-->Demand-side measures can end recession

Richard Werner Special to The Daily Yomiuri

The government white paper released by Heizo Takenaka, the state minister for economic, fiscal and financial policy, this week claims that asset deflation has already reached about 1.2 yen quadrillion. According to the report, Japan's decadelong underperformance and deflation is due to bad loans in the banking system and the outdated economic structure. It therefore calls for a rapid disposal of bad loans, including foreclosure on the firms that borrowed from banks, and deep structural reforms, in line with Prime Minister Junichiro Koizumi's structural reform agenda.

There is a serious flaw in these arguments. Over the past decade, 200,000 firms have already gone bankrupt. By accelerating the foreclosures of more and larger firms, bankruptcies and unemployment will rise again. This will reduce demand further. Meanwhile, continued structural reforms will drive down prices more and accelerate deflation. Thus the very problems identified by the annual white paper will be exacerbated, not alleviated. Surprisingly, the white paper on the national economy and public finance admits this, conceding that its proposals will increase"deflationary pressure" on the economy. So why should anybody in their right mind take these policies? Because, the white paper argues, by the firing of staff, closing of firms and scrapping of old factories, resources that had previously been tied up in industries without a future can be deployed in the service sector and used to implement new technologies. Thus--and this is the crux of the argument--through increasing bankruptcies and implementing structural reforms, Japan's potential growth rate would rise in the long run.

The question is, if Japan does take this prescribed medicine, when will the long run kick in? Before or after the patient has died from the expected deterioration of his condition? In 1930 and 1931, leaders in Germany, Britain and the United States also argued that their economies had to be stimulated not through demand-side measures, but by deflationary supply-side policies. Bankruptcies and layoffs were good, people were told, as resources could be redeployed more efficiently. The outcome is well known: Deflation accelerated, demand collapsed and the Great Depression led to one of history's largest losses in output, income and livelihoods. It was of little comfort to be told that things would be fine in the long run. Thus Keynes' famous quip that in the long run we're all dead.

The problem is that even if supply-side reforms succeed in raising the potential growth rate, potential growth only turns into actual growth when demand catches up with it. Since deflationary policies would reduce demand, a higher theoretical potential growth rate would not be attained without demand-stimulation policies. Unfortunately, the latest white paper remains silent on this crucial point. The main institution that could boost demand, but for the past decade has failed to do so--the Bank of Japan--was not criticized in the report, but instead lauded for its good deeds. This was not entirely a coincidence; the central bank first developed the supply-side argument and has since stuck to it faithfully.

The only argument that can be constructed in support of the deflationary policies favored by Koizumi, Takenaka and the Bank of Japan is that Japan's economy is currently already operating at maximum capacity and that the labor market is currently at the full employment level. In this case, it would not be possible to stimulate demand, and any such stimulation would merely raise prices. Thus, weak performance would be due to the inefficient allocation of the given income pie.

How can we determine whether this scenario applies to Japan right now? We need to measure unemployment, consider the operating rate and study prices. Unemployment has reached a record high of almost 4 million (according to the understated official figures), the operating rate remains close to the lowest levels seen in decades and prices continue to set world deflation records. All these are evidence that demand is lagging behind supply and Japan's actual growth rate is far below its potential. In this case there is no point in trying to raise the potential growth rate, because it would not do anything about the real problem--lack of demand. To the contrary, by boosting the potential growth rate without stimulating demand, the gap between the two would widen. The gap, however, is what determines prices. Whenever demand lags behind supply (the potential growth rate), prices must drop. Thus, the proposal will not only raise deflation, but will exacerbate the downward spiral in which Japan has remained for so long. As prices fall, real debt levels rise, corporate revenues must fall, more firms must go bankrupt and thus bad debts in the banking system must rise. It is like shrinking the income pie just so it can be carved up in a different, allegedly more efficient way.

This shows that the recession of the 1990s could not possibly have been due to Japan's economic structure. Indeed, we saw that Japan's growth rate was not enhanced by its past reforms, which shifted its economic structure toward the U.S. model. So if the white paper's analysis is wrong, why then has Japan remained mired in a recession for so long? The cause of the recession of the 1990s was the excessive bank lending in the 1980s for speculative purposes, which first drove up asset prices, but then could not fail to turn into bad debts. This paralyzed banks, reduced lending and hence shrank demand. This in turn increased bankruptcies and thus bad debts, further hurting banks and leading to a further fall in lending. Small firms with sensible projects, which continued to demand bank credit, became credit-rationed, as banks would not lend to them anymore.

Since lack of credit creation created the recession of the 1990s, policies that did not increase credit creation could not work--including fiscal policy, interest reductions, expansion of high-powered money and increases in the traditional money supply. The credit crunch and consequent lack of new purchasing power in the economy shrank the national income pie. In this situation, interest rate reductions remained without effect, since the quantity of credit creation did not increase. Fiscal policy also does not work, since it increases the government share of an unchanged or shrinking national income pie--thus crowding out private demand. Boosting high-powered money does not help, since monetary transmission through bank lending has stopped. Raising the growth of certain deposit aggregates (such as M1 or M2) is also not necessarily helpful, since these measures of savings do not tell us anything about how much money is actually spent and thus they are in no stable relationship to aggregate demand.

Instead, what has been necessary and sufficient to increase nominal gross domestic demand and close the yawning output gap is an increase in credit creation. This can be done (and could have been done for over a decade) through two avenues: increased central bank credit creation and increased bank credit creation. As to the former, the Bank of Japan can always expand its own credit creation by sharply increasing asset purchases as well as direct lending to those who demand money, such as the government and small firms.

Indeed, this happened after 1945, when the bad-debt problem was much larger--and it worked. The Bank of Japan printed money and injected it through asset purchases. It also lent directly to firms. Finally, it solved the bad-debt problem in the banking system by simply purchasing all the bad debts at prices far above market value. The costs of all these measures were zero, since they were not funded by tax money, but by newly created central bank money.

Former Deputy Bank of Japan Gov. Toshihiko Fukui dismisses the post-1945 example by arguing that just after the war much of Japan's productive capacity was destroyed, while today Japan suffers from excess capacity. But this counterargument does not make sense; the destruction of capacity after the war reduced Japan's potential growth rate. Today's unused production capacity means that Japan has a potential growth rate far in excess of its actual growth rate. Thus today there is a much bigger gap between actual and potential growth. If the central bank had a reason to inject more money and thus boost demand after 1945, it has a much better reason to do so now.


so, so,.....von daily Yomiuri