The Temptations of Safety Nets
Senior Fellow, RIETI
On Oct. 30, the government finally released its long-pending package of steps to accelerate non-performing loan disposal and a comprehensive set of measures to tackle deflation. As I have already given my assessment of some of the steps regarding the disposal of bad loans in a separate column, here I would like to discuss the safety net planned to ease the pains of such disposal and the new body, tentatively called the Industrial Revitalization Organization, that is to buy debts of ailing companies from banks and extend assistance to those firms.
Earlier in the month, the project team headed by Financial Services Minister Heizo Takenaka had to postpone its release of an interim report on bad loan disposal. At the time, it was explained that "announcing steps for accelerated non-performing loan disposal alone will only lead to unnecessary anxiety and confusion, so they should be unveiled together with a wide-ranging anti-deflation package that includes a safety net." The more aggressively bad loan disposal is pursued, the greater the likelihood of corporate failures and increased unemployment. Therefore, the argument that there should be a solid safety net to prepare for unforeseen situations has gained wide consensus, and there seems to be little visible opposition to this view among the ruling coalition parties, the government and experts. Rather, it almost seems as though "Establish a viable safety net!" has become a slogan of sorts for the entire country. Is this right?
For the Japanese economy, which up until the 1980s had maintained annual growth of roughly 3 percent even in times of recession and had extremely low unemployment compared with other developed countries, having a safety net was never really an issue. On the flip side of the coin, it is clear that now, amid the continued economic downturn and structural adjustment pressures, constructing a safety net of minimum necessary proportions is a matter that must be swiftly addressed. However, it is extremely difficult to ascertain what this bare minimum should be, because safety nets have the same allure as morphine.
Whenever the issue of safety nets is discussed, we almost always hear the argument that they may cause a moral hazard, that is, firms will not make efforts to shape up because the existence of a safety net makes them less fearful of failing. However, when things get desperate, such demerits of safety nets are all too often taken lightly. Why is this so? In essence, the merits of having a safety net - saving companies and people who have failed - becomes visible right away, while its demerit of being a moral hazard only appears gradually over time. When taking this temporal policy effect into consideration, it is obvious that politicians and government officials, who tend to be short-sighted and ignore future costs, will stress the merits of having a safety net, which in turn leads to the adoption of safety measures that are quite grand, despite the strains they will cause on the state coffers. Furthermore, once a safety net is in place, it becomes politically difficult to scale down because of resistance from vested interests.
For example, when we look at the experiences of European nations, we can see that the generous unemployment benefits (both in terms of levels and duration) introduced after the macroeconomic shocks of the 1970s transformed what would have been cyclical unemployment to long-term unemployment, and even chronic, structural high unemployment. It took an enormous amount of time and effort to turn this policy around. I cannot stress enough the moral hazard effect that safety nets have on individual economic bodies. In addition, aggravating moral hazards will, from the macroeconomic viewpoint, delay the redistribution of resources released by one sector to another sector that has higher profitability, a market mechanism that is the foundation of structural reform.
Given such observations, joblessness should not be tackled through such measures as increasing employment insurance, but by limiting steps to those that encourage labor mobility, such as retraining and reeducation and improving systems to match jobs to workers. Giving financial support to companies that hire the unemployed could adversely affect the redistribution of labor resources. On the financial front, I acknowledge that it is important to provide small and medium-sized enterprises with a safety net, because in the event of the failure of their main bank - which in all likelihood will have been monopolizing all the information of that firm - it is very difficult for them to quickly find a new lender. However, I still believe that providing a broad net like a special credit guarantee system is problematic. The postponement of the introduction of a limit on the government's guarantee on deposits at failed financial institutions is also a serious matter, as it effectively means we have lost the only market mechanism to push banks to restructure - that of having depositors select which banks are creditworthy.
Meanwhile, the special body to be established to revitalize companies, being a safety net of sorts, may also become a potential moral hazard, as it could lead to a delay in structural adjustment. According to media reports, the creation of such an organization was deemed necessary as the Resolution and Collection Corp., whose main function is debt collecting, effectively has no loan extension functions, and as such cannot sufficiently help companies get back on their feet. Traditionally, main banks have played a key role in assisting firms that are deemed capable of making a comeback. However, in recent years these banks no longer have financial resources to assist, and at the same time they are caught in a vicious circle as their burdens are getting heavier as other banks sever their own ties with the problem company. Nevertheless, the idea of having a public body decide whether a company can be resuscitated or not basically ignores market mechanisms. Only the market has the authority to judge whether a company should go on or fail. I cannot but fear that the new body may give the government's seal of approval to problem companies only because they happen to be too big to fail, or that it may give rise to socialist policies much like the soft budget constraint phenomenon seen in countries in transition to a market economy. Furthermore, according to the government's plan, the new organization will not be allowed in principle to purchase loans from main banks. This raises some doubt as to whether this policy will be effective in fully unloading bad loans from banks. While it is true that it will become easier to renegotiate loans and revive the company in question by reducing the number of creditors to two, the main bank and the revitalization body, I hope that this will not signal the birth of a massive government-led "rescue organization."
It seems that at present all eyes are only focused on the pain of accelerated non-performing loan disposal. The addiction to safety-net policies, however, would have a negative impact on the economy, like a "drug". The government should design policies by considering what is necessary to put an end to economic disorders quickly rather than to avoid the risk of economic crashes. More concretely, policies quickening bankruptcy procedure and those enhancing labor mobility by improving human capital and labor matching should be implemented.
October 31, 2002
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