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Home > Announcements > Speeches and Statements > Speeches 1999 > Remarks by Yutaka Yamaguchi, Deputy Governor of the Bank of Japan, before Colloque Monetaire International at Banque de France, October 8-9, 1999 (Monetary Policy and Structural Policy: A Japanese Perspective)
November 2, 1999
Bank of Japan
The topic for this session--"The Policy Mix and the Structural Policies"--stimulates our thoughts because it is a challenge facing many if not all central banks in both developed and developing countries, and to which we have not found definitive responses yet. I do hope, therefore, to take home some new insights through our discussions today. Meanwhile, this is a bittersweet subject for me, because, looking back with a 20/20 hindsight, the 1990's in Japan can be characterized as a decade during which disproportionate burden was placed on monetary and fiscal policies, while the speed of executing essential structural policies or adjustments in the Japanese economy or financial system was slow. Under such circumstances, the Bank of Japan had to conduct its monetary policy with one eye to the actual pressures on the economy and another eye towards traditional central bank policy philosophies--a decade in which best possible monetary policy was pursued under constraints imposed by structural problems. In the following minutes made available to me, I would like to give my account of what it was like to be "in the circle" during the 1990's: the constraints facing the Bank of Japan and the Bank's choices thereunder. This would be my contribution to the discussions in this session.
Let me start by describing the state of the Japanese financial markets today.
As you probably all know, the Bank of Japan has been driving down money market rates since July 1991, after the "bubble economy" came to an end. The overnight money rate, which was over 8% at its peak, was driven down. Our Bank decided this February to allow interbank interest rates to fall as far as possible (to practically zero), and subsequently announced in April that "zero interest rates" would be maintained until concerns over deflation would subside. Consequently, interest rates in Japan are at historic lows: beginning with the overnight rate at 0.03%, the two-month interbank rate is 0.04%, one year TB's are selling at 0.04% and long term rates are below 2%. Meanwhile, the Bank has actively discharged its responsibility to maintain the stability of the Japanese financial system, as regards its "lender of the last resort" functions, which is as important a policy tool of a central bank as the setting of interest rates. In addition to the more conventional liquidity support in crises, as outlined most eloquently by Bagehot, the Bank provided support in the form of equity in a few cases. Furthermore, not only deposit-taking institutions but, in one case, a nonbank, Yamaichi Securities, received the Bank of Japan's liquidity support.
The adoption of "zero interest rate policy" and the active exercise of its lender of the last resort functions beyond the traditional bounds would suggest that the Bank of Japan during the 1990's was an "outlier" in terms of policies adopted by central banks. Having said this, however, I should also point out that the more traditional concept of central bank functions as described in Bagehot's classic, Lombard Street, was a reflection of the unique conditions that existed in Great Britain towards the end of the last century. Accordingly, the choices made by the Bank of Japan in monetary and financial stability policies should be judged in the context of the conditions that existed in Japan during the 1990's. I would like to discuss this aspect over the next few minutes, concentrating on monetary policy as embodied in interest rate policy, but occasionally touching upon the lender of the last resort functions.
Through the decisive lowering of interest rates, what did the Bank of Japan achieve and what did it not?
What the Bank of Japan did achieve was preventing the Japanese economy from falling into deflation. In the light of a classic yardstick for identifying deflation--the general decline in price levels of goods and services, and contraction in money and credit--the Japanese economy has, if only barely, escaped deflation. To underscore this point, let me compare the present state of the Japanese economy, in terms of prices, money supply and GDP, with the U.S. economy in the 1930's, at the height of the Great Depression. With the first quarter of 1991 for Japan and the first quarter of 1929 for the United States as the benchmark, consumer prices in Depression era United States declined to a low of 74% whereas they are still standing at 107% in Japan, i.e., without any marked decline. Money supply in the United States bottomed out at 65% but it remains at 124% in Japan. A contrasting trend is also observable in GDP: 67% in the United States to 109% in Japan.
