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Understanding Japan's Financial and Economic Developments Since Autumn 1997

January 2000
Hideo Hayakawa
Eiji Maeda

Views expressed in Working Paper Series are those of authors and do not necessarily reflect those of the Bank of Japan or Research and Statistics Department.
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Japan's economy underwent an extremely severe recession. The real GDP recorded negative growth for five consecutive quarters, from the fourth quarter of 1997 on a quarter-to-quarter basis. Currently, Japan's economy is starting to pick up owing to positive effects from monetary and fiscal policies, and the recovery in the global economy, especially in Asia. This recession, however, turned out to be the worst ever experienced by Japan in the postwar era. Even at present, clear signs of a self-sustaining recovery in private demand have not been observed yet. These economic developments may be largely influenced by the disturbance in the financial system that occurred reflecting the failures of large financial institutions from autumn 1997. As a result, several unusual phenomena have been seen in the business cycle.

During the depressed phase of the economy from the end of 1997 for instance, business fixed investment declined substantially, especially in small firms reflecting a decrease in the lending ability of private banks. Paradoxically, however, the growth in money (particularly the monetary base) rather accelerated against the depressed real economy. On the other hand, the growth in money now seems to be slowing down gradually, while improvements are being observed in the economy such as the recovery in industrial production and the improvement in corporate sentiment. Thus, the relationship between the growth in money and the economy in the past two years looks different from what orthodox economic theory tells us. The savings rate of households, which is usually stable, has shown substantial fluctuations due to both mounting and easing of anxieties over the stability of the financial system. This has also been a characteristic of these two years. Furthermore, although this may be a favorable miscalculation, prices are recently starting to stop falling despite a seemingly substantial expansion in the output gap and a decline in wages.

In the financial market, various risk premiums expanded from the autumn of 1997 and remained large throughout 1998. The overnight call rate and the interest rates on term instruments such as the three-month Euro-yen detached substantially. Yield differentials between government bonds and corporate bonds, and yield differentials among corporate bonds across different ratings expanded, as well as the so-called Japan premium. By contrast, these risk premiums have contracted to a certain extent since the spring of 1999. Moreover, an unpredictable phenomenon has occurred within the interbank market: while the Bank of Japan has adopted the exceptional "zero interest rate policy," funds supplied by the Bank are not maintained as bank reserves, but are being accumulated as on-hand funds of tanshi companies (money market broker-cum-dealers).

These financial and economic developments in the past two years indicate that various events have occurred that cannot be easily understood by past experiences or by standard economic theory seen in textbooks. In addition, it seems that there is insufficient understanding of the much stronger interaction between financial and real economic developments in the past two years, thereby confusing discussions regarding monetary policy.

In these circumstances, it is very useful to review the financial and economic developments since the autumn of 1997, and examine the various events through empirical analysis and economic theory. By doing so, it may enhance understanding on how the financial system shock has influenced Japan's economy and what is happening at present. In this paper, we will first review chronologically the financial and economic developments in Japan during the past two years. Then, relying on empirical analyses conducted by staff members of the Research and Statistics Department, we will discuss the following two topics: (i) the relationship between money and the economy; and (ii) the relationship between the output gap and prices.

The outlines of this paper are as follows:

  • (a) Real economic developments have shown strong interactions with financial developments after the financial system shock hit Japan's economy in autumn 1997. The financial system shock decreased private consumption by discouraging consumer sentiment and business fixed investment through the tightened lending conditions on the part of private banks. In particular, when global concern over credit risks was heightened in the second half of 1998, the deterioration of the economy and tightening of financial conditions created a vicious circle. From the start of 1999, however, the opposite has been observed. Consumer sentiment and corporate financing have improved as financial anxieties have eased.
  • (b) Money and the real economy during this period have moved in opposite directions. The growth in money accelerated to some extent while the economy was depressed during 1998, but money growth has started to decelerate as the economy has started picking up in 1999. Thus, for the last two years, their relationship has been largely different from the traditional one.
  • (c) One explanation for this phenomenon is that mounting financial anxieties increase precautionary demand for liquidity. The financial system shock shifts the IS curve to the left as observed in (a) and simultaneously, it shifts the LM curve to the left reflecting the increase in the precautionary demand for money, exerting upward pressure on interest rates. Then, it is possible for money to increase while output decreases significantly, so long as the rise in precautionary demand for money is large enough. From the end of 1997 to 1998, this phenomenon may have been actually observed. On the other hand, in 1999, a shift of the LM curve back to the right (together with that of the IS curve to some extent) has occurred due to easing anxieties over the financial system. This may have resulted in the fall in interest rates and the recovery of the economy, but the growth in money has been moderated by the decrease in precautionary demand. Our empirical analysis also supports this interpretation.
  • (d) In terms of monetary policy, the Bank of Japan supplied funds to meet the increase in the precautionary demand for money, trying to suppress overall interest rates (to prevent a leftward shift of the LM curve) during 1998. As a result of the financial system shock, however, its effects were partly offset by the weakening of banks' credit creation ability and the expansion of various risk premiums in the financial markets. In 1999, precautionary demand has declined with receding financial anxiety and the Bank has supplied further ample funds. As a result, interest rates have decreased further (further rightward shift of the LM curve) and various premiums are also contracting in the financial markets. Thus, the effects of monetary easing are becoming full-scale.
  • (e) As for price trends, a sharp decline has not been observed, although the output gap expanded and wages continue to decrease. We suggest the following two hypotheses as its background; (i) firms change pricing-behavior and are focusing on the rate of margin and (ii) the output gap calculated based on the traditional method is overestimated.