeared to overlook the potential illiquidity of this collateral. The sizeable front end fees add to profits immediately and help attain market share. The problems that Japans banks faced, and still face, is that this leads to balance sheet concentration and left them highly vulnerable to long term interest changes. As he points out "the heterogeniety and legal complexity of property rights results in higher transactions costs, greater information asymmetry, lower marketability and greater risks than in other asset markets" which means the results when things go wrong can be extremely painful. In Japan, the problem is even worse, because in many cases the same piece of property will be pledged in a number of separate loans.

A discussion of the facts of land use is necessary. This is intended to show that land, other than purely speculative real estate, did not appear to have been the subject of bubble dynamics and thus did not appear to be valued to far above fundamentals. However, the sheer anxiety of banks in Japan to commit as much of their resources to property as possible meant that the implications for the banks of a collapse in property values were as serious as if the land price rises were the result of a bubble, which may or may not have existed for all classes of land in Tokyo during this period. Less than 5% of the land in Japan is used to house all of the population. In terms of density, Japans population per unit of habitable area is 30 times that of the U.S.. 62% of Japanese households own their home. Underutilization is caused by the near impossibility of evicting existing tenants- leases are effectively renewable indefinitely while rent increases are strictly limited. Strict regulations on zoning and height also apply. All the incentives favour holding land rather than developing it, thus limiting supply. If land is sold within two years of its purchase then 150% of the capital gain is added to the sellers annual income, and if sold within 5 years then 100% of the gain is added to income and taxed accordingly. On the other hand yearly taxes to hold land during the bubble were about 0.05% to 0.10%. For inheritance tax purposes, land is generally taxed at well below market value, unlike other financial assets. Therefore, the Japanese property market is extremely illiquid, so that whenever new property came to the market, it unsurprisingly tended to attract aggressive attention. Ziemba therefore suggest that non-speculative land prices in Tokyo were overvalued by only 10%. In this case, it is difficult to understand why banks should be in so much present difficulty. However, as I have said, it is the manner in which these price rises were engineered by the banks that is of importance. Stone and Ziemba also present evidence of a 99% correlation between biannual series of land and stock prices for the period March 1955 to September 1992. No such correlation is present in the U.S. data, suggesting some factor unique to Japan. This factor can only be the activities of the banks.

The bubble burst partly because of the incipient Gulf War, but primarily because interest rates were hiked from 2.5% to over 6% by end of 1991, after the Bank of Japan finally got concerned about the escalating asset prices. At the end of the bubble period in June 1991, at which time the stock market and land markets had declined by about 60% of their peaks, the main banks had lent Y116 trillion to property and construction firms and the value of loans collateralized by land represented an astonishing 50% of GNP. Because some of the firms that banks lent to were not directly involved in construction but still speculated in the market, property has been estimated as supporting as much as 80% of banks total loan exposure.

The amount of negative equity for the owner of a typical Tokyo apartment is now estimated at 12-15 million yen, and many people are 6 months in arrears on mortgage repayments. The OECD has suggested that this may represent a restriction of ½ trillion yen per year on consumption. In Table 4 I provide interesting data on the impact of the bursting of the bubble. The data contained therein provide stark evidence of the gigantic effect that the collapse of the asset prices had on the value of capital and net worth. My main contention with respect to the banking sector is that this shock to asset and collateral value is the main economic (as opposed to political) fact inhibiting recovery of the Japanese economy. This is not necessarily the type of outcome that would be predicted by all varieties of financial theory; in an Arrow-Debreu world of contingency and frictionless markets and perfect information, such a statement would not be tenable. Alternatively, appeal may be made to the Modigliani-Miller theory of finance which states that under certain conditions, the financial system is essentially irrelevant for outcomes in the real economy. Below, I present some recent theoretical analyses of this type of shock to support my contention. More recent problems and current policy responses to the problems generated by this episode are discussed later in the essay. I now turn to the macroeconomic implications and theoretical analyses of the banks difficulties.

