Home > Announcements > Speeches and Statements > Speeches 2001 > Speech given by Nobuyuki Nakahara, member of the Policy Board of the Bank of Japan, at the Capital Markets Research Institute on December 11, 2001 (The Japanese Economy and Monetary Policy in a Deflationary Environment)

The Japanese Economy and Monetary Policy in a Deflationary Environment

Speech given by Nobuyuki Nakahara, member of the Policy Board of the Bank of Japan, at the Capital Markets Research Institute in Tokyo on December 11, 2001

February 20, 2002
Bank of Japan


I. Introduction

It is a great honor to address such a distinguished group of experts from the banking and securities industries today, which happens to be my 67th birthday. This is the second time I have spoken at the Capital Markets Research Institute, the previous occasion being November 1, 1999. I would like to take this opportunity to explain my personal views. I believe that members of the Policy Board, including deliberative members, who have an independent status, should have their own individual views. When expressing one's personal views I think it inappropriate to use "the Bank of Japan" or "we" as the subject of sentences. The use of "the Bank of Japan" as the subject should be limited to situations where one is citing decisions made at Monetary Policy Meetings (MPMs) or Policy Board meetings.

Today, I will first review developments in monetary policy since November 1999 when I addressed this institute and then give my assessment of the recent economic environment before discussing, the problems with current monetary policy and market operations, monetary policy measures that I believe should be taken, and the nonperforming loan problem in that order.

My speech today will touch upon a wide range of issues but the main message I would like to convey is that (1) the economic situation is extremely severe and it is very likely that the economy has entered the first stage of a deflationary spiral, (2) against this background, current monetary policy is problematic-- it is inadequate in that it is passive in relation to liquidity demand, and thus (3) it is necessary to adopt measures that would achieve further quantitative easing and that would be feasible and not distorting-- one of the measures that meet these conditions would be for the Bank to purchase foreign bonds.

II. Monetary Policy since November 1999

Developments in monetary policy since November 1999 can be broadly divided into the following four phases: (1) the zero interest rate policy period up to August 11, 2000; (2) the post-zero interest rate period from August 2000 to March 2001 (overnight call rate at 0.25-0.15 percent); (3) the period from March 19, 2001 -- when the Bank adopted quantitative easing -- to the terrorist attacks in the United States in September 2001, during which the Bank had specific targets in market operations for the outstanding balance of current accounts with the Bank; and (4) the period starting September 18, when the Bank adopted the guideline to provide enough liquidity to accommodate demand. My stance at MPMs has been as follows: from February 25, 1999 to March 19, 2001, I proposed at every MPM that the Bank adopt quantitative easing with a target for prices; from April to August 2001, I did not make any individual proposals; but from the MPM on August 14, I have repeatedly proposed that the Bank adopt inflation targeting or price level targeting; and since the meeting on September 18, I have proposed that the Bank set a specific target for the outstanding balance of current accounts with the Bank.

Now, I would like to look back in detail in chronological order.

A. The Period from the Second Half of 1999 to Termination of the Zero Interest Rate Policy on August 11, 2000

From February 25, 1999 the economy showed signs of improving somewhat under the zero interest rate policy. Industrial production was growing fueled by exports, thanks to the booming information technology sector; corporate profits were recovering; business fixed investment also recovered in fiscal 2000; and private consumption was steadily on the rise. At the MPM in November 1999, I was the first member to point out that the economy had probably started recovering around April-May 1999. Against this background, some people started to voice the so-called dam theory. Believers of this theory held that the water (profits) that had accumulated in dams (firms) was likely to flow into business fixed investment sooner or later. I, however, was of the opinion that monetary policy was not loose enough and therefore I repeatedly proposed that the Bank synchronize its actions with the Government's fiscal expansion and implement quantitative easing, aiming to maintain over a period of about two years the potential economic growth rate of around 2 percent. The reasons for my proposal, which I explained a number of times, were as follows. First, although the economy was showing signs of slight improvement, the deflationary gap remained large, and regarding prices, the year-on-year declines in the GDP deflator and the CPI (consumer price index) seemed to be expanding. Second, the recovery phases in the past three economic cycles had lasted for more than two years on average but the length of these periods seemed to be shrinking. Third, from early spring to summer 2000, when cyclical momentum was considered to have been strongest in the recovery phase, there were clear signs of peaking out of the business cycle. During this period, indicators gauging business sentiment, such as the Tankan's (Short-Term Economic Survey of Enterprises in Japan) Diffusion Index for business conditions, surged to near the levels of the peak of the previous cycle. Furthermore, the ratio of current profit to sales was increasing at a brisk pace and was likely to surpass the previous cyclical peak and reach a record high. Fourth, the ratio of the coincident indicator to the lagging indicator for the composite index of business conditions, which is one of the most reliable indicators of future economic conditions, had been on the weak side since mid-1999. Fifth, regarding the New York stock market, some indicators were at unusual levels in excess of those before the great crash of 1929, a signal that New York stocks were about to hit their ceiling. And sixth, more basically, the Japanese corporate sector was suffering from the triple burden of excess capacity, excess labor and massive debts, and these weighed down on the momentum of the cyclical upswing.

Against this backdrop, from the spring the majority of Policy Board members grew increasingly optimistic about the outlook for the economy. At the MPM on July 17, when the cyclical peak was approaching, members, somewhat reluctantly, decided to delay lifting the zero interest rate policy as there was a need to monitor how the failure of Sogo Department Store would affect the economy. At the August 11 MPM, however, the Policy Board decided to terminate the zero interest rate policy and raise the target for the uncollateralized overnight call rate to around 0.25 percent regardless of the Government's request to postpone the decision. At the time, business sentiment was very strong throughout the country. I voted against terminating the policy since it ran counter to the economic reasoning in the six points above. Unfortunately, I was proved right. This was because I maintained the position that monetary policy should be taken from a forward looking viewpoint, based on analysis of the current economic situation and not on the wish to regain flexibility in monetary policy as quickly as possible. I was free from the fixation on ending the unusual zero interest rate policy as quickly as possible and from the a priori policy approach relying on the bullish view of the economy.

B. The Post-Zero Interest Rate Period from August 2000 to March 2001 -- Overnight Call Rate at 0.25-0.15 Percent

After the termination of the zero interest rate policy, major economic indicators started deteriorating having peaked out in the middle of 2000, and the IT bubble burst, triggering a fall in stock prices. These developments are broadly in line with the view of many economists that the economy peaked out in August 2000 or in the fourth quarter of 2000. Among real economic indicators, industrial production and exports, in particular, tumbled. Some were of the view that it was only the IT-related sectors that were facing difficulties, but I was of the opinion that, judging from analysis of various leading indicators, not only IT-related sectors but also non-IT sectors, including the "old economy" sectors, would deteriorate as well. Resilience in the New York Dow Jones Industrial Average seemed weak from September onward, and the fact that the ceiling appeared to have been hit, at historically high level, around January 2000 also gave cause for great concern. Signs of recession began emerging worldwide and on February 9, 2001, the Bank decided to establish a "Lombard-type" lending facility through which the Bank extends loans at the request of financial institutions at the official discount rate. The official discount rate was reduced by 0.15 percentage point to 0.35 percent on the same day. On February 28, the target for the overnight call rate was lowered from 0.25 percent to 0.15 percent and the official discount rate was also lowered from 0.35 percent to 0.25 percent. I had been proposing that the Bank take bolder easing measures: up to the MPM on February 9, I repeatedly proposed that the Bank adopt quantitative easing by raising the average balance of current accounts at the Bank to seven trillion yen, and on February 28, I proposed that the overnight call rate target be cut from 0.25 percent to 0.1 percent.

I believe that the decision to terminate the zero interest rate policy was definitely a mistake. Compared to February 1999, when the zero interest rate policy was adopted, the economic situation at the time of the MPM in February 2001 was more severe given the following developments: (1) nominal GDP was lower; (2) government debt had increased, restricting room for manoeuvre in fiscal policy; (3) the health of financial institutions had deteriorated further; (4) from the viewpoint of business cycles, the economy in February 1999 was just about to bottom out while in February 2001 it was just about to enter a downward phase. The tightening of monetary policy from August 2000 to February 2001 against this background, I believe, caused a further deterioration in the real economy.

