DEFLATION AND MONETARY POLICY IN JAPAN

DEFLATION AND MONETARY POLICY IN JAPAN

On March 31, 2003, the Center on Japanese Economy

and Business organized a symposium featuring Professor

Kazuo Ueda, Member, Monetary Policy Board, Bank

of Japan. Professor Ueda’s presentation, based on his

published paper below, discusses the relationship between

Japan’s stalled economy, the deflation of general prices,

and the deflation of asset prices. He argues that the collapse

in asset prices, not general prices, has had deleterious

effects on Japan’s financial system and, in turn, on the

economy. He further suggests policy responses to deal with

persistent deflation and Japan’s ongoing financial and

structural problems.

Frederic Mishkin, Alfred Lerner Professor of Banking

and Financial Institutions, Columbia Business School

and David Weinstein, Carl S. Shoup Professor of the

Japanese Economy, Associate Director for Research,

Center on Japanese Economy and Business, served as

commentators. Professor Hugh Patrick, Director, Center

on Japanese Economy and Business, served as moderator.

CENTER ON JAPANESE

ECONOMY AND BUSINESS

MARCH 31, 2003

PROFESSOR KAZUO UEDAMember, Monetary Policy Board,Bank of Japan

There is much confusion inpopular discussion of Japan’s

deflation and associated economicproblems. This confusion tendsto arise from a failure to distinguishbetween three related, but differ-ent phenomena: the stagnation ofthe real side of the economy, thedeflation of general prices, andthe deflation of asset prices. Thedeflation of general prices hascertainly persisted since the mid-or late 1990s, depending on theprice index one looks at. However,the extent of the price declinehas been mild. The cumulativedecline in the consumer priceindex (CPI) since its peak in 1998has been no more than about 3%. It is hard to believe that suchmild declines in general priceshave been the root cause of thestagnation of the economy.

Declines in asset prices havebeen as large as they were duringthe Great Depression. Both TOPIXand the price index of urbancommercial land have plummetedby 70-80% from their peaks. Thecollapse in asset prices has hadserious effects on Japan’s financialsystem, and in turn, on the econ-omy, including general prices. Inthis short paper I attempt to dis-cuss the relationship between suchdeflationary forces.

In section one, I first discusssome salient features of the recentdeflation in Japan. This section

contains a quick survey of analysesof the causes of the recent defla-tion of general prices. In sectiontwo, I briefly summarize thebehavior of the price level, andof nominal and real interest ratesduring the Great Depression. Ialso refer to the literature on thecauses of the Depression, payingparticular attention to the so-calleddebt deflation theory and the roleof the negative financial accelera-tor. The discussion in this sectionprovides a benchmark againstwhich to evaluate Japan’s defla-tion experience since the 1990s.This is done in section three,where I basically show that Japanin recent years has not seen as serious a debt deflation as that experienced in either Japanor the U.S. during the GreatDepression. There is no evidenceof a sharp rise in real interestrates and thus in the real debtburden as a result of the deflationin general prices. It is also clear,however, that any significant risehereafter in the rate of generalprice deflation substantially raisesthe risk of throwing the economyinto a deflationary spiral.

As stated above, it has beenthe deflation of asset prices, notthat of general prices, that hasgenerated serious negative effectson the balance sheets of borrow-ers and, over time, on those oflenders. Through this route anegative financial accelerator hasset in, adding to deflationary forcesin the economy. This process isdescribed in section four. Finally,in section five, I turn to the dis-cussion of the appropriate policyresponse to deflation. Debt defla-tion caused by deflation in thegeneral price level can be curedby macroeconomic policy to stop deflation, and measures toaddress problems in financialintermediation. Japan’s recentcase is, however, a difficult oneas the deflation of general priceshas not been the root cause ofthese problems. Moreover, assetprice deflation was a natural mar-ket response to the bubble of thelate 1980s. In addition, there is

some evidence that the return on capital has been on a seculardeclining trend since sometime in the 1980s, giving support tothe view that “reforms” are a keyto sustained recovery. Worse still,the failure to address financialsystem instabilities at an earlystage has substantially reducedthe effectiveness of macroeco-nomic policy in easing evengeneral price deflation. Such acomplicated chain of events hasnot been well understood andhas led to confusion in populardiscussion on “deflation.” Anyway,one thing seems clear, namely,the need to address the financialsystem problems as soon as possible.

1. Japan’s deflation since the1990s*

The behavior of Japanese final goods prices has been

fairly stable since the early 1990s.Figure 1 shows movements of theCPI and the GDP deflator1. Theaverage annual rate of change inthe indexes is 0.3% and -0.75%,respectively, over the period of1992-2001. The larger decline in the GDP deflator reflects thelarge secular decline in the defla-tor for investment resulting fromtechnological improvements, andalso its nature as a Paasche-typeprice index based on a commod-ity basket that changes over time.The two indexes have been fallingsince the mid- and late 1990srespectively. At the same time,however, there is at present noclear tendency for the deflationto accelerate..

