Monetary Policy in Japan

Executive summary

The Japanese economy experienced the lackluster period, often dubbed the “lost decade,” between 1990 and 2000. During it, what had been a phase of economic boom in the years preceding 1990s turned into sustained deflation and massive governmental debts alongside the negative growth rate. The point of contention concerning the academic realm on whether the causes of these problems were structural, emanated from the supply side or simply originated from the demand continues to persist. However, following in-depth analysis of the economic conditions between 1960s and 1980s, the period, during which unprecedented growth and operated budget surpluses in the country were recorded, the problems had largely structural character.

According to this realization, the discussion sought to focus on certain intervention courses, which the government and Bank of Japan pursued in a bid to stimulate growth as well as reverse deflation and revive the banking sector that had nearly collapsed. The exposition shows that the country used both fiscal and monetary strategies during the period of 1990-2007; at the final point, the economy gained full but short-lived recovery. However, in 2007-2008, the global crisis emerged. The fiscal policies, which the BOJ pursued, included increased governmental investment into the infrastructure of the country among others. It was a course designed to enhance the supply of money to Japan and strengthen private investment; however, it failed to deliver the desired results. Noting the failure, the BOJ sought to pursue monetary policies, especially from 1999 onwards, the elements of which were the reduction of interest rates to zero level alongside quantitative easing programs.

Specifically, the discourses aimed to eliminate the deflation by providing the availability of credit facilities or increase the supply of money by allowing the inflow of new cash into the economy. The combined effects of these discourses would later lead the economy to full recovery in 2006. At that point, the BOJ terminated the existing QEs and raised interest rates to non-zero level. The ineffectiveness of the pursued fiscal and monetary policies in delivering qualitative and immediate results to the economy of Japan has been the subject for investigation. The reason why the preferred approaches failed was related to the fact that the country experienced a decade of negative growth. The solutions include the adoption of more forward-looking methods in loan classification, pragmatic redress of the debt crisis, which can be conducted through the regulation of government intervention in businesses threatening failure as well as the pursuit of pertinent institutional reforms.

Introduction

It was 1989 that marked when the economy of Japan completed its fourth decade of sustained economic ascent. It became the world second largest economy. As compared to the U.S., its real GDP had outperformed the former both in the previous four years and decade. In addition to being wealthy, the country was also dynamic, which made it a leader in global economics. However, the events that would happen in the next two years, namely the stock bubble of the 1990 and real estate bubble of 1991, catalyzed its retreat from the economic pinnacle and send it follow the road of sustained economic underperformance. Hayashi and Prescott (2002, pp. 208-209) argue that the precursors of the sustained downturn that marked the “lost decade” included the failure to maintain financial transparency, ineffectiveness of the profligate use of fiscal stimulus, and the failure of debt-financing spending. As such, central to this discussion are the economic performance during the “lost decade,” assessment of the intervention, which the Bank of Japan employed during the same period, as well as probable means of addressing the economic woes.

Background: Japanese economic performance in the 1990s and 2000s

The performance of the Japanese economy over the last two decades has been particularly disappointing; the sustained deflation has been characteristic of that period. The 1990’s, often termed the “lost decade,” were particularly discouraging. The economy hardly recorded any growth. The progress averaged 1 percent every year. The economy experienced three bouts of recessions in contrast to other industrial countries, which only recorded milder downturns, and nominal GDP, which was much worse than the real GDP for the same period. It was the result of entrenched moderate deflation. The cause of the problems is largely attributable to structural problems, from which the failure to handle asset price collapse of the 1990s proactively takes precedence.

The asset bubble, which the credit availability easing strategies adopted by Japanese banks fueled, was the characteristic of the Japanese economy in the 1980s. However, due to the stock and real estate bursts of 1990 and 1991 respectively, the BOJ opted to raise interest rates. It was a move that came too soon and was excessively sharp for the economy to handle. The stock markets of the country crashed leaving banks and insurance companies with massive debts. The government sought to intervene in the situation to save financial institutions from failing, which, in turn, sustained the provision of cheap and easy credits to institutions deemed too large to fail. As a result, this “vicious cycle” has been spinning for a whole decade. Many economists agree with the fact that the response of BOJ was too conservative and put stronger deflationary pressure on the economy. The problem, however, had deeper roots. Various sources attribute it to demand or supply problems.

