Even worse than you think
inability to recover from its endless slump is, or should be, a source
of deep uneasiness for all advanced countries. Unlike the afflicted economies
of the third world, Japan has no obvious vulnerabilities: it is politically
stable, with a history of responsible macroeconomic policy, a massive net
international creditor and essentially no foreign-currency debt. How can
it be stuck in this rut? And if it can happen to them, why can't it happen
a comforting theory of Japan's woes has taken hold in respectable circles:
it's all a banking problem. Fix Japan's banks, the conventional wisdom
has it, and the economy will regain its vitality. This is why the recent
passage of a large bank rescue package is seen as a turning point.
problem with this theory is not just that it is almost surely wrong. The
fact that smart people are putting their faith in such a dubious explanation
is an indicator of the continuing reluctance of the policy elite, in Japan
and outside, to face up to the unsettling implications of the country's
immediate problem with Japan's economy is not in question: even at a near-zero
interest rate, aggregate demand is inadequate to employ the country's productive
capacity. Or to put the same point differently, at full employment Japanese
savings would exceed Japanese investment by more than the country's current
believe that banking reform will heal the Japanese economy, you must believe
that it will sharply reduce this savings-investment gap. Call it the "clogged
pipe" theory: it says that the weakness of Japan's banks depresses
investment, because it prevents liquidity from getting through to credit-constrained
this make any sense? Japan has not suffered from bank runs and massive
disintermediation: the public continues to believe, correctly, that its
deposits will be protected. And as long as this belief holds, the logic
of moral hazard says that bad banks - banks with low or negative capital
- tend to be more, not less, willing to make risky loans than they should,
because they have an incentive to play the game "heads I win, tails
the taxpayers lose".
same logic says that such banks will actually not want more capital, since
it reduces the value of their deposit insurance "put" - and indeed,
Japanese banks that have applied for capital injections have made it clear
that they are doing so only as a favour to the government, to avoid making
its rescue plan look foolish.
confirms this logic: overlending by undercapitalised banks was the driving
force behind America's savings and loan crisis in the 1980s. But if you
accept this logic, you should believe that increasing the capital of Japanese
banks will reduce rather than increase their willingness to lend - actually
worsening the savings-investment gap.
in the past year or so there have been many complaints about a credit crunch
in Japan. (Before then there is no evidence at all that credit conditions
were a source of economic stagnation).
timing of these complaints is no mystery: they began when the government
announced new capital standards for banks, and in general signalled that
it was unwilling to allow the questionable lending that had persisted through
the previous six years of stagnation to continue. But consider what this
timing implies for the nature of the "crunch". It says that the
problem is not that there are currently loans Japanese banks should be
making, but aren't; it is that a year or two ago there were loans banks
shouldn't have been making, but were.
capital into the banks is therefore unlikely to restore the credit conditions
of yore - and remember that even then the Japanese economy was operating
well below its potential. Why, then, have so many people been willing to
accept the idea that weak banks are the essence of Japan's problem? I suspect
that it is because they are unprepared to face the alternatives.
that even (or especially) with healthy banks, and even with near-zero interest
rates, Japan still suffers from an excess of savings over profitable investments.
Then one cannot avoid concluding that some kind of deeply unconventional
response is necessary. You don't have to accept my own notorious proposal
for "managed inflation", although to me the case for believing
that Japan's economy needs a negative real interest rate, and hence needs
inflation, seems overwhelming.
you must accept that something radical, something that would normally be
considered unsound policy, is the only way out. The real significance of
the fixation on banks as the be-all and end-all of the problem, then, is
that it means that Japan and those who advise it are not yet prepared to
rethink their ideas of what constitutes sound policy. And that, I fear,
means that there is not yet even a glimmer of light at the end of this
author is professor of economics at the Massachusetts Institute of Technology