A more disaggregated look atprice developments turns out tobe useful. Figure 2 presents aver-age inflation and output growthby industry for the period 1990-2002. The data points seem to lieon a downward-sloping schedule,suggesting the importance of sup-ply side forces as determinants ofcross sectional differences in therate of price changes. Among thecomponents of the CPI, althoughthe data are not presented, the

It has been thedeflation of assetprices, not that

of general prices,that has generated

serious negativeeffects on the

balance sheets ofborrowers and,

over time, on thoseof lenders.

—Professor Kazuo Ueda

2 Deflation and Monetary Policy in Japan

* For figures, see pages 10-15.1. In this paper, the CPI and GDP deflator have been adjusted for the effects of the 1997 hike in the consumption

tax rate. Specifically, the rate of change in the indexes has been adjusted downward by 1.5% for 1997 and by0.5% for 1998 to undo the effects of the tax change.

goods component has been fallingfaster than the others. Amongservices, those sectors that haveexperienced significant deregula-tion, such as transportation andcommunications, have seen largerdeclines in the rate of inflation.Deregulation in the non-manu-facturing sector has certainlybeen an important part of thebackground for the deflation ofgeneral prices. A closer look atthe goods component of the CPIreveals that import-competinggoods have suffered larger pricedeclines than the rest, as shownin Figure 3. This again lends sup-port to the view that supply sideforces have been important.

Turning to demand side factors,one can immediately point to the possible existence of a largeGDP gap as the dominating forcebehind the deflation of generalprices. Most estimates of the GDPgap are very large. For example,assuming 2% growth in trendoutput and the absence of a gapin the early 1990s, the GDP gapfor 2002 must be larger than 10%.This is, however, hard to recon-cile with the mild deflation ofabout 1% and the absence of atendency for this deflation toaccelerate. One needs to arguethat the gap is much smaller (thegrowth rate of trend output ismuch lower), or that the effect ofthe gap on prices has been verysmall. In addition, one needs torely heavily on supply side forcesas a determinant of inflation.

Hirose & Kamada (2002)present one estimate of trendgrowth and the GDP gap. It showsthat the trend growth rate is nowaround one percent, much lowerthan in other literature on thesubject. It also presents a statisticalanalysis pointing to the importanceof low-price imported goods as acontributing factor to the deflationsince the mid-1990s. Using timeseries analysis, Kamada & Hirakata(2002) attempt to decompose thecauses of changes in the rate ofinflation into demand side andsupply side factors. They find that,during the recent period of defla-tion supply, side factors such as

international comparative advan-tage shocks have played dominantroles.

It seems fair to say that moreanalyses and, perhaps, more dataare necessary to determine therelative contributions of supplyside versus demand side factors.The seemingly small effect ofcyclical factors on inflation remainsa puzzle.

In contrast to the behavior of general prices, the volatility ofland and stock prices during thelast two decades is worth pointingout. TOPIX went up by almost400% between 1980 and 1989 andhas fallen by about 70% from itspeak. Similarly, the price index of urban commercial land in sixlarge cities rose by almost 500%between 1980 and 1992 and hasdeclined by 85%. Moreover, as ofMarch 2003, i.e., more than tenyears since its peak, it is still notclear whether they have reachedbottom.

Asset price volatility has beenas high as it was during the GreatDepression, but has not beenaccompanied by volatility in gen-eral prices. In fact, this representsa shared feature in the experiencesof many industrialized economieswith respect to their stock marketbooms-and-busts since the mid-1990s. The asymmetry betweenasset and general prices is surelyan important topic for future study.

2. Why is deflation a problem?

Deflation of general prices, ifunanticipated, creates a trans-

fer from debtors to creditors byraising the real interest rate (expost). Even an anticipated defla-tion raises the real interest rate, ifnominal rates are at the zero boundand cannot be reduced further.

To the extent that debtorshave higher propensities to spendout of income than creditors, suchtransfers reduce aggregate demand,adding to deflationary forces inthe economy.2 In addition, underasymmetric information, banksmay reduce lending in responseto a decline in the net worth ofdebtors, setting in motion a negative

financial accelerator process.Accelerator effects become moreserious if financial institutionsalso suffer from balance sheetproblems.3

Examples of serious debtdeflation can be found in theexperiences of industrializedcountries in the 1920s and 1930s.Figure 4 shows Japan’s call mar-ket rate, the rate of change in theGDP deflator, and the real inter-est rate (defined by the differencebetween the two). Deflationexceeded 10% and the real interestrate 15% in the early 1930s. As aresult, the debt burden of borrow-ers rose sharply. For example, netinterest payment relative to cashflow rose from about 80% in 1929to more than 200% in 1930. As is well known, a similar patternof movement in the variables isfound for the U.S. in the 1930s.In addition, as Bernanke (1983)documents well, the debt deflationwas exacerbated by the declinein the economy’s ability to carryout financial intermediation.

