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Friday, Dec 13, 2002

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Deflation and economic slump — Japan's wait for another Keynes

P. Nagarajan

Japan is in desperate conditions. Bringing it back to a robust economic growth path is no easy task. The real solution lies in finding an appropriate policy-mix, with structural reforms, to revive the economy. Besides national economic policy measures, some well-coordinated complementary policies of the developed countries are essential to tackle Japan's deflation and economic stagnation.

JAPAN is home to 127 million people, equivalent to just 2 per cent of the world's population. However, it is the world's second-largest national economy, with a $4.1 trillion GDP, accounting for 13.5 per cent of the world's output in 2001. It remains the world's largest net creditor.

Also, Japan is known for its impressive savings performance, with the average annual national savings rate exceeding 30 per cent of GDP during the past four decades. The yen is the world's third most widely traded currency (behind the US dollar and the euro) in the foreign exchange market.

Japan, the economic juggernaut, achieved unprecedented economic growth and outperformed other countries from the 1950s through the 1980s. It became a leading manufacturing and exporting powerhouse of the world. Its financial system, industrial strategy, macroeconomic policies, business and labour-market practices received wider acclaim.

Economic pundits extolled Japan as a model economy. They widely believed that Japan would surpass the US to become the richest nation in the world, and the 21st century would be the "Asian Century" led by Japan.

Unfortunately, things did not turn out that way. Now, the `model economy' has been gripped with seemingly intractable economic and financial woes since the 1990s. It all started with the surging asset prices and its collapse. The Nikkei stock index trebled between end-1985 and end-1989, primarily fuelled by explosive bank lending and lax monetary policy.

The bubble burst in early 1990, following an increase in Japanese short-term interest rate to 6.0 per cent in 1990, from 2.5 per cent in 1989. The collapse of the asset prices has dragged the economy into a protracted economic and financial crisis. Who could have foreseen that Japan's economic miracle would turn into an economic debacle, and the 1990s would become Japan's `lost decade'?

Japan is in desperate conditions. Its crisis-ridden economy, with falling prices, shrinking output, anaemic aggregate demand and rising unemployment, has not been responding to the conventional monetary and fiscal policy measures. Economists and policymakers face a daunting task of rescuing the economy from a deepening deflationary slump, with no alternative economic medicines in the policy cupboards of the Bank of Japan and the Ministry of Finance.

Japan's protracted economic crisis has the potential of dragging the recessionary world economy into a full-fledged deflationary slump. Adam Pose, senior fellow at the Institute for International Economics in Washington, observes that an outright crisis in Japan would not be on the scale of the Argentina crisis. Yet, given its size and creditor status, it would have far greater international implications, with the potential for dauntingly negative outcomes.

Japan's banking system is under increasing stress. "A black hole of bad debt has sucked the life of the banking system," says Mr Brink Lidsey of the Cato Institute's Centre for Policy studies. According to some estimates, one-third of all loans in the banking system are non-performing loans (NPLs). One-fourth of all corporate borrowers are considered financially unsound. The NPLs increases, as the economy sinks deeper into a deflationary-slump.

The Bank of Japan's aggressive provision of liquidity through its ultra-easy monetary policy, with virtually zero interest rate, has failed to reverse the economic downturn. Banks' lending for investment in the private has been shrinking, despite a rapid expansion of the monetary base. There is compelling evidence that the economy has fallen into a Keynesian "liquidity trap". We can no longer effectively rely on the monetary policy engine to lift the economy out of the deflationary slump, by stimulating lending and spending even at interest rates virtually close to zero.

Another policy engine, the traditional fiscal policy, has also run out of steam. Several fiscal stimulus packages in the past decade have failed to avert deflation and prolonged economic stagnation.

The accumulation of fiscal deficits has become a serious problem. Consequently, the government's fiscal condition has been deteriorating fast, with a massive and unsustainable build-up of government debt.

The ratio of gross government debt to GDP has risen to 146 per cent in 2001, from 61 per cent in 1991, and this is estimated to hit 200 per cent by 2007. An alarming rising debt ratio is a serious concern. Under the present grim economic conditions, there is no chance of stabilising the debt ratio and, even less of bringing it down. The Maastricht criterion for financial stability calls for the public sector debt ratio to be less than 60 per cent of GDP.

What lies ahead?

Bringing Japan back to a robust economic growth path is no easy task. The effectiveness of the monetary and fiscal policy has come to the centrestage of macroeconomic policy debate. Obviously, there is no quick-fix for cleaning up the financial sector, swamped with non-performing and high risk assets.

The real solution lies in finding an appropriate policy-mix, with structural reforms, to revive the economy. Besides national economic policy measures, some well-coordinated complementary policies of the developed countries are essential to tackle Japan's deflation and economic stagnation.

The global financial landscape has become complex, with increasing financial innovation, internationalisation of capital flows and globalisation of financial markets. With the changing global economic environment, the economic and business models built in the past decades are no longer valid. Financial sectors have been undergoing extreme fluctuations and turbulence. Mere `economic fundamentals' can no longer explain excessive volatility of exchange rates and financial asset prices.

The electrifying changes and disturbances in the world of finance have major repercussions for the real economy. There has been an increasing realisation that monetary policy-makers' ability to monitor and stabilise the violent fluctuations in financial asset prices are far from satisfactory. Policy errors deepen and prolong the economic crisis.

Who is really in charge of the fast changing global financial markets? Major economic breakdowns originate from the bubble and the burst of the financial asset prices. In an era of increasing financial globalisation, it is the financial system that shakes and moves the real sector of the economy with thunders.

Systemic risks, and systemic instability of the financial system have increased in the past decades. Unfortunately, there are very few theoretical guidelines and techniques of correcting the "financial market failures''.

In the past two decades, more than 130 countries have experienced crisis in the financial system in one form or another, with varying intensity of repercussions on the real economy. A fast-track approach to financial globalisation, without taking into consideration the monitoring, governing and correction mechanism in case of financial collapse, is probably the root cause of the economic debacles in many countries.

At this juncture, there is no alternative except to use the standard policy matrix, with some structural reforms, while waiting for another Keynes to provide a new set of theories and policy prescriptions to deal with protracted deflation and economic stagnation.

(The author is Emeritus Professor of Economics, University of Price Edward Island, Charlottetown, Canada.)

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