Through the comprehensive analysis of the prevailing demand elements, Weinert (2001, p. 463) shows that the same had little contribution to the economic problems of the country. The researcher claims that the largest fluctuation in demand ratios is that of private business investment ratio, which, in the wake of the asset bubble, registered 15-percent equivalent growth, grew to nearly 20 percent in 1991, and slowed down to about 14 percent in the middle of the decade before stabilizing at between 15 and 16.5 percent (Weinert, 2011, p. 463). The author notes that the significant yet unusual change in consumption observed in 1997 was largely the result of consumption tax distortions that had significant influence on private household purchasing behaviors. Furthermore, the fact that these changes had limited impact on the economic slump offsets the longevity of the proposed argument. In addition, relatively small shift in the consumption to GDP ratio supports the idea that the asset burst had slight impact on private household demands and saving behaviors.

As such, the main precursor of the country’s economic weakness relates to the anomalous behavior, which business investments recorded. Weinert (2011, p. 465) attributes the cause of weak business investment to real factors that the financial factors, including low returns on investments and fluctuations in interest rates, partly support. The dismal profit opportunities that marked the recessions of 1992 and 1994 accompanied by high overcapacities, which were the result of significant investment growth at the second half of the 1980s, were characteristic of this weak business investment in the aftermath of the bubble burst was. The consistent demand slump led to less utilization of the capacities, which the manufacturing industries offered. The low investment, thus, pushed capital stock vintage to ten years in comparison with 8.75 years recorded in 1991 (Weinert. 2001, p. 466). Given this observation, the decrease in business investment does not appear to be a cyclical problem but rather the result of structural changes.

In early 2000s, the country sought for more pragmatic measures of solving the inherent problems within the economy. These assertive measures included the use of public funds in recapitalization of the banks, increased supervision of the banking sector, and improved means of tackling the problem of bad loans. In particular, the BOJ shifted to zero interest rates and quantitative easing measures. The unorthodox measures were designed to mitigate deflationary pressure through the creation of new money, which had to purchase bank assets, thereby increasing the amount of cash available in banks; it was made to enable them absorb the losses associated with bad loans (Fletcher, 2012, p. 150). The BOJ expanded the scale of these programs in 2004 given that the initial undertakings had failed to deliver the desired results since prices continued to fall. Then, the situation improved, and the BOJ announced its decision to terminate the QEs in 2006. The results were a healthier banking sector and increase in business investment.

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The global recession of 2008-2009 hit Japan eliminating all the gains made between 2003 and 2007. The GDP fell by 9 percent, and the country faced the return of deflation (Hoshi and Anil, 2012, p. 111). To stabilize the economy, the BOJ established a program dubbed “comprehensive monetary easing” that reduced official interest rates to just above zero; simultaneously, QE program marked the creation of new money and the purchase of government debts, which previously were in the hands of financial institutions. However, these measures would not deliver the desired results forcing their repetitive enhancement during 2010-2012. Eventually, the economy rebounded slightly. It was the aspect that would set the stage for the intervention of Abenomics.

However, the financial problems might have exacerbated the deterioration in growth expectations and accompanying unfavorable profit development. The prominent source of cheap funds at the time, equity financing, was harder to access after the burst. Such sectors as the construction and real estate suffered huge debt burdens that made them virtually incapable of pursuing new investments. Small and medium-size enterprises that were previously dependent on bank credits faced similar access problems due to the banking crisis of 1997-1998 that led to consequential reforms in banking sector. The issues surrounding the emergence of long periods of inexistent economic growth, contentious as it remains, include the reliance of economy on overtime work in the 1980s among others. However, the following increased social concerns reversed them. Furthermore, the existence of aging population in the 1990s alongside increased regional and global competition also contributed to economic slowdown observed at that time.

History of monetary policies

The troubles of the Japanese economy are attributable to its monetary policies and structural flaws related to the decision of the BOJ to adopt overly restrictive measures. Analyzing the precursors of the conditions characteristic of the “lost decade,” Ito and Mishkin (2006, pp. 131-132) confer that the burst bubble and the prevalence of nonperforming loans were in part to blame. They also contend that the experienced deflation was largely the result of failed monetary policies. As McCallum (2003, p. 4) observes that the failure of the BOJ to increase additional basic growth despite receiving professional advice to pursue it and the claim that it would not result in the stimulative effects enabled the sustenance of deflation in the long-term perspective. However, the history reveals more reasons for the recession.

The industrial expansion, which Japan experienced between 1955 and 1973, was unprecedented. The average economic annual growth of 9.1 percent, which tipped to over 10 percent in the 1960s, was characteristic of the late 1950s (Ohtsu and Imanari, 2002, p. 459); it became the pinnacle of the country’s high-growth era. Within a span of three decades, Japan managed to occupy the place among the wealthiest nations of the planet. Other analysts contend that the realized rapid growth was in part the result of favorable international conditions, namely technological capabilities, access to international markets, enactment of trade policies that protected market while driving aggressive export, and military protection, which the U.S. ensured to it during the Cold War.