3. Japan’s general price deflation since the 1990s andthe debt burden of borrowers

Japan since the 1990s is nowhereclose to the U.S. or Japan of

the 1930s in terms of the impactof general price deflation on thedebt burden. Figure 5 plots thereal interest rates faced by majorborrowers, non-financial firmsand the government. The realinterest rates are calculated asgross interest payments dividedby total debt minus the rate of increase in the deflator fordomestic demand. As may beseen, the real interest rates havedeclined slowly since the mid-1990s. Of course, one could saythat we would have liked to seemuch lower real interest rates to stimulate aggregate demand.4

There is, however, at least no evi-dence that deflation has increasedreal interest rates. A gauge likeinterest payments relative to cashflows tells the same story. For non-financial corporations this ratiohas been falling steadily since the

Examples of seriousdebt deflation can

be found in theexperiences ofindustrializedcountries in the

1920s and 1930s.


Symposium 3

2. See I. Fisher (1933) or M. King (1994).3. See, for example, Bernanke (1983) and Bernanke & Gertler (1990).

early 1990s. It is now around 12%,compared with a level of morethan 40% in 1991 and 1992.5

Several caveats have to bekept in mind here. First, the zerobound constraint will becomeincreasingly serious if the rate ofdeflation rises from here. Nominalinterest rates are virtually zero ondebt instruments with less than ayear to maturity. Even on thosewith longer horizons, rates arenot far from zero. For example,as of April 2003, the rate on fiveyear government bonds (JGBs) isaround 0.25%; that on the ten yearJGBs is around 0.7%. Obviously,the room for downward adjust-ment is limited. Consequently, it is very important to avoid anacceleration in the deflation ofgeneral prices.

Second, some debtors are introuble. A typical example is thebanks. Given that most of thebanks’ liabilities are short term, it would come as no surprise ifbanks were suffering heavily underdeflation and the zero bound onnominal interest rates. Figure 7shows the margin between lendingand borrowing rates for Japaneseand U.S. banks along with theircredit cost ratios, i.e., bad loanwrite offs and provisions relativeto total loans. Although marginsare much lower in Japan than theU.S., they have not been shrink-ing. In this sense, the deflation ofgeneral prices and the zero boundhave not bitten into banks’ prof-itability. However, the figure alsoshows that these margins havenot covered credit costs in somerecent years. This is the non-performing loan (NPL) problemand we will return to it shortly.

4. The negative financial accelerator in Japan since the 1990s

Without doubt the sharp fallin asset prices has been the

major reason for the recent insta-bility in the Japanese financialsystem. Less clear is the causalitybetween the financial systemproblems and the deflation ofgeneral prices. To shed somelight on this issue, let us first lookat Figure 8, where the relationship,by industry, between inflationand the degree of seriousness ofthe NPL problem is shown. Thefigure clearly reveals that thelower the rate of industry infla-tion, the less serious is the NPLproblem for that industry. Althougha correct interpretation of therelationship in the figure requiresfurther research, the relationshipis evidently at odds with the viewthat the deflation of general priceshas been the cause of NPLs.

In Figure 9 we show the relationship, by industry, betweenNPLs and the extent of land hold-ing (land as a share of total assets)at the peak of the bubble. Assumingthat the real estate observationdoes indeed contain significantinformation in this regard, therewould seem to be a positive rela-tionship between the two variables.That is, the larger the land hold-ing, the more serious the NPLproblem, providing evidence ofcausation running from asset pricedeflation to NPLs.6 One mightwonder why NPLs have not dis-appeared after a decade of badloan write offs and provisions.The total amount of money banksand the government have spenton NPLs amounts to about 20%of GDP. Figure 10 provides someclue as to why. The figure pres-ents the evolution of bank loansby industry since the late 1980s.Loans to “bubble industries” suchas real estate and constructiondid not begin to decrease until

the late 1990s. Only loans to non-banks began to decline in themid-1990s as public discussionand the government’s handling of NPLs focused on this industry.Thus, there was clearly reluctanceon the part of banks to disposeof NPLs swiftly, leading to for-bearance lending and to muchlarger NPLs later.

I hasten to add that the recentstagnation in the economy, espe-cially its weakness since 2001, is adding to the NPL problem.Although official bad loans arestill dominated by loans to bubbleindustries, loans requiring cautionare of a wider variety and seemto reflect the weakening of theoverall economy.

