Global financial markets remain fraught with instability
The U.S. financial crisis, which was initially triggered in 2007 by defaults among subprime mortgage borrowers and the resulting accumulation of bad loans, continued deteriorating to the point where it had caused an acute credit crunch following the failure of Lehman Brothers in 2008. With a number of financial institutions across the world exposed to derivatives based on such soured assets, the U.S.-initiated financial crisis quickly spread to other countries. While Japanese financial institutions are not immune to the crisis, their European counterparts have felt a much greater impact. The extreme tension in the financial markets has caused a global credit crunch, a flight to quality among global investors, and a huge plunge in asset prices. Thus, global financial markets remain fraught with great instability.
In the United States, the financial crisis has dragged down prices of subprime-related securitized products, mortgage loans, and commercial real estate. Not only has this resulted in greater burdens on financial institutions by increasing the amount of nonperforming assets to be disposed of, it has also substantially reduced the value of household assets. Indeed, stocks and real property held by American households lost 10% of their value in one year, and the effects of this have rippled throughout the real economy and caused a steep drop in consumer demand. In the wake of the sharp decline in consumption, many American companies have decided to forego or postpone capital investment projects, and the nation's employment situation has deteriorated significantly. But the impact is not limited to the U.S. Many other countries that have been dependent on the continuous growth of U.S. consumer demand are now suffering from a big drop in exports to the U.S.
In many countries, shrinking domestic demand and falling asset prices, both direct results of the credit crunch, have been compounded by falling external demand caused by the drastic downturn in the U.S. economy. The combination of these events has depressed consumption, driven companies to cut back on production, and begun to have a serious impact on the employment situation. And that is an outline of the financial crisis and subsequent economic recession experienced by the world in 2008. But, as the ongoing parade of bad news continues to spread across the world in a chain reaction, it serves as a renewed reminder of just how tightly countries are integrated with each other in both international finance and trade.
Comparison between Japan and the U.S. in terms of policy response
The U.S. government has been both quick and bold in its policy response to the crisis. In addition to providing $700 billion in public funds for financial institutions to facilitate the disposal of bad assets, the government has also made emergency bridge loans available for the three biggest U.S. automobile manufacturers to help them stave off imminent bankruptcy. Furthermore, the incoming administration of President-elect Barack Obama has already laid out plans for large-scale fiscal expenditures. Meanwhile, in December 2008, the U.S. Federal Reserve effectively adopted a zero interest rate policy by lowering its target for the benchmark federal funds rate to 0-0.25%. The Federal Reserve also announced its decision to purchase agency debt and mortgage-backed securities, thus embarking on a quantitative easing of monetary policy.
Although poor in comparison to the bold and rapid steps taken by U.S. officials, Japanese policymakers are also moving in the same direction as their U.S. counterparts by easing monetary policy and pursuing expansionary fiscal policy. The Japanese government committed to ¥1.8 trillion and ¥4.8 trillion of expenditures to the first and second supplementary budgets, respectively, for fiscal 2008 (April 2008 through March 2009). At the same time, the government decided to re-launch its emergency share purchase plan with a maximum of ¥20 trillion - compared to the previous ceiling of ¥2 trillion - set aside for purchasing shares held by banks. The plan was designed to prevent financial uncertainty, alleviate the credit crunch, and increase the amount of public funds available for injections into banks.
For fiscal 2009, the Cabinet has approved a record budget amount that calls for more than ¥88 trillion in general account expenditures. Meanwhile, the Bank of Japan lowered the target of the benchmark uncollateralized overnight call rate from 0.3% to 0.1%. In addition, the central bank decided to proceed with quantitative easing measures such as increasing its outright purchases of long-term Japanese government bonds (JGBs) and commercial paper (CP) from financial institutions.
All these measures taken by the Japanese fiscal and monetary authorities before the end of 2008 are emergency plans in nature, designed to put the brakes on the steep downward slide in asset prices and prevent the economy from receding further. As short-term measures they are definitely needed, but they do not come without non-negligible side effects.
In its fiscal policy, the government relies on debt to finance its aggressive spending plans, which has led to an increase in government bond issuance to about ¥33 trillion in both fiscal years 2008 (after the second supplementary budget) and 2009. The expansionary fiscal measures come with serious side effects, namely an acutely deteriorating primary balance. Japan's primary deficit more than doubled from ¥5.2 trillion in the initial budget for fiscal 2008 to ¥13 trillion in fiscal 2009, with the ratio of government debt outstanding to gross domestic product (GDP) reaching 114%.
In its monetary policy, the central bank has begun shouldering some of the credit risks of private-sector companies, but since returning to an ultra-low interest rate policy it is once again left with virtually no room to maneuver in money market operations. Obviously, the government cannot afford to continue today's expansionary fiscal and monetary policies forever. However, in spite of the extraordinary fiscal and monetary steps implemented or proposed to date, it is hard to expect the credit crunch will subside and the Japanese economy will emerge from recession in the coming fiscal year.