Modern theoretical analyses of this type of situation have been pioneered by Ben Bernanke and Mark Gerteler. In two papers, they argue for the pre-eminent role played by borrower net worth in financial fragility and macroeconomic fluctuations. They define a financially fragile situation as one in which borrowers have low wealth relative to the size of their projects. This is because the less of his own wealth a borrower can commit "the more his interests will diverge from those of the people who have lent to him". This issue will be recognized by the lender so that agency costs, and therefore the cost of investing, will also rise. This implies investment accelerator effects- healthy balance sheets increase investment demand and thus boost the economy as a whole; the opposite is true for a downturn and this analysis clearly applies to Japan at present. Bernanke and Gerteler identify such a situation as likely to happen in a prolonged recession or subsequent to a debt deflation. Japan is certainly in the former case and compelling reasons exist for believing that the economy is already in a deflationary crisis. During a debt deflation there is a fall in borrower net worth due to a decline in the relative price of collateral; the causal influence of the banks condition on the process of deflation is examined below.

Ben Bernanke has developed an influential theory of the Great Depression in the U.S. in the 1930s which follows from his observation that bank failures tended to be coincident with adverse developments in the macroeconomy. He seeks to extend and improve on the monetarist analysis of the role of the banks in this period, which he claims tends to rely too heavily on the contraction of money demand caused by a fall in bank lending in this period, arguing that the fall in money supply is quantitatively too small to account for the huge downturn in output. His theory revolves around the role played by the cost of credit intermediation, which he defines as the cost of channeling funds from ultimate savers/lenders into hands of those who desire loans in order to undertake investment projects. With a fall in collateral value (consider Table 4 again to see how large the declines in Japan are), the representative investor becomes more and more insolvent. Every class of loan now faces a higher risk of default. Consequently, lending is restricted because the cost of credit intermediation has risen because the new riskiness means higher interest rates, which is likely to be a self defeating process. Although Bernanke's theory accords an important role to the effects of panic and bank runs as well as the monetary contraction, it is supportive of the notion that the collapse in credit causes an increase in debt through its effect on collateral. In turn, this will hurt output. Another related issue that is important for Japan at present is the liquidity of collateral; property is Japan tends to be very illiquid because of the very slow volume in the market caused by the benefits from holding land. Furthermore, property, especially speculative downtown real estate, tends to be illiquid- for example, how many buyers will want a multi-storey skyscraper with specifications designed for the late 1980s and located in a particular part of town?

Aside from the implied increase in agency costs of credit intermediation that the above predictions entail, there are significant associated costs with debt deflation; a situation first analysed by Irving Fisher. "Each dollar of debt still unpaid becomes a bigger dollar…the every effort of individuals to lessen the burden of their debt increases it, because of the mass effect of the stampede to liquidate…the more the debtors pay, the more they owe". In other words, holding cash during deflation rewards the holder at a rate directly proportional to the rate of decline in prices. As Gerteler notes, this is a redistribution from debtors to creditors, and as this class includes those most efficient at managing investment projects, investment and output will decline. Because of the main banks relationship, firms have generally had much higher debt levels than their U.S. counterparts but the more general debt problem that Japan faces is that they acquired too many assets at too high a price and now liquid markets do not exist to allow for disposal. Therefore, in a deflationary environment, with a fall expected in prices, consumers have an incentive to defer as many purchases as possible till tomorrow. This is a serious problem for current Japanese fiscal and monetary policy. John Makin has pointed out that current Japanese inflation indexes understate the amount of deflation present in the Japanese economy because they fail to measure falling prices in newer, more competitive retail units. Noting the switch into cash, a sure sign of deflation, he makes the following observation "For a Japanese household, the 0.2% offered by banks on time deposits does not compensate for the widely advertised risk that many financial institutions may be insolvent".

This discussion of the effects of declining prices and very low interest rates points to an observation that is increasingly becoming more apparent in the West and in Japan. This is that Japan appears to be immured in the depths of a canonical Keynesian liquidity trap. Paul Krugman at M.I.T. has been at the forefront of efforts to redirect scholarly attention to a neglected area of modern macroeconomics. In the following section, I show how inappropriate fiscal and monetary policies have rendered monetary policy impotent and exhausted the potentialities of expansionary fiscal policy. Once again, the condition of the banks will obstruct much of the advice that would flow from this investigation, because the banks are themselves a constituent of the failure of monetary and fiscal policy.