Researchers have had difficultyobtaining solid results on the effectsof financial instability on theeconomy. With the accumulationof data and use of fine techniques,however, the literature is finallyobtaining some interesting find-ings in this area. Nagahata &Sekine (2002) carry out a timeseries cross section analysis ofthe determinants of businessfixed investment. Along withother determinants, their analysisexamines the importance of thebalance sheet conditions of bothborrowers and their main banks.They find that the deteriorationof borrower balance sheets hashad significant negative effectson investment. They also findthat the deterioration of lenders’balance sheets has exerted signif-icant negative effects on theinvestment of firms without accessto the bonds market. The deterio-ration of balance sheets can bemostly explained by declines inasset prices and by NPLs (in thecase of banks). Moreover, mostof the declines in bank lendingsince the mid-1990s can be attrib-uted to these two factors, togetherwith the liquidity problems ofbanks during 1997-98. Thus, a

Accelerator effectsbecome more

serious if financialinstitutions also

suffer from balance sheet

problems.



4. One reason for the small declines in real interest rates is shown in Figure 6, where the spread between the inter-est rate paid by non-financial firms and the 10 year government bond rate is plotted. The spread has clearly risensince 1997. This is, however, not directly due to the deflation of general prices, but, as we discuss in the nextsection, to declining borrower creditworthiness and the increased cost of financial intermediation.

5. Of course, deflation decreases this variable by lowering nominal interest payments faster than cash flows. Thiseffect is offset by a rise in the real value of the principle. In order to see the net impact one needs to look at thereal interest rate, which is what we have in Figure 5.

6. See Ueda (2000) for a more careful analysis of this point along with the discussion of other causes of the NPLproblem.

negative financial accelerator hasclearly been working.7

The negative effects of financialinstability spread throughout theeconomy during the credit crunchin 1997-1998. The Asian economiccrisis, a premature tightening offiscal policy in 1997, and theRussian crisis in 1998 were thetriggers for the crunch. Severalfinancial institutions went under.Risk premiums and the demandfor liquidity rose sharply acrossthe financial system. Japanesebanks, already suffering fromNPLs, were now facing difficultyin raising funds. Naturally, theystarted calling in their loans tonon-financial companies. Evenlarge companies were feeling thepressure of the credit crunch.Many said in our interviews thatall but the main banks are sayingthat they would not be able toroll over loans at the year’s end.Therefore, businesses had to cutback on their investment. In ret-rospect, the failure to resolve theNPL problem at an early stageresulted in the credit crunch andhas become one of the reasonsfor the stagnation of the economysince.

5. Policies to deal with theproblems

The prescription for 1930s’ typedebt deflation has been pro-

posed by, among others, Bernanke& Gertler (1990). The financialaccelerator problem may be dealtwith by transferring income todebtors with promising projects,at least to the extent that suchprojects and borrowers are iden-tifiable. The same thing may besaid about banks. Macroeconomicpolicy can take care of generalprice deflation.

The case of Japan since the1990s is more complicated. As Ihave hopefully made clear, thedeflation of general prices hasnot been the major problem.Instead, asset price deflation andits interaction with the financialsystem and the economy havebeen at the core of the problem.There are two views on the assetprice deflation of the period. Oneview holds that the bubble of thelate 1980s had to burst. The otherrecognizes a secular decline inthe return on capital startingsometime in the late 1980s andassociated declines in asset pricesand investment.8 The two are notinconsistent with each other, butmutually reinforcing. The secondview seems to need the first toexplain the temporary rise inasset prices. The two differ intheir estimates of where priceswill end up, but are in accordancein claiming that adjustments inasset prices and investment wereinevitable. To be sure, the nega-tive accelerator story suggests thatthe economy and asset pricesmay fall further than is necessary.Hence, beyond a certain point,policies to support asset pricesmay be justifiable. It would, how-ever, be difficult to determinewhether the economy had reachedsuch a stage. Also, a more funda-mental policy response would beto address the problems of thefinancial system and other ineffi-ciencies in the economy.

The role of macroeconomicpolicy is also not straightforward.Stopping the deflation in finalgoods prices will surely ease thepain of the type of adjustment Ihave just described, but it doesnot mean that the economy can dispense with the need foradjustment. Raising the rate ofinflation of general prices by a

couple of percentage points wouldnot mean much for asset prices.9

In fact, it is the ratio betweenasset and general prices that hashad to adjust.10 Moreover, as Iexplain below for monetary policy,the problems in the financial sys-tem have lowered the effectivenessof macroeconomic policies instimulating the economy.

Focusing now on monetarypolicy, I show in Figure 11 thedifficulty the Bank has been fac-ing in combating deflation. Theratio of base money to nominalGDP shown in the chart displaysa sharp upward deviation from itstrend prior to around 1995, withthe ratio roughly doubling sincethen. Yet deflation has persisted,albeit at moderate rates. This is aclear case of monetarism failingto explain the relationship betweenmoney and inflation. Possiblereasons behind this are suggestedin the same figure. The rate ofgrowth of bank loans has beeneither around zero or negativeduring the same period, in linewith financial sector problems. As I mentioned above, this hasreduced the ability of low interestrates to stimulate the economy.Moreover, as the chart makesclear, short-term interest rates hit the zero bound during thisperiod, depriving the Bank offurther room to use standardmonetary policy.11

Given the nature of the problem, it would be nice ifmeasures could be found thataddress financial sector problemsas well as macroeconomic defla-tionary forces. The Bank, in fact,has been adopting such steps. In an attempt to ease corporatefinancial problems, the Bank hasbeen accepting commercial paper,corporate bonds and some assetbacked securities as collateral

The problems in the financial system have lowered the

effectiveness ofmacroeconomic

policies in stimulating

the economy.


