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Structural Problems and the Effectiveness of Monetary Policy

Based on a speech given by Kazuo Ueda, Member of the Policy Board, at the Meeting on Economic and Financial Matters in Maebashi City, Gunma Prefecture on April 24, 2002.

April 24, 2002
Bank of Japan


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1. The monetarist view of the relationship between money and inflation does not hold in recent Japan

The Bank has kept providing large amounts of liquidity to the economy in recent years. The pace of liquidity provision has accelerated since March 2001 under the heading of "quantitative easing." The current year-on-year growth rate of the monetary base (as of March 2002) is 32.6 percent. The economy has not seen a rate of growth in the monetary base of above 15 percent since the early 1970s when it experienced a bout of inflation in excess of 20 percent. However, despite this sharp growth in the monetary base, deflation has persisted in the economy, albeit at low rates.

The relationship between the monetary base and the economy is shown in Chart 1.1 The chart plots the ratio of the monetary base to nominal GDP. It may be seen that the ratio was fairly stable with a small upward trend until around 1995, when it started to deviate sharply from its past trend in an upward direction. The size of the deviation is unprecedented.

According to the monetarist view of the economy, high growth in the money supply eventually leads to high inflation. A monetarist would conclude from Chart 1 that Japan is in serious danger of hyper-inflation. On the contrary, however, the "excess liquidity" of the last few years has been associated with mild deflation.

Needless to say, money affects the economy with long and variable lags. We may have to wait just a bit longer. In fact, the Bank's position on this has been that we continue both to hope and to watch carefully for the emergence of possibly stronger effects on the economy from this liquidity injection. The usual range for the lag in the effects of monetary policy on the economy, however, lies somewhere between half a year to approximately two years or so. Consequently, we seem to be witnessing something very unusual in the relationship between money and the economy. The following is devoted to an analysis of the background to this unusual observation.

  • 1  The monetary base has been smoothed to adjust for the Y2K effect.

2. The Near-Term Economic Outlook

Although the economy is still contracting, it is declining at a slower pace than before. The stabilization is due mainly to the recovery taking hold in the United States and East Asia, and an associated increase in Japan's exports. The background for the U.S. and Asian recovery is the completion of inventory adjustment in especially IT-related goods that started late in 2000. There seems to be a stronger-than-expected reversal in inventory adjustment taking place in East Asia. Accordingly, Japan's exports to the region are evincing signs of a V-shaped recovery.

Japan's economy is lagging somewhat behind other economies, but is also close to completing its inventory adjustment. Manufacturing production is about to or may have stopped declining. By mid year production is expected to start rising; corporate profits will probably begin to increase in the near term, especially in the manufacturing sector.

In contrast to the recovery in external demand, domestic demand remains soft. Leading indicators of business fixed investment are still contracting. Declines in wages have weighed on consumption.2

Turning to the prices of goods and services, we find some moderation in the decline in wholesale prices due to the worldwide economic recovery, the rise in oil prices and the recent weakness of the yen. Despite this outlook for wholesale prices, however, the near-term future of consumer prices remains uncertain given the possible effects of declining wages on service prices.

It will be a while before we can determine whether the recovery in manufacturing will precipitate recovery in the economy as a whole. A strong world recovery continuing into the second half of the year would surely increase the likelihood of a turn-around in Japanese domestic demand. But other uncertainties exist, to which I now turn.

  • 2  More precisely, consumption seems to be holding up fairly well, at a growth rate of around zero, despite large declines in wages.

3. Structural problems as impediments to strong recovery

The issue of how to translate rises in external demand into sustained growth in the rest of the economy has been familiar in Japan recently. For example, between the second quarter of 1999 and that of 2000 real GDP grew at 2.3 percent. Business fixed investment contributed 1.6 percent and exports 0.7 percent to this growth in real GDP; however, it is fair to say that exports went up first, and that this then stimulated business fixed investment in the manufacturing sector. In contrast, consumption contributed only 0.3 percent, becoming a major obstacle to a more sustained, stronger recovery.

The weak performance of wage income was a major reason behind the stagnation of consumption. Wage income declined on average by 0.4 percent per year in fiscal 1999 and 2000. The share of wages in national income, excluding short-run fluctuations, has steadily increased during the last three decades and surpassed 85 percent in 1998, so that a significant subsequent adjustment became perhaps inevitable.3

Rising imports of consumption goods also dampened the effects of the small increase in consumption on the economy. The period saw the emergence of new business models in which innovative firms manufactured goods in China and sold them at very low prices in Japan, short-cutting existing Japanese retailers/wholesalers. Traditionally, consumer prices have risen faster than wholesale prices in Japan. Between 1981 and 1998, the growth of consumer prices outpaced that of wholesale prices by 2.3 percent per year. However, this difference declined sharply to 0.1 percent per year between 1999 and 2001.

Weakness in consumption and rising imports weighed on the nonmanufacturing sector, especially on small companies. Chart 2 reveals that business fixed investment of small and medium-sized firms in the nonmanufacturing sector rose scarcely at all in 1999 and 2000. Up until the 1980s, it was this group's business fixed investment that led economic recovery by responding positively to monetary easing in advance of spending by others.

The major reason for the disappointing performance of business fixed investment by the nonmanufacturing sector, however, has been the so-called balance sheet problem of borrowers and lenders. Chart 3 shows the capital to asset ratio of manufacturing and nonmanufacturing firms by size adjusted for capital gains/losses on their assets. The ratio has declined sharply to very low levels among small firms in the nonmanufacturing sector as a result of falls in land and stock prices during the last decade. Though not shown in the chart, the return on assets has also declined. Even disregarding their declining profitability, low levels of capitalization and the reluctance of banks to lend to them have naturally made it difficult for such firms to engage in expansion of business fixed investment on a large scale.

