The Economic Disputes of the Past Decade

Fellow, RIETI

1) The reasons for confusion

Since the burst of the economic bubble in the early 1990s, Japan has been wallowing in a protracted recession, throughout which the debates by economics scholars and economists regarding economic policies have been extremely chaotic.
Various suspects have been named as the culprits for the prolonged recession, such as deflation, nonperforming loans, structural problems and lack of demand. There have also been a myriad of policy proposals that were discussed as means for getting out of the recession, such as "boost public works spending," "have the Bank of Japan purchase stocks" and "dispose of nonperforming loans."
Of late, disputes over economic policy have not caught the public eye as much as they used to, thanks to indications of economic recovery. However, the debate itself is far from over. Many may think: "So what was all that debate for?"
Why do debates on economic issues fall into confusion?
The first problem is that economics is not yet a fully developed science, like natural science or medicine.
Macroeconomics, which discusses economic trends, is not a truly unified science because of the quarrels between the two schools of "Keynesian economics" and "Neoclassical economics." While unification is proceeding in the area of economic theory, when it comes to actual policy proposals, the chasm separating the two schools becomes evident.
Keynesian economists believe that the government and the Bank of Japan can control the economy through fiscal and monetary policy, and condone large government. Neoclassical economists question the effectiveness of fiscal and monetary policy and opt for structural reforms and a small government.
The points of opposition, for example the issue of "whether the economy should be stimulated by issuing deficit-covering bonds or through structural reforms brought about by deregulation," can largely be reduced to the antagonism between Keynesians and Neoclassicals.
The second problem is that there is a deep-seated distrust of "market economy" in Japanese society.
Because a recession is a disease of the market system, the mechanism of market economy must first be understood in order to discuss the issue of recession. However, Marxist social views took root among Japan's postwar intellectuals, and the argument that rejects market economy itself holds sway. Thus, market economy is swiftly abandoned as being useless, and calls surface for "the search for a third way."
Furthermore, economic debates are not contained within discussions of scientific methodology, and inevitably reflect the values of the people doing the debating.
Recession should be corrected by stimulating the economy through public works spending. What lurks behind such policy proposals may be a value judgment on how the government and the public should face each other.
When trying to resolve the nonperforming loan problem, how should banks, borrowers and depositors/the general public shoulder the losses among themselves? A social standard regarding the responsibility for mistakes must be established to find an answer to this question.
It may be said that the reason why much of the debate after the bubble's collapse was sharply confrontational and reached no conclusion was because there was no public consensus on the standards for fundamental social values, in other words, on what kind of society we want to establish.

What questions have the economic debates of the past decade or so on such issues as nonperforming loans, deflation and fiscal reconsolidation put to us? How will they affect Japan's future? I shall try to answer such questions by categorizing the points of opposition in these debates.