Symposium 5

7. One could say that a similar mechanism was working during the Great Depression, which was only aggravatedby the deflation of general prices.

8. See, for example, Hayashi & Prescott (2002) for an expression of such a view.9. This could be a debatable point. A rise in the rate of general price inflation will leave asset prices unaffected if

the real interest rate remains unchanged. If, however, the zero bound on nominal rates were to have preventedthe real interest rate from falling, the real rate would decline as inflation rises. Discussions in section 3 suggestthat evidence is mixed on this point. There is no clear sign that the real interest rate has risen because of defla-tion. But it is also difficult to refute the possibility that the real rate is higher than it should be.

10. The ratio of asset prices to the GDP deflator has declined sharply since the peak around 1990 and is now backat where it was around 1983 for both stock and land prices. Thus, a fair amount of adjustment has already takenplace. As pointed out above, however, it is difficult to determine whether the process is over, incomplete or hasgone too far.

11. See Ueda (2001) & (2002) for more detailed accounts of monetary policy during the period.

when carrying out its operationsto supply liquidity. In the lastmonetary policy meeting the Bankdecided to study the possibility ofbuying some asset backed securi-ties outright in order to strengthensuch efforts. Since late last year,the Bank has been buying equi-ties from banks, helping them toreduce equity holdings to belowTIER one capital, as dictated bylaw. Its intention has been to easethe pain of asset price adjustmentfelt by the banking system with-out necessarily supporting assetprices. We would like to try harderto find other measures to achievethe same end.

References:♦ Bernanke, B. (1983) “Nonmonetary

Effects of the Financial Crisis in the Propagation of the GreatDepression,” American EconomicReview, Vo. 73, 257-276.

♦ ______ & M. Gertler (1990)“Financial Fragility and EconomicPerformance,” Quarterly Journalof Economics, 87-114.

♦ Fisher, I. (1933) “The Debt-Deflation Theory of GreatDepressions,” Econometrica,Vol.1, October, 337-357.

♦ Hayashi, F. & E. Prescott (2002)“The 1990s in Japan: A LostDecade,” mimeo.

♦ Hirose, Y. & K. Kamada (2002)“Estimation of Japan’s PotentialGrowth Rate Assuming VariableNAIRU (in Japanese),” WorkingPaper, Research & StatisticsDivision, The Bank of Japan.

♦ Kamada, K. & N. Hirakata (2002)“Import Penetration and ConsumerPrices,” Working Paper, Research& Statistics Division, The Bank ofJapan.

♦ King, M. (1994) “Debt Deflation:Theory and Evidence,” EuropeanEconomic Review, Vol.38:419-445.

♦ Nagahata , T. & T. Sekine (2002)“The Effects of Monetary Policyon Firm Investment After theCollapse of the Asset PriceBubble: An Investigation UsingJapanese Micro Data,” WorkingPaper, Research & StatisticsDivision, The Bank of Japan.

♦ Ueda, K. (2000) “Causes of Japan’sBanking Problems in the 1990s,”in Crisis and Change in theJapanese Financial System,Hoshi, T. & H. Patrick (eds.)Kluwer Academic Publishers.

♦ ______ (2001) “Japan’s LiquidityTrap and Monetary Policy,” speechgiven at the meetings of the JapanSociety of Monetary Economics,http://www.boj.or.jp/en/press/koen072.htm.

♦ ______ (2002) “The TransmissionMechanism of Monetary PolicyNear zero Interest Rates: TheJapanese Experience, 1998-2000,”in Monetary Transmission inDiverse Economies, Mahadeva,L. & P. Sinclair (eds.) CambridgeUniversity Press,http://www.boj.or.jp/en/press/03/press_f.htm.

FREDERIC MISHKINAlfred Lerner Professor of Bankingand Financial Institutions,Columbia Business School

I agree with a fair amount ofProfessor Ueda’s analysis, but

I have some different views abouthow much the Bank of Japan(BOJ) is to blame for the malaisein the Japanese economy rightnow and also what the centralbank and Japan should do. First,I will talk about what I agree with.

The first issue that ProfessorUeda raised is that mild deflationby itself is not a disaster, and thisis not the same kind of deflationthat we saw in Japan and theUnited States in the 1930s. I shouldpoint out that we have not had adepression in Japan of the typethat occurred in the U.S. in the1930s. Japan has had a very ane-mic growth rate over the past tenyears or so, but we have not seena collapse of the Japanese economy.