In the meantime, in October 2000, the Bank released the forecasts for the economy and prices, not of the Bank as a whole, but of the individual Policy Board members. I had been suggesting that the Bank make public such forecasts. With regard to a report titled "Outlook and Risk Assessment of the Economy and Prices," released the same day, I cast a negative vote because I believed that the standard scenario in the report was overly optimistic given the severe economic situation at the time.

C. The Period from March 19, 2001 to the September 11 Terrorist Attacks in the United States, during which the Bank had Specific Targets for the Outstanding Balance of Current Accounts at the Bank

After lowering the interest rate target slightly on February 28, the Bank adopted a policy of "quantitative easing" at the MPM on March 19, an epoch-making policy and unprecedented in the 120 years of the Bank of Japan's history. The decision took into consideration (1) the deceleration in production and exports, (2) concern about the outlook for capital spending, (3) the increase in the downside risks in overseas economies, and (4) the fall in prices. Specifically, in the area of market operations, the Bank changed the operating target to the outstanding balance of current accounts at the Bank from the uncollateralized overnight call rate, and made a commitment to maintain this new framework until the CPI registers stably a year-on-year increase of zero percent or more. Also, when necessary, the Bank will increase outright purchases of long-term government bonds with the proviso that the outstanding amount of long-term government bonds the Bank holds (i.e., after taking account of government bond sales under gensaki repurchase agreements) must be less than the outstanding balance of banknotes issued. The guideline for market operations set the target for the outstanding balance of current accounts at five trillion yen. The debate at the MPM was heated, with opinions divided on whether (1) the Bank should shift to quantitative easing to further relax monetary policy given the zero lower limit on interest rates, allowing market forces to vary interest rates to a certain extent, or (2) interest rates should be kept as the main target for market operations, which meant micromanaging interest rates at near zero percent while providing enough liquidity to satisfy demand. In the end, the majority of members voted to adopt a quantitative target. I was more or less satisfied with this decision at the time because it was similar in essence to my proposal for quantitative easing with a target for price stability. Both use the outstanding balance of current accounts as the operational target and have the objective of increasing the year-on-year change in the CPI (excluding perishables) to zero percent or more.

Subsequently, the economy deteriorated further -- exports continued to decline, industrial output slumped, and it became clear that business fixed investment would decline. As for market indicators, stock prices, which had been rising until early May, started falling and long-term interest rates started to ease in early August reflecting concerns about the deterioration in the economy. Due to such business condition, the target for the outstanding balance of current accounts was increased from five to six trillion yen at the MPM on August 14. The outstanding balance had been around five trillion yen under the zero interest rate policy, which was lifted in August 2000, and the increase to six trillion yen therefore meant the Bank had at last effectively stepped into the territory of quantitative easing. In July, I had believed that the appropriate target was six trillion yen but I did not propose that target level due to factors including the surge in New York stock prices. On August 14, I proposed that the target should be increased to seven trillion yen given the substantial deterioration in the economy, evidenced in the sharp fall in industrial output. My proposal was voted down. It is very unfortunate that the Bank hesitated to raise the target for the outstanding balance with the result that it did too little too late.

On September 11, the United States was hit by terrorist attacks. In response to this emergency, the Bank provided ample liquidity and the outstanding balance of current accounts at the Bank rose to around eight to nine trillion yen. I think that the Bank's decision was appropriate as it was consistent with the provision stating "Should there be concern for financial market instability such as a rapid surge in liquidity demand, the Bank will provide ample liquidity irrespective of the guideline above..

D. The Period following September 18, when the Bank Provided Enough Liquidity to Accommodate Demand

After the terrorist attacks, some financial institutions, concerned about possible market turbulence, held funds in excess of the amount required under the reserve requirement system. They continued to hold these excess reserves even after financial markets had stabilized. Over this period some Japanese institutional investors increased investment in U.S. dollar-denominated bonds through yen-carry trades aiming to profit from the differential in interest rates as well as from capital gains to be expected from a likely easing of U.S. monetary policy. Against this background, foreign financial institutions started to maintain a large amount of excess reserves partly in order to earn profits from arbitraging transactions using negative yen funding costs. In addition, among Japanese banks, some regional banks have recently started to hold excess reserves as they chose not to invest in the interbank market where returns are extremely low. Meanwhile, undersubscription in market operations, which had occurred frequently until the summer, has disappeared.

In this environment, the Policy Board decided by majority vote on September 18 to change the guideline for money market operations to "For the time being, the Bank will provide ample liquidity to the money market by aiming at maintaining the outstanding balance of current accounts held at the Bank at above six trillion yen." This guideline remains in effect. On the same day, the interest rate for borrowing under the Lombard-type lending facility was lowered to 0.1 percent.

The current guideline merely means that the Bank will accommodate liquidity demand in the interbank market and is a far cry from sending a strong signal that the Bank intends to halt deflation by drastically increasing the outstanding balance of current accounts. It also goes against the objective of the March 19 change in the market operation framework since it does not have a specific target for the outstanding balance of current accounts and only aims to accommodate funds demand and as a result, micromanage the overnight call rate to stay below 0.01 percent -- this is tantamount to interest rate targeting. Another problem is that interest rates are left with little room for fluctuation as a result of the lowering of the official discount rate from 0.25 percent to 0.10 percent. I will explain these issues in more detail later.

E. Improvements Made since November 1999 and Issues Yet to be Tackled

I believe there are still many issues where further improvement is needed in the Bank's monetary policy. At the same time, there are a number of improvements that have been made. I will now give a list of improvements from among the issues I raised in my November 1999 speech.

First, the Bank has adopted a form of quantitative easing, using the outstanding balance of current accounts as the operating target of market operations. As I have already explained, there are some problems with this easing, among them the fact that, in some respects, it is in effect interest rate targeting.

Second, at the time I gave my speech in 1999, the Bank was using "the excess of reserves" as a signal for its market operations. It now uses "the outstanding balance of current accounts," which is simple and easy to understand.

Third, the Bank's daily projection for funds supply and demand ("Supply and Demand of Funds and Market Operations") was renamed "Sources of Changes in Current Account Balances at the Bank of Japan and Market Operations" in June 2000. Its content has also been revised in such a way that market participants can get a better idea of market conditions. Other statistics regarding the supply and demand of funds, data on current accounts at the Bank, and the monetary base have also been greatly improved. Notable among these improvements is the definition of the monetary base, which has been changed from "the total amount of Bank of Japan notes issued, coins in circulation, and reserve balances" to "the total amount of Bank of Japan notes issued, coins in circulation and current account deposits at the Bank of Japan." As a result of this change, the monetary base now includes funds held by money market brokers-cum-dealers ("tanshi" companies), thereby enhancing its significance as quantitative data.

Fourth, the transition to Real Time Gross Settlement (RTGS) has prompted an increase in broking in the collateralised overnight call market, which is a favorable development. The share in market transactions of dealing has increased recently, but I expect broking to increase as and when awareness of credit risk increases.

Fifth, in my speech in November 1999, I said that if funds provision through market operations was inadequate, the Bank should buy instruments with longer maturities such as long-term government bonds. From August this year, the Bank's outright purchases of long-term government bonds, the amount of which had been unchanged for a long time, has been increased from 400 billion yen per month through two market operations to 600 billion yen through three operations.

Sixth, in the same speech I suggested that the Bank institute a lending facility similar to that of the European Central Bank (ECB). On February 9, the Bank decided to introduce the "Lombard-type lending facility," a standby lending facility through which the Bank extends loans at the official discount rate at the request of financial institutions.