2) Nonperforming loans

Since the collapse of the bubble, Japan has suffered from a serious nonperforming loan problem. However, there is heated debate over whether this was the cause or the result of the protracted recession.
In the first place, the way in which the debate on nonperforming loans proceeded was unusual.
The seriousness of the nonperforming loan problem has been widely recognized since the first half of the 1990s. However, the issue was long ignored in debates on economic policies.
Firstly, the nonperforming loan problem was perceived as an "industry problem" in the narrow sense, and seen as irrelevant to matters concerning economic trends or the overall economy.
The dominant view among economists was that "nonperforming loans are the waste products of past mistakes. They have nothing to do with future economic trends. The matter should be settled by banks and borrower firms." Both the banking industry and financial regulators stuck to the position of "not inconveniencing the general public" and failed to disclose information, attempting to have the matter settled within the "financial community."
There was also a problem with the common sense of economic scholars and economists.
The banking system is omitted from textbook economic models cited in policy debates. The standard economics lacked the framework for considering the nonperforming loan issue.
In addition, the fact that the nonperforming loan issue was haunted by a dirty image also played a major role. Economists naturally avoided having anything to do with matters that could not be reasoned out through economics.
For such reasons, policy debates during the first half of the 1990s proceeded without touching upon the crux of the matter - nonperforming loans.
Various reasons were repeatedly given to support the view that "economic recovery was near," but the essence of the problem was not discussed, and it was indeed irritatingly beside the point.
The situation changed drastically toward the end of the 1990s, with the series of collapses of major banks.
Must not the nonperforming loan issue be resolved if the Japanese economy is to get back on its feet? Such perceptions held by those actually in the thick of things finally came to be reflected in the debates of economists.
Furthermore, the possibility that "the financial system can be the root cause for recession" was shown through economic studies as this became another major factor that drove the issue into debate. While such arguments had been discussed among Western scholars, unfortunately it was only in the late 1990s that they began to penetrate policy debate in Japan.
The debate over the causal relationship continues, but we are beginning to understand, even through studies using statistical data, that delay in disposing of nonperforming loans is linked to stagnation in various industrial activities.
However, some economists vehemently rejected the argument that nonperforming loans exacerbate recession. They maintain that nonperforming loans increase because companies cannot repay their debts due to the recession. Conversely, if nonperforming loans were to be blamed for the recession, the issue could not be contained within the "financial community," and various outside parties would start meddling in the disposal of nonperforming loans.
Thus the debate became more an exchange of criticisms rather than rational arguments based on scientific facts. The debate regarding the nonperforming loan issue is closely linked to the issue of how to perceive the "responsibility" of banks and borrowers. Together with the lack of a basic consensus on how to take responsibility for mistakes, the debate became emotional, and the discussions never found a common platform. For the most part, this situation still prevails to this day.

3) Economic stimulus measures

Over the course of the past decade or so, economic stimulus through fiscal outlays such as public works has been implemented virtually every year. It is said that in total, more than ¥100 trillion has been allocated in this way.
Owing to such repeated economic stimulus packages, since the 1990s it has become common sense among Japanese for fiscal measures to be adopted in times of economic slowdown. However, the ongoing economic recovery is taking place naturally, without any especially large fiscal stimulus.
So then, what was the basis for implementing economic stimulus measures during times of recession in the first place?
Fiscal policies are based on Keynesian economics. When goods do not sell because of recession, the harmful influence of the recession can be eased if the government buys goods by increasing public works. In addition, if the government's purchases are very large, they can "prime the pump" and invigorate the private-sector economy.
Such was the way of thinking that formed the foundation of Japan's measures for dealing with recession.
Based on this "pump-priming" theory, fiscal expenditures should have brought about sufficient results after just one or two stimulus packages.
In fact, policymakers who were in charge of economic stimulus steps immediately after the collapse of the bubble also said they thought, "Only one or two injections of fiscal outlays would be needed."
However, in reality, we saw time and again that once the effects of the fiscal stimulus had worn off, the economy swiftly decelerated. In the end, the government had no choice but to continue providing fiscal stimulus practically every year. Such a situation clearly runs counter to the assumptions of Keynesian economics. Under the textbook assumptions, the economy should recover on its own once the pump is primed.
This led more people to support the view that the post-bubble recession was not a normal recession but was caused by some structural problem.
Those who supported such a view opposed the continued dependence on fiscal policies alone, and called for the resolution of structural problems. This is the argument that fiscal policies are in the end only "painkillers," and that to completely cure the disease, surgery - that is, structural reform - is necessary.
In response, those supporting fiscal expenditures began to argue for a larger amount of fiscal stimulus to be administered in one stroke. Simply put, they suggested that "if fiscal policies are ineffective, then the size of the stimulus should be increased as much as is necessary until they are effective."
This assertion deviates from the assumptions of Keynesian economics, and would be difficult to justify scientifically.
In the first place, the assertion that "fiscal stimulus should continue until it is effective" cannot be disproved, and this line of reasoning would justify any policy proposal. For example, the assertion that "the disposal of nonperforming loans should continue until the economy recovers" also cannot be disproved. If the economy does not recover, it can be blamed on the lack of progress in nonperforming loan disposal.
In other words, faced with the reality that fiscal policies do not work, those in favor of such policies had no choice but to resort to a quite unreasonable argument.
However, the argument for fiscal policies remains stubbornly popular. This reflects the voices of such parties as companies that are dependent on public works projects more than the fact that it is more persuasive. The traditional consciousness among Japanese to "depend on authorities" may also be at the root of the line of thinking that it should be the government that works to get the economy back on its feet.
It might be said that in Japan, only one part of Keynesian economic theory was adopted and used as a tool to justify and aggravate this Japanese tendency of depending on the government.

