A speech given by Susumu Taketomi, Member of the Policy Board, at an Economic Seminar on the Japanese Economy in Bangkok on June 29, 1998.

The Seminar was co-organized by Thai-Japanese Association and the Embassy of Japan with the support of Institute of Asian Studies, Chulalongkorn University and The Japanese Studies Center, Institute of East Asian Studies Thammasat University.

Good afternoon, ladies and gentlemen.

I am delighted to be here today to share with you some thoughts on what is really taking place in the Japanese economy.

Speakers are normally expected to come up with a joke or two at the beginning of their speeches. I feel inclined not to do so in view of the agonizing economic conditions here in Thailand and back in Japan. May I save a joke until our economy and your economy get better?

Let me start out my speech by suggesting that the Japanese economy stands at a historical turning point both from a domestic and an international perspectives.

You may have heard the expression "systemic fatigue" from some of the opinion leaders in Japan. We also often use the word "1940 regime" referring to the economic system we have used over the past half century.

Faced with a prolonged recession throughout the 1990's, many people in Japan have come to realize that the post-world war II system, which was once so instrumental in achieving a high economic growth, may no longer be so effective going into the 21st century when the four mega-trends already in place will further intensify: namely, (1) acceleration of economic maturation, (2) further aging of the population, (3) acceleration of globalization and (4) advancement of information-based economy.

From the standpoint of a domestic time horizon we have clearly reached a stage in history where we must shift from our traditional system into a regulation-free, market-oriented and open economic regime if, in the future, we are to maintain or improve our standard of living in terms of real disposable income per capita.

On the international dimension, in the post cold war environment, the Japanese economy has been exposed to the pressure of having to adopt "internationally-accepted standards" in order to survive much fiercer world-wide mega-competition, with the US economy revitalizing itself and newly emerging countries entering world markets.

Just when these pressures, domestic and international, were mounting to force drastic changes in the basic framework of the Japanese economy, the "bubble economy" burst, intensifying and prolonging the subsequent process of structural adjustment. Continuous appreciation of the Yen through the mid-1990's dealt an additional blow to the economy. In my view, the kind of structural adjustment our economy has been struggling with since the beginning of the 1990's would normally take over a decade before being consummated. Any system, however beautiful and successful, cannot escape eventually becoming obsolete and outdated. It is no exaggeration to say that this is a paradigm conversion and seismic plate shift for our economy.

Putting aside this long-term assessment and focusing on the short-term Japanese economy, it can be said that we are in the middle of a second cyclical downturn in the structurally-stricken 1990's.

It is recently announced that the Japanese economy started receding in March, 1997. Most likely, this was due initially to the expected accentuation of the fiscal drag, especially the often-quoted three-stage outflows of income from the household sector to the government, which took place from April through October,1997, in the form of a consumption tax hike, discontinuation of a special tax cut and a reduction in medical expense subsidies. It is said that these burdens add up to nine trillion yen.

This income transfer played a key role in reducing demand, particularly consumer spending. The decline in final demand was much deeper than suppliers had originally anticipated. Production had to be sharply cut back to bring inventory down to an appropriate level, but this move was unsuccessful. As a consequence, corporate profits sharply deteriorated in the second half of fiscal year 1997, thereby further curtailing capital investment. Adjustments in the corporate sector had to be extended to reducing overinflated work force, leading to the unprecedented high unemployment rate.

In addition to coping with the adverse impact from this reversal of income distribution, however, the Japanese economy, in the late autumn of 1997, came to be forced to adjust itself even further. The collapse of large-scale financial institutions triggered a deterioration of confidence held by bankers, industrialists, savers and consumers alike. Sharper consciousness of credit risks, concern over a credit crunch and apprehension over the safety of deposits prevailed. This gave rise to the mutually-reinforcing process of aggravated financial conditions, on one hand, and the slide of the real economy, on the other. In addition, it became increasingly evident that the swing in confidence amplified the downturn in business conditions.

