No Way Out For Japan
By David Ingram
03/2/01 8:30 AM ET

On Wednesday, the Japanese Ministry of Economy, Trade and Industry (METI) announced that industrial production plunged by 3.9% in January, counter to a consensus forecast for a 0.4% gain. The fact that the broad array of forecasters missed the mark by such a wide margin, and even failed to anticipate the direction, emphasizes the speed at which Japan's economy is deteriorating.

More discouraging, the industrial production report was just one data point in a day that painted a dark picture of things to come in Japan. Sales also declined in January, posting a 3.8% monthly drop. Further, inventories are accumulating, suggesting further weakness in manufacturing through mid-year. Reinforcing this dismal picture is the fact that construction was off by more than 10%, and export orders have begun to decline. All told, Wednesday's data releases were an uninspiring lot.

In response, the Bank of Japan (BOJ) reduced its target for the overnight call rate--its key monetary policy variable--to 0.15% from 0.25%. This marks the first quantitative easing of monetary policy since the BOJ defiantly ended the zero interest rate policy (ZIRP) last August. The motivation for and potential ramifications of that action were documented on the Dismal Scientist at the time (see The BOJ Is Still in A Jam) and will not be rehashed here.

A more important issue is the myopic emphasis that is currently placed on monetary policy in general, and the BOJ's interest rate target in particular. Japanese politicians have been clamoring for the BOJ to reverse course and reinstate the ZIRP, believing that a marginally more expansionary monetary policy is the key to repairing what ails the Japanese economy. More aggressive proposals that would have the BOJ directly purchase Japanese government bonds, and, in doing so, monetize the debt, have also been suggested as a means of pursuing a hyper-expansionary monetary policy. These proposals exist, despite the fact that the BOJ's interest rate target has moved within a half a percentage point of zero for more than a year, and the economy has yet to achieve a self-sustaining recovery.

Thus, the chronically weak Japanese economy has led politicians into a policy cul-de-sac. Correctly so, Governor Hayami has argued that simply pumping more money into the economy will not resolve the crisis. He would rather have the policy attention focus on resolving the debt burden that is constraining the ability of banks to lend. This plan of action is also unlikely to end Japan's problems. To understand why, consider the fact that most of the recent strength in the Japanese economy was derived from investment in equipment, and increased production by firms, which occurred despite the fact that banks are embroiled in a credit crunch originating from their debt overhang. Firms were, nevertheless, able to acquire the financing required to undertake those investments. The production surge petered out when households failed to respond to higher output with more consumption. Inventories began to accumulate, and yesterday's weak industrial production report is the result. That is not to say that restructuring Japan's bank debt is not important, it is simply not sufficient to resurrect Japan's economic prospects.

Where, then, should the focus be? The fact that a strong industrial sector early last year failed to translate into a sustained recovery suggests that the more important problem lies in the spending behavior of households. The fundamental difference between U.S. and Japanese households is that Japanese consumers are more future oriented, and as a result, tend to delay current consumption by saving (see An International Tale of Two Consumers). This is not necessarily a bad thing if the saving activity is guided by efficient market mechanism signals. However, if Japanese saving is the result of market distortions that lead to too much saving, the economy will suffer from an insufficient level of demand.

To understand how market distortions can lead to too much saving on the part of households, one must consider the historic role of banks in the Japanese economy. Traditionally, the Japanese economy has been organized around financial/industrial conglomerates known as keiretsu. At the center of a keiretsu is a large commercial bank. Surrounding the bank are industrial companies and smaller financial firms to which the commercial bank channels cheap credit. This organizational structure was preserved after WWII when the government built a banking system whose sole purpose was to funnel Japanese household savings to Japanese industry. Profit maximization was not a consideration in banking operations, but rather, the overriding goal was to support industry with the cheapest possible source of financial capital. As a result, bank loans in Japan have traditionally been the major source of corporate finance, far outsourcing equity and debt markets.

Also, most households have had relatively few savings options but to invest their money in insurance policies and savings accounts that pay a relatively low rate of return. This large pool of savings was then channeled from financial intermediaries to industrial firms within the keiretsu. Thus, corporate Japan has had at its disposal the savings of an entire nation, priced at an interest rate that ignores risk, profit or efficiency. The result is that corporations have overinvested in capital. Simple laws of supply and demand dictate that when the supply of anything increases, its price falls. Therefore, the overaccumulation of capital has precipitated an enormous and prolonged capital loss by the household sector, which financed the investment.

Recent research by Albert Ando of the University of Pennsylvania has estimated that the size of this capital loss is $400 trillion yen at 1990 prices since 1970. If one assumes that the propensity to consume out of net worth is 0.05%, then the capital loss detracted 30 trillion yen in 1990 prices from consumption in 1998 alone-that amounts to an astounding 6% of GDP during that single year! If one then considers the fact that the additional consumption would have motivated supporting increases in private sector investment, one begins to understand how much has been lost to the Japanese due to the market distortions. While America enjoyed an enormous wealth-effect consumption binge during the second half of the 1990s, Japan has suffered an even larger negative wealth-effect, to the detriment of its economy.