The financial crisis has been even more challenging for other countries in the world. Benefiting from higher prices of natural resources, both Russia and Brazil had been enjoying robust economic growth relative to the rest of the world and were receiving significant inflows of funds. Today, however, these two countries are suffering far steeper declines in stock prices relative to the U.S. as investors redirect their funds to safer assets. Meanwhile, in China and other East Asian countries that depend heavily on the U.S. as an export destination, manufacturing output dropped sharply in the latter half of 2008 due to a large decrease in exports to the U.S. It is expected that economic deterioration will worsen from 2008 to 2009 in BRIC (Brazil, Russia, India, and China) and East Asian countries, which were recently being championed as the emerging new growth engines of the world economy.
Reversing slowing GDP and combating surging unemployment are top priorities
The current state of the world economy, where recent declines in energy, resource, and asset prices are occurring simultaneously with the deepening of the recession, can be defined as the beginning of a deflationary spiral caused by the credit crunch and declining demand. It will be a long time before the world economy recovers from the crash of both financial asset values and real property prices. And it will take even longer for the recovery of depressed demand, i.e., consumption and capital investments. Last year the U.S. economy slipped into negative growth and its unemployment rate has been rising sharply. For the Japanese economy, the government is now forecasting zero growth for fiscal 2009. Meanwhile, BRICs, which had recorded high growth for years, have also begun making significant downward revisions to their 2009 growth forecasts. Unfortunately, as far as this year is concerned, the gloomy outlook will not be too far off the mark. How soon countries can stem sharply declining GDP growth and bring down high unemployment are shaping up to be the biggest challenges in 2009.
Admittedly, governments addressing this situation are not left with many policy options apart from those that have already been carried out. The U.S. government is expected to launch a large-scale economic stimulus package, but its resulting fiscal deficit will bring new problems to both the U.S. and world economies. Few policy options are available for the Federal Reserve outside of underwriting the Treasury securities that are expected to finance massive fiscal expenditures.
Likewise, Japanese fiscal and monetary authorities have little room to take additional measures. As a result of steering into expansionary policy, by the time the government finalized its budget bill for fiscal 2009 it had already destined itself to running a large fiscal deficit, which may cause profound negative effects for years to come. Furthermore, even if the situation further deteriorates in 2009, it will be impossible to bring about a sustainable economic recovery simply by continuing the expansionary policy of the past several months. In the not-so-distant future, the time will come for the government to leave things to the market. However, overcoming today's unprecedented difficulties and transforming the Japanese economy into one capable of bringing long-term prosperity to the people are much more demanding than what can be achieved by small government and market functions. In this context, the government still has many cards that need to be played.
As many people may remember, World War II is what finally put an end to the Great Depression, which had begun in 1929. If the depression engulfing the world economy today is worse than the Great Depression, the way out definitely involves a drastic transformation of social and economic structures. That is, in order to find an exit from the worldwide depression, radical changes must take place in the structures of demand, production, fiscal discipline, and financial rules across the world. And such changes must come with innovation-driven "creative destruction" of social structure.
A new social infrastructure is needed
In the formulation of further policy measures to respond to the economic shocks stemming from the ongoing crisis, the Japanese government needs to develop and incorporate a long-term vision for drastically changing the nation's economic structure. Such a vision must be constructed on the basis of innovation and new rulemaking. If the government irresponsibly continues vast fiscal expenditures on infrastructure construction and other conventional public works projects for the sake of economic stimulus, taxpayers will be forced to bear the costs for many years to come. Obviously, this will not lead to economic recovery. To the contrary, it would increase people's anxiety about growing future tax burdens and could conceivably delay the recovery.
Fiscal expenditures of this kind cannot provide any foundation for inducing innovation. Instead, the government needs to (1) promote innovation by creating a social infrastructure and systems capable of overcoming challenges posed by climate and other environmental changes; (2) establish a financially sustainable social security system that can reliably address health and welfare needs arising from the nation's rapidly aging population and decreasing birthrate; (3) accumulate internationally competitive human resources by allocating intensive capital resources to the area of human resource development; and (4) work to develop global market rules that ensure the proper evaluation and management of risks related to new financial instruments such as the subprime and nonrecourse loans that triggered the current financial crisis.
These proposed measures are fundamentally different from the short-term, emergency measures formulated and/or implemented in rapid succession during 2008. The most critical pending policy issue for overcoming the oncoming depression is the creation of a new social infrastructure capable of sustaining economic growth over a long period of time.
No optimism is warranted regarding the possibility that the Japanese economy will bottom out in 2009. However, if this year marks the beginning of structural innovation, the recovery will definitely start earlier than it would have otherwise. The Japanese economy is not big enough to lead the recovery of the global economy, and neither does it have the capacity to bear such a burden. Yet by spearheading innovation and structural changes in its economy and society, Japan will be able to send out an effective message - and thus make a great contribution - to rebuilding the integrated world economy.