Furthermore, the Bank has started since October 2000 to release board members' views on the economic outlook. Although I did not touch upon this point in my speech in November 1999, I had been suggesting that the Bank make public its economic forecasts. At present, the Bank releases members' forecasts for real GDP growth, the WPI, and the CPI. I think the report would be more appreciated and even compare favorably with similar data released by other central banks if it included a breakdown by demand components and indicated the expected economic path by, for example, explicitly showing projected quarterly change data or the Bank of England type fan charts.

Another point I would like to add, although it has nothing to do with monetary policy, is that the Bank started index-based management of its external reserves in the first half of fiscal 2000. I had been recommending that the Bank start management of this kind.

In contrast to those listed above, some of the suggestions I made have not been implemented.

First, the Bank has not set a specific target for price stability. The current guideline for market operations states that the outstanding balance of current accounts at the Bank will remain the target of market operations until the CPI (excluding perishables) registers stably a year-on-year change of zero percent or more. However, this does not create an impression that the Bank is prepared to take a resolute and proactive stance to generate a desired rate of price increases by any specific date. It is important that the central bank set a target for price stability and indicate the period over which it will attempt to achieve the target. I believe that in this deflationary environment, the responsibility of the central bank requires such a target as early as possible and even that the evaluation of the policy performance of the Bank of Japan, as a chartered public corporation, will depend on this issue. I will enlarge on this point later on. I will also add that the ECB has a numerical target for price stability without a specified timeframe, which is not quite as satisfactory as inflation targeting, but the Bank of Japan does not even have a numerical price target.

Second, I raised the issue of foreign currency swaps to supplement the Bank's funds provision in my November 1999 speech. Given the possibility that the Japanese economy may deteriorate further, the Bank should start considering increasing the range of instruments it uses in market operations. In addition to currency swaps, it could use, for example, foreign bonds and derivatives as a means to diversify market operations instruments. The Bank should make all necessary preparations for prompt introduction of foreign bond purchases and currency swaps in its market operations.

III. Assessment of the Current Economic Situation and Outlook

I will now explain my view of the Japanese economy.

A. The Current Economic Situation

Taking a broad view, the Japanese economy at present is approaching a phase where the recession is deepening as a result of an unavoidable decline in personal income prompting a fall in consumption. This comes against the background of a rapid decline in the international competitiveness of Japanese firms due to the higher cost compared with other countries, in such areas as salaries, land prices, electricity, and other infrastructure. I believe the third downturn in the "Heisei Depression" now in progress will force on us, within two to three years, an overall resolution of the various problems that have been left unresolved and postponed to the future. In fiscal 2001, contraction in both nominal and real GDP growth is inevitable. I believe that there is a possibility that they will also contract in fiscal 2002. Japan experienced contractions in both nominal and real GDP growth in fiscal 1923 after the Great Kanto Earthquake and in fiscal 1998, after the year in which Yamaichi Securities and Hokkaido Takushoku Bank collapsed. Though supporting data are not available it is possible that they contracted in 1892 during the Matsukata deflationary period and also immediately after the Second World War. If both real and nominal GDP growth are negative for two consecutive years from fiscal 2001, it will be the first time for Japan since the beginning of the twentieth century. This shows severity of the current deflation.

One of the indicators that I consider most important in analyzing the economy is the Indexes of Business Conditions. A comparison of the most recent coincident CI (composite index) with past data gives a clear indication of the rapidity of the current economic decline. Assuming that the economy peaked in December 2000, the fall in the coincident CI closely resembles that in the eleventh business cycle, which occurred after the bubble burst in 1991, and also the decline in the seventh cycle following the 1973 oil crisis. During the eleventh cycle, the coincident CI declined for a very long period, with the descent slowing down after the initial plunge. The recession in the seventh cycle, as you all know, was triggered by the impact of the oil crisis, an exogenous factor, and did not last as long as that in the eleventh cycle, but the decline was fast and almost vertical from the beginning to end. The available data up to October shows that the economy has deteriorated at an extremely fast pace in the current downturn. We need to wait another two to three months before we determine whether the recession will be moderate and long-lasting as in the eleventh cycle mentioned above or will take the form of a rapid deterioration as in the seventh cycle. However, judging from both the past patterns of business cycles and the long-term movement of leading indicators, it seems unlikely that the economy will start recovering in the next eight to ten months.

I would also like to point out that the current recession appears to have taken a turn for the worse around October 2001. To be specific, official data released on November 30 show that the unemployment rate for October was a record high of 5.4 percent while corporate bankruptcies for October, announced on November 14 by Tokyo Shoko Research, reached 1,843 cases, up 250 from the previous month, and was the highest since the 1,888 cases recorded for October 1984. These are lagging indicators and are likely to continue rising. Furthermore, despite the Bank's provision of ample funds, various surveys on corporate financing show that funds procurement is becoming increasingly difficult, mainly for small firms. The increase in the credit spread, the yield differential between government bonds and bonds issued by firms in certain sectors also gives cause for concern. As for the Tokyo Stock Price Index (TOPIX), on November 12, the subindex for the banking sector declined to below the October 1998 low and has remained sluggish since then. Regarding funds procurement by financial institutions, the Japan premium on short-term funds is stable at around zero percent but the credit default swap rate on five-year instruments, used to gauge medium to long-term risk, is on an upward trend, warranting caution. It normally starts declining after the end of September, the end of the first half of the fiscal year. As we have seen here, some indicators are marking their worst levels ever, while some others, which had so far remained stable, are starting to deteriorate, amongst them the financing conditions index for small firms. Leading indicators are showing no signs of improving while consumption, which accounts for almost 70 percent of GDP, is showing the first signs of weakening after a period of stability. I am afraid that a purely objective reading of these signs gives one the strong impression that the Japanese economy is now experiencing the worst recession in decades.

B. The Japanese Economy is Already in the First Stage of a Deflationary Spiral

The Bank of Japan as a central bank should pay the utmost attention to price movements. Prices are falling as evident in the year-on-year declines in the GDP deflator, WPI, CPI, and CSPI (corporate service price index). The GDP deflator has fallen for 14 consecutive quarters on a year-on-year basis, and the fall even expanded in the July-September quarter of 2001, while the CPI has recently been marking its steepest falls ever. GDP rose in January-March from the previous quarter but contracted in the April-June and July-September quarters -- minus 1.2 percent and minus 0.5 percent, respectively -- falling for two consecutive quarters for the first time since the January-March, April-June quarters of 1998. These data confirm that the Japanese economy has been growing at a substantially lower rate than its potential, that the decline in the output gap has been widening further, and that the downward pressure on prices stemming from weak demand is growing stronger.

There has been a lot of debate on whether or not the Japanese economy has already entered a deflationary spiral. My view is that it is in the first stage of a deflationary spiral. There are various definitions of a deflationary spiral, but if you accept that it is "an accelerating pace of price falls in a recession" or "a recession caused by price falls, leading to further price falls," a deflationary spiral is already under way. The September Tankan survey shows that the current profits of all enterprises rose by 18 percent in fiscal 2000, but that their current profits for fiscal 2001 are forecasted to fall by 9 percent. This forecast is likely to be revised downward, given their lackluster performance up to the present. A survey by Shinko Securities released on November 30 shows that current profits are expected to decline by 36.5 percent in fiscal 2001. According to data on special cash earnings in the Monthly Labor Survey, which has the widest coverage for wage payment surveys, summer bonus payments at establishments with five or more employees declined by 1.1 percent in 2001. Winter bonuses are likely to see a sharper fall, and summer 2002 bonuses, which largely reflect corporate earnings for fiscal 2001, might fall by close to double digits. I expect some decline in basic salaries, which will be negotiated between labor unions and employers, in fiscal 2002 and thus the decline in total scheduled cash earnings, which will be reflected in the Monthly Labor Survey, is likely to be greater. In addition, the unemployment rate is likely to continue rising, to around 7 to 8 percent. I am concerned that these developments are likely to dampen consumer sentiment. Signs of such developments have already emerged in the compensation of employees in the July-September GDP data, consumption data including chain store sales, and car sales. It is inevitable that consumption, which had just been managing to stay steady, should dip in line with the decline in income, followed by faster declines in the price of services, which have a strong correlation with the index of total cash earnings. The price of goods are already falling sharply due to a rise in low-priced imports from countries such as China and also a resultant increase in competition. The price of services will probably show clear declines from now on. As for GDP, as I explained earlier, in the July-September quarter real GDP growth contracted from the previous quarter and the output gap is currently expanding. From a cyclical perspective, there is little possibility of the economy to enter a recovery phase for the time being, and there is no doubt that the output gap will grow further. Thus, the path of the economy described above is very much in line with macroeconomic indicators available to date. Taking a forward looking view of the economy, I am of the opinion that the economy is now in the first stage of a deflationary spiral and that even the CPI, which could be said as a kind of lagging indicator, would begin to expand the annual rate of declines by the second half of 2002.

