The 15-year War on Nonperforming Loans and Deflation

Fellow, RIETI

This article will discuss the issue of deflation based on my book, "Tohi no Daisho - Bukkageraku to Keizaikiki no Kaimei" ("The Price of Escape - Clarifying Deflation and Economic Crisis") (Nihon Keizai Shimbun), as well as lessons from history.
Let me summarize the points for discussion. First, the fact that the disposal of nonperforming loans is as yet incomplete threatens to be the greatest destabilizing factor for the economy at this stage. Second, the most effective way to tackle deflation is not through public works spending or inflation targeting, but by restoring the soundness of banks through capital infusions.
People argue that proceeding with the disposal of nonperforming loans exacerbates deflation, but it depends on how it is done. Of course, fiscal policies and monetary policies would be effective to an extent. However, bringing the banking system back to good health by disposing of nonperforming loans through the sufficient infusion of capital is the proper way to tackle deflation. In this article, I will explain just why this is the case. I would also like to point out that the opinions expressed here are my own.

Another 15 trillion yen's worth of nonperforming loans need to be disposed

The Nikkei average of 225 blue chip stocks had been floundering around the ¥8,000 level since October 2002, but as of summer 2003 it has been holding steady at the ¥10,000 level. Both capital expenditure and exports are strong, and real gross domestic product has grown for seven straight quarters. While nonmanufacturers and small and medium-sized businesses are still facing tough times, it may be said that on the whole, the economy is beginning to see signs of recovery. However, we need to note that there is still no end in sight to deflation. The pace at which prices fell during the July-September quarter of 2003 (2.7%) was greater than that in the previous quarter.
Both real and financial factors are contributing to this economic trend.

On the real front, corporate structural reforms - in other words, cost-cut - are progressing. Corporate earnings reports for the business year ending March 2003 are symbolic of this. Through the compression of fixed costs and reduction of wages and work force, listed firms recorded huge profit increases. However, if it were simply a matter of improved corporate performance, such a trend had been seen since the end of 2002. Regardless of this, stock prices continued to fall until the Nikkei average hit ¥7,607 on April 28, 2003, and business sentiment did not improve until around the summer of 2003. Why was the recovery in stock prices and business sentiment so slow? This is where the second (financial) factor comes in.

It is the fear of a financial crisis. No matter how visible the signs of improvement in corporate performance may be, if there are strong concerns that a major bank may fail, there is no way that perceptions of the economy will improve. What swept away such concerns (if only temporarily) was the infusion of public funds into the Resona banking group. On May 17, 2003, the government held a meeting of the Financial System Management Council and decided to infuse some ¥2 trillion into Resona Bank. It was at this point that stock prices began to rise.
By injecting public funds into Resona, the government did not hold existing shareholders responsible. In fact, after the capital injection, these shareholders even made a profit through the subsequent rise in Resona share prices. Because of this, the market was calmed by a sense of security that, should it become necessary, the government would protect bank shareholders, and this in turn spurred the purchase of stock in banks and related firms. Foreign investors were especially keen to buy Japanese stocks. As a result, share prices rose sharply. However, this was a buyback of bank stocks based on the belief that the government would provide relief, and not the result of any improvement in the management of banks and associated companies. There has been little change in the situation of banks and companies with excessive debts, and the root of the problem has yet to be solved.
For example, in its midterm earnings report Resona Bank boosted the ratios of its loan loss reserves (50% for loans requiring special attention and 90% for loans to borrowers that may go bankrupt). The average figures for banks nationwide are about 19% for loans requiring special attention and roughly 34% for borrowers that may go bust. If Resona's reserve ratios were applied to other banks, the entire banking industry would have a reserve shortfall of at least ¥12 trillion, and many banks would see their capital dry up.