4) Deflation

The greatest theme in recent economic debates is probably deflation (the decline of prices).
Deflation began in Japan in the mid-1990s for such indexes as wholesale prices.
The word deflation is now used practically synonymously with recession (a situation where goods do not sell and unemployment and bankruptcies rise). The assertion that deflation is the cause of the protracted recession seen since the latter half of the 1990s has often been repeated.
However, it is not self-evident that a fall in prices triggers recession.
In the first half of the 1990s, the high-cost structure of the Japanese economy was seen as a matter of concern. The fall in prices was welcomed as a result of an improvement in the constitution of the Japanese economy. Many people thought that "price-busting" was good for the economy. As a matter of fact, land prices have fallen so that good real estate can now be purchased at low prices. We cannot deny that thanks to deflation, in some respects the lives of Japanese have improved.
According to a recent study by an American economist, of the 73 instances of deflation experienced by major industrialized countries in the past century (excluding the Great Depression), only eight were accompanied by recession.
Then what about the assertion that deflation is the villain?
Since the end of the 1990s, there has been much talk about a deflationary spiral. When prices fall and corporate profits decrease, earned income levels fall, bringing about a further decline in the sales of goods. As a result, the economy falls into a vicious circle where prices drop further. Because this indeed is the mechanism behind recession, we need to stem deflation in order to get out of recession. So runs the theory that deflation is to blame.
This argument seems easy to understand at first glance, but it does have some peculiarities.
For example, if prices fall there should be more buyers and so sales volume should increase. This is because if prices fall when the purchaser has a fixed amount of assets, the amount of goods he or she can buy with those assets increases. As a result, there is the possibility that corporate profits will also grow.
In fact, statistics show that there are examples when profits have increased in industries where prices have gone down. A recession does not always occur when there is deflation.
Of course, there are cases where deflation does not stop. This occurs when companies and banks are shouldering a huge amount of debts. This is because real debt burdens increase when deflation progresses, causing economic activity to contract excessively.
This is the debt deflation said to have occurred in the United States during the Great Depression of the 1930s.
The debt deflation spiral inflicts damage on the economy, but deflation is not solely to blame - it occurs when a nonperforming loan problem and deflation occur simultaneously. We should not overlook the fact that the nonperforming loan issue and the structural problems related to it are at the core of the vicious circle.
The argument that deflation is the reason for the recession has received enthusiastic support from many economists and commentators in recent years. Here too, we see that the values of the debater creep into the discussions.
If deflation is to blame, then nonperforming loans have nothing to do with the recession, and there would be no need to discuss responsibility. Such a line of thinking suggests that banks and corporations are the victims of deflation, and even if they do nothing themselves, they have the natural right to be bailed out by the government and the Bank of Japan.
Although there are some who calmly advocate that deflation is to blame for the recession as a scientific theory, I believe the reason most people support this view is because it is a comfortable one for all parties concerned.