Given that the economy is probably in the early stage of a deflationary spiral, the Bank should confront any uncertainty and technical difficulties that may be inevitable in implementing the policy and find and adopt a policy to ease money still further.

I believe that at present the Indexes of Business Conditions, stock prices and credit default swaps, mentioned earlier, are of particular importance for forward-looking analysis. These indicators contain, in my view, the information likely to provide clues to the future direction of the economy.

C. The Productivity of Nonmanufacturing Industry

In explaining why the Japanese economy has fallen into such a critical situation that it can be described as a national crisis, I must refer to the low productivity, mainly in nonmanufacturing industry.

A comparative study of the economies of Japan and the United States conducted by McKinsey Global Institute shows that Japan's real GDP per capita in 1999 was about 77 compared with 100 in the United States. GDP per capita is the product of labor productivity (GDP divided by hours worked) and labor inputs per capita (hours worked per capita). The former in Japan is about 69 percent and the latter about 111 percent of the United States. Furthermore, labor productivity, the product of capital productivity (GDP divided by capital stock) and capital intensity (capital stock divided by hours worked), at 69 percent of the United States, is derived from 61 percent for capital productivity and 113 percent for capital intensity. These figures show that Japan manages to partially offset its low capital and labor productivity through labor input and capital intensity, both of which are higher than those of the United States, and is just able to maintain the real GDP per capita at about 80 percent of the United States level. The same survey also shows that labor productivity in export driven manufacturers (four sectors), which account for 10 percent of Japan's employment, is 120 percent of the U.S. level, but that productivity in the service sector and the domestic market oriented manufacturing sector, which, respectively, employ more than 70 percent and around 20 percent of the workforce, is in both cases a mere 63 percent of U.S. levels.

A different set of data on relative wages by type of industry in the United States and Japan from 1970 to 2000 shows that in the United States, wages in the manufacturing sector are higher than in the service and wholesale sectors, and that it was in the latter half of the 1990s that wages in the financial sector, including insurance, surpassed those in manufacturing. In Japan, in contrast, though wages in the wholesale and retail sectors are slightly lower than in manufacturing, wages in the service and financial sectors are substantially higher.

Moreover, a look at the long-term relationship between the rate of rise in labor productivity and in product and service prices (average rate of change since 1970) by industry shows that the labor productivity of electrical machinery manufacturers has increased by an annual average of more than 10 percent, while the increase in the construction, real estate and service sectors has been zero to 1 percent. With regard to product or service prices, on the other hand, those for the electrical machinery manufacturers have fallen by an annual average of about 5 percent, while those for the construction, real estate and service industries have risen by an annual average of between 4 and 5 percent. This indicates that nonmanufacturers, despite their lackluster productivity performance, have been allowed to maintain profit margins and enjoy higher wages than export driven manufacturers by large increases in selling prices, and are protected by various regulations. It is my understanding that until recently, nonmanufacturers have been able to fix their selling prices by adding a certain margin to the cost. However, globalization and deregulation now in progress are forcing them to abandon this practice and, consequently, their profitability is declining. In the process, nonmanufacturers, especially construction firms, are suffering from their large excess of employees. It is against this background that financial institutions are burdened with mounting NPLs, consisting mainly of those extended to nonmanufacturers.

In relation to capital productivity, which I touched upon earlier, firms are coming under increasing pressure to make efforts to improve their returns on assets (ROA) and on equity (ROE). I have long assiduously stressed the need for corporate restructuring. At present awareness of need of restructuring has been increased. In order to improve ROA and ROE, in addition to repaying debt, companies need to make efforts to restructure their balance sheets by selling off low-earning and inoperative assets. By these means the size of the denominator for calculation of the returns is reduced. At the same time they need to increase profits (the numerator) by differentiation of products to secure margins or by venturing into new profitable product lines, while engaging in vigorous cost-cutting. In this context, the demand-creating measures are efforts to boost sales so that the numerator, that is, profits, is increased. Of course, these measures alone are not sufficient. Corporate executives need to meet the challenges from the new, more competitive market and unless they successfully meet them, they are doomed sooner or later to retreat from the market.

Further easing of monetary policy will in no way hamper efforts to increase capital and labor productivity or any other forms of corporate restructuring and structural reform.

D. Envisioning the Next Economic Recovery

Given the low productivity of nonmanufacturers and the substantial amount of time it is likely to take to achieve structural changes, what kind of economic recovery can we expect? At this point in time, the only recovery I can visualize is one driven by exports, not one led by domestic demand.

Looking at the patterns in the past ten recovery phases by demand factor, it seems that, in general, it has been either exports or public investment that has hauled the economy out of the troughs and, thus, it is unlikely that other factors will act as the driving force. Consumption in particular, which accounts for a large share of GDP, has in most cases increased very slowly. The possibility is further diminished by the fact that, as I mentioned earlier, firms are likely to start full-scale adjustments of wages. The outlook for business fixed investment is also dim at the moment. Recently, the following pattern has been observed in fixed investment. First, orders for semiconductor manufacturing equipment recover on a value basis. Then with about a year's lag, machinery orders start picking up. A few months later, business fixed investment starts increasing. Assuming that the latest trough for semiconductor manufacturing equipment orders was in June 2001, business fixed investment is likely to start recovering in the second half of fiscal 2002 at the earliest. As I have already explained, Japan's capital intensity is far higher than that of the United States. Investment as a proportion of GDP, which still remains higher than in the United States, is likely to trend downward in the medium term. Thus, it is unlikely that it could act as the driving force. It follows, therefore, that our hopes must hinge on either exports or public investment, the engines of many previous recoveries. But in light of the direction of current fiscal policy, we are left only with the option of an export-driven recovery. If overseas economies, led by the United States, recover in the second half of 2002, the Japanese economy is likely to start recovering gradually from 2003. However, it is unlikely to be a powerful recovery since Japanese manufacturers have been shifting a large part of their production base overseas, and also it will take quite a while before the productivity of nonmanufacturers begins to recover.

IV. The Issues in Monetary Policy Implementation

I would next like to talk about the issues in implementing monetary policy and in market operations.

A. The Basic Rules for Implementing Monetary Policy

I believe the following are the three basic rules the central bank must follow in monetary policy implementation.

First, the main concern should be macroeconomic conditions and any side effects that might arise in money markets or any consideration for financial institutions should be of secondary concern. Furthermore, monetary policy is basically for the welfare of the people as a whole, although money market participants, specialists and financiers are of course important.

Second, there are basically only three options in monetary policy -- to ease, to maintain, or to tighten. At present, monetary policy should be eased because (1) actual prices are falling and (2) the deflationary gap is expanding -- in other words, downward pressure on prices from weak demand is increasing. Implementation of any policy against this rule must be supported by proof that the merits of such action are greater than the benefits to be gained from monetary relaxation.

Third, the central bank should be bold in monetary policy implementation, taking action without hesitation and with a forward-looking view of prices and the economy. I, for one, do not agree to passive and piecemeal implementation of policies responding to such developments as the release of poor data on GDP or industrial output, sharp falls in stock markets, instances of financial crisis or political pressure.