Looking from the other side of the coin, so to speak, the low interest rate policy adopted by the Bank of Japan only succeeded in maintaining the levels of prices and money supply. As I noted a few moments ago, the level of money supply is now 124% of what it was at the end of first quarter of 1991 at the peak of the "bubble economy," but, looking at how this money is created through the assets of deposit-taking financial institutions, we see that claims on the public sector, including the purchase of government bonds has increased to 126%, whereas claims on the private sector remain virtually flat at 107% at the end of July this year. Real GDP has barely grown, an annual rate of 1%, during the eight years since the collapse of the bubble. If I may refer also to fiscal policy, according to the latest OECD forecasts, the general government surplus of 2.9% of nominal GDP in 1991 is expected to deteriorate to a 8.7% deficit in 1999, but this massive deficit spending was only sufficient for maintaining the levels of economic activity, not turning it around onto a growth path. Of course, Japanese monetary and fiscal policies is still in full swing towards restoring Japan to a sustainable growth path, and it is too early to make a definite assessment.
Recent developments in the Japanese economy that I have just described raise a question. Why has macroeconomic policy--the drastic reduction in interest rates and increases in government spending--failed to reflate the Japanese economy? The shorthand answer is probably that there existed tremendous structural problems that could not be overcome by measures aimed at boosting aggregate demand in the short run.
Economic growth is a constant process of adapting to changes. Changes could be technological innovations. Changes in the relative prices of goods, services and factors of production could also initiate this process. Whatever the initial change, firms would attempt to adapt to the new environment and maximize profits. New products could be developed, production and distribution could be overhauled, or the management of the firm could be transformed. This is the essence of the process of "creative destruction" that is the driving force of economic growth. Economic growth in the medium to long term is, according to basic textbooks in economics, determined by inputs of factors of production such as labor and capital, and by increases in productivity. Of these elements, from the perspective of individual firms, it should be safe to say that increases in productivity are governed by firms' ability to adapt to changes. If so, the quest into why the Japanese economy stagnated during the 1990's would become a search for the reasons why the capacity to adapt was impaired. The stagnation of the Japanese economy in the 1990's could be attributed to the interactions between the declining ability to adapt to changes by Japanese firms and globalization, which was effecting critical changes in the economic environment.
Why had Japanese firms taken so long in adapting to changes? Let me offer three factors that are most relevant to monetary policy.
First and foremost was the drag on economic activity resulting from non-performing assets. In other words, the erosion of capital at firms weakened the overall resiliency of the economy. For example, as banks' capital base was eroded, banks became less inclined to take on new risks. In case of non-financial firms, i.e., the borrowers, the want of capital prevented them from effectively adapting to changes through new investments and research and development. As a result, the growth in bank credit slowed considerably.
The second factor I would like to point out was the delay in improving economic infrastructure in the broadest sense--laws, regulations, taxes, etc. Global business opportunities offered by the revolutionary progress in information and communications technology were forfeited as existing infrastructure became strictures on innovations that could have exploited such opportunities.
The third point was the Japanese corporate culture, in particular concerning employment and corporate governance. In the case of the employment system, the Japanese system based on so-called "lifetime employment" featured the accumulation of firm-specific human capital on the side of employees. This was once regarded as the source of competitive advantage of Japanese firms, but might have hindered labor mobility from declining industries to ascendant industries and/or from inefficient firms to efficient firms, which is essential if an economy is to overcome a major structural adjustment. As to corporate governance, board members comprised mostly of corporate insiders and cross-holding of shares used to be regarded as a virtue of Japan Inc., because such a system was deemed to enable management to focus on medium to long term strategies. The other side of the coin is that it shields management from market pressures to improve the return on capital.
Though I do not wish to sound too fatalistic, these three factors I have just noted are "preconditions" to monetary policy, and in that sense "structural." If I may repeat myself, non-performing assets hindered the ability of firms to adapt to changes by discouraging risk-taking by firms. Outdated economic infrastructure deterred innovations even if firms had the will to take on risk. Employment practices and poor corporate governance dampened the motivation of management to effect the necessary changes.