While it is true that the total amount of nonperforming loans is decreasing, we cannot be overly optimistic. Although publicly announced figures put the total amount of nonperforming loans at ¥35 trillion, private-sector analyst David Atkinson estimates that, in real terms, the figure stands at ¥87 trillion. It is said that the nonperforming loan problem can be solved if ¥11.5 trillion to ¥14.4 trillion of this amount is written off, but the issue is whether the banks still have the strength to do so. Banks managed to find the funds to write off sour loans through the surplus acquired from megabank mergers in fiscal 2001 and by straining to boost capital in fiscal 2002, but what will they do for fiscal 2003? The essence of the anxiety regarding the financial system is whether the banks can write off some ¥15 trillion worth of nonperforming loans without the infusion of fresh capital.
Furthermore, by looking at the recent injection of public funds into the Ashikaga Bank, it is still difficult to say that financial uncertainties are a thing of the past.
It is also important to think hard about the lessons of the "economic recovery that was not felt" between 1994 and 1995, and the exacerbation of the banking problem under the administrations of Prime Ministers Keizo Obuchi and Yoshiro Mori. If the speed of nonperforming loan disposal slackens because the rise in stock prices and signs of economic recovery leads to a relaxing of policies, then the problem will recur as sour loans multiply with time. It is said that if the current pace of disposal continues, the nonperforming loan issue can be cleared up within three years. In order to ensure that we do not come back to where we started, we must not let up on the disposal of nonperforming loans.
However, many people may think that rushing ahead with nonperforming loan disposal will lead to a rise in corporate failures and aggravate the ongoing deflation-induced recession. But there is an aspect to the nonperforming loan problem that causes deflation in the economy as a whole. This is seen in the history of the long-term deflation that gripped Japan between 1920 and 1932.

Deflation spawned by the "Cancer of the Business Community"

During the dozen years or so between 1920 and 1932, the Japanese economy was struggling amid a protracted economic slowdown and depression. The course of events that took place during this time is strikingly similar to the long-term stagnation we have been experiencing since the collapse of the bubble economy.

After the end of World War I, Japan saw the creation of a speculative bubble that burst in 1920. Just as was the case in the 1990s, the disposal of nonperforming loans was put off for years, and forbearance lending and window-dressing accounting were widespread among banks and businesses. Because earthquake bills issued as relief measures for the Great Kanto Earthquake of 1923 were abused to conceal loans that had gone sour, the nonperforming loan problem during this period was summed up by such earthquake bills, prompting them to be called the "cancer of the business community." As the nonperforming loan issue continued to be put off, deflation worsened, and in 1927 the matter could be neglected no longer and a financial panic ensued. This was exactly like the financial crisis we saw from the autumn of 1997 to 1998. Support for structural reforms mounted as the financial panic exposed the corruption among businesses, leading to the birth of the Osachi Hamaguchi Cabinet (with Finance Minister Junnosuke Inoue), which pledged to return Japan to the gold standard. This sequence of events is similar to that which led to the creation of the administration of Junichiro Koizumi. However, Inoue actively adopted deflationary measures so that the nation could return to the gold standard, and in 1930 the economy plunged into a severe deflationary spiral (the Showa Recession). When Finance Minister Korekiyo Takahashi succeeded Inoue in late 1931, the Japanese economy recovered sharply as a result of the reabandoning of the gold standard and the implementation of expansionary fiscal and monetary policies, as well as the yen's depreciation.

When written this way, it may seem that history teaches us that structural reforms are bad and economic stimulus measures that focus on lavish spending are the path to take, but the issue is not that simple. The following three lessons can be learned from detailed study of the Taisho and early Showa periods mentioned above.
(1) Neglecting the "cancer of the business community" (nonperforming loans) was a major cause of the protracted economic slowdown and deflation of the 1920s.
(2) Although Inoue tried to deal with this cancer through very austere fiscal policies between 1929 and 1931, deflation was exacerbated and farmers and small businesses that had nothing to do with the flaws in the business community were reduced to poverty.
(3) It was only after the cancer was removed by the Showa financial crisis and the Showa Recession that the economic stimulus measures implemented by Korekiyo Takahashi proved greatly effective in boosting the economy.
I will discuss the mechanism by which such a cancer leads to deflation later, but let me now review these lessons in focusing on the policy front.

