Financial Crisis and Economic Policy

KIYOTAKI Nobuhiro

Credit expansion and asset inflation in the 1980s

Land, buildings, and machinery are production factors. At the same time, these are also assets that can be used as collateral for bank credit. Following the Plaza Accord, the yen appreciated sharply from 1985 through 1986, pushing the Japanese economy into a temporary slump. In response, the Bank of Japan (BOJ) embarked on massive monetary easing from 1986 through 1989. Partly because of the influence of such monetary policy, Japanese land prices and stock prices soared two- and five-fold respectively over the 1980s.

In the case of a normal credit expansion, funds shift from non-productive players to productive players, resulting in the accumulation of capital. However, what Japan experienced in the 1980s is considered to be a distorted credit expansion. As funds shifted from risk-averse players to risk-tolerant players, easier credit did not necessarily lead to a boost in production. Rather, credit ballooned typically in the form of speculative financial investments.

When a decline in interest rates coincides with certain other factors such as growth in productivity, demand for assets will grow as net worth held by financially constrained players increases in value. An accumulation of such assets on balance sheets gives rise to the expectation that demand for the assets will continue to grow in the future, which in turn will lead to a further increase in the current prices of assets. This occurs because "prices move on expectations," which is a characteristic unique to asset markets. Furthermore, in the case of financially constrained players, their net worth could increase more sharply than market prices of assets. This is what we call the "leverage effect of debt financing" or referred to simply as "leverage."

Where such leverage is employed, there often occurs a phenomenon in which the higher the prices of assets are, the greater will be the demand for assets. And when this happens, the rise in asset prices will be amplified further. A phenomenon opposite to this is a financial crisis. Falling asset prices reduce the net worth on balance sheets, whereby demand for assets will decrease in spite of falling prices. This is the reason why investment banks were driven to sell their assets even at a huge loss in the course of the financial crisis.

Recession from 1992 onward

After hitting an all-time high above 38,900 yen in December 1989, the Nikkei index plunged to 14,000 yen in July 1992 and then dipped below 8,000 yen in April 2003. Meanwhile, the index of urban land prices peaked at 148 in 1991 and dropped to 100 in 2000 and 54 in 2012.

As a result, non-performing loans increased. But both the government and banks did not act quickly, leaving losses on non-performing loans unrecognized and the problem of capital inadequacy unaddressed. For one thing, the tax system at the time was not in favor of immediate loss recognition. At the same time, however, they might have thought optimistically that the situation would reverse in due time. In the meantime, the government implemented traditional expansionary monetary and fiscal policies repeatedly. By doing so, the government ended up helping declining industries and regions.

A comparison of the government's growth forecasts against the actual trajectory of real growth in the gross domestic product (GDP) reveals that the economic policies of the government and the BOJ were overly optimistic (see Hoshi, T. and A. Kashyap (2013) "Will the US and Europe Avoid a Lost Decade?" working paper, Stanford and Chicago). Public investments operated in the direction of lowering potential growth as they were mostly made in the form of providing support to declining, low-productivity industries.

As a result, the recession aggravated. In 1997, major financial institutions—including a major bank and a couple of large securities companies—went bankrupt. This gave rise to the so-called "Japan premium," the extra interest rate charged to Japanese banks for borrowing money in the interbank market, and bank credit contracted drastically. It is against this backdrop that Japan slipped into deflation. Nominal GDP, which peaked at 523 trillion yen in 1997, has been on a declining trend since and stood at 470 trillion yen in 2012.

Structural reform in 2001 through 2007

The period from 2001 through 2007 was characterized by drastic structural reform implemented under the leadership of Prime Minister Junichiro Koizumi.

The government and banks took drastic steps to put an end to the problem of non-performing loans and capital inadequacy, and the scale of public spending and government loan and investment programs was curtailed. In parallel with this, the BOJ embarked on drastic monetary easing measures, which led to an economic recovery driven by a weak yen and exports.

According to data from the Federal Reserve Economic Data (FRED), a database of the U.S. Federal Reserve Bank of St. Louis, the ratio of non-performing loans to total loans in the Japanese banking system rose to 8% in 2001 after hovering around 6% for some time. However, with progress made on the Koizumi reform, the non-performing loan ratio declined sharply and fell below 2% in 2005 and thereafter. This led to the recovery of Japan's banking sector.

To sum up, for 10 years since the beginning of the financial crisis, Japan continued to tackle the problem of non-performing loans and Japanese banks remained undercapitalized. Things began to change drastically only after Prime Minister Koizumi took the helm. This pattern resembles the ongoing situations in Spain and Italy. In other words, these countries may follow the same path as Japan into a prolonged spell of recession.