It appears that, beneath this sudden and abrupt change in the tempo of cyclical decline, our economy has an inherent vulnerability and weakness which tends to force economic entities to nervously react to the outbreak of various shocks, such as a major bank failure or a sharp turnaround in the performance of the Asian economies. This vulnerability is the end result of the prolonged structural adjustments which our economy has been making since the bubble economy burst.

There are many current issues which our economy is facing. Due to time constraints, I will only discuss three key issues here. The first is the question of whether we are really on the brink of a deflationary spiral. The second addresses the role confidence plays in the economy. The third regards the linkage between the restoration of the financial system's stability and the recovery of the real economy. I am fully aware of other issues such as an increase in unemployment and currency fluctuations, but these problems are closely tied to the issue of how we will help the economy recover, which I do intend to cover.

Let me start with the first question. Many people seem to be concerned that the aggravated environment of income and employment may reignite a second round of cyclical decline with the reduced consumption leading the way. They are apprehensive because they feel that the gap between supply and demand may widen as domestic demand erodes, thus pushing prices down a little further and more extensively.

May I humbly submit to you, however, that by virtue of Japan's large-scale stimulus package there is at least a chance that our economy can avoid a deflationary spiral. The effect of the pump-priming effort will naturally depend on how expeditiously the package can be implemented. In anticipation of the pace of implementation accelerating this late autumn, most business executives will continue to carry out their current destocking of inventory for a few more months, in order to more effectively capitalize on the demand created by the government. This will mean, however, that economic indicators released between now and autumn may not necessarily point to improvement in business activity. It is therefore crucial whether or not business sentiment, consumer confidence and market psychology can endure growing skepticism during the interim. In this connection, I am somewhat relieved by the result of the Bank of Japan's Tankan survey which was released just this morning. As you may know, the Tankan is a quarterly survey on economic conditions. The diffusion index of the current survey has worsened from the previous one. This, however, was expected. What is important is the outlook for three months ahead: business sentiment in September is expected to be less severe.

In looking at the substance of the package, I can perhaps say that the current measures are better placed than those in the first half of the 1990's. To begin with, there is much less dependence on Investment and Trust Accounts. Aside from the conventional public works which the government hopes will have an immediate effect on creating demand, there are measures addressing enhancement of structural reform and promoting resolution of bad debt problems, including securitization of non-performing properties.

Regarding the phase of the business cycle, there may be less risk now than there was in the first half of the 1990's for the package's effect to be offset by overwhelming downward pressures on demand. Capital stock adjustment seems less severe now than then, when private sector fixed investment had to be reduced for three consecutive years. There was also pressure from the yen's appreciation at that time. Production facilities had to be relocated overseas in an attempt to pursue a horizontal division of labor with Asia. Today, however, we face different environmental hazards, such as the surfacing of an asset deflation problem in the form of collapses of major financial institutions and the severe recession in Asia. At the very least, it can be said that the negative forces at work today are different from those in the early 1990's.

A discussion of deflationary trends is incomplete without any mention of the current decline in prices.

There are three dimensions to the present fall in prices. First, prices have been plummeting throughout the 1990's, probably reflecting a rectification process of our former price structure. The relationship between prices of goods and those of services and assets was hardly rational. If the general price level has been dropping in search of a new equilibrium as a key to rationalizing the conventional price structure, then this is somewhat encouraging because it implies a narrowing of the productivity and profitability gap between different sectors.

Second, stagnation in prices for primary products is currently spreading through our economy. At this stage, this is a positive phenomenon because it means improvements in the terms of trade.

Third, decline in prices stemming from the widening gap between supply and demand in the domestic market has the potential to be particularly rough if a second round of demand shrinkage were to take place. However, as I indicated earlier, we will probably be able to preempt this risk with the help of the demand creation effect the stimulus package is supposed to have.

Now let me turn to the second issue of whether or not restoring confidence will lead to some recovery in private sector demand.