Then, the oil shock of the 1970s and the slowdown in the economic growth of Japan came. However, many economists contend that the latter begun earlier. The supply of money within the Japanese economy increased rapidly due to the first oil shock, which was largely the result of the BOJ decision to partake of massive dollar purchase with little sterilization. Moreover, the country adopted more expansionary fiscal policies, which was a move that led to massive inflation. The effect of the first oil shock was the surge in both WPI and CPI inflation with the former rising faster. Hoarding of consumer goods by the populace followed it. It has led to supply shortages as well as shortages in industrial inputs. As a result, Japan registered its first post-war negative growth, which was equivalent to 0.8 percent and termed “stagflation” (Ohtsu and Imanari, 2002, p. 459).

Furthermore, the fact that the country had huge surplus implies that the yen could not depreciate both during the 1977 and 1991 recessions. In both instances, Japan did not have a sufficient bargaining power with the U.S., which operated huge deficits able to absorb the Japanese surpluses for fair exchange rates. Correcting these elements through trade proved difficult since the Japanese export-led model was a matter of government policy, which impeded adopting a more balanced model. This fact explains why no pragmatic measures were taken to address the surplus issue from this perspective even though the same would have been quite productive.

Three factors explain the origin of the Japanese economic slowdown of the 1970s. The first relates to the floating of world major currencies through the Bretton-Woods system. Japan was a lone floater of the dollar in Asia. It conducted most of the financial transactions in dollars, held huge amounts of unhedged dollar assets, the value of which depreciated or appreciated depending on the dollar value, and any overvaluation of the yen forced Japanese output and investment to stagnate as well as suppressed wages and prices leading to financial strain. The second relates to the delayed systemic reforms. Specifically, stable relationships that were vital to growth when the catching-up phase became obsolete in the 1970s that demanded more mature industrial societies. Finally, the existential friction with the U.S., which shifted from managing deficit in the 1950s and early 1960s to managing surplus in the late 1960s, the characteristic of which was the financing of American deficit by Japanese surplus, proved to be detrimental to the Japanese economy sooner than it was expected.

Alternatives: BOJ actions during and after the “lost decade”

With the economic miracle in the past, the country sought to pursue specific monetary and fiscal policies, the pertinent of which occurred between 1998 and 2003 as well as 2003 and2008 while some came in 1993. One of the most remarkable monetary policies, which the BOJ adopted under the governorship of Hayami, emerged in 1999 with the reduction of interest rates to zero, famously termed the “zero interest rate policy” (ZIRP). The interest rates in the years preceding 1999 had reached the low level of .25, and many economists and analysts held belief that moving it to zero would be the last resort. In his analysis of the Japanese economic situation in the latter part of the last century, Krugman (1998, p. 137) argues that setting the interest rates at zero level pushed the Japanese economy into a liquidity trap, a situation, in which monetary policies become ineffectual and the quantity of money becomes irrelevant given that money and bonds essentially turn into perfect substitutes.

Earlier, in 1993, the Japanese government sought to pursue Keynesian economics principles by increasing public investment in the hope that it would boost the economy. However, the fact that the country had major infrastructure projects already complete implied that the increased investment would have little effect on the economy, which is the result of reduced multiplier for public investment. The equivalent results emerged when the country pursued the intentional biased investment of agriculture and rural development. The fact that these fiscal policies failed led to their abandonment in favor of monetary ones, the latter of which became dominant and integral to the recovery of economy between 2003 and 2007 (Harari, 2012, p. 12).

Setting interests rate at zero level had deep flaws because the rates barely stayed at that stage for a year. ZIRP termination would follow in 2000, and the fact that no precise definition of deflation concerns emerged thereafter explains the lack of a clear price indicator used on the basis of regarding a given rate of change as deflationary. Krugman (1998, p. 140) states that these circumstances make it difficult to assess the monetary aggregates. The conditions are the reason why ZIRP termination came that soon; it relates to the fact that the BOJ established the arising impossibility of increasing broader monetary aggregates, and any increment only affects reserves and currency holdings. Thus, these factors are not reliable indicators of defining the stance of the monetary policy.

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The exit of ZIRP paved the way for the entry of quantitative easing whose major mark was the setting of official discount rates at .35 down from .5 percent alongside Lombard-type lending that set interbank rates at .35 percent for anyone with collateral (Ito and Mishkin, 2006, p. 14). The changes, however, did not have strong impact on the market, which prompted further actions, an example of which was the decision to shift policy instruments from interest rates to the accounts held at the BOJ, the sum of reserves both required and excess as well as the need to maintain excesses. BOJ argued that those conditions would remain in place until the CPI registered a stable zero or positive annual increase. Other measures included the decision to increase government bond purchases, which grew from 400 billion yen in 1998 to 1,200 billion yen in 2002 (Auerbach and Obstfeld, 2005, p. 110).