The long-term trends of private-sector investment and government expenditure on goods and services as ratios to GDP (see Hoshi and Kashyap (2013)) exhibit a clear inverse relationship pattern, i.e., when the ratio of private-sector investment to GDP increased, that of government expenditure decreased, and vice versa. Although this cannot be taken as evidence of a causal relationship, we can see a pattern in which fiscal spending was reduced under the Koizumi government and that coincided with a recovery in private-sector investment.

In 2008, the world economy entered into a serious financial crisis. Japan and Switzerland were the only major economies whose currencies appreciated against the U.S. dollar in the midst of the crisis and Japan's exports declined sharply, posting a 40% year-on-year decrease in January 2009. This was coupled with other negative factors, such as a further deterioration in the government's fiscal condition and electric power rationing in the aftermath of the Great East Japan Earthquake. As a result, Japan's real GDP dropped sharply.

Abenomics from 2013 onward

One of the policy pillars of Abenomics launched in 2013 is monetary easing. The BOJ's policy prior to that was like stepping on the brake and gas pedal at the same time; the central bank was trying to end deflation by easing the monetary policy, but it was afraid of inflation. Since Prime Minister Shinzo Abe came into office, the BOJ has been compromising on the stability of the financial system to prioritize ending deflation. As a result, the yen has weakened significantly, which led to a recovery in exports, corporate profits, and stock prices. Japan's nominal GDP also bottomed out in 2012 and has been on a recovery trend since.

Another policy pillar, or the second arrow of Abenomics, aims to bring about economic recovery by increasing fiscal spending while at the same time raising the consumption tax rate. But I am afraid problems remain regarding fiscal reconstruction. With the third arrow, which is targeted at the successful conclusion of the Trans-Pacific Partnership (TPP) and the promotion of structural reform, the government wants to boost productivity and thereby achieve an increase in real national income.

Importance of a long-term vision

In order to achieve those goals, it is crucial to have a long-term perspective. When corporations suffer a contraction in their business activities due to a recession or lower productivity, they want to reduce both fixed and current assets. However, since reducing fixed assets is no easy task, they are typically compelled to cut down only on current assets, and often they do so too much and way beyond the equilibrium point (moving from Point A to Point B in the figure) particularly where there exist financing constraints. This will be followed by a gradual decrease in the value of fixed assets toward a contracted equilibrium (moving from Point B to Point C in the figure). In the early stage of an economic recovery, current assets begin to increase first while fixed assets are slow to pick up (moving from Point C to Point D in the figure). Only after the recovery moves into a full-blown stage will fixed assets begin to increase. Such is the typical pattern of adjustments in corporate asset holdings in response to business cycle fluctuations. Therefore, when the economy turns up, current assets show a relatively quick recovery, as seen in an increase in inventory investment and production, but investment in fixed assets is slow to follow.

Since the mid-1990s, Japanese companies have reduced the number of new hires and job-training opportunities, and they have been also cutting back on investment in research and development (R&D) and advertisement. In other words, they have reduced investment in intangible assets. Not only did this slow economic growth, but also it has created a situation where the lifetime income of the young and future generations falls below that of the older generations, causing many young people to postpone marriage and family making and thus resulting in a population decline. As Japan's fiscal condition continues to deteriorate, its social overhead capital is being depleted, people start worrying about their future pensions and medical benefits, and the government is not making sufficient investment in education. In order to cut this vicious circle, restoring growth is imperative.

Figure: Irreversibility of Fixed Assets and Credit Constraints

A. Caggese, "Financing constraints, irreversibility and investment dynamics," Journal of Monetary Economics (2007)

Necessity of fiscal reconstruction

The International Monetary Fund (IMF) Fiscal Monitor published in April 2014 shows that Japan's net government debt-to-GDP ratio has been continuing to rise at an extremely high level, reaching 170% in 2013. Simply servicing the existing debt would require a fiscal surplus of 1.7% of GDP. That, however, is a far cry from the ongoing critical condition; Japan's primary fiscal balance—which was maintaining a surplus of 1.7% of GDP in the 1980s—turned negative in the 1990s with a deficit level at 0.6% of GDP, and the size of the deficit continued to increase to 4.4% in 2000 and 7.8% in 2013.

Shaping policies for the future of Japan

A 1.5 percentage point increase in the nominal interest rate on government bonds, whether due to an increase in credit spreads or growing inflation expectations, would increase Japan's fiscal deficit by 2.6 percentage points as a percentage of GDP. Furthermore, the outright purchases of government bonds by the BOJ would further increase credit spreads and inflation expectations.

Therefore, the BOJ must end deflation and increase nominal income. And the government should press forward with its comprehensive tax and social security reform and structural reform. Since social security represents the largest area of government spending, carrying out fiscal reform without cutting into this area is nearly impossible. The minimum pensionable age must be raised in a step-by-step manner. Otherwise, Japan's fiscal path would not be sustained.