Of course, there are arguments against such a view stressing structural influences. Critics point out that Japan had long lagged behind in improving economic infrastructure. They also argue that Japanese corporate culture, such as employment and governance mechanisms, had not changed and was, in fact, deemed the source of strength for the Japanese economy in the 1980's. I do not dispute that such arguments have a grain of truth in them. If an economy could sustain robust growth for some time under a certain established economic mechanism or system, it should be presumed that such a mechanism or system was adopted rationally. Japanese practices concerning employment and corporate governance were, at least until quite recently, probably constituted a rational mechanism or system to sustain robust growth for a few decades. Nevertheless, it must also be recognized that when the economic environment changes significantly, systems and practices that used to be rational could become, at least temporarily, constraints on economic growth.
During the 1990's, in addition to the changing pattern of the division of labor between Japan and its Asian neighbors and a rapidly aging population, the most significant changes in the economic environment were advances in information and communications technology, and the resulting globalization and integration of the world economy and financial markets. Under such environment, firms are confronted with ever stronger competition in the global marketplace. The lines that we have taken for granted between manufacturing and service industries, or that between tradable and non-tradable goods are quickly becoming thinner and thinner as information and communications technology advances by leaps and bounds. In this regard, recent developments in Japan are symbolic in that the services industry, which was heretofore been shielded from international competition, is experiencing a more acute adjustment process.
Having said this, I should also point out that systems and practices are not set in stone, so to speak. They would change, however gradually, under pressures from the changing environment. For example, according to economic historians, lifetime employment, which is now closely associated with major Japanese corporations, was not widely adopted until the 1920's. I believe, therefore, that constraints on economic growth from existing systems and practices are temporary, until the economy adapts to the new environment. In other words, it would be too pessimistic to say that the Japanese economy could not be reflated until Japanese employment practices and corporate governance are reformed. What is important is to keep our heads up and carry on with the necessary structural reforms.
Now that I have given you an overview of the structural dislocations behind the economic stagnation in Japan, I would like to turn to the issue of structural adjustment and monetary policy: how should a central bank conduct its monetary policy in such an environment? Furthermore, if we name policies that address structural factors "structural policies," what are the relations between such policies and monetary policy?
The most important contribution that monetary policy can make is to maintain price stability: i.e., ensuring that the economy does not fall into inflation or deflation. It is solely under such an economic environment that economic agents can accurately discern the changes in relative prices and efficiently adapt to structural changes. Looking back, in Japan in the late 1980's, we saw extensive investments that would only be profitable if the bubble had not burst. Such investments, be they buildings or factories, are still standing, but they are now economically worthless. The huge dynamic resource misallocation is still haunting the Japanese economy. I should also note that such effects of large fluctuations in prices are similar between asset prices and prices of goods and services.
The second role of monetary policy is to mitigate the adjustment pressures on the economy by lowering interest rates, when structural factors are acting as strong head winds. One example of such a policy effect was observed in the United States in the early 1990's: the Federal Reserve's decision to lower the short term interest rates (the Federal Funds rate) led to wider spreads between long and short term interest rates, which acted as an earnings buffer to support the restructuring of financial institutions. Nevertheless, in order for such a policy decision to bring about the desired results, structural adjustment--in the case of the United States in the early 1990's, the restructuring of financial institutions and a redefinition of their business strategies--must be carried out in earnest. Monetary policy can only "buy time," so to speak, in such circumstances. This was why the Bank of Japan had in its recent policy statements stressed the importance of structural adjustment. For example, when the official discount rate was lowered to 0.5% in September 1995, the Policy Board issued a statement stressing that such monetary easing would only be effective if it was accompanied by structural policies such as deregulation.
My third point is corollary to the point I have just mentioned, and is actually what we should not expect of monetary policy: monetary policy cannot replace the necessary structural policies or adjustments. The decisive monetary easing and active interventions to support the financial system by the Bank of Japan no doubt averted deflation or financial panic in Japan. On the other hand, those policy decisions might have dampened the restructuring efforts at Japanese financial institutions. They had also hidden the gravity of the situation from the general public, which resulted in the feeble support for legislative initiatives and budget outlays in response to bank failures. This was a big dilemma for the Bank of Japan. A central bank must avoid first and foremost the economy from falling into a deflationary spiral, no matter how structural policies and adjustments are lagging behind. The result of the monetary easing of the Bank of Japan might have been a Pyrrhic victory: we have succeeded in avoiding deflation but the mitigation of immediate risks resulted in the delaying of adopting ultimate solutions. We must closely examine if this was indeed so in the coming years.
