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Fukui's mission impossible: some now argue the Bank of Japan—with a would-be reformer at the helm—is the answer to Japan's economic malaise. Actually, the Central Bank is still part of the problem

International Economy, The, Summer, 2003 by Tadashi Nakamae

The gist of my last article for The International Economy was as follows: The capital investment bubble of the late 1980s created a glut of supply capacity in the Japanese economy. Protected by ultra-low interest rates, this excess of supply capacity has remained at around 30 percent since the bubble burst. Balance can be restored to the Japanese economy only through market-driven reduction of supply capacity. To this end, interest rates must rise substantially. But this will not happen until the decline of Japan's current account surplus, combined with capital flight from the household sector, triggers a significant depreciation of the yen.

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This still represents in a nutshell my view of the Japan problem. I wrote last time of the tragic futility of attempts to solve the problem by boosting demand. In fact, government attempts to boost demand through fiscal expansion, and the Bank of Japan's attempts to boost demand through low interest rates, have not been merely futile; they have been decidedly counterproductive, because they have prevented the market from addressing the issue of supply-side reform.

Like central banks the world over, the BOJ is not given to radical new initiatives. Rather, it responds to events in predictable ways. In particular, the BOJ has shown itself capable of vigorous reaction to three stimuli, namely: (1) weakening of the economy; (2) decline of the stock market; and (3) perceived threat to the banking system. And successive reappearance of these stimuli has consistently elicited the same response from the BO J: lowering of the interest rate. Thus, as a result of the BOJ's plodding reactivity since the bursting of the capital investment bubble, the interest rate has seen a truly drastic decline, from 8 percent in the early 1990s to its current rate of zero percent.

Given that the BOJ has lowered the interest rate in order to revive economic growth, support the stock market, and help the banking system, let us consider whether lower interest rates have in fact brought benefit in each of these areas.

Lowering of the interest rate is the normal reaction of a central bank to a cyclical downturn in the economy. But even reducing the interest rate to zero has not caused Japan's economy to recover. Why not? Because Japan's ills are not cyclical; they are structural.

On the supply side, lower interest rates have made it possible for inefficient corporations to survive on meagre rates of return on capital. This has been the biggest obstacle to the structural supply-side reform upon which overall recovery depends.

Moreover, by absolving weak firms of the need to maintain return on capital up to the international standard, zero interest rates have promoted asset deflation. In view of the global deflationary trend and the pressing need for Japanese companies to cut costs, a degree of what I call 'flow' deflation has become acceptable and in any case inevitable. Asset deflation is a different matter. Even under flow deflation, if return on capital is improving, the price of equities, property, and other assets should increase. The falling price of such assets, because it reflects the deterioration of return on capital, is a sure sign that the supply-side reform that should be happening is not in fact happening.

The bubble years left structural problems to be resolved on the demand side also. In the four years from 1987 to 1991, capital investment increased on average by 11.4 percent per year. Following such extravagance, there was no way that demand for capital equipment could be revived, even by rock-bottom interest rates. Therefore, inevitably, between 1991 and 1997 capital investment decreased, by an average 1.5 percent per year. This was not a cyclical downturn; it was the beginning of a necessary structural adjustment to which lowering of interest rates was not the appropriate response.

Consumption and housing investment, too, were inflated by the wealth effects of the bubble. They grew by almost 5 percent per year in the four bubble years. In the six subsequent years consumption increased by only 1.5 percent per year while housing investment decreased by 0.8 percent per year. Again, this was part of a structural adjustment to which lowering of interest rates was not the appropriate response.

What made lower interest rates particularly inappropriate, from a demand-side point of view, was the effect they had on interest income in the household sector. In 1992, with the cost of borrowing at 7.6 percent and interest on savings at 5.2 percent, households paid interest totaling [yen] 22 trillion and received interest totaling [yen] 37 trillion, for a net gain of [yen] 15 trillion. In 2001, with the cost of borrowing at 4.4 percent and interest on savings at 0.9 percent, households paid out [yen] 15 trillion in interest on liabilities of [yen] 337 trillion. Yet they received only [yen] 8 trillion on assets of [yen] 855 trillion, for a net loss of [yen] 7 trillion. At 1992 interest rates, this net loss of [yen] 7 trillion would translate into a net gain of [yen] 19 trillion.

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Fukui's mission impossible: some now argue the Bank of Japan—with a would-be reformer at the helm—is the answer to Japan's economic malaise. Actually, the Central Bank is still part of the problem

International Economy, The, Summer, 2003 by Tadashi Nakamae

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