First, let me speak about lesson (1). Throughout the 1920s, the government and the BOJ pumped an abundance of funds into the business sector to bail companies out. Such relief measures are said to have exacerbated forbearance lending and window-dressing, and put problem banks and business management into an unimaginable state of lawlessness. The post-bubble 1990s also saw rampant window-dressing, known as "tobashi," to hide sour loans and forbearance lending in connection with land deals. This situation, where corporate society became corrupted a result of neglecting to deal with the nonperforming loan problem, was no different in the 1990s from what it was in the 1920s. We should further note that the person who aggressively pursued these bailout measures in the 1920s was the same Junnosuke Inoue who later put deflationary policies into force.
By the way, when comparing the 1920s with the present, it may seem that putting post-bubble issues on the backburner is a bad habit unique to the Japanese, but in fact it is a universal trend. This postponement of necessary reforms has become a serious problem in Latin American countries, especially since the 1980s. In the United States, the savings and loan (S&L) industry was saddled with a serious nonperforming loan problem in the 1980s, which was finally sorted out in 1989 with the infusion of a massive amount of public funds. However, the S&L crisis first surfaced in the early 1980s. In other words, the U.S. government left the S&L problem untouched for nearly a decade and as a result deepened the wound. It is safe to say that this course of events was virtually the same as that seen in Japan's banking administration from the 1990s onward.
The measures taken to assist the business sector in the 1920s were the same as the economic pump-priming steps implemented in the 1990s (the use of fiscal stimulus and monetary easing to funnel funds to the private sector) in the sense that they poured a huge amount of BOJ funds and fiscal funds into the corporate sector. However, such stimulus measures - just as in the 1990s - failed to put an end to deflation and recession, because the funds were sucked up by nonperforming loans. This indicates that economic stimulus measures cannot be effective if the "cancer of the business community" (ie the nonperforming loan problem) remains untouched.

Next, let us move on to lesson (2). There are some who liken the fiscal policies Inoue implemented between 1929 and 1931 to the structural reforms launched by the Koizumi Cabinet. What can we learn from the policies of Junnosuke Inoue? As mentioned above, Inoue is responsible for forcibly carrying out policies in the 1920s that bailed out companies by allowing them to postpone dealing with their problems. Why did he suddenly change course and implement austere policies?
In this policy shift, we can see the deep psyche of those who formulate Japan's economic policy that is common to both then and now.
When thought out simply, all that is needed to fix the "cancer of the business community" is surgery to remove the tumor. In other words, only problem banks and problem companies need to be liquidated on a pinpoint basis. But Inoue felt that the process of sorting out the business sector was not something that should be handled by "humans" (the government), but by the "natural dispensation" of market economics (what we now call market mechanisms). If the government took it upon itself to sort the rotten apples out from the corporate sector, it would have no choice but to arbitrate on the issue of management responsibility at banks and companies. In their hearts, this was the last thing government leaders wanted to do. They wanted to be able to say that bank collapses and corporate failures "occurred due to circumstances beyond [the government's] control."
This is why the issue was put off throughout the 1920s, while authorities waited for problem banks and companies to be weeded out. However, because of widespread window-dressing and forbearance lending, adjustments did not occur in the corporate sector through natural forces. Thus, Inoue tried to nudge this process forward by implementing austere and deflationary policies on the premise of returning Japan to the gold standard, thereby using the natural dispensation of the gold regime to achieve this aim. This course of policymaking is extremely similar to the situation in present-day Japan, where policies have shifted from economic stimulus to structural reforms.
Reorganization of the corporate sector proceeded under Inoue's deflationary policies. Furthermore, as we will see below, this in turn formed the base for the success of Takahashi's fiscal policies. But on the other hand, these deflationary policies pushed farmers and small businesses that had nothing to do with corporate reorganization into the depths of poverty, fomented social unrest and as a result paved the way for terrorism and fascism. Because policymakers were so intent on trying to avoid having to directly tackle the issues of corporate restructuring and management responsibility, Japan paid a heavy price in the end.
What lay under both "postponement" and "misguided austerity policies" (the destruction of farms and small firms as a result of corporate reorganization) was the instinctive desire to "avoid the issue of responsibility." By trying to reorganize the business sector through deflation and austere fiscal policies, while steering clear of the issue of responsibility, people on the street who have nothing to do with the problem became engulfed in deflationary recession. This is the lesson to be learned from Inoue's fiscal policies. Policymakers should have resorted to surgery to remove the cancer (putting the financial system back on its feet through the disposal of nonperforming loans) so that the rest of the public would not have been adversely affected.