While those in the market admit that the stimulus package will halt the slide in demand, they are still skeptical about the spill-over effect as the expected rate of GDP growth is much lower now than in the past. Apparent market sentiment is that, despite a continued low interest rate policy and a large injection of public sector demand, private sector investment will show very little, if any, sign of moving forward in the absence of new production frontiers. Moreover, there seems to be a sense of uncertainty with regard to how various efforts for structural reform will converge and how economic reinvigoration can be achieved without fundamental changes in the tax structure.

Hopefully, however, this subdued market sentiment will change for the better if and when markets detect early signs of increasing order flow from the government and fundamental changes in the policy stance with regard to the tax reform and the resolution of the bad loan problems.

Over the past year or so, the household sector has not been free from a confidence crisis, either, as the sharp drop in propensity to consume so eloquently demonstrates.

According to a survey by the Bank of Japan, consumers have restrained spending due primarily to anxiety about job security and future income stream. Frequent major bankruptcies and the fragile financial system may have played a role in this erosion of confidence.

It is important to add that an expected increase in the burden resulting from reforms in the tax and medical insurance systems, together with concerns over future pension and social insurance receipts, has contributed to spending cuts by young people in their twenties and thirties.

It is only fair to point out, however, that the recent decline in consumption is not solely attributable to the deterioration of confidence.

There has been an inconsequential change in the structure of consumption. The share of optional personal expenditures out of total household spending has increased from about 17% in pre-bubble 1984 to nearly 26% in 1997. Optional consumption is the purchases of consumer durable goods and expenditures on non-essential services such as leisure.

As any economy matures and becomes affluent, optional spending tends to increase in share. As a result, the trend of total economy is likely to be determined by the consumption cycle. In this sense I like to interpret the recent downward swing in the propensity to consume as evidence that Japanese consumers have some room to maneuver during times of adversity.

My review of the confidence issue has led me to the policy implication that top priority must be placed on measures which specifically aim at removing the sources of apprehension.

This in part ties into the third issue which requires most urgent and careful attention; that is, it is difficult for economic recovery to materialize without restoring public trust in the soundness of the financial system.

Back in February of this year, the framework of injecting up to 30 trillion yen of public funds was established to stabilize the financial system. 17 trillion yen is meant to unconditionally protect depositors until March, 2001 when the so-called Big Bang is to be completed, while the remaining 13 trillion yen is supposed to be mobilized in recapitalizing the banking industry.

As the first step, subordinated loans/notes and/or preferred stocks of 1.8 trillion yen was injected in major banks, predicated on the submission of restructuring plans from individual banks. Disclosures of bad loans in accordance with SEC criteria were also made.

Yet bank stocks have dropped, the yen has depreciated and JGB yields have been reduced. In recognition of this serious situation, the government and the ruling coalition parties have embarked upon conceptualizing an "Overall Strategy for Revitalizing the Japanese Financial System." However, the difficult question is how to sort out conflicting requirements: avoidance of moral hazard, maintenance of transparency and crisis management. Unfortunately, at this early stage, we cannot predict precisely how markets will respond to the final outcome of this overall strategy.

At any rate, the time for deliberation has ended and the time for action is upon us. It is imperative to end the vicious cycle between lingering concerns over the fragile banking system and worsening of the real economy.

As I have elaborated all along, the Japanese economy is at a watershed. I am hopeful, however, that we can somehow get through the imminent difficulties by taking bolder actions in accordance with the policy framework available to us today.

In this regard I would like to draw a parallel between the policy structure in Japan today and that in the US in the early 1990's.

In the US, supply-side policies like deregulation since the Carter administration and the tax system reform introduced by President Reagan, coupled with the development of information technology in the 1990's, paved the way for an industrial comeback. In addition, there was an accommodating macro-economic policy set-up of low interest rates as well as a weak dollar. It was against this background that the Resolution Trust Corporation was introduced to resolve, once and for all, the problems of the ailing financial industry.

There is no reason why we in Japan cannot overcome our economic and financial difficulties. The road ahead of us may be rough, but with a firm determination supported by a proper set of policy menus, problems can be resolved. We are fully aware that this is in the interest of not only ourselves, but also of our partners in Asia. With this remark I will conclude my speech and open up the floor for questions and answers. Thank you very much for your kind attention.