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The Course of the Economy Critically Hinges on Policy Choices in 2010
GOTO YasuoSenior Fellow, RIETI
Policy choices have a great influence on the course of the economy at all times, but in 2010, this will be even more so the case both in Japan and abroad. In what follows, I would like to provide a prospect for 2010 by focusing on finance and economic trends, which are areas of my expertise.
Global economy surrounding Japan
First, let's take a look at overseas economic conditions surrounding Japan. Major disruptions in the U.S. financial market and economy were the root cause of the crisis that began unfolding in 2008 and sent the whole world into a tailspin. The United States has found some breathing space and is in a lull for now. However, in my view there are problems that have yet to be fundamentally solved and the U.S. government has a crucially important role to play in putting a final end to the crisis. Simply put, what the U.S. is facing today is the problem of bad assets held by U.S. financial firms and the problem of over-indebtedness of American households. As Japan knows all too well from its own experience in the 1990s and the years that followed, the dysfunction of the financial system put the real economy (or economic trends) under continuous, strong downward pressure. Economic trends are measured in terms of flows, whereas the problem of the financial system caused by bad assets is a phenomenon in which stocks, as an accumulation of flows, fall apart in a very short period of time. In the case of the latter problem, it is not simply a matter of leaving it to the power of natural healing because the pain spreads with time. Solving this problem surely takes bold policy measures by government authorities.
President Barack Obama implemented a range of economic stimulus measures shortly after taking office. However, as the effect of these changes will gradually wane in 2010, the U.S. economy could once again lose steam. Should this happen, the true state of the problems in the financial system, hidden beneath the temporary lull, could surface.
Such a trigger mechanism is even more conspicuous in Europe. It is believed that the financial system in Europe has been undermined by the crisis just as badly as, if not more severely than, the U.S. financial system. However, being in the process of building an economic system by integrating countries with different circumstances, Europe faces particular difficulties in making policy decisions. Monetary policy is a typical area where such difficulties arise. Countries that have adopted the euro as their official currency are placed under the single monetary policy regime of the European Central Bank (ECB). Monetary policy is often effective as a tool to appease worries about the financial system but the ECB finds itself in a situation where it is difficult to use this tool in an expeditious manner.
The deterioration of the financial function of Europe, a major hub for the world's capital flows, including those from oil producing countries, has a serious impact not only on Europe but also on the world economy. It is thus necessary for Japan to closely monitor the situation in Europe.
Seen in a somewhat optimistic light against this generally bleak backdrop is China. Indeed, a huge economic stimulus package, which is now being implemented by China, has well taken into account prospective developments in 2010, and it is expected that there will be a boom in domestic demand in the run-up to and during Shanghai Expo later this year. It is fair to say that these factors warrant relatively bright prospects for China as compared to those for the rest of the world. Yet, even for China, a foundation for growth is not rock-solid. Furthermore, there will likely be a resurgence of calls for an upward revaluation of the yuan. Throughout the world, governments find themselves stuck in a policy deadlock, having no more cards to play. Developed countries are left with little room to initiate new policies as virtually all of these countries face serious fiscal deficits with their interest rates already reduced to historically low levels. For developed countries (particularly for the U.S.), an upward revaluation of the yuan is one of the few remaining cards. Even if China revaluates the yuan to some extent, it would not necessarily bring significant changes to the overall economic trends of developed countries. But there is a good chance that world opinion will move in that direction.
Rebuilding an international monetary system is a challenge for the world
The rebuilding of an international monetary system is a key policy challenge that concerns and must be addressed by all countries around the world. This may sound somewhat vague. But one critical question is how to monitor and regulate speculative capital flows, a culprit that has thrown the whole world into confusion. The answer to this question will not come quickly because every country has its own policy philosophy and economic conditions. Another pressing issue on the international monetary front, which will also likely have an impact on economic trends, is how to ensure stability in foreign exchange rates. Japan is a central player in this endeavor with the yen coming under increasing upward pressure.
When we take an overview of the current state of international affairs, we can see certain seeds of conflicts between the U.S. and Europe as well as between Japan and the U.S. As it appears, these key players are not in the mood to talk frankly and work together to forge a new framework for international foreign exchange coordination. However, if disruptions occur in the foreign exchange market for any reason, it may become necessary to implement certain measures. The U.S. dollar will remain the key currency of the world but its foundation is not being greatly eroded. A sudden and sharp depreciation of the dollar is not what the U.S. wants.
Such is the situation overseas. But then, what about Japan? It seems that the future course of the Japanese economy, even more than that of overseas economies, hinges more critically on policy actions to be taken this year. Indeed, Japan's fiscal deficit has swollen to a level that is the worst among advanced economies. Even though uncollateralized overnight call rates, Japan's benchmark interest rate, have already fallen to the zero percent level, deflation is proceeding.
Determining the true ability of the Japanese economy is the key
These are not the kind of problems to which I can prescribe simple solutions here. But as someone closely watching economic trends, I believe that it is about time for Japan to make a practical judgment on the "true ability" of its economy as a starting point for policy discussion.
The economic growth rate that is considered to represent the true ability of a country's economy is called a "potential growth rate." Such a rate is not directly observable but calculated by some sort of estimates. Up until a year or two ago, Japan's potential growth rate had been estimated to be around 2% in real terms. But it is quite possible that the potential growth rate or the true ability of the Japanese economy has decreased due to various factors, for instance, overseas demand that turns out to be less robust than has been hoped for or less-than-expected progress in technology innovation by industries. I believe that Japan's potential growth rate has fallen to 1% or lower. Such downward adjustment of measurements may be necessary not only in gauging the nation's economic performance in the next few years but also in developing a medium- to long-term outlook in terms of decades.
For years since the collapse of the bubble economy, Japan has been unable to get a real sense of recovery. However, provided that its potential growth is actually slowing down, it would be excessive if Japan continued to pump prime the economy until there was a sense of recovery akin to past recoveries. Where to set the measurement level will affect every economic policy. This is directly linked to not only economic stimulus measures, a short-term scheme addressing immediate needs, but also long-term policy planning, for instance, as to how Japan should proceed with fiscal reconstruction and how the nation's social security system should be designed. Basically, government revenue goes up and down in tandem with economic growth. Thus, when the government assumes a higher-than-reasonable growth rate, any plans for fiscal reconstruction will be destined to fail. And any social security system based on such optimistic assumptions will be unsustainable. The current critical state of Japan's fiscal and social security systems is nothing but the inevitable outcome resulting from years of overestimating the future growth of the economy and population.
The new government of Prime Minister Yukio Hatoyama has been working to review a broad range of policies. In formulating its own set of policies, the government will be required sooner or later to determine the true ability of the Japanese economy, which will serve as the starting point for any policy discussion. This decision will have a significant impact on the direction of government policies as well as on the lives of Japanese people.
That is how I perceive the world economy as seen from the viewpoint of finance and economic trends. Although background factors and the degree of urgency differ from one country to another, I believe that the policy choices to be made by each country this year will have a significant impact on the future course of each country's economy.
The original column was published in Japanese on January 05, 2010.
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