Fifth Installment
Macroeconomic Policy and Measures for the Financial System
- Divided arguments (Part 2)
Sound financial institutions enable productivity improvements
Prof. Krugman's argument might be summarized this way. An unsound financial system will discourage business investment. If returning the financial system to health had been the driving force of the recovery of the Japanese economy, the economy should have recovered because of increases in capital expenditure. However, capital expenditure did not increase when the Japanese economy recovered after 2000. Rather, the economy recovered because of a rise in exports. Prof. Krugman therefore believes that the economic recovery in Japan was not a result of the restoration of the health of the financial system.
I feel that Prof. Krugman's argument reveals two problems in present standard economics.
First, the argument about a macroeconomic recovery and the argument about a healthy financial system are basically seen as two separate issues. No logical connection between them is considered. Because of this, economists are placed at the level of journalists and commentators in the sense that all they can say, instinctively, is that "both arguments are important."
Second, the intermediary function of the financial system in funds settlement and payment is not considered all that important in macroeconomics. This seems to be behind the division in the arguments. The image of the financial system offered by Prof. Krugman seems to be a system providing real investment goods for businesses (as it is in the textbook macroeconomic model), rather than a system that acts as a medium of exchange and provides a settlement function. As a result of this image, a fixed idea is formed, namely that a functional failure in the financial system only reduces investment.
However, the settlement of funds through the financial system is related to not only investment but to other aspects of economic activities as well. Especially in day-to-day operations, the settlement of businesses' working capital accounts for a large part of the flow of funds into the financial system.
Recent research discovered that if working capital is constrained (by unsound financial institutions and the collapse of the prices of pledged assets, for example), it is observed in macro data as waning productivity (total factor productivity, or TFP). To be exact, if financial constraints tighten at a time when the corporate sector is dependent on borrowings and inter-business credit for funds for purchasing intermediate input goods, it looks as if TFP is falling.
If nonperforming loans and other problems were constraining the working capital of firms, it should have looked as if the productivity of the entire Japanese economy (or the rate of productivity growth) declined. If the financial system regains health, its effect will be observed as a rise in productivity (as a result of the easing of constraints on working capital). If we look at it this way, Prof. Krugman's assumption that the restoration of financial system health should be observed as an increase in capital expenditure will not hold. Macro data shows that the greatest factor in economic fluctuations in Japan after the collapse of its bubble economy was changes in productivity (TFP). We would not be very far off the mark at all if we were to argue that the business downturn that Japan experienced in the 1990s was prolonged because the rate of TFP growth slowed and the Japanese economy recovered after 2000 because the rate of TFP growth increased.
It is not clear why the TFP growth rate slowed in the 1990s and then rose after 2000. If we think that an unhealthy financial system was a primary reason why the working capital of businesses were constrained, as discussed above, we can assume that uncertainty about the financial system associated with the worsening nonperforming loan problem determined changes in productivity and macroeconomic trends. This assumption is compatible with Japanese macro data (capital expenditure did not rise as the economy recovered; business trends were controlled by changes in TFP). The assumption cannot therefore be ruled out with the simple logic that Prof. Krugman employs.
Financial system dissociated by macroeconomics
The problem with Prof. Krugman's argument and the standard macroeconomics in Europe and North America that he represents is that macroeconomic recovery and the disposal of nonperforming assets (stabilization of the financial system) are not discussed in an integrated framework. I suspect that one major reason is that macroeconomics today does not consider the settlement and payment intermediary function of the financial system as an intrinsic function of the financial system.
As a result, the very existence of the financial system is omitted in the basic structure of the present macroeconomics. As everyone who has engaged in macroeconomic analysis would know (while conversely, people who are not familiar with macroeconomics would be shocked to learn), the standard macroeconomic model has three sectors-household, business, and government-and leaves out the financial (banking) sector as a basic constituent. Households provide the labor force and savings to businesses, and buy goods from businesses and use them. Businesses produce goods using the labor provided by households and invest using savings from households. The financial sector plays the role of a conduit, connecting the savings of households with the investment by businesses. This is the basic structure of the macroeconomic model. In other words, the financial system functions only as a conduit and is not considered to proactively influence economic trends. If there are any issues in the financial system, it is that the flow of funds is held back and investments by businesses reduced due to the clogging of the conduit. Funds flowing through the conduit of the financial system are thought of as merely raw materials for capital equipment, or investment goods, rather than money functioning as a medium of exchange (a means of payment). Given this, Prof. Krugman's argument, summarized at the beginning of this installment, agrees with the basics of the macroeconomic model.
Faced with an actual global financial crisis, however, we need to consider the possibility that the structure of the textbook macroeconomic model is seriously flawed.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the August 31, 2009 issue of Kinzai Financial Weekly