B. The Problems with the Current Policy

The traditional and fundamental problems with the Bank's monetary policy, which usually go unnoticed, are coming to light under the current guideline for market operations to maintain the outstanding balance of current accounts at the Bank at above six trillion yen. I believe these problems point to the need of framework change to follow in the Bank's market operations. First, I would like to go over the current guideline. I apologize if it is a little repetitive.

The first problem is that current market operations have in effect gone back to interest rate targeting. The Bank is simply providing funds to accommodate funds demand without fail, thereby creating market conditions that are overly stable. This is not in line with the change of objective introduced on March 19 in the procedures for market operations. The present guideline for market operations introduced on September 18, states "For the time being, the Bank will provide ample liquidity to the money market by aiming at maintaining the outstanding balance of current accounts held at the Bank at above 6 trillion yen." However, as I explained earlier, the target for market operations has actually been interest rates -- the target has effectively been to keep the overnight call rate steady at below 0.01 percent, or more precisely, at 0.001 to 0.003 percent. The action taken by the department of the Bank responsible helps support this view. From late September to early October, the department concerned, at its own discretion, absorbed surplus funds from the market although the guideline for market operations does not set an upper limit on funds provision. To be more specific, during the reserve maintenance period from September 16 to October 15, the Bank absorbed a total 3.7 trillion yen in funds on six separate days through seven operations with the same offer and exercise date, and in the following reserve maintenance period, from October 16 to November 15, the Bank absorbed a total 8.5 trillion yen on ten days through 17 operations. This shows that the operations are not intended to raise the current account balance as high as is achievable. The reason seems to be consideration toward interbank market participants. If financial institutions subject to the reserve requirement system accumulated a large portion of their required reserves at an early stage in the reserve requirement period, the volume of their required reserves would fall sharply toward the end of the period and this might cause financial institutions' current account balance to fall sharply. An unexpected increase in funds demand for settlements in this environment would send market rates surging -- a situation the Bank wants to avoid for the sake of interbank market participants. The department responsible of market operations often cites the following as a reason for funds absorption: "We absorbed funds because that was what the market wanted." I, however, believe that there is no need to micromanage interest rates given that the operating target is the current account balance and the upper limit on rates -- the official discount rate used for borrowing under the Lombard-type lending facility -- has been set at a low level of 0.1 percent. Except in situations where a financial crisis is emerging, market operations should be conducted basically with the objective of achieving macroeconomic policy goals, and financial institutions should manage their reserves at their own risk.

Second, the Bank of Japan's monetary policy continues to place the emphasis on provision of liquidity since the terrorist attacks in the United States. The Bank has yet to switch back to the monetary policy of normal times, that is, a policy pursuing macroeconomic objectives. Furthermore, the goal of the current guideline is not clear and it fails to deliver any announcement effect. If the goal of the present monetary policy is to halt deflation, the Bank should set a specific figure for the balance of current accounts. The current guideline's "at above 6 trillion yen," which merely accommodates liquidity demand, is insufficient -- a higher figure, for example, 10 trillion yen or 12 trillion yen should be targeted. The Bank would not conduct funds absorbing operations with the same offer and exercise date if it was aiming for a level as high as possible above 6 trillion yen. Three months have passed since the terrorist attacks, yet the Bank has not set a specific figure for the current account balance, the guideline with emphasis on liquidity demand remains unchanged -- it merely accommodates funds demand, and, in the meantime, demand for liquidity rocketed to 14 trillion yen, more than double 6 trillion yen, at the end of November. In such circumstances, it is extremely difficult to understand the macroeconomic goal of the Bank's market operations. In stark contrast, the Federal Reserve Board switched its stance on monetary policy back to normal mode a week after the terrorist attacks and has embarked on a new course in its monetary easing policy. In addition to periods of instability such as the one recently caused by terrorism, the Bank of Japan has also traditionally provided ample liquidity for extended periods at the end of business terms in September and March. In this way, the Bank's action in the past has placed too much emphasis on liquidity accommodation and I believe that from the viewpoint of making market operations reflect monetary policy more accurately, the Bank should go back to normalcy in its monetary policy as quickly as possible and aim at maintaining a high and specified level of the current account balance to match the economic situation.

Third, the fact that the Bank does not set a specific target for the current account balance means that the operating target of monetary policy is practically speaking decided by the department in charge of market operations. Although there is always a possibility that funds demand will fluctuate, the Bank's Policy Board should decide the appropriate target for the current account balance at each MPM, in other words, normally twice a month. If funds demand changes drastically and it becomes inappropriate to accommodate the demand by following the provision in the guideline ("Should there be a risk of financial market instability, such as a surge in liquidity demand, the Bank will provide more liquidity irrespective of the guideline above."), the Policy Board should hold an emergency meeting and adopt a new guideline. The board should take the initiative in deciding the level of the operating target even if it involves some difficult issues. Recent market operations are explicable if the operating target has returned to interest rates from quantitative liquidity management. But if such a change is to be made, it is in the nature of its accountability that the Policy Board should make an official decision and make public announcement fully explaining the change.

C. The Inherent Problems in the Banking Sector

The Bank's "state of the art" control of interest rates gives me the impression that the Bank implements monetary policy with too much emphasis on market operations. In other words, the achievement of perfect control of the overnight call rate through market operations takes precedence over monetary policy. In a deflationary environment, however, monetary policy should be bold enough to influence expectations -- the Bank's aim should not merely be to provide ample funds in a stable manner. The Bank should therefore discard the present guideline of maintaining the current account balance "at above 6 trillion yen," which merely accommodates funds demand, and conduct market operations aiming to achieve a specified reserve target. The Bank's market operation departments should free themselves from supplicant financial institutions and proceed with a specified reserve target of monetary operations, even if it causes some antagonism on the part of market participants. In that event, some fluctuations in money rates, if they occur, should be permissible.

I also think that market participants are at fault. For example, I happened to learn that there was an executive who reprimanded a subordinate for procuring funds at 0.004 percent when funds were in fact available at 0.002 percent. The difference of 0.002 percent, however, works out at a mere 550 yen per day when procuring 10 billion yen and 5,500 yen per day when procuring 100 billion yen. Many city banks seem to be continuing the practice of taking the utmost care to keep as small as possible the excess of their reserves over the amount required under the reserve requirement system. A rational manager with foresight would allow a certain level of excess reserves and at the same time cut costs by, for example, reducing the workforce in the funds procurement section or merging the section with the investment section. I also think that fluctuations in rates from, for example, 0.002 percent to 0.01 percent, do not have a large impact on costs and thus do no warrant media coverage. .

D. Has Quantitative Easing Really Been Ineffective? -- Signs of Change in Financial Markets

I have so far explained that monetary policy has not been effective enough. This is mainly because the Bank has not been bold enough in policy implementation, and not because quantitative easing itself is ineffective. I consider that quantitative easing actually started in August when it was decided at the MPM to raise the target for the current account balance from five trillion yen, just the level at which the overnight call rate reached zero percent, to six trillion yen.

Given that only three months have passed since quantitative easing, meaning beyond zero interest rate policy, started, it is still premature to judge whether it has or has not been effective. However, changes are emerging in reserve management, and these may lead to portfolio rebalancing and affect the behavior of financial institutions. The most significant change is that some city and regional banks, in addition to foreign banks, have started to hold substantial excess reserves. Keeping zero excess reserves used to be regarded a virtue, especially by city banks and they hardly ever held excess deposits. However, due to the fall in funds procurement costs, a few Japanese banks are beginning to hold excess reserves. The current account balance might increase sharply if banks in general realize that it is more rational costwise to hold a large amount of excess reserves and thereby reduce personnel costs as I mentioned earlier. A slight change in the outlook for interest rates or in the expected inflation rate under these circumstances is likely to prompt large-scale portfolio rebalancing.

The effect of quantitative easing cannot be judged at this time since it normally takes about a year and a half to two years for monetary easing to produce an effect on the real economy, including price levels. In any case, in order to change expectations, it is necessary to commit to further easing of monetary policy, while bearing in mind that quantitative easing is the sole option available to us.

