This essay is based on Keiichiro Kobayashi, "Crash or Revival: Trap of the Japanese Economy" (in Japanese, Bungeishunju, April edition). Part 2: Policies and Scenarios will describe necessary policies and possible scenarios for Japan in the coming decade.

The last decade of the twentieth century is often described as "the Lost Decade" for the Japanese economy. Although the country had enjoyed 4.0 percent growth in the 1980s, Japan suffered nearly zero economic growth in 1990s (except for 1995 and 1996) after the asset-price bubble has burst in 1991. Asset prices (land prices and stock prices) collapsed and continue to stagnate. Land prices have continued to fall after 1991 and are still declining in 2001, ten years after the bubble collapsed. The Nikkei stock price index is now at its lowest level since 1985. The Japanese economy is still in the midst of persistent stagnation.

The government tried to lift shrinking demand with massive fiscal stimulus (public works and tax cuts) no less than nine times, and undertook drastic deregulation. The Bank of Japan has kept short-term interest rates at nearly zero for more than five years. Why couldn't these policies effectively get the Japanese economy back on track? In this essay, I would like to try to answer this question.

A recent speaker at our Brown Bag Lunch seminar series was Paul Sheard, Chief Strategist for Asia at Lehman Brothers. He likened the recent ¥60 trillion fiscal stimulus package to a gamble, with the government spending half that amount and then waiting, in vain, for it to spur growth that would resolve the bad-debt problem. My conclusion here is that the bad debt problem has made stagnation persistent. The bad debt problem is not only a result of the obstinate recession, but it prolongs stagnation through the mechanism of debt disorganization, which I present below. Thus, we cannot expect that economic recovery solves the non-performing loan problem; but solving the bad debt problem first is necessary to recover sustainable growth.

1. Why were Keynesian policies ineffective for Japan?

Right after the bubble burst, policy makers expected that the Japanese economy would recover while they supported aggregate demand with fiscal and monetary expansions, i.e., typical Keynesian policies for aggregate demand management.
This logic implicitly assumes that the stagnation of the Japanese economy is just a big business cycle and that the economy would get back on track sooner or later even if no policy measures are taken. The diagnosis was that the Japanese economy temporarily fell out of equilibrium (the optimal state). Keynesian policy should have provided "pain relief" during the economy's recovery process.
Our experience in the last decade proved that this diagnosis was wrong. The stagnation is not a temporary deviation from optimal equilibrium, but a state of "low equilibrium" (non-optimal state), where the Japanese economy is now trapped. If the stagnation is a kind of equilibrium, there is no reason to expect that the economy will recover to an optimal state eventually. Because the stagnation is the result of rational choices by economic agents in Japan, the "pain reliever" (Keynesian policies) cannot change the state of equilibrium once the economy is trapped in it.

2. Why was structural reform (deregulation) ineffective in dealing with stagnation?

In the middle of the 1990s, after the failure of Keynesian strategy, policy makers focused on structural reform and deregulation. The diagnosis by structural reformers was that inefficiency in the market structure causes low equilibrium. Thus, creation of competitive and efficient markets through deregulation should have brought the Japanese economy back to a state of "high equilibrium." However, this argument overlooked the fact that stagnation is due to shrinkage of demand. Low equilibrium is realized by contraction of demand, not by inefficiency of the supply side. Deregulation has improved the efficiency of the supply side. While efficiency raises the long-term potential growth, it may cause shrinkage of aggregate demand in the short term due to thrift by corporations that are more efficient than before. The efficiency in the supply side may result in an even greater contraction in demand. The argument of structural reform could not resolve this "fallacy of composition."

