Parallel Monetary Mistakes in Japan and America

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Thank you for this opportunity to offer my thoughts and suggestions in regard to Japan’s current economic and banking policies.

What I will present, to a large extent, challenges the conventional wisdom, both in Japan as well as the United States. In offering policy suggestions, I do so in the most humble manner.

While I strongly believe the United States has much to teach, and learn, from the rest of the world; I would not offer our current framework of financial regulation as a model for any country.

Much of the discussion in the US repeatedly asks what we can learn from Japan’s banking crisis, in the hope of avoiding our own “lost decade.” What motivates my remarks today is a deep concern that rather than learning to avoid each other mistakes, Japan and America are copying each other mistakes. Learning the wrong lessons, if you will.

Foremost among these policy errors is a single‐​minded, narrow obsession with deflation, which is a situation of actual declines in the price level. This obsession is all the more surprising in the United States, where we have yet to actually experience deflation.

Of course, here in Japan you have experienced almost a decade of continual deflation. Although until 2009, deflation never got much beyond 1 percent declines annually. Fears of a “deflationary” spiral turned out misplaced. Deflation, instead, was slow and steady, until 2009.

Like much of the rest of the developed world, Japan suffered a dramatic fall in consumption and production in the fall of 2008, with an accompanying decline in unemployment. As is almost always the case with such a dramatic decline in consumption, consumer prices dramatically fell. Such should come as no surprise, as a drop in demand in the face of stable supply will result in a reduction in prices.

I believe this episode is something quite distinct from the deflation trend which has characterized the last decade or more. In fact today both consumer spending and consumer confidence in Japan have been increasing, as is the money supply.

While consumption is still off from its 2008 peak, it is not far below it. My point, in discussing the trend in consumption, is that the primary problem facing Japan’s economy is not a lack of aggregate demand.

The primary issues facing the Japanese economy are: first the absolute declines in both population and the size of the labor force, along with, second, a substantial slowing in the rate of increase in labor productivity.

In the face of a shrinking population and any positive level of labor productivity, some degree of deflation is what one would expect, all else equal.

I should say, as an aside, that issues of population growth are at their heart as much policy choices as economic ones. We, economists, tend to always think “more is better.” It is quite possible to be a wealthy and happy country, while also being a shrinking one. The most important issue with a shrinking population is not economic growth, but rather then ability to manage long term entitlements related to the care of the elderly and retired.

I will come back to the issue of labor productivity in a moment, which I believe is far easier to fix than a country’s demographics.

Let’s go back to the topic of deflation. It is the fear of deflation and a belief that insufficient aggregate demand are holding back the economy, which has provided the rationale for the Bank of Japan’s long‐​running quantitative easing, or “comprehensive monetary” easing.

The first element of comprehensive easing is a reduction in the target overnight bank rate from around 0.1 percent to around 0 to 0.1 percent. Obviously a small, if even observable, change; but nevertheless, a commitment to maintaining extremely cheap credit.

The second element is more one of timing. The Bank of Japan has committed to maintaining an essentially zero overnight rate until it appears that medium to long‐​term inflation approaches a sustained positive level.

Lastly the third element of comprehensive easing is an expansion of the purchase of financial assets by the Bank of Japan, including an extension beyond government securities, to include commercial paper, corporate bonds, exchange‐​traded funds and real estate investment trusts.

Recall that the Bank of Japan has been conducting extensive quantitative easing measures since at least 1998; although the majority of those purchases have been government bonds. The BoJ has also provided, for several months, long‐​term, low cost funds to financial institutions for the purpose of business and investment lending.

All of this easing has, of course, shown up in the money supply. M2 has witnessed an annualized growth of close to 3 percent over the past months and years.

The problem, of course, is that most of this liquidity has not made its way into the business sector. In fact, it appears that much, if not all, of the last several years’ corporate investment has been funded by internal cash‐​flow, that is retained earnings, rather than via bank lending.

To a large extent, the Japanese banking sector has shifted from its traditional role as a provider of industrial credit, to the role of primarily a provider of credit to the government. Of course, we have witnessed a similar trend in the United States, where the decline in bank lending to business has been off‐​set by increased lending to government.

I believe there are several factors behind this shift. One is that in an environment of deflation, even the relatively low government bond yields, currently around 1.2% on Japanese 10 year bonds, look attractive on a risk‐​adjusted basis. When AA corporate bonds are only about 10 to 20 basis points above government bonds, this is hardly a risk worth taking, especially in a weak economy.

The yield on new bank loans to business is also barely above the return on government bonds. And obviously the risk on a business loan is above that of a loan to government.

Second, banks are still trying to reserve capital in the aftermath of the 1990s banking crisis and recent disruptions to the international capital markets.

One cannot necessarily blame the banks for this behavior. However, the behavior does have a significant negative impact on overall economic activity.

As I mentioned previously, increasing labor productivity is likely the most important issue facing the Japanese economy. First, productivity, driven by the deepening of the capital stock, is really the only avenue for raising wages over the long run. So for the purposes of improving the well‐​being of households, there is no more important channel than capital investment.

