RIETI Report March 2011

Overcoming Challenges Brought on by the Unprecedented Disaster: Post-quake economic policies

In this month's RIETI Report, KOBAYASHI Keiichiro, RIETI Senior Fellow, attempts to chart a direction for government policies to overcome the daunting challenges brought on by the Great East Japan Earthquake that hit the Tohoku Region on March 11. Drawing on lessons from the experience with the Great Kanto Earthquake of 1923, he asks whether Japan should abandon its fiscal austerity efforts for the sake of post-disaster reconstruction.

The answer, he says, is a clear-cut "No." He argues that, unlike in the 1920s, today's Japan should be able to pursue the right mixture of fiscal austerity and monetary stimulus to anchor market confidence in the nation's fiscal position and ensure smooth financing for post-disaster reconstruction. Stringent fiscal policy would surely involve painful reform in various sectors but, he says, realizing this is the responsibility of those of us who have not been severely affected by the quake so as to facilitate the quick recovery of the afflicted areas.

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Overcoming Challenges Brought on by the Unprecedented Disaster: Post-quake economic policies

KOBAYASHI KeiichiroSenior Fellow, RIETI

I would like to pray for the repose of the souls of those who perished in the Great East Japan Earthquake and ensuing tsunami, and I offer my heartfelt sympathy for all the people in the affected regions.

One of the most devastating earthquakes in history hit our country, and it breaks my heart to see media reports on the suffering of people and the tragic situation in the disaster-stricken areas. In addition to the colossal damage inflicted by the earthquake and tsunami, an emergency situation continues at nuclear power plants, particularly at the Fukushima No.1 Nuclear Power Plant, and we have yet to know the exact extent of radiation leakage as of this writing.

In the midst of this calamity, it may be premature to discuss post-disaster economic policies. However, in order to facilitate the rebuilding of people's lives in the affected areas, we should ensure the strong and sound management of the economy going forward. For this reason, I would like to explore the direction of Japan's economic policies specifically from the viewpoint of supporting and facilitating post-disaster reconstruction.

Quick and massive foreign exchange intervention

In the foreign exchange market, the yen's value has been on a sharp upward trend. The yen broke the previous record, briefly strengthening to 76.25 yen against the dollar before receding to around 79 yen. In response, the Group of Seven (G7) finance ministers and central bank governors held an emergency video conference on March 18 and agreed to jointly intervene in the currency market to stem the yen's surge. The yen has since been hovering at the 81 yen level.

The earthquake and the ongoing nuclear power plant incident are, in nature, factors that would drive down the value of the yen, as they have a huge negative impact on the Japanese economy. Thus, the strengthening of the yen is seemingly inexplicable. One reason behind the ongoing upward pressure is massive speculative yen buying by overseas investors on the anticipation that disaster-hit Japanese companies would sell their foreign currency-denominated assets and buy the yen to secure funds for reconstruction. However, we cannot conclude that the current appreciation of the yen is a passing phenomenon caused by an overreaction of the market. After the Great Hanshin-Awaji Earthquake in January 1995, the yen's appreciation continued for more than six months, in the course of which its exchange rate against the dollar hit the previous record of 79.75 yen in April 1995. Should the current appreciation of the yen continue for several months as had been the case after the 1995 earthquake, it would put a heavy shackle on Japanese exporters struggling to recover from the disaster. Japanese stock prices, which suffered a sharp plunge in the wake of the earthquake and the risk of nuclear fallouts, appear to be headed further downward as the yen strengthens.

At the same time, however, it is quite conceivable that the yen would weaken sharply as worries about Japanese government bonds (JGBs) would surface with the unfolding of the reality of the disaster-stricken Japanese economy, given the facts that the earthquake and the nuclear power plant incident are factors weakening the yen and that the current state of Japan's public finance is far worse now compared with the period shortly following the Great Hanshin-Awaji Earthquake.

Further back in history, after the Great Kanto Earthquake of 1923, Japan's imports rose steeply due to massive demand for reconstruction materials, which caused the depletion of foreign reserves and put the Japanese economy in jeopardy. Turning to the current situation, if Japan's production level fails to recover in a timely manner (for instance, due to insufficient power supply), it is quite possible that we will see a surge in imports from overseas. Should this become reality, Japan's trade balance would turn and remain negative over a considerable period of time, resulting in a significant decrease in foreign reserves and a weakening in the yen.

At the moment, while a higher yen is posing an imminent risk factor that may impede Japanese companies' reconstruction efforts, the risk of a sudden and excessive weakening in the yen is also on the rise. Given these circumstances, the Japanese government should act quickly and boldly to let market participants around the world know of its strong determination to safeguard the yen. For this, the Japanese government should promptly embark on massive yen-selling intervention in accordance with the recent G7 agreement. In order to fight against the shock caused by the quake on the market and correct the excessive appreciation of the yen, the Japanese government and the Bank of Japan (BOJ) must act resolutely, and it may take several dozens of trillions of yen-selling intervention.

Even if such massive intervention—selling yen against foreign currencies—turns out to have a limited effect in stemming the yen's rise, it will be effective as a way to maintain investors' confidence in JGBs and help secure financing for post-disaster reconstruction. Regarding the reason for this, though I have discussed this on other occasions, I would like to provide a brief summary.

