Monetary Policy Cannot Substitute for Structural Policy¹

1. 1 English translation of an article by the author entitled "Kin-yu Seisaku wa Kozo Seisaku madewa daitai dekinai," which originally appeared in Shukan Daiyamondo, January 29, 2000. The views expressed in this article are those of the author and do not necessarily represent those of the Bank of Japan.

January 2000
Masaaki SHIRAKAWA

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Recently, two contrasting policy arguments have emerged regarding the conduct of monetary policy in Japan. One posits that, given the stagnant economy, every conceivable measure should be mobilized. And, specifically with regard to monetary policy, that the Bank of Japan should pursue further monetary easing using whatever measures possible, even though such measures would only have a small impact on the economy. The other argument holds that all feasible policy measures are exhausted and what is needed for Japan's economy at this juncture is structural reform. Which one of these two arguments is dominant depends very much on whether prevailing sentiment is optimistic or pessimistic. Bearing in mind these contrasting arguments, I would like to examine what is necessary to bring Japan's economy back onto a sustainable growth path and the role of monetary policy in the process.²

1. 2 See "Monetary Policy and Structural Policy: A Japanese Perspective," Bank of Japan Monthly Bulletin, November 1999.

As a starting point, let us examine the background to Japan's 'lost decade.' In the 1990s, Japan's real GDP growth was next to last and marked the largest decline compared with the 1980s among the G7 countries (see Figure 1). The main reason often cited for such poor performance is the emergence and subsequent bursting of the bubble during the late 1980s and early 1990s. In this regard, Sweden shows an interesting record. Experiencing a bubble and banking crisis similar to Japan's in magnitude, Sweden subsequently saw a new peak in stock prices and has now returned to a sustainable growth path. This example suggests that it may not be so convincing to almost exclusively attribute the stagnation of Japan's economy in the 1990s to the emergence and bursting of the bubble.

What monetary policy can and cannot do

Did monetary policy cause stagnation? While short-term interest rates have declined from the 8 percent level in early 1991 to virtually zero percent currently, during the same period money supply has increased only 25 percent, that is, 2.5 percent on an annualized basis, and is now growing at around 3 percent on a year-on-year basis. Such low growth of money supply reflects some characteristics of economic stagnation. Looking at the change in the assets of financial institutions corresponding to the above increase in money supply, their loans to the private sector have grown only 6 percent, significantly lower than the 62 percent increase in their credit (bond purchases, etc.) to the government. Needless to say, reductions in interest rates by the Bank of Japan will not automatically lead to an increase in money supply unless financial institutions respond to such rate cuts. Money supply will only grow if financial institutions engage in credit creation activities in response to declines in interest rates, i.e., making loans to firms after appropriate assessment of their borrowing plans, and also investing in securities. A small increase in loans to the private sector, which is in sharp contrast to credit extended to the government, vividly illustrates that financial institutions have had few profitable lending opportunities given their risk taking capacity.

It should be noted that the monetary policy stance for the past few years has been as accommodative as, or perhaps even more accommodative than, the early 1990s when monetary activists advocated that the economy would recover if active monetary easing were pursued. Despite such an accommodative stance, monetary easing in the 1990s was not so effective as to enable Japan's economy to return to a sustainable growth path. This does not mean that monetary policy was ineffective. In fact, it was quite effective as witnessed by the fact that following the bursting of the unprecedented bubble Japan's economy barely escaped tumbling into a deflationary spiral on several occasions, which mainly reflects the Bank of Japan effecting a drastic reduction in short-term interest rates. This is very evident when we compare Japan's prolonged stagnation with the Great Depression in the US during the 1930s: while the drop in stock prices in both Japan and the US was somewhat similar, prices, real GDP, and money supply showed quite different movements (see Figure 2).

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Nor has fiscal expansion proved effective in bringing the economy back onto a sustainable growth path. While Japan's general government fiscal balance showed a surplus of 2.9 percent as a percentage of GDP in 1991, the OECD estimates that it will become a deficit of 8.7 percent in 1999, the worst figure among OECD economies. Furthermore, government debt outstanding is estimated to increase to nearly 120 percent of GDP. As has been described, and in line with conventional theories in macroeconomic textbooks, both fiscal and monetary policy have been actively mobilized to the maximum extent possible. Hence, the fact that the economy has not regained strength despite such active policy implementation suggests that Japan's economic stagnation in the 1990s should be understood not only from the viewpoint of the business cycle but also in the context of a decline in growth potential.