Second, given the declining population and labor force, increasing labor productivity is perhaps the only way to increase the size of the Japanese economy.

While Japanese labor productivity has increased over the last decade at a rate surpassing many other industrial economies, such as France or Germany, part of this increase has been driven by a declining labor force. There are clearly limits to a country’s ability to raise its labor productivity by removing its least productive members.

Of course, some of the increase in labor productivity has come about from business investment. In fact, I believe one of the unintended benefits of deflation has been placing pressure on business to reduce costs and improve efficiencies, rather than rely on passing along costs to the consumer, which is not much of an option today.

All of this discussion about labor productivity leads me back to my concerns regarding the current stance of monetary policy. One must find some avenue for shifting bank lending away from government and toward the private sector, particularly long‐​term capital investment.

It is the methods which I am going to suggest that my analysis most challenges the conventional wisdom.

First, I believe it is obvious that one problem that is not facing either America or Japan is the cost of credit. In fact, the cost of credit that banks are facing is actually too cheap.

This leads me to my first recommendation. Rather than maintaining rates at essentially zero, the Bank of Japan should begin a slow steady increase in rates. I emphasis that rates should not be increased to a level where credit is tight, but should be increased in the medium term to around 1 percent. This would discourage banks from investing in predominately government securities and push them towards riskier, higher yield lending in the private sector.

As there’s little evidence that massive government stimulus activities are increasing capital deepening and hence labor productivity, shifting lending away from government spending toward private should improve economic performance.

While net social savings, that is savings after combining the household, corporate and government sectors, has been low, but positive, around 3 to 4 percent of GDP, over the last decade, it has been essentially zero since 2008. And an economy that does no net savings is an economy without real net investment. Again that is setting aside the issue of quality of investment, as opposed to simply quantity.

Again contrary to the conventional wisdom, I would suggest the Japanese government move to reduce its budget deficit and do so via exclusively cuts to government spending.

For instance, I believe potential increases in a consumption tax would have detrimental impacts upon the economy.

Deficit reduction should also focus upon long‐​term imbalances, particularly those arising from retirement and health care.

In order to encourage alternative flows of capital into the corporate sector, I believe substantial reform of the financial sector, along with a reconsideration of the dominant role of commercial banks, is very much in order.

Despite all the talk about “shadow banking” in the United States, our recent financial crisis was concentrated predominately in our commercial banking sector, along with our government sponsored enterprises, Fannie Mae and Freddie Mac.

And despite disruptions to the US commercial paper market, those disruptions were almost exclusively limited to commercial and asset‐​backed paper issued by financial institutions. The market for industrial and non‐​financial corporate paper witnessed little disruption and never froze.

Nor did America’s alternative investment sectors. While a significant number of hedge funds did fail, as they do even in normal times, the hedge fund and private equity sectors continued providing investment resources to corporate America.

The lesson is that a diversified financial services sector is better able to weather market disruptions. Of those alternative investment funds that ran into trouble, most were heavily invested in real estate.

I think this is an important lesson, both for the US and Japan. Financial institutions that are extremely vulnerable to downturns in the housing market, will fail when a housing bubble bursts. As importantly, losses on their housing investments will place a drain on the remainder of their portfolios, limiting the overall ability of such institutions to provide credit, housing or otherwise.

One of the reasons I believe the US has moved through its financial crisis quicker, is that significant parts of our financial system are not directly tied to the housing market.

The point is that I believe it would greatly be in the interest of financial and economic stability for Japan to remove barriers and encourage the formation of alternative investment vehicles, such as hedge funds and private equity, as well as venture capital.

Another lesson of the US financial crisis is to the limit the extent of government guarantees behind the financial sector. Both implicit and explicit guarantees. Just as the US is in desperate need of reforming Fannie Mae and Freddie Mac, the Japanese government should devote considerable attention to reforming, if not privatizing, its postal financial system. Of course, the German experience with its Landsbanks should serve as an important warning that how privatization is done is as important as if it is done.

I would like to end my remarks with a focus on what I believe to be the largest problem facing both Japanese and American banking regulation; ending the perception and practice that financial institutions are “too big to fail.”

Both during the recent financial crisis and during the 1990s Japanese banking crisis, policymakers took extreme efforts to protect creditors from losses in the event of a bank failure. As banks generally receive 90 percent or more of their fund via debt, the rescue of creditors has largely eliminated any market discipline in banking, particularly among the largest institutions.

Despite recent regulatory changes, I believe that the largest banks in both the US and Japan are still being protected from market forces. Without placing bank creditors in a potential loss position, credit will flow to less efficient uses, ultimately resulting in lowered productivity.

I recognize my remarks touched upon a number of issues, most just scratching the surface. I look forward to going into greater detail during the discussion. Thank you.

Mark A. Calabria

Mark Calabria is director of financial regulation studies at the Cato Institute.

Remarks before the Keizai Koho Center, Tokyo, Japan, January 28, 2011.