Finally, let us turn to the third point. The success of the fiscal policies of Korekiyo Takahashi is often said to be proof of the effectiveness of Keynesian economic stimulus policies (boosting fiscal outlays and monetary easing). However, the fact that economic structural reforms were already in progress when Takahashi's policies were implemented also played a vital role in the process of economic recovery. This is something stressed by economic historians.
As a result of the financial crisis and the bank mergers that ensued, many problem banks and firms that were effectively insolvent were liquidated. Furthermore, as a result of Inoue's deflationary policies, companies, especially smaller ones, had streamlined and the Japanese economy had regained its competitiveness. The rationalization of the nation's coalmines during the Showa recession supported the shift to heavy and chemical industries during Takahashi's tenure, while the leaner domestic cotton spinning industry drove out British and Indian products from overseas markets, bringing an export-driven economic recovery to Japan.

Why zero interest rates lead to deflation

The lesson to be learned from the experiences of the early Showa Period is that removal of the "cancer of the business community" (nonperforming loans) played a pivotal role in eradicating deflation. Here I would like to confirm the mechanism by which the "cancer of the business community" caused deflation.
The deflation of the 1920s is believed to have been a classic case of "debt deflation." First, comprehensive treatment of the "cancer of the business community" is neglected, and depositors who become anxious about the creditworthiness of banks rush to withdraw their deposits. Banks, for their part, have no choice but to recover their loans to meet such withdrawal demands. Borrower firms start dumping their assets and merchandise to repay their loans. As a result, the prices of assets and goods plunge, triggering deflation. Deflation leads to an increase in debt burdens in real terms, further tightening the noose around banks and companies that are in negative net worth and accelerating the dumping. Debt deflation is when deflation and excessive debts creates a vicious circle causing the situation to worsen.

What about the ongoing deflation that began around the latter half of the 1990s?
A unique characteristic of present-day Japan is the zero interest rate - a situation where the nominal interest rate is virtually zero percent. There has never before, in any time or place, been a country where the nominal interest rate has remained at zero percent for more than five years. The BOJ introduced this zero interest rate policy in 1999, but in fact the interest rate has been standing at virtually zero percent since the mid-1990s. When measured by the GDP deflator, a comprehensive price index, deflation can be seen to have begun in the mid-1990s, so the time that deflation started coincides with the period when the nominal interest rate fell to zero percent.

Let me briefly explain why zero interest rates affect deflation. Deflation is a situation where inflation - the rate at which prices rise - is negative. The relationship between interest rates and inflation rates can be shown by the identical equation "the inflation rate equals the real interest rate subtracted from the nominal interest rate." The real interest rate is determined by markets, reflecting economic realities, and will be positive. In other words, when the nominal interest rate is zero, the inflation rate, which is the result of deducting the real interest rate (a positive figure) from the nominal interest rate (zero), becomes negative. For example, if the BOJ sets the nominal interest rate at zero when the real interest rate for the Japanese economy stands at 2%, the inflation rate becomes negative 2%, and prices fall by 2%. This is deflation.

Let me explain by using a more intuitive example.
Let us imagine that someone borrowed ¥1 million from a bank and used the money to purchase a cow. If the nominal interest rate is zero percent, then this person will only have to repay ¥1 million to the bank the following year. Let us suppose that during that year the cow gave birth to a calf, and that there were now two cows (this is equivalent to the production activities of companies). What would happen to the price of one cow the following year? This person would only need to repay ¥1 million to the bank, and would be satisfied so long as they obtained ¥1 million through the sale of the two cows. Then, amid a price-slashing war in the market, this person would happily reduce the price of a cow to ¥500,000 per head. In other words, a cow that was worth ¥1 million the previous year would only be worth ¥500,000 a year later. This is deflation. However, if nominal interest rates were higher, the price of a cow would not decrease. For example, if the nominal interest rate was 100%, the person would have to repay the bank ¥2 million and would not reduce the price of the cows from ¥1 million per head. If they did, they would not be able to repay the ¥2 million even if both cows were sold.
In summarizing the above, it can be said that deflation occurs because the nominal interest rate stands at zero percent. If the BOJ sets the nominal interest rate at zero percent when the real interest rate based on economic realities is positive, deflation is inevitable.