Needless to say, banks' balance sheets have also been impaired by declines in asset prices. Thus, the growth of bank lending has surely been adversely affected not only by the conditions of struggling borrowers, but also by a reduced ability to provide financial intermediation on the part of lenders. Whatever the allocation of culpability, however, the end result is that banks' success in finding and lending to new, promising borrowers and/or projects has been compromised.

Going forward, even if a recovery does take hold in the economy, it will be led by the manufacturing sector. Thus, the structural problems I have discussed will be very likely to stay with us for some time.

  • 3  The Ministry of Finance, "Financial Statements Statistics of Corporations by Industry, Quarterly."

4. The decline in the effectiveness of monetary policy

The foregoing discussion hopefully has made clear why the effectiveness of monetary policy has declined in recent years. Unlike in the past, small companies in the nonmanufacturing sector have not been able to respond to monetary easing due to the deterioration of their balance sheets and other structural problems. More generally, the balance sheet problems of borrowers and lenders have prevented low interest rates from stimulating investment and bank lending. Chart 4 shows the growth rate of bank lending, where it may be seen that the period during which there was a large build-up of "excess liquidity" (as we saw in Chart 1) coincides with a period of near zero to negative growth rates in bank lending.

The second reason for the reduced ability of the Bank to stimulate the economy is the so-called "zero bound" on nominal interest rates. The same chart presents the time path of the overnight call rate. The rate has been below 1 percent since late 1995--the period under consideration--and has been virtually zero since early 1999. As a result, there has been little room for the rate to move downward.

Despite such limitations, recent monetary policy has played important positive roles. The most significant has been the role it played in preventing or containing liquidity crunches. In late 1998 a serious liquidity crunch developed in the aftermath of the Russian crisis and the collapse of LTCM. The zero interest rate policy along with large-scale operations in the commercial paper and other markets were instrumental in containing the crunch. Similarly, concern over the soundness of the financial system resurfaced in early 2001 and in the second half of fiscal 2001, leading to declines in stock prices and larger risk premiums. Again, attempts by the Bank to provide large amounts of liquidity mitigated the concern and prevented the financial system from experiencing a more serious liquidity and/or credit crunch. Without such attempts deflation would have accelerated.

5. The respective roles of monetary and other government policies

I have discussed the background to the recent weakness in the effects of monetary expansion on output and inflation. Among the problems impeding the efficacy of monetary policy, the nonperforming-loan (NPL) problem stands out and will definitely have to be resolved. It will require the restructuring of both borrowers and lenders. The deflationary pressures that new innovative firms exert on incumbents are a healthy dynamic in a market economy. In fact, the emergence of many more such firms will enhance the effectiveness of monetary policy.

There is a familiar question about the appropriate order in which to execute the policies to stop deflation and those that address the NPL problem. The case viewed from the standpoint of the macroeconomic policy-maker has already been put: progress must be made on resolving the NPL problem, since without functioning financial intermediaries the effectiveness of monetary policy is heavily compromised. At the same time, from the viewpoint of banks, no significant increases in lending can be expected without improvements in the economy as a whole.

It goes without saying that fewer bad loans will develop and that lending will increase in a better macroeconomic environment. Does this mean that the NPL problem will disappear once deflation ends? Most of us know that it has been the deflation of land prices that has generated the problem. The consumer price index (CPI) rose on average at a rate of 0.8 percent per year between 1991 and 2000. During the same period, the urban land price index declined by 10.6 percent per year on average. Thus, a sharp correction in land prices took place while there was near stability in the general price level. The major reason for this correction was not deflation of the general price level, but rather the large rise in land prices in the mid to late 1980s that was not supported by economic fundamentals. Perhaps it is fair to say that the degree of correction in land prices would not have been much different had the average rate of CPI inflation been one or two percentage points higher. For land price deflation to come to an end will require either an appropriately large correction or successful attempts by users of land to increase rents significantly.

To repeat, a favorable macroeconomic environment mitigates the pain of, but does not wipe out the need for structural adjustment. During 1999 and 2000 stock prices rebounded sharply, but land prices continued their decline with only a few limited exceptions. These movements reflected on the one hand the IT boom that supported the stock prices of many manufacturing firms, and on the other the fact that land prices had not yet completed their process of adjustment.

Without the zero bound constraint on nominal interest rates, it might be possible for monetary policy to stop deflation even in the presence of balance sheet problems. Yet land prices would continue to decline until they reached equilibrium levels, and a sustained recovery would still require the resolution of the NPL problem.

Given the current limitations on monetary policy, the only choice for us seems to be to continue efforts on both fronts. Monetary policy will need to keep injecting large amounts of liquidity into the system. On the NPL problem, we need to proceed as swiftly as possible, while being careful to use every means at our disposal to mitigate possible deflationary pressures in the process. We may also have to go through a temporary period of larger declines in bank lending before seeing a return to a sustained economic growth. After that, the effectiveness of monetary policy will be significantly enhanced.

The painful nature of such a policy mix can be somewhat mitigated by a temporary fiscal stimulus. It is important that such a stimulus does not take the form of pork-barrel public expenditures. Not only are the effects of such expenditures limited but they run counter to attempts to restructure the nonmanufacturing sector of the economy. More productive moves seem possible both on the revenue and spending sides of the budget.

I may have painted a too negative picture of the Japanese economy. As I pointed out at the outset, however, we are beginning to see some encouraging signs in the economy. Even small firms in the nonmanufacturing sector, the sector in need of most serious restructuring, have come up with better-than-past investment plans for fiscal year 2002 in the most recent Tankan survey. It is important to continue our efforts at reforms, however, even with clearer signs of an economic upturn.