A key to economic growth depends on how society can respond to changes

What determines growth potential? It is determined by an increase in measurable factors of production such as labor and capital, and a rise in total factor productivity which is not explained by these two factors of production. In my view, total factor productivity, though it may sound rather technical, is quite important in the sense that it signifies the capacity of society to continuously adapt to various changes. Changes may be caused by technological innovation, or they may be caused by a change in the relative prices of goods and services. They may also result from macroeconomic shocks. Whatever the cause may be, firms need to develop new products and services or review their production and sales methods in response to, or in anticipation of, a variety of changes. In making decisions at any particular point in time, firms take the existing institutional framework such as tax, legal, and accounting systems as given. Thus, if this framework is rigid, firms may find it difficult to flexibly adapt to change. In this context, the authorities bear a heavy responsibility for constantly reviewing the institutional framework and should endeavor to alter it as deemed appropriate in view of ongoing changes. Whether sustainable growth can be achieved depends largely on to what extent and how flexibly society, both private and public sectors, can adapt to change.

Why was there a delay in addressing the financial system problem?

Japan's stagnant economy of the 1990s was to some extent due to society's declining capacity to adapt to change. As an example, let us examine why there was a delay in addressing the non-performing asset problem. First, we can point out that there existed rather optimistic expectations on the part of bank management as to the future recovery of the economy and property prices. Second, the constraints hampering the flexible disposal of non-performing assets and provisioning had a negative impact on dealing with the problem. Above all, the delay was attributable to the fact that it took quite a long time before public funds were injected to reinforce bank capital and the legal framework to deal with troubled financial institutions was established. And, more fundamentally, as background to all these factors, it took a while for the public to be convinced of the serious impact of the huge non-performing asset problem on the economy. While the public understood systemic risk triggered by the failure of financial institutions as an abstract concept, it had tended to regard such risk as something that only concerned financial institutions or the financial market rather than being related to the economy. The severity of the non-performing asset problem and its impact on the economy was only truly realized when large institutions such as Sanyo Securities, Yamaichi Securities, and Hokkaido Takushoku Bank went bankrupt in fall 1997 and the economy experienced an abrupt credit contraction. If the seriousness of the problem had been recognized sooner, capital injection using public funds and the establishment of a legal framework to cope with the disposal of troubled financial institutions would have been realized much earlier. Hence, the restoration of financial system soundness might have resulted in an early recovery of risk taking ability in various sectors of the economy.

Importance of the ability to identify and solve problems

We can learn two lessons from the above episode with respect to society's ability to adapt to change. First is the importance of the market mechanism. It was pressure from international money and capital markets, for example in the form of the Japan premium, that urged Japanese financial institutions to conduct a full-fledged review of their management strategy. Of course, we should be mindful of possible overshooting when evaluating pressure from the market. However, the larger the problem, the more difficult it is for firms and society to change in the absence of pressure from the market.

The second lesson is the importance of society's ability to identify and solve problems. Having said that the market exerts strong pressure on economic agents, they compete in the market under a given institutional framework and economic environment. If the institutional framework such as legal, tax, and accounting systems and other regulations impose a high cost on society, then such framework will eventually be reviewed. Right now, however, what is crucial is the speed of review. With economic and financial globalization, the negative impact of maintaining the institutional framework at a high social cost to the economy would be fatal. In this regard, as experience after the bursting of the bubble shows, it is extremely important to make efforts to promptly identify the risks and structural factors which hinder economic growth and development, to present concrete measures for solving the related problems, and finally to implement such measures. These efforts are required not only of the private sector such as firms and universities but also of the authorities who, as experts in various systems and regulations, play a particularly important role in improving the institutional framework.