A country may be said to be in a liquidity trap if, because of poor long term growth prospects, the short term real interest rate may have to be negative to match full employment savings and investment. In this situation aggregate demand may "consistently fall short of productive capacity despite essentially zero short term nominal interest rates". Official rates in October were less than 30 basis points above zero. Krugman suggests that even with a very optimistic estimate of growth in productive capacity of 2% since 1990 the economy appears to be operating at well below capacity.

Monetary policy can't be used by the Central Bank to reinflate the economy because with near zero nominal interest rates, a Central Bank monetary injection in the form of bonds will have no effect since cash and bonds will be close substitutes once for another. The key point to understand, as Krugman points out, if people have low expectations about their future income, they may want to save more than the economy can absorb, despite extremely low nominal interest rates. The upcoming decline in the labour force will reduce the return on investments, thus adding impetus to the desire to save. This problem of an ageing population is central to an understanding of the contemporary Japanese economy and its liquidity trap. The 1.2 million live births born at the peak of the bubble in 1990 was the lowest since 1893, compared with half a million more births a decade earlier. The population is expected to decline in absolute terms after the end of the next decade. Optimistic projections put the ratio of those over 65 to those aged between 20 and 64 to rise from 0.23 in 1995 to 0.65 in 2050. The Japanese saving rate has fluctuated between 15-20% since the 1950s and has consistently been one of the highest in the OECD. If individuals are saving mainly for retirement, as predicted by the Ando-Modigliani life cycle hypothesis, then this represents an important constraint on Japanese fiscal policy. A recent study of this very issue by Japanese economists provides very strong support in favour of the life cycle hypothesis.

In a study of the implications of Japan's declining population for economic growth, it was noted that a declining labour force, caused by a decline in fertility rates may help to stimulate efficient technological changes ‘by tightening labour and capital resource complaints', so that the source of economic growth will shift to being driven by efficiency gains, rather than being input driven. This, however, is a long run analysis and not immediately applicable to the medium term implications of an ageing society for the liquidity trap. In any case, it still implies a lower long run rate of growth, with immediate consequences for the decisions of ordinary consumers as to whether or not to save or spend.

Therefore, it is not implausible that the equilibrium real interest rate is negative, leading to Krugman's recommendation of a period of sustained inflation to get the economy of its current illiquid deflationary scenario. This argument implies that the central bank needs to convince agents that it will not reverse its monetary expansion once inflation starts to kick in. In other words, the Central Bank has to make a credible promise to be ‘irresponsible'. This thesis - that Japan needs inflation - has been winning advocates both inside and outside of Japan, where the most prominent advocate is Kezuo Ueda, who sits on the Bank of Japans policy board. The recommendations are not uncontroversial, however. For one thing, despite the seriousness of the slump, the pedestrian observation that the inflation will raise long term interest rates still holds and this may cripple debt ridden firms. As The Economist has pointed out, the monetary injection necessary to produce the inflation will be intermediated by the commercial banks, and given the decimated nature of banks balance sheets, it is likely that the banks would use the injection to consolidate their capital base and patch up their balance sheets. Another problem is that even if the monetary expansion is successful in creating inflation, the subsequent depreciation of the yen may have extremely serious outcomes for the economies of South East Asia, struggling desperately to recover from their own financial crisis.

Any depreciation of the yen would also hurt those sectors who have borrowed heavily abroad; most conspicuous amongst this class are, once again, the banks. At the collapse of the bubble nearly 50% of the city banks assets were denominated in foreign currency, a consequence of the huge increase in overseas lending in the 1980s. Like so many of the problems facing Japan, her liquidity trap is tied up in the difficulties of the banking sector, an ageing population and extremely tough decisions which will affect different sectors of society in dramatically different ways. This brings us back to the banks and the current policy responses to this extremely grave situation. The state of the economy and possibilities for the future are discussed after a review of the proposals dealing with the banking industry, itself one of the most crucial elements in the future success of the economy.