E. The Monetary Policy the Bank Should Now Adapt

The Japanese economy is facing the threat of unprecedented deflation. Nominal GDP has decreased from the peak of 526 trillion yen in the January-March quarter of 1997 to 502 trillion yen in the July-September quarter of 2001. In this national crisis of severe deflation, the Bank's monetary strategy should not be event-driven, or reactive, that is, taking action only after, for example, a collapse in the stock market or a great economic shock. It should immediately take preemptive measures, taking a forward-looking view of economic activity. I believe if a central bank takes either (1) a negative stance toward adopting measures on the grounds that they may not be effective or that the effects may be limited, or (2) a wait-and-see stance out of concern that the inflation rate might soar in some distant future, the impact of the central Bank's policy measures will be negated and the public's deflationary expectations reinforced, as has been the case a number of times in the past. The measures the Bank should adopt, in my view, are as follows. First, the Bank should adopt inflation targeting or price-level targeting and make clear the degree of price stability it is aiming for and the period over which it would attempt to end deflation by setting specific numerical targets. Second, to achieve the targets, the Bank should maintain annual growth in the monetary base at around 15 percent and, if necessary, further ease monetary policy so that the monetary base increases further and maintain that increasing rate for about two years. Obviously, I am not preaching that the Bank should take every unconventional measure available to it, but since market operations that amount to the exchange of almost perfect substitutes, that is, short-term government securities and money, have become ineffective, the Bank should free itself from the past and be more flexible in its search for new measures. We can not afford to forget that Japan is experiencing an unprecedented deflationary phase.

Although the results may not be entirely predictable, I believe that people's expectations can be changed if a target for price stability is adopted and further quantitative monetary easing measures are implemented. Furthermore, foreign exchange rates can be influenced by raising the growth rate of the monetary base relative to that of the United States in the period of monetary easing. Lower interest rates are unlikely to help further cost-cutting but the additional quantitative easing measures are likely to help the economy by changing people's expectations and foreign exchange rates.

Next, I would like to explain the concrete measures I proposed at the October 29 MPM, which were published in the minutes released on December 4.

I proposed two changes regarding the framework for market operations. At present, the Bank is committed to continuing with a quantitative target for the outstanding balance of current accounts until the CPI (excluding fresh food, on a nationwide basis) registers stably a year-on-year increase of zero percent or more. One of my proposals was to change this to "The Bank of Japan will conduct money market operations, aiming at maintaining the average of the CPI (excluding fresh food, on a nationwide basis) in the January-March quarter of 2003 at not less than the level for the January-March quarter of 2001, the benchmark level." The Bank should indicate in advance the period -- about a year and a half later -- by which time it would aim to achieve the price-level target so that the public can assess the Bank's performance. In the case of inflation targeting, the target may be regarded as having been achieved even in a deflationary environment where the price level declines below the benchmark if prices on a year-on-year basis happen to rise to the target level in the final year. In these cases, deflation may not necessarily have been halted. By adopting a price-level target and maintaining a certain level in a price index over a certain period of time, it becomes possible to avoid what economists call "base-drift" in the price level and a central bank can make clear its strong determination to halt deflation. Let me give a simple example where the target is to achieve zero percent inflation over a period of two years. If the price index started at 100, fell to 80 the following year, and stayed at 80 at the end of the second year, the inflation target of zero percent would have been achieved in two years. However, the price index would have declined by 20 percent from the base year. In price level targeting, the target would be to prevent deflation from worsening by keeping the price index above the base figure of 100. By setting a clear timeframe and target price level, the Bank of Japan would be able to assess its own performance, while helping its own corporate governance.

My second proposal is to remove the following restriction from the framework for market operations, that is, "The outright purchase of long-term government bonds is, subject to the limitation that its outstanding amount effectively held by the Bank, i.e., after taking into account of the government bonds sales under gensaki repurchase agreements, be kept below the outstanding balance of banknotes issued." I have also suggested that the Bank should (1) increase the amount of government bonds it may purchase outright in market operations from a total of 600 billion yen through three operations per month to a total of 800 billion yen through four operations per month, and (2) at the same time purchase foreign bonds to the value of around 200 billion yen per month on a regular basis. In view of the difficulties Japan faces in combating deflation, the Bank should immediately take measures to diversify and improve the means of providing funds. In other words, the Bank should purchase assets that are as remote as possible from money.

The current guideline for market operations, which states that the Bank will aim at maintaining the outstanding balance of current accounts at above 6 trillion yen, gives too much discretion to the Bank's staff and does no more than accommodate demand. It is a de facto zero interest rate policy. Instead, I have proposed that the target should be raised to 10 trillion yen to achieve further quantitative easing. This is merely a reiteration of what I have already said. But I expect that when the target will be raised to 12 trillion yen or even to 15 trillion yen, the need for new operational tools will emerge in order to avoid too much reliance on outright purchases of long-term government bonds.

F. Purchases of foreign bonds

Among the methods I have suggested for market operations, I would now like to expand on the purchase of foreign bonds.

I have proposed purchases of foreign bonds because: (1) deflation in the Japanese economy is worsening, (2) against this background, a large increase in purchases of Japanese government bonds through market operations should be avoided as it would give rise to concern over loss of fiscal discipline, and (3) at this moment in time, the United States and leading European countries are unlikely to oppose the idea. I am making this proposal purely to broaden the range of means to aid smooth supply of yen funds, and not in order to stabilize the foreign exchange rate. For this reason, such purchases should be made, for the time being, on predetermined monthly dates and in fixed amounts and may supplement outright purchases of Japanese government bonds. In comparison, intervention in the foreign exchange market is carried out in a flexible manner with a certain exchange rate in mind and with the objective of restraining volatile movements. Thus, it is clearly distinguishable from regular purchases of foreign bonds with the objective of expanding base money. In other words, such purchases would be within the scope of regular business of the Bank prescribed in Article 33 of the Bank of Japan Law and would not be in contravention of Article 40, paragraph 2, which imposes conditions on the Bank's foreign exchange transactions aimed at market stabilization. Thus, there should not be any legal problems. As stopping deflation, an objective of the Bank, is vital for the nation, the Bank ought to be allowed 100 percent freedom in monetary measures it chooses to take. This proposal should be feasible from the operational viewpoint since the Bank has an accumulation of experience in managing its foreign currency assets and has sufficient expertise in purchases of foreign bonds as well.

Foreign exchange rates are determined by economic fundamentals and the role of intervention in the foreign exchange market is not much more than smoothing out short-term market gyrations in an appropriate, flexible manner. The huge market intervention from September 17 to 28, in the amount of 3.2 trillion yen, was concentrated over this short period. My proposal for buying a fixed amount of foreign bonds on a regular basis has no element of surprise and in the size of 200 billion to 300 billion yen per month, is a mere drop in the ocean of the 1.2 trillion dollar average daily market worldwide. Even if the Bank bought foreign bonds through the markets, I am sure there would be no misunderstanding as to its objective.

In the present severe economic condition, relying heavily on an increase in outright purchases of government bonds, coupled with a possible change in their credit rating, could lead to an unexpected surge in long-term interest rates. Therefore, diversification of the means employed in market operations is a necessity at an early stage. At the MPM on October 29, I proposed increasing outright purchases of government bonds and purchasing foreign bonds. I believe that, of these two, the priority at the present should be given to the purchases of foreign bonds.

If necessary, I believe foreign exchange swaps as a short-term measure for supplying funds should be considered. According to standard text books, the effect of these transactions on the market is neutral, and thus, they should not involve any legal problems. Some central banks are known to use foreign exchange swaps in their market operations and the technical know-how should not be hard to acquire.