Under the current taxation structure in Japan, the progress portion of the national individual income tax is not necessarily in accord with changes in price levels. Thus, an increase in the nominal income of people would likely lead to an improvement in the fiscal situation. With regard to structural reform, the impact of an expected population decline would be negated to a significant extent by trading with countries with large populations. It is also about time for Japanese companies to adopt a long-term perspective and accelerate investment in intangible assets.

The household, corporate, and government sectors need to create a system where people can choose to work longer years when the minimum pensionable age is raised, but they would not necessarily need to work fulltime. Education and job training are important as a means to increase intangible assets. The Japanese system as a whole should make a gradual shift toward a system that facilitates the employment of women, elderly people, and foreign nationals by allowing for diverse working styles.

Q1: Do you think that the lowering of corporate tax rates will lead to greater investment?

KIYOTAKI Nobuhiro:
A reduction in tax burdens will certainly enable companies to accumulate net assets more easily. I believe it is correct to say that when that happens, financing would become easier and those companies that have many investment opportunities but face credit constraints would increase investment. A weaker yen also helps increase net assets of exporting companies.

Q2: Although Abenomics has led to an upturn in corporate earnings and a remarkable recovery in stock prices, exports have not recovered as strongly as expected. Is this just a matter of time lag or a result of certain structural problems?

KIYOTAKI Nobuhiro:
It is true that the real volume of exports increased by only 2% despite a significant weakening of the yen. One reason behind this is the growth of vertical trade, in the course of which Japanese exporters have relocated much of their manufacturing operations to countries with a freer trade regime in a bid to avoid higher tariffs. Therefore, in addition to seeking a favorable currency exchange rate, Japan needs to implement further trade liberalization, not only in the area of tariff reduction and elimination but also in terms of removing regulatory impediments. In that context, the TPP holds the key to reviving Japanese exports.

Also, we should remember that Japan's exports and imports move in tandem as the vast majority of its trade is accounted for by intermediate goods. And, in order to boost both exports and imports, it is necessary to push forward trade liberalization. Overseas direct investment by Japanese companies does not necessarily reduce domestic jobs. I believe that the liberalization of capital and trade flows will become increasingly important in the coming years.

Q3: I believe that Japan is currently in the phase of shifting from deflation to moderate inflation. How do you assess the current situation in terms of its relation with the BOJ's quantitative easing policy?

KIYOTAKI Nobuhiro:
Prior to Abenomics, the BOJ was keeping an eye on both deflation and inflation, and it was particularly concerned about the interest rate risk. At the moment, I am not so much concerned about the inflation risk. I would rather think that the interest rate risk might surface first. So, I think that prioritizing measures to stop deflation is the right decision.

Moderator MORIKAWA Masayuki:
If the government and the BOJ are to have a realistic, long-term vision by avoiding the upward bias, what goals and targets do you think should be included?

KIYOTAKI Nobuhiro:
That is a difficult task because you cannot draw up a vision unless you assume a bright future to some extent. Also, it is the nature of politics to favor higher—rather than lower—growth forecasts because that would allow for greater fiscal spending.

However, a good economy does not come without cost. In order to improve fiscal health, it is necessary to cut expenditure and increase taxes. And, in order to achieve growth, we all have to work, by which I mean that both companies and households must do what they are supposed to and pay what they are supposed to pay. Things will not work themselves out.

Q4: Aggressive fiscal and monetary policies under Abenomics have achieved a remarkable economic turnaround. In addition to this, I believe it is also important to spur business activities. However, Japanese companies are not responding as quickly as to keep up with the pace of policy change. Business demand for funds remains weak, and I do not think that Japanese companies are fully demonstrating their vitality. What do you think is necessary in order to boost the vitality of the business sector and enable Japanese companies to develop a more forward-looking perspective on the future as quickly as possible?

KIYOTAKI Nobuhiro:
The essential nature of business is to earn returns by contributing to the society. When companies find what contribution they can make, it will lead to profits in the long run. So, it is important to look for and identify what they can do. In this vast world, there are many things you can do for society. In many countries in Africa and other parts of the world, people are living in poverty. Helping to improve their living standards is a significant contribution to the society. You go there and you can see it yourself. There are many extremely poor countries where people live in incredibly harsh conditions.

In the past, when Japanese manufacturers were developing new products one after another, those engaged in the development loved and had a passion for their products, and they were confident that they would be able to contribute to the world through their products. Entrepreneurs should have such a spirit.

Q5: What problems do you find with Prime Minister Abe's growth strategy?

KIYOTAKI Nobuhiro:
What I find most problematic is the old-fashioned way of public spending. The growth strategy calls for increasing public investment in areas where marginal productivity is low such as the further construction of roads and expansion of the shinkansen bullet train networks.