With increased call for better commitment to eliminating deflation, the application of inflation-targeted measures became more plausible. In 2001, the BOJ established the CPI index excluding fresh food (CPIexFood). The objective was to maintain the relaxed monetary policy until the rate of inflation, which the CPI ex-Food measured, became stable or rose above zero. Despite its adoption, the BOJ remained skeptic about the move. Probably, the reason for that skepticism was the fear that its intention was to delete the problem of non-performing loans or fear of further deterioration of the bank balance sheet. When Fukui replaced Hayami at the helm of the BOJ, BOJ moved very quickly to increase the current account balances and expressed commitment to maintaining ZIRP until inflation rates become stable at above zero (ZIRP having been readopted in 2001 alongside quantitative easing).

With the interest rates already at zero level, the limit, below which it could not go implied the fact that the period from 2003 to 2006 was focused more on QEs. The major QE undertakings include an increase in the purchase of monthly long-term bonds and setting targets for reaching current account balance (Ito and Mishkin, 2006, p. 36). In a bid to show its commitment to eradicating deflation, the BOJ raised its target concerning account balance and underwent three bouts of further increment; the final one took place in January 2004. The institution also adopted other non-conventional measures earlier proposed, for example, the purchase of equities from commercial banks but rejected some of them including the purchase of foreign currency bonds and execution of non-sterilized intervention among others. It is remarkably noteworthy that the BOJ under the leadership of Fukui adopted clearer exit conditions. The first concerns the fact that QE would continue until CPI excludes perishables stabilized at above zero level year on year and the use of CPI ex-Food in judging inflation as well as deflation and until the establishment of a numerical condition of zero or above as an exit condition, all of which matured in 2006 or thereabout.

Proposed solutions: Addressing Japan’s economic woes

Having done very little to the economy, the interest rates should be disregarded. Among the courses that can potentially alleviate the problems, there are the adoption of a more forward-looking approach to classification of loans and the establishment of provisions to ensure realistic valuation of loans on bank balance sheet as well as enhancement of the government commitment to ending deflation through further quantitative easing. The need for more pragmatic structural reforms designed to raise productivity and growth over the medium term remains a pertinent one. Adopting such strategies will ensure that banks only avail sustainable and secured credit facilities. Inflation targeting guarantees that deflation does not affect people’s savings or expenditures in the short-term, hence alleviating further problems in the economy.

 The track to regaining economic health must entail astute redress of the debt crisis. The government must terminate the provision of subsidies and protection for private business. In particular, it should allow the insolvent institutions to fail, restructure business through mergers to form stronger ones, separate good assets from bad ones, and foreclose the latter assets. Second, the country needs to focus on forecasting inflation. The need for the forecast targeting, for instance, a ten-year period or investigating delicate boundaries of monetary policies is a pertinent one (Cecchetti, Gensberg, Lipsky, and Wadhwani, 2000, p. 113). Furthermore, the immediate response to sharp asset price inflation occurring simply out of concern for the prospects of future inflation but devoid of predetermined influences would be ideal.

Finally, the necessity of institutional reforms in the backdrop of high and variable inflation that King (2004, p. 4) describes as crucial to shaping attitudes towards the design of institutions is a pertinent on. Specifically, resolving the inherent problem of non-performing debts and the adoption of free market competition require pragmatic institutional reforms. The proportion of non-performing loans is rising. The result is a lack of cash for financing new loans. Resolving these problems requires foreclosures, an approach that also needs commitment to reforms. The country must embrace free market, which the domestic competition characterizes, fair enough to allow the failure of inefficient businesses.

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Conclusion

The Japanese economic struggle has been largely the effect of the failure of its economic system to take bold actions on the emergent issues. The incapability to align the economic practices with internal and global dynamics in the 1970s, the pursuit of optimistic discourses in the 1980s, and failure to respond proactively to the stock and real estate bursts of the 1990s were collectively the precursors of the decade-long deflation in the country. The problems, however, were more of structural origin than of demand one although the latter also had mild influence on the economic deterioration observed during the period under study. The monetary policies pursued under Hayami, namely ZIRP either appeared too late or received early termination; hence, they were largely ineffectual. Under the leadership of Fukui, the country integrated ZIRP with quantitative easing, the result of which was significant economic improvement.