So, when we consider the factors behind the current deflation, we come to the question of why the zero interest rate policy is continuing. We often hear the explanation that the BOJ continued to slash the nominal interest rate in order to stimulate the economy until it reached the critical point of zero, but this cannot be the only reason.
The other reason why the nominal interest rate needs to be fixed at zero is probably to extend the life of banks and borrower firms that have a negative net worth. At such banks and companies, liabilities are greater than assets (in other words, there is a discrepancy between assets and liabilities that can be described as a "hole"). In order to fundamentally solve this problem, there is no choice but to plug this hole with infusions of capital. However, because of such reasons as political limitations, capital injections have so far been insufficient. If the hole cannot be completely plugged, then these banks and firms must be left to continue operations despite the hole. What would happen if the nominal interest rate were positive under such circumstances? The nominal interest rate is also the rate at which the gap between assets and liabilities grows, so the hole would widen year by year, and at some point the failure of the bank or company would be exposed. In order to maintain the current status quo without exposing the fact that these entities have a negative net worth, the nominal interest rate must remain at zero, so that the gap does not expand.

The above discussion can be summarized as follows:
(1) The deflation of the 1920s was debt deflation, in which depositors became concerned about the health of banks amid the postponement of efforts to tackle the "cancer of the business community" (the negative net worth of many banks and businesses), rushed to withdraw their deposits, and a dumping of assets ensued.
(2) In the current Japanese economy, authorities have had no choice but to adopt a zero interest rate policy because of the postponement of capital infusions. Gradual deflation is continuing because the nominal interest rate has been fixed at zero in an environment where the real interest rate is positive.
While there is a slight difference in mechanisms, the fact that long-term deflation was brought about as a result of the "cancer of the business community" (the debt issue) being left unattended is common to both the situation in the 1920s and the present one.

First, inject public funds

The zero interest rate is prolonging deflation.
Then, would deflation stop if the nominal interest rate were boosted? Of course, that is not the case. If the nominal interest rate were to rise without any capital infusion into banks or disposal of nonperforming loans, banks and businesses would collapse. The Japanese economy would fall into a situation similar to the financial crisis of the early Showa Period. If that were to happen, we would see deflation worse than what we are experiencing now.
Therefore, the proper order of policies is for the debt issue to first be resolved through such means as injections of public funds, with the nominal interest rate to be raised once the banking system and the corporate sector have fully regained their strength.
Plugging the hole of negative net worth in the banking system with public funds and proceeding with the weeding-out and resuscitation of insolvent firms are surgical policies. Anesthetics such as fiscal outlays and monetary easing are necessary when conducting an operation. Fiscal expenditures to deal with unemployment, quantitative easing by the BOJ and other such measures must be continued until both the capital shortfall at banks and the nonperforming loan issue are solved. It would be wrong to introduce belt-tightening measures equivalent to cutting off the anesthetics during an operation. That is the lesson learned from the fiscal policies of Junnosuke Inoue.

For the time being, the core policies are (1) resolve the capital shortage at banks through injections of public funds (2) use this new capital to dispose of nonperforming loans and rehabilitate firms that have a negative net worth, and (3) avoid a deflationary spiral similar to that seen during the Showa Recession by implementing measures to deal with unemployment and pump-priming steps such as monetary easing.
The disposal of nonperforming loans has progressed rapidly over the past few years. As mentioned above, it is said that there is only about 15 trillion yen's worth of loans that still need to be written off. If the banks have the funds, this is a figure that can be taken care of in some three years. Therefore, if public funds could be used to this end, the nonperforming loan issue would be resolved in roughly three years. However, should the infusion of public funds be delayed and banks be left to deal with the matter by themselves, loan disposal will not progress and there is a high likelihood that nonperforming loans will increase and the problem would again take a long time to correct.
The key is to keep up the pace of nonperforming loan disposal by injecting money (public funds) for financial revival. Once it is completed, the zero interest rate policy can be scrapped and the nation can come out of deflation by raising the nominal interest rate.