5) The zero-interest rate policy and the Bank of Japan

The argument that the Bank of Japan should resolve this deflationary recession through monetary easing has been widely supported not only by private sector economists but also macroeconomic scholars, including those in the United States and Europe.
This argument is linked to the bitter experiences of the huge failure of the policies of the Federal Reserve System, the central bank of the United States, during the Great Depression of the 1930s.
In the early stages of the Great Depression, the Federal Reserve tightened monetary policy at a time when banks were collapsing one after another amid worsening deflation. It is believed that this resulted in a depression that spun out of control. It is the greatest lesson the Great Depression taught modern macroeconomics.
This lesson has become imprinted into the instinct of macroeconomists. That is why when deflation and financial crisis grip modern-day Japan, it gives rise to the opinion, especially among U.S. macroeconomists, that say, "Remember the mistakes of the Great Depression. The central bank should do something to secure economic recovery."
However, there is a major difference between the environment that surrounded monetary policy in the days of the Great Depression and the protracted recession of present-day Japan. That is the fact that the nominal interest rate in Japan is now at zero. Normally, the monetary easing policy implemented by a central bank is the lowering of nominal interest rates. But if the rate stands at zero, it cannot slash it any further.
Even if the Bank of Japan wanted to boost the economy by easing monetary policy, it has been cornered into becoming unable to do so through normal means.
On that point, the situation in the U.S. during the Great Depression was different. Because the nominal interest rate in the U.S. was positive, the Federal Reserve could have slashed it if it thought of doing so. The reason why the Federal Reserve at the time of the Great Depression is criticized is because "it did not lower interest rates even though it could have." The Bank of Japan currently finds itself in a position where "it cannot slash rates even if it wanted to," so the two cannot be criticized in the same way.
In traditional Keynesian economics, a situation where nominal interest rates stand at zero is called a "liquidity trap," and monetary policies by the central bank are said to lose their effectiveness in boosting the economy. In a liquidity trap situation, fiscal policies by the government are said to be more effective than monetary easing.
The reason why calls for the Bank of Japan to do something remain strong despite this is because of the reality that the government cannot continue providing fiscal stimulus as it is so heavily in debt. The government's policies have reached their limit, and now they want the Bank of Japan to do something.
In recent years, as if following on the heels of this reality, within economic academia several theories which say that "economic recovery is possible through monetary easing even under zero-interest rate conditions" have been proposed. This is the argument that deflation can be eradicated if the general public harbors inflation expectations through monetary policy.
However, nothing certain can be said on the effectiveness of the manipulation of expectations or policies under zero-interest conditions, and it is difficult to just simply apply such theories to reality. The theories are still in the developing stage.
The actual policy proposal put forward to create inflation expectations is that "the Bank of Japan should continue to purchase stocks and land until effects become visible." As I have already said, a proposal that calls for "continuation until effects are seen" cannot be disproved, and cannot by any means be called a reasonable argument.
Solving the problem through inflation is the same as getting rid of such losses as nonperforming loans by widely and thinly taxing the entire public. Inflation is convenient for those who want to make responsibility for mistakes ambiguous. Perhaps the reason for the popularity of inflationary policies lies in such desires.