Professor Ueda mentioned thatthe big problem is what I like tocall a “creeping financial crisis”.The financial sector is in hugetrouble with very weakened bal-ance sheets, and this means thatbusinesses that are very depend-ent on bank lending have beendoing very poorly. In fact, whatyou see is a bifurcated Japanese

economy in which bank-dependentbusinesses are languishing whilelarge exporters who have accessto international capital marketsare doing well. So I strongly agreewith Professor Ueda that this is akey problem.

Another point that ProfessorUeda mentioned is the need forstructural reforms in Japan. I alsobelieve that a key issue is theproblems in the banking sectorand also in other parts of thefinancial sector.

I also agree that the BOJ cannot solve all of the problemsand there is no question in mymind that, without a banking anda financial sector that it efficientlytransfers capital to people withproductive investment opportuni-ties, the Japanese economy cannever reach the growth rates thatit should reach. You may recallthat it was only approximatelyten years ago that everybody wastalking about the Japanese over-taking the U.S. economy. Actually,this was something that couldhave happened. I think that thereare tremendous inherent strengthsin the Japanese economy, but itis being held back. At any rate, Ithink that this is very important.

Professor Ueda also mentionedthat many people try to blamethe Bank of Japan for being theinitial cause of these problems. Iagree with him that this view isincorrect. The initial cause was abursting of the asset price bub-ble. There were serious problemsin the prudential supervision ofthe banks that helped lead to thiskind of bubble, and then whenthe bubble popped, it createdsome serious problems.

However, there is one area of Professor Ueda’s discussionthat I strongly disagree with. Heimplies that the BOJ really cannotfix the problems or help the econ-omy recover from these troubles.

I think that the BOJ has madeit much more difficult to solve thefinancial sector problems. TheBOJ has also made it more diffi-cult to get the structural reformsthat the Japanese economy needsto get its growth high again.

Japan has had a very anemic

growth rate overthe past ten yearsor so, but we havenot seen a collapse

of the Japaneseeconomy.

—Frederic Mishkin


Within this context, let metalk about the issue of monetarypolicy and asset prices. One ofthe points that Professor Uedatalked about was that monetarypolicy cannot do a whole lotabout asset prices. Also he claimsthat deflation itself is not what'sreally hurting asset prices: theproblem is that asset prices arejust too low, and they are stilldeclining, as is the case for landprices.

I disagree, because the realissue is what the Central Bankcan do about aggregate demand.One of the reasons that assetprices are so grim in Japan isbecause there are expectationsthat the monetary authorities areeither not capable of or will nottry to actually expand aggregatedemand sufficiently to make itpossible to make big profitableinvestments. When you are in adeflationary environment whereyour expectation is that this Bankof Japan either can't stop thedeflation or won't stop it by pur-suing sufficiently expansionarymonetary policy, then you reallyhave problems. One view is thatthe BOJ may not be able to stopthe deflation, but I think there is another view, which is that the BOJ actually has one of themost peculiar credibility problemsamong central banks throughoutthe world right now.

Usually we worry about centralbanks having credibility in termsof keeping inflation low so thatthere is always a concern that theywill pursue job creation throughexpansionary policy that will leadto inflation. I think the BOJ hasthe opposite problem. They havevery little credibility with regardto their willingness to continuallypursue expansionary policy for asufficient period to get the econ-omy rolling again. In particular, Ithink this had a lot to do with theprevious governor of the BOJ whofocused on the horrors of infla-tion and very little on the dangersof deflation. Furthermore, whenthe BOJ pursued expansionarypolicy, they would take it back.For example, the BOJ pursued a zero interest rate policy for aperiod of time, and then whenthe economy started to perk up

they raised interest rates again. This has led the BOJ into a

trap. If there are expectations thatwhen monetary policy is expan-sionary, it will be taken back, thenit is not going to be as expansion-ary as the monetary authoritieswould like. Indeed, the BOJ findsitself in exactly this situation. Themarkets clearly take the view thatthe BOJ is not willing to pursueexpansionary policy for a suffi-cient period of time to make surethat the economy will come backstrong again.

I think that the BOJ is in a situation where, as Franklin DelanoRoosevelt said during our GreatDepression, the only thing theyhave to fear is fear itself. The BOJis very reluctant to take what theysee as risks, which as I see it arenot great risks because the thingthey need to fear is not inflationbut deflation.

In this case, I think the BOJhas to achieve reflation and do itwith both words and actions. Bywords, I mean establishing aninstitutional framework that actu-ally indicates what the central bankwill do over a longer period oftime. This is important becausethe key to effective expansionarypolicy is what you do to expecta-tions. The BOJ needs to do twothings. First, it needs to indicatethat it is going to reflate the econ-omy by making very strong effortsto get the price level back to whereit would have been in the absenceof deflation. Second, once thisreflation is achieved they shouldthen adopt an inflation target ofapproximately two percent. Thereason for the inflation target isto protect the BOJ against fearsof having uncontrolled inflation.What we have seen is that credi-bility for price stability is creatednot just by keeping inflation low,but also by not keeping inflationtoo low. That is what we meanby price stability. This is a veryimportant issue and, in one sense,inflation targeting is an institutionalframework that needs to be usedby the BOJ to get out of theirexpectational trap.