As I have explained, foreign exchange swaps should be used for provision of short-term funds, and purchases of foreign bonds as a supplementary measure for provision of long-term funds. Added to these, an increase in outright purchases of government bonds would greatly expand the scope and extent of market operations. Some people have suggested that the Bank purchase stocks and land. I, however, believe that there is no need for the Bank to buy assets which lack standardization in terms of market trading, a step that I consider unsound. There is much to be achieved by purchases of foreign bonds, government bonds, and from foreign exchange swaps. Other options put forward are use of Real Estate Investment Trusts (REIT) and Exchange Traded Funds (ETF) as collateral or purchasing these instruments after making the necessary amendments to the existing law. The time, however, is not yet ripe for these options, given that their markets are not yet fully developed and limited in size.

G. Issues relating to Policy Announcements

I have earlier pointed out the technical problems of market operations when the Bank implements its monetary policy. I would like to point out another important issue here, an issue related to the announcement effect. There is a risk that the effect of monetary policies will be substantially diluted if and when the following contradictions become apparent: (1) being forced to introduce quantitative easing having stated that such a move would be out of the question or that, in any case, it was doubtful whether introducing it would be effective; (2) expressing doubts about the effectiveness of quantitative easing having introduced it on the grounds that it would be effective; (3) stressing concerns over hyperinflation while having introduced quantitative easing to combat deflation. These would give a self-contradictory impression to the public, give rise to misunderstandings, and could easily undermine the policies in question.

Regarding the above points I would like to emphasize that: (1) it is inappropriate to state that monetary policy cannot be eased any further in the present severe economic phase; (2) the Bank should adopt a realistic stance toward and should not rule out the possibility of adopting measures for further easing, including inflation targeting; and (3) the risk of hyperinflation, a nightmare for anyone, occurring within the next two to three years is extremely low. In relation to (3), given that deflation has continued for a long period of over 10 years, it should be considered a positive development if the CPI stopped falling or rose to the levels of a couple of years ago. If the inflation rate does rise to 3 percent or 4 percent, the Bank could then begin to tighten monetary policy. It is unlikely that hyperinflation will suddenly break out. Therefore, the Bank should not hesitate to adopt policies or make announcements that would help to remove deflationary expectations.

V. On Nonperforming Loans

I would next like to outline my views on an issue which is the focus of great attention -- the nonperforming loan (NPL) problem. My opinion is that in addition to halt deflation with monetary and other policies, bold and speedy actions are required in order to: (1) solve the NPL problem; (2) improve labor productivity, mainly in the nonmanufacturing industries; (3) abolish regulations and protective policies that have allowed prices to diverge from market fundamentals, and (4) reexamine management practices of private sector companies.

A. The Cause of the NPLs

In my view, a combination of the following factors caused and has exacerbated the NPL problem. First, the primary cause is the low productivity and lack of competitiveness of the main recipients of bank loans, that is, companies mainly in the nonmanufacturing industries. Second, the so-called "overbanking" -- the inordinately heavy dependence on bank loans among businesses, with Japan far above other countries in terms of the ratio of bank loans to GDP. Third, since the 1980s Japanese financial institutions, reflecting fierce competition within the industry, have rushed to increase the volume of medium to long-term loans to small companies in the nonmanufacturing sector. Fourth, the lending banks, not only failed to improve their screening process, but also been easy-going in accepting real estate as collateral without a due process of evaluation. Fifth, failure of the past government policies as well as the Bank's policy, which after accelerated the enlargement of the bubble by monetary easing, abruptly applied the brake, causing the massive bubble to burst.

The outstanding balance of loans extended to nonmanufacturers by Japanese banks accounts for 60 percent of total loans. On the other hand, of the total of loans classified as NPL or assets requiring special attention, those to nonmanufacturers account for 80 percent of the total and in terms of the number of firms, nonmanufacturers account for 90 percent. The predominance of nonmanufacturers is thought to be related to their low productivity.

B. The Business Model at the Root of the NPL Problem

There are a few points I would like to raise here based on my experience as a CEO in a private sector company. From the point of view of management, the bankers' problem was that they failed to develop their own management styles by accumulating skills in borrowers' credit risk assessment and risk management of other assets. On the contrary, they merely competed within the industry by expanding loans significantly using land as collateral. The well-developed system of state registration of land holdings is used when taking collateral. About 70 to 80 percent of bank loans are extended against land and the upper limit of the loan is, more often than not, determined as a percentage of the official land price valuations. On the other hand there are cases where loan officers are not equipped with adequate expertise about the project for which the loan will be used. It appears to me that there are banks that had extended loans simply for the sake of expansion without giving much thought to, for instance, to discounted cashflow or the cut-off rate (the minimum required rate of return). The same can also be said of firms' capital expenditure plans. The consequences of these attitudes became evident in the 1990s. Among lenders business has been reasonably brisk for consumer finance companies, which lend mainly to individuals, and for business loan companies, specialized in lending to small business organizations. It may sound harsh but all this goes to show that banks, which relied comfortably on the uninterrupted rise in land prices until around 1990, are typical of the low-productivity nonmanufacturers mentioned earlier. They failed to make efforts to develop expertise or their own business models. Recently some new banks such as Internet banks and convenience store banks have been launched in the area of settlement banking. I hope to see innovative banks also appear in the lending area, leading to diversification of business models.

C. Disposal of NPLs

As I have explained, the NPL problem is deep rooted. The problems evident today are only the tip of the iceberg. If the difficulties faced by the top 30 problem borrowers were resolved, that would be a great step forward, but not an overall solution to the problems.

The banks should set aside sufficient provisions based on strict examination of all the borrowers, especially all the small nonmanufacturers, and not just the top 30 problem borrowers. After the reserves have been set aside, banks whose capital adequacy ratios fall below required levels under the current rule should undergo detailed inspection of their assets to determine whether are viable or not. If public funds injections to boost capital is deemed necessary for banks that have been judged capable of continuing business, one effective way would be for the government to buy their ordinary stocks through third-party allocation on condition that the banks agreed to take measures such as suspending dividend payment, reducing capital, completely replacing top management, and reorganizing the banking sector as a whole. Such capital injection should be enforceable rather than waiting for application from the banks concerned as has been the case up to the present. At the same time it is essential that a further deterioration in the economy is averted and that measures to prop up and improve the economy are taken. Given that the amount of NPLs disposed of every year is offset by an almost equal amount of bad loans that emerge in the same period, all available means, including monetary relaxation, must be utilized to improve economic conditions. There will not be any fundamental solution to the NPL problem as long as deflation continues. Regarding the Resolution and Collection Corporation of Japan (RCC), I consider its role in disposing NPL is rather limited. I do not think that transferring NPLs to the RCC would yield any fundamental solution since its workforce consisting only debt collectors and lawyers for lawsuits therefore company reconstruction would be too much of a strain for RCC.

I am quite concerned that we are running out of time since financial markets have become alert and quick in adjusting their perception of the economy as it deteriorates. As I mentioned earlier, the credit default swap rate has not eased since the end of September and is poised to reach the level seen in 1997-1998 when Yamaichi Securities and Hokkaido Takushoku Bank and other financial institutions collapsed. It is also clear that the economy is likely to continue deteriorating for the time being and that land prices are trending downward. Furthermore, financial institutions have increased their holdings of government bonds as their commercial lending has stagnated, resulting in increased exposure to the risk of price volatility. At the same time, the series of the write-offs sustained in the past has significantly weakened their financial strength. Taking all of these developments into consideration, the Bank should stem any further deterioration in the economy by means of monetary easing while strict inspections of banks should be carried out at an early stage ensuring adequate provision for loan-loss reserves and if necessary they should receive public funds injections. All this needs to be done with a sense of urgency.

VI. A Few Further Issues I Would Like to Comment On

Today I have talked comprehensively about my views on monetary policy, the economic situation and the NPL problem. I would now like to make the most of this opportunity by adding a few words on issues that have come to my attention during my tenure so far, some three years and nine months, as a member of the Policy Board of the Bank of Japan.

A. Decision Making by Board Members and the Risk of Falling into "Groupthink"

First, I hope that discussions at MPMs will continue to be lively and motivated.