6) Deregulation

As the post-bubble recession dragged on with economic measures that focused on fiscal stimulus having no effect, the view spread that structural problems might be why the economy was not recovering. Debate on deregulation intensified around the early 1990s because it was believed that excessive, outdated regulations were depriving the Japanese economy of its vitality.
Everyone would assent to the argument that economic vitality would increase if regulations were scrapped as much as possible to pave the way for free competition.
The idea that "it would be better to lessen regulations and let the private sector do whatever it pleases" became stronger among those tasked with formulating economic policy in the 1990s. This even gave rise to an atmosphere that rather than coming up with corrective policies, it was right for "the government to do nothing."
However, there were two pitfalls in this line of thinking.
Firstly, deregulation improves the efficiency of the supply structure of the economy, and so it will boost growth in the long term. However, it will not necessarily put an end to recession in the short term.
Secondly, distortions in the system will not necessarily disappear even if regulations are eased. This can be particularly understood if we look at the nonperforming loan problem.
Initially, it was believed that the nonperforming loan issue would be solved of its own accord through the mechanism of free market competition. However, due to imperfections in the accounting system and the system for dealing with bank failures, the disposal of nonperforming loans was put off endlessly throughout the 1990s.
The government had avoided interfering in the nonperforming loan issue, but in the late 1990s, it was forced to resolve the issue through measures such as injections of capital using public funds and strict inspections by financial authorities, which amounted to stiffer regulations.
In short, deregulation, or regulatory reform, may have been Chinese herbal medicine that helps strengthen the constitution of the economy, but did not have the power to immediately cure the malady at hand (which was the recession).
But from now on, there is no doubt that the importance of regulatory reform will increase. This is because as the end of the recession draws near, the next task will be to boost the vitality of Japanese society in the long term.
However, there is stiff resistance to regulatory reform. The biggest issue is the problem of social regulations.
Social regulations in such areas as medicine and education are explained as existing for the pursuit of values on a level different from economic efficiency. For example, it is said that medical regulations exist to protect "human life," agricultural regulations work to ensure "food safety" and education regulations promote "child development."
The opposition toward easing social regulations holds the argument "how can you destroy things that society should protect through deregulation for the sake of economic efficiency?"
It is true that if it were a choice between economic efficiency and life and safety, the latter would be declared the winner.
However, I believe it is wrong to make the basis of the argument a choice between this or that. Economic efficiency and values such as life and safety do not run counter to each other.
For example, in the area of medicine, cost-cutting that ignores the viewpoint of patients cannot be called proper regulatory reform. The purpose of improving efficiency through regulatory reform is to remove wastefulness and distortions in the current system and maximize the number of lives that can be saved through medical treatment while upholding the basic premise of the dignity of life.
What is the target, and what measures should be used to achieve it? Calm debate that does not lapse into unproductive dualism is essential.

7) Fiscal reconsolidation

During the protracted recession of the past decades, tax revenues have fallen while fiscal expenditures to boost the economy have ballooned. How should the critical state of the nation's finances be corrected? This was another major theme of economic debate.
The government wavered between fiscal expansion and fiscal reconstruction.
The outstanding balance of government bonds has been increasing since the 1970s, and fiscal reconsolidation had been the fervent wish of the government even before the bubble economy. However, in the early 1990s, the government took the plunge to expand fiscal outlays as an emergency measure for dealing with the sharp decline of the economy. At the time, it was positioned as a temporary policy.
In the mid-1990s, when the problem of the "jusen" housing loan lenders was resolved and temporary economic recovery was achieved, the government of Prime Minister Ryutaro Hashimoto made a sharp shift to belt-tightening policies in 1997 by raising the consumption tax and enacting the Fiscal Structural Reform Law.
However, the economy rapidly deteriorated in the fall of the same year due to the crisis in the financial sector, and the government of Prime Minister Keizo Obuchi made an about-face to a policy of extreme fiscal expansion. Now, the government of Prime Minister Junichiro Koizumi is once again striving for fiscal reconstruction.
Various criticisms have been directed at the nation's fiscal policy, which has wavered between expansion and austerity.
For example, there was criticism that "the government did not provide sufficient fiscal stimulus for economic recovery because its real intention was fiscal austerity."
However, the debts shouldered by the public sector have topped ¥700 trillion due to public works spending and the fall in tax revenues as a result of tax cuts and recession. This translates into an increase of ¥400 trillion in public debt since the 1990s. I do not think we can say that fiscal outlays were insufficient.
There was also the criticism that "the economy cannot move forward because fiscal policy is alternating between stepping on the accelerator and the brakes."
However, it is probably more accurate to think that the reason why the economy decelerated immediately after pressure on the accelerator of fiscal stimulus eased was because there were structural problems in the economy.
As a result, the ratio of public debts in the national economy has exceeded the level recorded right after World War II, and it continues to increase. We have reached a situation where a crash in the price of government bonds and fiscal bankruptcy are no longer fantasy.
However, there has been little reaction to the crisis facing the nation's fiscal problems, and no indication that government bonds might crash. Although the Koizumi government is trying to implement comprehensive reforms in various areas in an effort to rebuild the nation's finances, a consensus stands obstructed by objections. This may be said to be the result of an unremarkable sense of crisis regarding fiscal issues.
One reason for the lack of panic is because interest rates remain at zero percent.
Usually, fiscal deterioration leads to a rise in interest rates, and weighs heavy on the lives of the people. This leads to a sense of crisis, and fiscal reforms move forward. However, in present-day Japan, because monetary authorities cannot scrap the zero-interest rate policy, the deterioration of the nation's finances does not immediately lead to a rise in interest rates. Thus, because interest rates remain at zero, expectations continue that government bond prices will rise and a crash will not occur. Therefore, no danger is felt.
Put the other way around, it may be said that the sense of crisis over the fiscal situation will become clear when the Japanese economy fully emerges from the prolonged recession and the zero-interest rate policy is lifted.
When that time comes, the reality that the debts of the government are the debts of each and every citizen will hit home. To pay off these debts, there can only be three options - reduce expenditures, raise taxes or accept high inflation. All of these will bring great pain to people's lives.
So, what should be done now? We need serious debate to plot a course for fiscal reconsolidation and choose a method for achieving it that is the least damaging.

