On April 25, 2001 Paul Krugman argued in his New York Times column, "Reckonings," that the reform plans of Japan's new Prime Minister Jun Koizumi may exacerbate the economy's already sluggish growth. We would like to share with you what we think Mr. Koizumi is trying to do.
Japan's problem is the shrinkage of demand, as Professor Krugman pointed out. The question is, what caused this demand shrinkage? Widespread uncertainty in the economy due to financial instability and distress in both the corporate and public sectors have generated anxiety, depressing consumption and investment. John Maynard Keynes also argued that uncertainty causes shrinkage of aggregate demand, for example, by lowering business people's propensity to invest.
Japan has been a faithful believer in Keynesian economics for years. Policy makers assumed that, with fiscal and monetary policies supporting demand, the bad debt problem would resolve itself and the business sector would restructure due to competition, getting the economy back on track. Uncertainty should have been wiped out by Keynesian policy, as in an ordinary business cycle. But an unexpected thing happened: economy-wide procrastination.
With the pervasive debt overhang, transactions among corporations have been shrinking due to concern about the soundness of their business partners. The suspicion has created huge uncertainty in the Japanese economy, which shrinks aggregate demand. Corporations with excessive debt have not been able to aggressively invest; banks cannot expand corporate loans since the risk in the business sector is too high; the number of investors also shrinks because stock prices stagnate in an uncertain business environment. At the beginning of the 1990s, banks and firms decided to continue to refinance bad projects until the recession ends and asset prices recover. Their decision has increased uncertainty, starting the vicious circle of uncertainty, shrinkage of demand, procrastination and more uncertainty.
Purging of uncertainty should be our eventual aim, as Keynes originally intended, but fiscal policy tools are not the right ones, because public spending itself is another source of uncertainty in today's Japan. Long-lasting fiscal expansion has deteriorated the balance sheet of the government. The ratio of public debt to the nominal GDP is now at the same level as just after World War II.
Trying to promote inflation could create another kind of uncertainty, because inflation is quite difficult to control. Professor Krugman's prescription for more expansionary monetary policy can be fully effective only after restructuring the balance sheets of the financial and corporate sectors. On one hand, monetary expansion is rendered ineffective when banks cannot transmit the money to the economy. On the other hand, huge public debt can be a source of hyperinflation. Thus the outcome is unpredictable. One direct measure to wipe out uncertainty from the Japanese economy is to clarify how and when to resolve the bad debt problems in the corporate and public sectors. Koizumi declared firmly that he will push forward with "structural reform." Our understanding is that his reforms will not only to make the supply side more efficient but also to get rid of the uncertainty that reduces aggregate demand.
Koizumi's rhetoric is very radical, but he does not necessarily mean to do everything at once. His policy plan will be realistic: he knows that a depression could result if bankruptcy and unemployment are neglected when implementing reform.
For example, he is proposing to set a ceiling for government bond issuance for the next fiscal year starting in April 2002 at 30 trillion yen, which is 2 trillion yen more than the new JGB issuance planned for the current fiscal year. This not Hoover-like fiscal austerity. Koizumi certainly must have learned a lesson from former Prime Minister Hashimoto's failed attempt in 1997 to rush fiscal reform.
Koizumi is no doubt ready to take any measures necessary to avoid depression without increasing uncertainty. If he undertakes the right policy in the correct order, there is a good chance that he can wipe out the uncertainty that hinders Japan's recovery.
Co-authors:
Tatsuya Terazawa
Special Research Fellow, Research Institute of Economy, Trade and Industry, M.E.T.I.
e-mail: terazawa-tatsuya@rieti.go.jp
tel: 03-3501-1480 fax: 03-3501-1704
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
Vice President, Senior Fellow
Research Institute of Economy, Trade and Industry, IAI
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).