Before the March 11 earthquake, Japan was already ridden with massive public debt. Serious damage resulting from the quake and subsequent nuclear power plant incidents would further weaken the nation's fiscal health and, sooner or later, undermine market confidence in JGBs. Should this happen, market confidence in the Japanese currency would be undermined as well, hence a fall in the value of the yen. Before the yen loses market confidence, Japan should accumulate foreign reserves or assets denominated in foreign currencies through government intervention, i.e., selling yen against foreign currencies. Those assets would generate foreign exchange gains on the weakening of the yen, thereby automatically improving the government's financial position (in terms of the yen). By thus accumulating foreign currency-denominated assets beforehand, Japan should be able to mitigate the decline of market confidence in JGBs and the yen when the Japanese currency begins to weaken (and JGB prices begin to fall). In other words, the government's intervening to sell yen against foreign currencies is tantamount to Japan's fiscal authorities hedging against risk associated with the weakening of the yen. And this, in effect, would put some brakes on a decline in the value of the yen (and in JGB prices).

For this reason, it is believed that quick and massive currency intervention by the Japanese authorities would be effective, not only in terms of having a direct boosting effect on the Japanese economy, but also as a means to help stabilize the JGB market over a medium-term horizon, thereby facilitating financing for post-disaster reconstruction.

Securing corporate financing flows—Moratorium on payments for business-to-business transactions

In the months following the earthquake, economic damage may spread to areas outside the disaster-stricken region, as disruptions in supply chains on the physical side of the economy and disruptions in credit chains on the financial side could trigger a chain of bankruptcies. It would be difficult to rebuild physical supply chains by means of government policies. However, when it comes to addressing problems on the financial side, the BOJ has an established set of measures as part of its contingency plans for the protection of the Japanese people as provided for under the Act Concerning the Measures for Protection of the People in Armed Attack Situations, etc. The law stipulates that designated public organizations, including the BOJ, establish such contingency plans to protect Japanese citizens in times of emergency such as armed attack by a foreign power. The BOJ's contingency plans call for, among other things, extending the settlement date for notes and placing a moratorium on the penalty (suspension of transactions with banks) for dishonored checks in times of emergency. By establishing such an emergency system for providing a moratorium on the settlement of business-to-business transactions under the initiative of the BOJ, Japan would be able to avoid a situation in which a default on payment could lead to a chain of bankruptcies. Such a scheme is readily applicable to the current situation in coping with uncertainty and contingencies arising from the quake. Also, given the fact that an increasing number of business-to-business transactions are now being settled by means other than bills of exchange, further and more drastic measures may have to be taken. For instance, as medium-term measures for the period of several months to one year going forward, the government should facilitate private-sector bank loans collateralized by business-to-business credit through either of the following ways: 1) the BOJ expands credit to private-sector banks by accepting business-to-business credit—trade receivables, etc., as collateral, or 2) the government or the BOJ guarantees the value of trade receivables and other assets pledged as collateral. Another policy option would be for the BOJ and the Development Bank of Japan (DBJ) to purchase commercial papers, reviving the scheme introduced in autumn 2008, following the collapse of Lehman Brothers, and maintained through spring 2009. Those measures are, in essence, the same as the special treatment of the so-called "shinsai tegata" or "quake-affected bills," a measure implemented after the 1923 Great Kanto Earthquake. Back then, in order to prevent credit jitters from spreading, the BOJ underwrote quake-affected bills—those issued by quake-affected companies and therefore posing high risk of delinquency and default—to provide a total of 350 million yen in cash for circulation. The scheme was arranged in such a way that the government would cover up to 100 million yen in losses incurred by the BOJ from dishonored quake bills.

In the forthcoming months, it may become necessary to implement measures similar to those for quake-affected bills to buoy business-to-business credit and thereby prevent the situation from developing into a major credit crisis. Government authorities in charge of economic policies must closely monitor market developments and take appropriate steps to preempt the risk of systemic crisis such as a chain of corporate bankruptcies and/or major bank failures.

Securing stable financing for reconstruction by stabilizing JGB prices—Long-term fiscal reconstruction and social security reform

On March 12, the government designated the Great East Japan Earthquake as a "disaster of extreme severity" thereby committing large-scale financial support for the restoration of affected areas pursuant to the Act on Special Financial Support to Deal with the Designated Disaster of Extreme Severity. Given the fact that the areas damaged by the quake and tsunami are geographically widespread, and considering the need to clean up and restore the site of the damaged nuclear power plant as well as to rebuild the nation's power grid system, the post-disaster reconstruction could cost a total of several dozens of trillions of yen to above 100 trillion yen in fiscal expenditures. Needless to say, such expenditures would have to be financed by issuing the so-called deficit-covering bonds (or a new kind of special bonds, which we might as well call "post-quake reconstruction bonds") that are exception to Article 4 of the Public Finance Act. This would no doubt pose significant downside risk to JGB prices. Even before the March 11 earthquake, market confidence in Japan's fiscal sustainability could have been lost at any time because of the presence of massive public debt. Now, after the quake, the possible loss of market confidence and a sharp plunge in JGB prices as an inevitable outcome would spell a significant delay in the post-quake reconstruction, increasing the pain by many folds for those people in the afflicted areas.

