Japan: Monetary Action -- Necessary but Not Sufficient
Robert Alan Feldman (Tokyo)
Morgan Stanley
Mar 10, 2003
Is it too late for Japan? The monetization is now complete along the yield curve. So is hyperinflation the next stop? Is Japan about to enter its Weimar Republic phase? Recently, questions of this sort have come more frequently from investors, particularly foreign investors. Moreover, the questions are coming from investors who have little direct interest in Japan. Examples include European investors who worry that Germany might be the next Japan, or that somewhere else might be the next Japan. In particular, criticism has been targeted at the Fed and ECB for not moving aggressively enough in the face of deflation potential. Japan is cited as the example of what not to do, for example, in a paper by the Federal Reserve (“Preventing Deflation: Lessons from Japan’s Experience in the 1990s,” by Ahearne et al., June 2002).
Although I agree that Japan has provided some examples of what other countries should not do (just as have European and North American economies at times), the contention that monetary policy was the key failure is, in my view, absurd. Rather, the key omission was an aggressive approach to structural reform in both financial and industrial sectors. To support this contention, let me review some of the history of the 1990s.
Myth 1: Mieno Pricked the Bubble
One of the key myths is that Gov. Mieno pricked the Japanese equity and land bubbles. While Mieno’s appointment clearly changed expectations, the actual shift of monetary policy had begun long before he took office. Indeed, Gov. Sumita (his predecessor) knew that the equity/land bubble was a threat, and finally implemented the first rate hike in May 1989 (75 bps), when the stock market was at 34,000 (up by about 25% in the year to that hike). The stock market and the land market ignored him. Gov. Sumita hiked again in October (50bps), when the stock market was at 35,000. Again, the markets ignored him. Gov. Mieno took office in December, 1989, and hiked that month (50bps), when the market was 38,000. This time, the equity market got the message, but the land market did not. Land prices kept rising for another year. When industrial production began to plateau and inflation showed its very first signs of peaking in mid-1991, Mieno reversed course. His first cut was July 1991, taking the discount rate from 6% to 5.5%. He cut rates twice more in 1991, for a cumulative cut of 150bp. By year end, inflation was down to 2.5%.
There was nothing slow about Mieno’s reaction to the peak of inflation or the business cycle. This is especially true when compared to the reaction of PM Miyazawa, who was reputed to be adept at economic policy. Miyazawa refused to use active fiscal policy -- despite a fiscal surplus of 3% of GDP -- until August 1992 -- fully 15 months AFTER Mieno started to move. And when Miyazawa finally did announce a fiscal support package, the equity market rebounded sharply. In this case, the fault lay not with Mieno for not cutting early or enough, but rather with Miyazawa for dawdling. And no one even discussed the adequacy of the financial regulatory system at the time.
Myth 2: Faster Rate Cuts Could Have Saved Japan
Mieno is next accused of not cutting fast enough thereafter, but this accusation is unsupported, in my view, for two reasons. First, as the Fed report admitted, the economic forecasts of the time did not consider deflation to be a real threat. In fact, if you use the Taylor rule logic of the Fed paper and insert a plausible estimate of potential GDP from that time, his policies seem about right. (See data below). The real short term rate (measured by the unconditional call rate minus year-to-year change of the CPI, ex fresh food, and adjusting for consumption tax changes) peaked at 5.3% in 3Q90, fell to 4.4% a year later, but was smushed to only 2.1% in autumn 1992. Mieno did not overdo it in 1990-92, and he cut real rates quite substantially in 1993-94.
Second, and far more important, the financial oversight authorities (at that time, the Ministry of Finance) were proving themselves wholly naïve (and some commentators have attributed darker motives) about the nature and extent of the bad loan problem. As bad loans piled up, the authorities dragged their feet on accurate inspections, and relied on profit taking of quickly vanishing gains on equity holdings to reassure the public that the system was sound. Indeed, parts of the MoF and parts of the political world were hoping that the BoJ would print enough money to bail the whole system out. The willingness of the BoJ to do the right thing in the early 1990s gave hope to those managing regulatory policy that their own mistakes could be concealed. The public did not buy the MoF’s sanguine view, and confidence in the financial system eroded.
Myth 3: Monetary Policy Can Work when the Financial System Is Broken
By 1995, coordination between the BoJ and the regulatory authorities became essential -- but was not to occur. This presented the BoJ with a dilemma: If the regulatory authorities fail in their job, the central bank becomes overloaded. It must handle both the moral hazard problem (which requires high rates to squeeze out misallocated capital) and recession (which requires low rates to spur activity). This is a dilemma that no one can solve. If a beneficial outcome for the economy requires coordination, but the policy counterpart refuses to coordinate, is it better for the central bank to give priority to the moral hazard issue or to the cyclical issue? With the economy recovering in 1993-94, the question was left hanging as Gov. Mieno left office.
Mieno's successor, Gov. Matsushita, ducked the problem, but it came back to haunt him and eventually cost him his job. Lax oversight practices resulted in the collapse of several financial institutions in 1997 and in entertainment scandals at both the Ministry of Finance and the BoJ (in both cases, officials had accepted lavish entertainment in return for favorable regulatory decisions). At this point, Gov. Hayami was appointed, and had to clean up the mess. Unfortunately, his counterparts, the financial regulatory authorities, remained in disarray. There was a merry-go-round of changes of presiding minister, so that policy was not stable. Public confidence fell even more. In addition, the regulatory authorities were severely understaffed. To boot, the capital weakness of financial institutions -- coupled with lax oversight -- encouraged the misclassification of loans and lax definitions of capital.
The result was that banks were forced, year after year, to admit that their initial assessments of NPLs were wildly optimistic, and to take huge hits to their capital. Public injections were required in 1999, in order to stave off under-capitalization of major institutions. With the dramatic collapse in September 2001 of a retail company that the authorities had allowed to be classified as only moderately troubled, the public smelled deception again. Only after September 2002, when the FSA accepted BoJ ideas on more credible loan classification and IMF ideas on stricter definition of capital, was the groundwork for successful monetary policy re-laid.
The Real Lesson: Effective Monetary Policy Requires Effective Structural Policy
So we get back to the debate on what monetary policy should do. For those who think that ending deflation simply means lowering rates a lot and/or printing a lot of money, Japan’s experience should toll a warning bell. Base money is up by 80% since 1997, while deflation has continued. Even monetarists in Japan now agree that the collapse of money velocity cannot stop without structural reform. Moreover, the Weimar experience suggests that rapid money printing will not end the troubles of the Japanese economy. Even in less dramatic contexts, no one has ever argued that high inflation improves resource allocation -- even if it removes bank debt at the expense of creditors. On the contrary, capital flight is the natural result of such an approach, in the wake of which both confidence and real investment collapse.
I agree with my colleagues that it is necessary for the ECB and the Fed to move aggressively, in order to prevent deflation. Where my approach differs is on the question of whether monetary aggressiveness is sufficient. Easy money was NOT sufficient for Japan to avoid deflation. Structural policies were necessary too. In my view, the real lesson from Japan will be learned only when both Europe and the United States focus on the heavy, political issues of dealing with structural impediments to resource re-allocation in their own economies.
By the way, I do NOT think that Japan is about to enter a Weimar Republic phase. Too much has progressed on the structural side, particularly in the last few months, for this to be the most likely scenario. Japan, at least, appears to have learned the lesson of its own recent history.
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