On the 17^th October 1998, new Prime Minister Keizo Obuchi managed to push through the Diet, a mammoth banking bill which represents the most concerted efforts of the government yet witnessed in the current crisis to deal conclusively with the banks. The bill was introduced against the background of huge numbers of corporate failures and instances of corporate distress. Even comparatively healthy banks are accumulating bad debts faster than the growth in their profits, so that no new provisioning against bad debts is possible after new ones have been provided for. The broad goal of the package is to deal effectively with bank failures and thereby help the banking system to become a source of strength, rather than instability, within the economy as a whole.

The package provides funds equivalent to 10% of Japan's GDP. This ¥60 trillion is be directed in two main ways. ¥43 trillion is to be provided for ‘nationalising' banks about to fail and ¥17 trillion is to be provided for recapitalisation of weak but viable banks. Under the nationalisation scheme, the government intends to acquire a significant portion of the shares of a company in an effort to stop shareholders profiting from state handouts to the banks. Depositors funds will be guaranteed until 2001. For the failed banks, a type of receiver will be appointed by the Financial Services Agency (FSA) to ensure that the business of the banks is continued and neither borrowers nor depositors suffer. The recapitalisation scheme is directed mainly to the larger banks in recognition of their importance for the economy as a whole by boosting lending and by absorbing failing banks by merging. The programme will operate by having the banks apply for funds whenever their capital to risk asset ratio falls below the BIS required level of 8%.

At least part of the rationale of the package can be seen as an attempt to secure the well being of banks deemed ‘too large to fail'. The FSA also has the job of inspecting the condition of the 19 most important bank, but the agency has a staff of only 550 and moreover, many of the professional staff are former Ministry of Finance officials which does not bode well for the objectivity of its operations. Bad debts are to be put under the control of the Resolution and Collection Bank (RCB) for collection and sale of collateral. It will also mediate amongst creditors to determine ownership of collateral. So far, however, it has been conspicuous in its reluctance to sell assets.

For the fiscal year ended 31^st March 1998, the city banks had made provisions against non-performing loans (NPLs) of ¥10.5 trillion, the largest ever figure, achieved mostly through increased reserve levels (dealing with debt). In line with the Prompt Corrective Action guidelines introduced on 1 April 1998 and the adoption of US Securities Exchange Commision rules about accounting, the banks own unaudited assessment of their problem loans put the figure at ¥77 trillion, although most observers expect the true figure to be well over ¥100 trillion. The provision brings the total loan loss charges over the past years to around ¥38 trillion. If this figure seems large, it must be remembered that by the end of 1991, none of the significant banks had made any provisions against bad debts and that the capital of the 146 largest banks is ¥31 trillion. A more serious issue is that these loans have been merely written down, and not written off. When a loan is written off, its value is automatically zero, and the bank can suffer no further losses in connection with that loan. When a loan is written down, it stays on the balance sheet at a reduced value, and the backing collateral is not sold, so the bank must set aside more reserves if the collateral- usually real estate- falls further in value. I have attempted to show how (perhaps ad nauseum) important the banks are to understanding the state of Japan. The banks emaciated condition makes them less able to intermediate credit; the solutions to the liquidity trap suggested by Krugman could be neutralised if the banks used monetary injections to patch up balance sheets; the huge amount of negative equity and declining net worth caused by the activities of the banks is increasing risk aversion among potential investors. Now, huge amounts of public money are being directed towards the sector, involving taxes and yet more national debt. I turn now to the present condition of the economy and its prospects.