3. Debt disorganization

Now we are focusing on the non-performing loan problem as the true obstacle for the Japanese economy. In that case, what is the mechanism by which the bad debt problem traps the whole economy in "low equilibrium"? How does bad debt create contraction of aggregate demand? The most famous theory for the significance of the bad debt problem is "Debt Deflation," by Irving Fisher. To explain the shrinkage of the U.S. economy in the Great Depression, Fisher proposed the following theory: Debtors sell off their commodities and assets to reduce outstanding debt, and the selling causes deflation, which makes the real burden of the debt larger. Thus, debtors' effort to reduce their debt actually increases it, in real terms. Since this story is in line with Keynesian thought that depression is a temporary deviation from optimal equilibrium, Fisher's prescription (reflation policy) is not sufficient for today's Japanese economy, which has fallen into the "low equilibrium" described below. (Paul Krugman has also argued that reflation policy works for Japan, though his reasoning is different from my line of thinking.)

"Low equilibrium," where aggregate demand shrinks, may appear as the following story of "Debt Disorganization." After the bubble burst, creditors (banks) hesitated to invoke bankruptcy on debtors, since defaults were seen as being due to bad luck, and not to debtors' faults or moral hazard. However, once a creditor "rationally" decides to forbear punishing a de facto defaulter, which can survive only by receiving additional credit, the trading partners may distrust the defaulter's commitment to investments to maintain the supply chain for the trading partners. This is because the creditor may invoke bankruptcy on the debtor at any time. If this suspicion on debtors' commitment prevails, chains of production by specialized suppliers break down.
As Adam Smith explains with the example of the pin factory in "The Wealth of Nations," firms improve their productivity dramatically by forming supply chains and by the division of labor in supply networks. In the reality of incomplete contracts and relation-specificity, the "credibility of commitment" to each other is the key factor for development of efficient supply chains. The point of "debt disorganization" is that the bad debt problem destroys the credibility of the debtor's commitment. The loss of credibility creates an inefficient equilibrium where supply chains are disorganized, economic activities stagnate and aggregate demand shrinks.

4. Evidence in the Japanese economy

I analyzed the "disorganization" using the Input-Output Tables of Japan. The method is the same as that of Olivier Blanchard and Michael Kremer who studied "disorganization" in the former Soviet countries after the Cold War (Blanchard, O. and Kremer, M., 1997,"Disorganization," QJE). I implemented regression analysis on the growth of output in each industry. The key explanatory variable is the complexity of supply chains, where the complexity is defined as one minus Herfindahl index of input shares. If the coefficient on the complexity is significantly negative, we infer that disorganization occurs.
Empirical evidence suggests that disorganization did not occur before 1990 in Japan, and that disorganization occurred only after the bubble burst and forbearance was chosen as the method to deal with bad debt at the beginning of the 1990s.

5. Policy implications

The story of debt disorganization tells us that we need to resolve the bad debt problem (bad loans of banks and excessive corporate debt) completely in order to recover the balanced growth path of the Japanese economy. Unless all the bad debts are resolved, suspicion remains and destroys the credibility of commitment. Keynesian policies, especially monetary expansion, might be necessary to mitigate deflationary pressure caused by debt restructuring, and deregulation might be also necessary to raise the long-term potential for growth. But both of them are not sufficient for recovery from a state of low equilibrium. To achieve economic recovery, the bad debt problem must be resolved and debt disorganization must be stopped.

Our working paper, Kobayashi, K. and M. Inaba, 2000, "Disorganization Due to Forbearance of Debt Restructuring" will become available over the Internet soon. We will notify you as to the address as soon as we can. Please refer to it for the detail of the theory and empirical results.

Author, Keiichiro Kobayashi, Ph.D.
Special Research Fellow, Research Institute of Economy, Trade and Industry, M.E.T.I.
e-mail: kobayashi-keiichiro@rieti.go.jp
tel: 03-3501-1480 fax: 03-3501-1704

Editor in Chief, Nobuo Tanaka
Executive Director, Research Institute of Economy, Trade and Industry, M.E.T.I.
e-mail: tanaka-nobuo@rieti.go.jp
tel: 03-3501-1362 fax: 03-3501-8391

The opinions expressed or implied in this paper are solely those of the author, and do not necessarily represent the views of the Ministry of Economy, Trade and Industry (METI), or of the Research Institute of Economy, Trade and Industry (RIETI).