And so it comes to the issue of government bonds

Once the nonperforming loan issue is solved by the injection of capital, we can put an end to deflation by raising the nominal interest rate from zero. The problem that will then crop up is the state of the nation's finances and the government bond market.
Capital injections and the disposal of nonperforming loans are, in other words, nothing but having the government (namely taxpayers) foot the bill for the hole of negative net worth that has opened up in the private sector economy. It means that the government will shoulder the debts which banks and businesses have become unable to repay. From the taxpayer's point of view, it is an unpersuasive argument which says that banks and companies can become healthy at the expense of the government. But this cannot be helped so long as someone must take charge of the hole of debt that has opened in the Japanese economy. Both banks and companies are at the limits of their strength, and unless they regain their health, the livelihoods of the general public will only worsen.
Therefore, there is no way the government can avoid shouldering these debts if the economy is to be rid of deflation and recover. That is why the biggest issue after deflation is conquered will be that of the inflated national debt (government bonds). The problem lies in the fact that the risk of a government bond crash will surface once deflation has abated.

Because the private sector has no demand for funding at present, financial institutions such as banks hold a huge amount of government bonds, and no one plans to sell them. This is why so long as deflation continues government bonds will not crash. However, once deflation is eradicated and the economy starts to recover in earnest, there will be an active demand for funding at companies. It will become more profitable for financial institutions to sell their government bond holdings and lend that money to companies. Then the risk of a dumping of government bonds will grow, and the possibility of a government bond crash will increase. Should such a crash occur, there would be a chain reaction of collapses of life insurance firms and banks that hold huge amounts of government bonds, as well as a series of corporate failures due to a surge in interest rates. The likelihood of hyperinflation - of more than 100% - would also be high. It would be the start of a recession triggered by a plunge in government bonds.
In order to prevent such a scenario, the government must strengthen its bond management. The Finance Ministry and the BOJ have to join hands in holding the government bond market afloat and preventing a crash. In addition, the role of the postal savings system, which is a major purchaser of government bonds, will probably draw close attention. When the economy recovers, it is certain that postal savings will play a large role in the support buying of government bonds. On the issue of privatizing postal services, this point should also be taken into consideration.

If the BOJ purchases government bonds to prop up the market, the amount of money circulating within the economy will increase, leading to inflation. Normally, monetary policy would call for anti-inflationary measures (ie the selling of government bonds) at a time when the economy is growing so as to prevent any overheating, but when the outstanding government bond issue is huge and there is a risk of a government bond crash, policymakers must take inflationary measures (ie the purchase of government bonds) even during an economic upswing. As a result, it is likely that the Japanese economy would have to endure quite serious inflation (possibly 10% or more) for several years. However, we have no choice but to accept the continuation of high inflation as the price that must be paid for economic recovery.
This sort of fiscal course is the same as that taken by the government bond policy of the United States after World War II. U.S. government bond issues surged during the war. Because the risk of a government bond crash increased as demand for corporate funds rose following the end of the war, the Federal Reserve Board adopted a policy of unlimited purchasing of government bonds at a high price. As a result, the U.S. economy struggled under high inflation, but was able to prevent a crash in government bonds and hyperinflation. It was only around 1980 that the U.S. was able to normalize its ratio of outstanding government bonds to gross domestic product - indeed, by this time 50 years had passed since the Great Depression.

In Japan also, it is likely that the private sector economy will be able to shrug off deflation in three years or so if there are capital injections and the disposal of nonperforming loans proceeds swiftly. Once that happens, unemployment will decrease and the lives of the general public will become brighter. As for the remaining problem of fiscal stability, it would seem that there is no choice but to try to restore normalcy over a span of several decades by continuing a policy of managing government bonds.

>> Original text in Japanese

* This article appeared in the January issue of the Bungei Shunju magazine.

January 2004 Bungei Shunju

February 20, 2004

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