Unfortunately, this most obvious fact that monetary policy cannot replace structural policy seems to be understood only in the abstract. We often hear arguments that call for monetary policy actions in lieu of structural policies under clever disguises. For example, economists both inside and outside Japan often call on the Bank of Japan to increase the purchase of Japanese Government Bonds in the market or begin buying from the Government directly and monetize government debt. Before making such recommendations to pump liquidity into the market, I wish that the advocates would observe closely what is actually happening in the Japanese money market. Under the zero interest rate policy, we are conducting open market operations almost daily to provide reserves, but we often receive bids for funds which fall short of our targets. It should also be noted that much of the funds in the interbank market are remaining in the accounts of money market brokers at the Bank of Japan. This indicates that the liquidity needs of deposit-taking institutions are more than satisfied, and that the shortage of liquidity in the form of central bank reserves is not a constraint on the growth of the Japanese economy.
Inflation targeting is another popular recommendation. I believe that our Bank is fully aware of the pros and cons of such a proposal in conducting monetary policy. The question is whether it would be an effective policy tool under the present circumstances in Japan. The first issue is whether the Bank of Japan can ever guide the expected rate of inflation to a stable and desirable level by mere announcements. The second point is that in relation to what Japan needs at this moment-- returning Japan to a sustainable growth path--whether inflation targeting is an effective tool or not. The driving force behind sustainable growth is, obviously, expenditure that is determined by expectations consistent with the growth rate. If we recognize that consumption is a function of expected future income streams, it is evident that a central bank announcement would not be able to increase consumption because it should have little effect on consumers' expectations on future income streams. Even if consumption were accelerated because of an increase in the expected rate of inflation, it would be a one-off event, not having any lasting effects. What the Japanese economy needs is not an artificial increase in expected rates of inflation but an improvement in the expected rates of economic growth.
If monetary policy cannot substitute for structural policy, what can be done to accelerate structural adjustment? Let me offer two impressions.
The first concerns adjustment pressures exerted by globalizing markets. The balance sheet problem at Japanese banks is a good example. One of the factors that prompted the implementation of necessary measures to resolve the problem, such as injection of public money and defining procedures to dispose of failed institutions, was, unfortunately, the pressure from the global marketplace, such as the increase in funding costs of Japanese financial institutions as evident in the "Japan premium," and the concerns over the availability of foreign currency funding. If a market neglects to review existing regulations and adapt market infrastructure accordingly in the light of the changing environment--advances in technology in particular--such a market is likely to drop out of global competition. Japanese employment practices are also changing as evidenced by an increasing acceptance of foreign firms as employers, and not many workers, even in large corporations, expect lifetime employment to be maintained in the coming years. Finally, the cross-holding of shares is on the decline reflecting the heightened pressures from shareholders to increase profitability, and, as foreign investors hold more shares of Japanese corporations, we are observing remarkable changes in the valuation of individual corporations. Globalization, as I have noted earlier in this session, is on the one hand highlights structural problems, but on the other hand it embodies mechanisms for structural adjustments as well.
My second impression and final words for today involves what authorities should do when confronted with structural dislocations. Under such circumstances, the public sector must clearly spell out what the issues are and offer possible solutions as a matter of public policy. This is easier said than done. Looking back, much time was needed before the public at large understood the macroeconomic implications of structural problems, such as non-performing loans on the balance sheets of banks, and before accepting necessary measures to resolve such problems. We must also consider that frictions between market-based solutions and long-established social systems and structures are on the rise, in the context of the increasing pressures from the global marketplace. As I noted at the beginning, there is no right answer concerning appropriate structural policy. Having said this, it should be stressed that the ability to address issues, i.e., identifying structural issues, developing concrete solutions thereof, and taking prompt actions, is becoming more and more important. I believe that we are now in the age where states compete as regards such ability to address issues. Central banks' monetary policy cannot replace structural policy. Nevertheless, looking back on the experiences of the Bank of Japan during the 1990's, I believe that central banks are counted on to determine quickly any major structural changes in economies, analyze accurately their implications, and explain them persuasively to the public at large.
Thank you for your kind attention.