The current form of monetary policy decision making was introduced in April 1998, when the revised Bank of Japan Law was promulgated. Until then, the decision-making process was not transparent. At present, the nine members of the policy board discuss the issues in question first, and proposals need to win a majority to be adopted. This differs from government cabinet meetings, at which decisions must win unanimous approval. The minutes of MPMs, which provide readers with necessary information about the debate at the meetings, are released about one month afterwards. Some people are of the opinion that they should be released more promptly or that full transcripts, currently released after 10 years, should be released at an earlier date. However, the fact that the minutes and the full transcript are released at all has been a great step forward and, by and large, I believe that discussions at MPMs have been made known to the public without restriction. In the past, I used to think that a ten year delay for the release of the full transcript was about right. However, with the enactment in 2002 of the Law concerning Access to Information held by Administrative Organs and the need for information for re-election of policy board members, I now think that the full transcript should be released within five years, or better still, three years.

During the past three and a half years as a policy board member, my view of the economy has been gloomier than those of other members, and so my proposals have most of the time been in the minority. Initially, most of my proposals have been greeted with grave doubts as to their practicability, but I am grateful that after a time most of them have been adopted. A great deal of energy, both physical and mental, is necessary to make proposals that differ from the majority view, but my actions have been based on the belief that having accepted a political appointment with a guarantee of independent status, I should go on making my proposals to properly perform my duty as a member of the board.

In relation to this point, there is debate regarding "groupthink" in the United Kingdom. It is generally considered that decisions made by groups are superior in quality to those made by individuals, but that groups are at risk of falling into "groupthink" -- standardization of thinking patterns -- which hinders flexible decision-making. The Bank of England (BoE), which has a highly advanced method of board management, seems to be aiming to avoid the negative effects of groupthink by ensuring individual accountability of the members of the board. Each board member is asked to be individually accountable and is obliged at hearings at the time of inauguration or on occasions after the release of the BoE's inflation report to expound on their views. I heard that Dr. DeAnne Julius, a former member of the Monetary Policy Committee of the BoE, said that when members are not individually accountable, they lose the incentive to make public their position at the voting stage even if they had voiced opposing views during the debate, and that it will become easier for the majority, which would include the most influential individual, to carry the vote. To avoid this situation, the parliament holds individual hearings. Although the connection is not clear, since April 1998, deputy governors, though they are chosen from the staff of the BoE, are known to have cast eleven minority votes on eight occasions. As for the Bank of Japan, it was revealed at a recent parliamentary session that there had never been a division of views of the governor and two deputy governors.

Japan has a tradition of attaching great value to "perfect agreement", "heart-to-heart understanding", and "equal status". This leads to the general tendency for people to go along with the majority view. However, I am one of those who would like the practice of decision-making by a majority vote to be studied carefully. The aim is an improvement in the quality of future monetary policy of the Bank of Japan.

B. Relations with the Government

Second, I would like to raise the issue of coordination of views between the Bank and Government. Article 4 of Bank of Japan Law stipulates that "In recognition of the fact that currency and monetary control is a component of overall economic policy, the Bank of Japan shall always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government's economic policy shall be mutually harmonious." As you all know, at the MPM in August 2000, the Government's request to postpone the vote on terminating the zero interest rate policy was rejected by the Policy Board by majority vote.

As a board member, I always base my arguments on the logic of economics, while the government and the parliament apparently often reach decisions using political logic. To improve the functioning of the central bank and enhance its credibility, there is a need for both parties to discuss and discover ways of streamlining the logic of the Bank and government. I believe that a central organ or system to coordinate economic and political logic should be established and that the Council on Economic and Fiscal Policy could play such a role. I also believe that my proposal for inflation targeting or price-level targeting would be instrumental in helping to narrow the differences between the Government and the Bank. Now, Japan is facing unprecedented deflation and to avert this situation, the central bank has no choice but to join forces with the Government. If deflation worsens, I believe that the Government would consider fiscal stimulus measures to create effective demand, and that, in that event, monetary policy should be eased simultaneously, thereby creating a synergy between monetary and fiscal policies. Such harmonized action by the Bank and Government would strengthen the market's confidence in monetary and economic policies and would make it possible to climb out of the depths of deflation.

I would like to stress that by harmonized action, I do not mean that the Bank should comply with every word of the Government regarding its policy. I have always made this point clear when discussing the Government's request for the postponement at the time of the vote-taking. The Bank should express its own opinion promptly and effectively. The independence and initiative of the central bank will be built on a tradition of positive and articulate expression of its opinions..

C. The Future of Monetary Policy

Third, there is still much room for further progress and development in Japan's monetary policy.

In the past five to six years, the world's financial and economic scholars have made great progress in the theory of near-zero interest rates, the zero lower bound in nominal interest rates, and deflation.

In addition to using the traditional instruments such as the GDP gap and other economic indicators in the analysis of the real economy, the ECB and the Swiss National Bank have noted information value in various monetary variables, such as the money gap and the growth rate of credit. These variables are analyzed and then applied to cross-check the conditions of the economy or financial market. This method is called the active-money paradigm, and analysis using the P*model is well known.

There also seem to be many central banks that make some use of the optimum interest rate calculated using the Taylor Rule and the optimum growth rate of the monetary base using the McCallum Rule. Application of these tools of analysis, however, is not without difficulties.

The Bank of Japan's research on these methods, which are already being utilized in the monetary policy of other countries, has made much progress, but they have not necessarily been used formally in the policy decision-making. It is still in the future whether they will be of use in Japan.

I also believe that there is still much room for improvement in the technical aspects of monetary policy, because, as I said earlier, there are many realistic options yet to be utilized for market operations, such as foreign exchange swaps and purchases of foreign bonds.

D. In Conclusion

Looking back, the Japanese economy in the 1980s was a period of relatively high growth, supported by a moderate increase in labor productivity, which was fueled by advances in microelectronics technology. However, the bursting of the bubble threw the economy into chaos in the 1990s -- a period that has been dubbed the "lost decade." In contrast, the United States achieved rapid growth in the 1990s as a result of the information technology revolution and the expansion of the financial industry. In Japan, structural problems centering on the mounting NPLs remain unsolved and deflation has worsened. On the other hand, in the United States the economy is slowing due to the cyclical downturn, coupled with the negative impact of the terrorist attacks. Both countries are caught in severe economic conditions.

In my view, the next two to three years will be crucial for the Japanese economy. However, I am in no doubt that the present difficulties will be solved if industry succeeds in raising its labor productivity and capital efficiency to international levels by boldly tackling the problems it faces, such as low productivity, restructuring as looked at from the viewpoint of both the balance sheet and the income statement while adopting a forward-looking management style. If the economy remains inflexible, and the rule of market principles and market prices do not embrace the entire fields of the economy, Japan may find itself looking back on a "second lost decade". In any case, the probability that the Japanese economy will approach an extremely severe phase in the near future is very high, and, I assure you, making full use of monetary policy, the utmost effort will be made to help avert such severe phase.

In fact, there must be far more room for maneuver for monetary policy than is currently realized. By drawing on the wealth of wisdom that should be available, I am certain the pain for the Japanese economy can be substantially alleviated. I believe an appropriate combination of policies -- monetary and fiscal carried out with prudence -- will regenerate the Japanese economy from the bottom of 2003 with a margin of one year on either side.

Finally, let us take a look at the price on the over-the-counter market of shares in the Bank of Japan with a par value of 100 yen. Its peak was 745,000 yen in October 1989 and it slumped to one fifteenth of that value -- 54,000 yen -- in January 2001. Although it has recently recovered to 58,000 yen, this can hardly be seen as a strong rebound and it has been on a long downward trend. This decline can be interpreted in various ways. In my view, it reflects, at least in part, the severe assessment of the Bank's policy by the financial market. As a board member, I take very seriously the development in the stock price since April 1998. The time that the Bank's stock price reverses its direction will probably be the time when some rays of hope for the Japanese economy appear. From the perspective of long-term economic cycles, the Japanese economy is likely to enter a strong expansionary phase from around 2010.

Thank you very much for your kind attention.