The current macroeconomic condition gives little comfort. An election is widely expected in the latter half of this year, and there has been a tendency to pursue expansionary spending policies before an election and then contracting afterwards. This is what happened in 1996-97. In the period 1993-96, the government flooded the money markets with liquidity and introduced a fiscal stimulus equivalent to Y60 trillion or 3% of GDP. Growth had averaged barely 1% in the period 1992-95 and hit a low in 1993. The stimulus managed to raise the growth rate to over 3% by the end of the 1996 fiscal year and avert some of the corporate failures and bank collapses that Japan is now witnessing; corporate profits are currently down by 25%. The Hashimoto administration, with an eye to the sustainability of fiscal policy in light of the upcoming demographic pressure, pursued a sharply contractionary fiscal policy in 1997, imposing a 2%-3% tax on consumer consumption and cutting public works expenditure by 14% that wiped out the previous years growth gains. Hashimoto also seems to have initiated deregulation of the financial markets at the wrong time, since the measures will lead to a contraction in the amount of credit banks can extend, precisely a time when the government was trying revive the ailing banks. Business and consumer confidence was further damaged by a series of banking and financial scandals and private consumption and residential investment has collapsed. Consumers willingness to spend has fallen to its lowest since the 1960s.

In response to the obviously detrimental effects of the previously contractionary budget, the government undertook an embarrassing U-turn and introduced a supplementary budget in February 1998 for fiscal year 1997 that included a¥2 trillion worth of tax cuts. For the current fiscal year, each taxpayer will be receiving a rebate worth about ¥25,000, and the amount of spending will work out at about the size of the Polish economy. Critics have argued that such huge spending is unnecessary in a country that does not need any new bridges or roads.

In the labour market, there is growing evidence of skills mismatch, and unemployment reached a post-war high of 4.3% in June 1998, and appears to be heading towards 5%. Net exports fell in the first quarter of 1998 by 3.7% because of the Asian crisis; Barclays bank has estimated that the Asian crisis will reduce growth by between 0.5% to 1% as exports fall and competition increases in third country markets. This has occurred despite the fact that by the summer one US dollar was worth over 140 yen, representing an eight year low. The decline was due to the extremely easy monetary policy and differing growth prospects for the two economies. At the launch of the euro, the yen had regained some ground to stand at 111 to the dollar.

This was the first drop in exports since the endaka or high yen crisis of the mid 1980s. With capital spending down in the first quarter by 5.1% and the public debt expected to rise to almost 110%, the macroeconomic outlook on the whole is unambiguously grim. Morgan Stanley Dean Witter Research forecasts for the new two years are given in the Appendix as Table 2. Looking at these figures suggests that at this moment in time, it is hard to see any prospects for an upturn in the immediate future. Policy makers in Japan have been justifiably preoccupied over recent years with the problems of the banking sector and apart from the above fiscal stimulus, little in the way of macroeconomic solutions has been proposed. Fiscal stimulus can not give boosts to an economy forever, especially with the large public debt tending to make consumers more Ricardian in their outlook. At this stage it seems that Krugmans recommendations of a period of sustained inflation are the most viable ideas yet proposed. Japan may be assisted in this regard if other major countries also ran an inflation to assist them.

To return to an issue I raised at the start of this essay, what is at least clear from Japan's economic debacle of the 1990s is that factors which boosted Japan's economic growth in the past may be now inhibiting growth. Nouriel Roubini has identified areas where Japan needs to change. The first is a willingness to accept greater global competition, arguing that the reluctance to liberalize trade has prevented the type of structural adjustment that the US went through in the 1980s. In the 1980s, he points out the US suffered from freer trade and stronger competition but the benefits this restructuring forced are now being reaped. He also argues for general corporate restructuring, to destroy the oligopolistic and over-regulated markets that characterise the Japanese non-traded sector. A transition is also required away from manufacturing to the provision of high value-added services. Moreover, the traditional keiretsu firm is much less suited to services than to manufacturing, because of the reluctance of the keirestu to cut out group middlemen. Perhaps most necessary of all, however, are the difficult and significant decisions required to reform the banking sector, whose difficulties are an unavoidable obstacle to be overcome if the economy is ever to return to a more optimistic outlook.

The Japanese economy depends on the ability of the workforce and firms to endure the painful downsizing and readjustments that America witnessed in the 1980s. The quality of the recovery will be determined by the effectiveness of the responses to these difficult realities. They have shown in the past that they are an extremely adaptable people, especially after the Meji restoration of 1867 and after WW2. What is certain is that Japan is moving towards a more US style of capitalism. As the New York Times put it:

With the economy stuck between a rock and a hard place, it looks like the Japanese people have no option but to change their society irrevocably.

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