In the face of this unprecedented emergency, I would like to urge Japanese investors to act according to the principle of "political" rationality that supersedes the principle of economic rationality. By purchasing and holding JGBs thereby facilitating financing for post-disaster reconstruction, they should demonstrate their determination and strong will to stand firmly in solidarity with those people suffering from the unprecedented disaster and to uphold the values and virtues that our country seeks to cherish. However, simply appealing to investors' spirit of solidarity and patriotism is not enough. All of us in this country must join forces to support the reconstruction efforts. How can and should we do this? What is required of us to do is to carry through, with a strong political will, with the kind of reform that would restore the nation's fiscal sustainability. Furthermore, we must implement economic structural reform, boldly and free from vested interests, so as to improve productivity and recover economic growth. By doing so, we should restore fiscal stability, because fiscal sustainability is essential to the smooth issuance of JGBs to raise massive funds required for reconstruction and thus pave the way for early reconstruction.

Fiscal reform is politics per se, rather than being an economic policy. Regarding the proposed tax and social security reform, the ruling and opposition parties must reach agreement for the sake of national salvation and work out specific reform plans for quick implementation. This would involve reducing pension benefits to wealthy elderly people and increasing consumption and other taxes. Such reform pain must be borne by all the people of Japan. The same holds true for the civil servant system reform and cuts in government expenditures unrelated to reconstruction. It is absolutely imperative to provide specific plans and a timetable for cutting expenditures and increasing taxes in order to anchor market confidence in JGBs. Furthermore, in implementing fiscal reform from a long-term viewpoint, existing policies—such as a child allowance for families with children aged 15 and under and the phasing out of highway tolls—should be reexamined from the same viewpoint to present a policy set that can ensure long-term consistency.

In order to restore fiscal health and secure funds for reconstruction, simply pursuing fiscal austerity is not enough. It is indispensable to increase tax revenue by achieving strong economic growth. From this viewpoint, it is important to enhance the overall productivity of the Japanese economy. And in order to achieve this end, we need to put through regulatory reform free from vested interests, even in areas traditionally entwined with vested interests—agriculture, medical and welfare services, etc., and make the Japanese economy more open through participation in the Trans-Pacific Strategic Economic Partnership Agreement (TPP) and by other means.

By solving all those issues that have existed but left unaddressed for many years, we must build a solid fiscal foundation that can ensure smooth financing for reconstruction. Realizing this is our responsibility to the people suffering from the quake.

Fiscal expansion or austerity? Lessons from the Great Kanto Earthquake

Now, I would like to look at the business cycles following the Great Kanto Earthquake of 1923. In the period immediately after the quake, economic activity boomed on the back of large reconstruction demand. However, this induced a sharp rise of imports on speculation for further growth in reconstruction demand, causing an acute decrease in foreign reserves and dragging Japan into a balance of payment crisis. Furthermore, it became difficult for the Japanese government to find buyers for reconstruction-financing bonds in the market because of uncertainty over Japan's ability to redeem them. Faced with this situation, the Cabinet of then Prime Minister Takaaki Kato cut fiscal expenditures by 15% through drastic administrative and fiscal reform. This caused significant deflationary pressure, throwing Japan into a serious depression.

What lessons should we learn from this? Should we avoid austerity measures and expand fiscal expenditures?

In the reconstruction period following the Great Kanto Earthquake, it was surely difficult to find buyers for reconstruction-financing bonds and, if without austerity measures, it would have been even more difficult to raise funds for reconstruction. Therefore, in order to ensure smooth financing for reconstruction and prevent fiscal austerity from leading to serious deterioration in the economy, it would be effective to combine fiscal austerity and monetary stimulus, a macro economic policy formula that became a prevailing orthodoxy in the 1990s in the United States.

Back in the 1920s, Japan's monetary policy was under constraints imposed by the gold standard (to be precise, when the 1923 quake hit, Japan was off the gold standard but it was taken for granted that Japan would eventually return to the system with the previous convertibility). Thus, when the yen lost value due to a sharp increase in post-disaster speculative imports, the Japanese monetary authorities were constrained by their policy objective of stemming the yen's fall and could not maintain accommodative monetary policy.

Today, Japan does not have such a policy that would mandate the central bank to elevate the currency value to a specific level. Thus, it is possible to significantly expand monetary stimulus to spur aggregate demand while implementing stringent fiscal policy to enhance market confidence in JGBs. This is a strategy designed to expand external demand through the effect of a weaker yen resulting from monetary easing. Such macroeconomic management—one that aims to achieve economic growth by the right mixture of fiscal austerity and monetary stimulus—was implemented under the government of Prime Minister Junichiro Koizumi in the first half of the 2000s and brought the longest economic expansion since the end of World War II. I believe this is the direction in which we should be heading in order to recover and rebuild from the devastation suffered from the Great East Japan Earthquake.

>> The original column was published in Japanese on March 18, 2011.

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