What measures does the BOJhave to take to do this? ProfessorUeda made two points. One isthat monetary policy is not as

effective as it was. However,does that mean monetary policyshould not be used to get aggre-gate demand back up? I think the answer is no, and the BOJjust needs to be that much moreaggressive and push harder. Indeed,there are many other measuresthat the BOJ can take, such asopen market operations in otherassets like long-term bonds. Theirinterest rates can be driven evenfurther down. There is also theissue of equity prices and the FXmarket. Open market operationsin these asset markets can helpproduce asset price changes thatwould be helpful in terms of get-ting the economy going again.Part of the reason I think the BOJhas been very reluctant to do this may have to do with theirdiscomfort about the degree ofindependence they have.

Professor Ueda is concernedthat expansionary policy wouldbe at odds with the reform process.He does see that structural reform,particularly in the bankruptcysector, is critical, and I wouldagree. However, I take the viewthat expansionary monetary pol-icy is exactly what is needed toget the reform process going. For example, I would not havecharacterized the bank restructur-ing process in Japan the wayProfessor Ueda did. He character-ized the government as doing theright thing but just not at the righttime. They did not do the rightthing. They injected capital intothe banking system, but they didit as a half-measure with only apartial recapitalization of thebanking system while allowingweak banks to remain open. Weknow, for example, that a half-measure is the worst thing to do. One must fully recapitalizethe potentially healthy financialinstitutions so they start lendingagain. Half measures just leavebad banks in operation and donot stimulate the lending process.

Bank restructuring has nothappened because the banks are politically powerful and theyare in a situation where they cansay, “if you close us down it isgoing to hurt the economy”. Thisis exactly a case where activemonetary policy to pursue very

Expansionarymonetary policy is exactly what is needed to get

the reform process going.

—Frederic Mishkin

Symposium 7

expansionary policy can help theprocess. If restructuring the bank-ing system would initially weakenthe economy, monetary policycan help overcome this weaknessby stimulating the economy.

The second issue is structuralreform. In order to do structuralreform there needs to be invest-ment. I see structural reform asless a problem for the businesscycle issues in Japan but verycritical for long run economicgrowth. It is not acceptable forJapan to have a GDP growth rateof one percent per year. It is clearthat they should have numbersvery similar to the United Statesand I would argue that there iseven the potential for Japanesegrowth to be higher than the U.S.

Having very expansionarymonetary policy will raise assetprices, will end the deflationarypsychology in Japan and wouldactually be a tremendous help.

In conclusion, my view is that it is true the BOJ is in a verydifficult situation. On the otherhand, in a difficult situation youdo not want to fight the last war,but rather the current one.

DAVID WEINSTEINCarl S. Shoup Professor of TheJapanese Economy; AssociateDirector for Research, Center onJapanese Economy and Business

Thank you for inviting me here.I have a reputation for being

an excessively blunt and sharpcritic of Bank of Japan analysesof the economy. Indeed, when Iheard that I would be discussingKazuo Ueda’s presentation, I didworry that I might be overly criti-cal. However, as usual, Kazuothrew me a curve ball. Simplyput, Kazuo Ueda’s presentationwas the best presentation onJapanese monetary policy that Ihave heard from a BOJ official ina long time. The only one thatwas this good was the last Uedapresentation I attended, but thistime he has outdone himself.

Of course, I now have a majordilemma. The rule for discussantsis, “If you can’t say anything criti-cal, don’t say anything at all.” SoI could end my comments now,but I won’t. What I will do is askone question and amplify a fewof his comments. The question Ihave is, “what is the message thatthe BOJ is trying to get out?” Thereseem to be two messages andthey are confusing for economistsand probably for market partici-pants. One of the central resultsof monetary economics is thatmonetary policy can affect prices.In a move that is quite surprisingto me, a large number of BOJofficials have disputed this resultpublicly and privately. To sharpenthe point, there appears to be afundamental divide between aca-demic economists who argue that

prices reflect monetary policy andthe BOJ who argue that monetarypolicy cannot affect prices. Tosome degree I sense a tension in your remarks between Uedathe economist who writes, “Macro-economic policy can take care ofthe deflation of general prices,”with some of your commentstoday which reflect a notion thatprices and money are completelyseparate. This may reflect a largerdebate in the BOJ about theeffectiveness of monetary policyin reducing deflation. For example,you showed a figure that showedan increase in base money wasinteresting, but only showed upthrough 2001. In recent years, basemoney growth has been comingdown. In fact, the latest numberon base money for February ofthis year-end growth was 12.6percent, which is the lowest growthrate since September of 2001.Many economists would arguethat this reflects the excessivetimidity of the BOJ in making alarge and sustained increase inthe money supply.