Importance of government debt management

Then, from the viewpoint of identifying and solving problems, what are the current issues Japan should focus on? Here, such issues as Japan's rapidly aging society, the large increase in government debt, and the high level of government investment in comparison with foreign countries are often pointed out as structural problems. In this article, I would like to focus on the importance of managing ever-increasing government debt in Japan. As has been mentioned, Japan's current government debt as a percentage of GDP is extremely high even viewed internationally. Its sustainability has often been explained by the high rate of personal savings. However, the private sector cannot be forced to use its savings for financing government debt, and, in this sense, the high rate of personal savings itself does not necessarily provide reassurance. For example, a hike in income tax rates is politically difficult. Furthermore, it would have a negative impact on the supply side of the economy including the shift of activities overseas, and is thus unlikely to result in an increase in tax revenue over the long run. Some advocate reflation as a remedy to the high level of government debt. Since Japan is not a controlled economy like it was immediately after the war, but now has a developed capital market, reflation would only bring an increase in future interest payments. After all, reform based on the market principle is fundamental to solving government debt. And for this we also need a mechanism by which to appropriately assess government activities. Whether public investment or foreign exchange intervention, any government activity must be financed. Hence, it is a prerequisite for debt management to have a system which correctly grasps the entire debt situation and the cost of government activities.

In the context of debt management, reform of the government bond market is important in addition to the reduction of government debt. Government bonds are important not only as a means of government financing but also as a benchmark for pricing financial products and also as a hedging instrument. Stable economic growth needs both a sound banking system and a developed capital market, and the sound development of the corporate bond market presupposes a highly liquid government bond market. Last year, various reform measures were taken in the government bond market and some improvements made. Unfortunately, we have not yet made enough improvement in promoting the greater entry of non-residents to the government bond market, which is a pending problem.

Role of the central bank

The central bank is also required to be able to identify and solve problems. In this regard, the first role expected of the Bank of Japan is to analyze and explain what upward or downward risks the economy faces as a whole. For example, we should recognize the risk related to the fact that the decline in property prices has not yet stopped. We also need to be thoroughly aware of the risks that the present extraordinary zero interest rate policy might have for the economy. Needless to say, it is important to recognize short-term risks. But, it is much more important to have an insight into medium- and long-term risks. The most crucial lesson that we have learned from the experience since the latter part of the 1980s, be it the creation or the bursting of the bubble, is that monetary policy should be conducted preemptively by taking due account of medium- to long-term risks. In this regard, textbooks regarding monetary policy have recently been substantially rewritten. While the old textbooks emphasized that monetary policy should be adjusted according to the state of the economy, the new ones emphasize that monetary policy should provide a stable environment, both economically and financially. Since the central bank now must conduct monetary policy in anticipation of risks which have not yet materialized, policy explanation by the central bank is more difficult than otherwise and sometimes invites criticism. However, I firmly believe that accountability is both an obligation and responsibility of an independent central bank.

The second role of the Bank of Japan is to constantly review its operations in response to market changes. For example, the Bank is currently in the process of implementing real time gross settlement regarding funds and government bonds. In daily monetary operations, various reviews are underway such as the introduction of buying operations using short-term government bills which began to be issued through public auction in April last year. As for eligible collateral when extending loans to financial institutions, the Bank started accepting asset-backed securities last year and has also been making some improvements in the method of evaluating collateral. The services provided by the central bank constitute part of the institutional framework, and thus the review of central bank operations in response to market changes is significant in supporting structural reform.

Signs of change

From the viewpoint of enhancing the potential for sustainable economic growth, we have begun to see some positive movements. For example, the authorities are devoting more time to explain their policies, and channels for obtaining public comment have gradually been introduced to the policy-making process. In addition, public interest in the accounting system and disclosure regarding public sector activities has increased. I welcome these positive movements which strengthen the intellectual foundation for formulating appropriate public policy, which, in turn, leads to a greater ability to identify and solve problems. Moreover, looking at the recent increase in direct investment into Japan, the level of which is not so high as that flowing into the US, corporate management has been rapidly changing as illustrated by the recent spate of reorganization including M&A and split-ups.

Monetary policy may be able to buy time until necessary adjustments are made, but it cannot substitute for structural reform. What is needed currently in Japan is structural reform which will enable sustainable economic growth as well as an appropriate framework to identify and solve problems.