8) The role of debate

As we have seen, the confrontations seen in economic debate strongly reflect the opposing values of debaters.
The root of such opposing values may lie in the different historical views of "what on earth was the period of protracted recession seen after the collapse of the bubble economy?"
Should we perceive the present recession as the second coming of the Great Depression of the 1930s or a new phenomenon that mankind has never before experienced?
If it is the second coming of the Great Depression, economics textbooks have plenty of prescriptions. All we would have to do is to find and apply the existing prescriptions accumulated through economics to the current recession in Japan. By existing prescriptions, I mean fiscal stimulus such as public works spending and monetary easing by the Bank of Japan.
Therefore, from the historical viewpoint that Japan's recession is simply one variety of the Great Depression, the argument would be "to keep implementing fiscal policies and monetary easing until we see results."
There are especially many economics scholars in the U.S. who discuss Japan's recession from its similarities to the Great Depression.
Noted U.S. economists are seen as very great authorities in Japanese economic circles. Owing to this, there was probably right from the start a climate to accept without question the arguments put forth by U.S. scholars when it came to economic debate.
The argument for inflation targeting, which claims that deflation is the problem behind the recession, was also triggered by comments made by a well-known U.S. economist and won explosive support among Japanese academics.
However, we can see things in a different light if we take the historical approach that the current recession is a new phenomenon that humankind has never before experienced.
Only in the ongoing recession in Japan do you see a situation where the disposal of massive amounts of nonperforming loans is postponed indefinitely and the nominal interest rate has remained at zero percent for several years. This situation is something that was not assumed by existing economics. If we were to perceive the current recession as something different from the Great Depression, then we may need to come up with new prescriptions. For example, the idea of placing priority on nonperforming loan disposal can be said to have been born from the peculiar nature of the current recession.
The discussions may stretch beyond economic policy and touch upon political systems. When the world experienced the Great Depression of the 1930s, an answer was to root out the causes of the depression by rejecting the idea of markets through fascism and communism.
Looking around the global economy today, the creation and collapse of bubbles, persistent nonperforming loan problems and issues such as financial crisis frequently occur around the world, not just in Japan.
How to resolve the recession in Japan is also an answer to the problem of how to deal with the economic situations that other countries are facing.
The madness of the bubble era and the protracted economic slump after its collapse may have been a depressing time during which many ridiculous things occurred. It can be understood why many who take part in such debate become irritated and say, "At any rate, the government or the Bank of Japan should prop up the economy."
However, this attitude would just leave us with the conclusion that "the Japanese economy just had some foolish experiences." What was the historical significance of Japan's protracted recession? I believe that it is also the role of economic debate to clarify this point.

>> Original text in Japanese

* Asahi Shimbun, April 8 - 19, 2004, printed in eight installments. Reprinting of this article without the consent of the author and the Asahi Shimbun is prohibited.

April 8-19, 2004 Asahi Shimbun

May 18, 2004

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