Let me now make a fewamplifications of your comments.I think that we are in completeagreement that deflation exists in Japan. The next question is,“how much does deflation mat-ter?” A sensible metric is realinterest rates. The reason why we focus on real interest rates isbecause they tell us the trade offbetween savings and consump-tion or savings and investment.In the US, core CPI inflation is1.9%, and the Federal funds rateis 1.25%; this implies that realinterest rates are -0.65 %. In Japan,by contrast, the core CPI is -0.7%,and interest rates are 0. This meansthat the real interest rate is +0.7%.In other words, real interest ratesfor consumers are around 150basis points higher in Japan! The Fed would need to raiseinterest rates by 150 basis pointsto accomplish a comparable dragon the economy. Few doubt thiswould throw the US into a majorrecession. Put simply, there is a very fundamental differencebetween Federal Reserve andBOJ policy. Some work done by my colleague Jim Harriganand Ken Kuttner at the Federal

The BOJ has toachieve reflation

and do it with bothwords and actions.

—Frederic Mishkin


Reserve Bank of New York showsfairly clearly that the Fed movedreal interest rates more in theUnited States in five quarters thanthe BOJ did in five years. Thismakes clear my main point aboutdeflation in Japan. Deflation hasnot raised Japanese real interestrates to historically high levels,but deflation does mean that theBOJ’s zero interest rate policy issignificantly tighter than the Fed’scurrent policy.

As a fan of Japanese economichistory, I can’t resist talking about the prewar comparison. I completely agree that Japan’sproblems today are less than inthe great depression. However,I’m not sure why BOJ officialskeep bringing this period up. Whatmade things worse during thedepression was Inoue Junnosuke’spolicy of tightening money bygoing on the gold standard as thebanking and world trade systemscollapsed. Hayami’s policies havebeen substantially better.

However, stories of the 20’sand 30’s demonstrate the clearpower of monetary policy. Asshown on the chart, between1931 and 1932 GDP deflator rosefrom -12 % to 3 %. Governmentexpenditure only rose 7 % in realterms. The real reason why Japanpulled out of the depression soquickly was not the relativelymodest fiscal stimulus but thedevaluation of the yen from 0.5

to 0.2 in 1931. This would be the equivalent to moving the yento around 300 yen to the dollartoday. I think that the clear les-son from Japan’s experience inthe depression is that monetarypolicy works!

My final comment centers onhow to ease the pain of adjustment.While I agree with your statementthat “stopping the deflation offinal goods will ease the pain ofadjustment, but it will not dis-pense the need for adjustment,” I think that it is important toremember that easing the pain of adjustment may make theadjustment easier to accomplish.For example, inflation may helpresolve some of the bad loans.Consider the following back ofthe envelope calculation. Thereare currently 482 trillion yen ofloans outstanding in Japan. A reasonable estimate of the levelof bad loans is 70 trillion. If theBOJ inflates by 15 percent whilekeeping interest rates at zero, thecapital gain to banks would offsetthe bad loans! There is precedentfor this. Indeed, this is how Japansolved the crisis following WWII.This may not satisfy an urge topunish bankers, but it wouldsolve the problem.

(Figures follow)

There appears to bea fundamentaldivide between

academic economists whoargue that pricesreflect monetarypolicy and the BOJ who arguethat monetary policy cannotaffect prices.

—David Weinstein

Symposium 9

Left to right:Professor Hugh Patrick, Professor Kazuo Ueda, Professor Frederic Mishkin, Professor David Weinstein


Figure 1: Rate of Inflation

Figure 2: Real Growth & Inflation

Symposium 11

Figure 3: CPI-based comparison between imported and other goods

Figure 4: The Real Interest Rate, Japan 1922-1935


Figure 6: Interest Rate Spread against 10Y JGB (Nonfinancial Business)

Figure 5: Estimates of Real Interest Rates

Symposium 13

Figure 7: Developments in Overall Margins


Figure 8: Deflation vs NPL

Figure 9: NPL vs Land Holding

Symposium 15

Figure 10: Bank Lending By Industry, 1989=1

Figure 11: Amount Outstanding of Bank Lending, Overnight Call Rate, and Nominal GDP/Monetary Base

EDITORJoshua SafierAssociate DirectorCenter on Japanese Economy and Business

ASSOCIATE EDITORMr. Toshi IchidaProgram ConsultantCenter on Japanese Economy and Business

PHOTOGRAPHYJoseph Piniero

DESIGN/PRODUCTIONMelanie Conty

CENTER ON JAPANESE ECONOMY AND BUSINESS

Columbia Business School321 Uris HallMail Code 59983022 BroadwayNew York, NY 10027Phone: (212) 854-3976Fax: (212) 678-6958Email: [email protected]://www.gsb.columbia.edu/japan

Documents

DEFLATION AND MONETARY POLICY IN JAPAN