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Economic Research – Flash Report
8 June 2010
Richard Koo: a personal view of the macroeconomy
Kan replaces Hatoyama as PM after Futenma imbroglio
It has been several weeks since my last report. During that time the eurozone turmoil sparked by problems in Greece grew and spread to Hungary. The euro weakened further and gold resumed its rise amid a global equities correction. The US payrolls report for May, released last Friday, was also a disappointment: despite a headline increase of 430,000 jobs, the private sector generated only slightly more than 40,000 jobs when temporary hirings of census workers are excluded. In Japan, Yukio Hatoyama resigned as prime minister after being driven into a corner on the Futenma air base issue, and the DPJ chose Naoto Kan to succeed him. * Pragmatism informs Kan’s economic perspective I would first like to touch on Mr. Kan’s policy skills and vision. As noted in previous reports, his primary interest lies in social and not economic issues. He played a particularly important role in obtaining relief for hemophiliacs who contracted AIDS via contaminated blood products. A survey of his past statements and actions reveals a careful observance of the ideals of social justice and democracy. It also leaves the impression that he is less interested in economic matters, particularly macroeconomic matters. But at the same time, the fact that he is not tied to a single economic theory or set of economic principles allows him to adopt a pragmatic and flexible stance on economic matters. I suspect this characteristic will receive more attention as the market digests the new administration’s policies. * Was Kan’s “tolerance” of weaker yen born out of economic pragmatism? A prominent recent example of this pragmatism can be found in Mr. Kan’s indication soon after becoming Minister of Finance that he would be willing to tolerate a weaker yen. In the statement in question, made in January, he did not actually call for a weaker yen—he merely said that many companies were in favor of a weaker yen. The markets, however, interpreted the comment as an attempt to guide the currency lower. The statement hardly came as a surprise, given that the yen has become perhaps the world’s strongest currency, causing great suffering among Japan’s export-dependent manufacturers. Too, many investors in Japanese equities argue that a weaker yen is the quickest shortcut to higher share prices in Japan. Against this backdrop, it would hardly be surprising if Mr. Kan envisioned a scenario in which a weaker yen pushed stock prices higher, thereby contributing to a Japanese economic recovery. * Aso and Fujii saved global economy from competitive currency devaluations In contrast, Yasuhisa Fujii—Mr. Kan’s predecessor at the Ministry of Finance—and former Prime Minister Taro Aso had a deep understanding of both the real economy and economic history. They were well aware that when the global economy faced a similar crisis in the 1930s and countries tried to export their way out of their problems, the result was a round of competitive currency devaluations that led to protectionist measures and, ultimately, a global economic collapse. Mr. Aso and Mr. Fujii feared that if Japan—a trade surplus nation—were to guide its currency lower, it would provoke a round of competitive devaluations by the US and other trade deficit nations. Consequently, they never suggested that a weaker yen would be preferable or even tolerated, which was understandably quite unpopular within Japan.
8 June 2010
(issued in Japanese on 7 June 2010)
Chief economist Nomura Research Institute, Tokyo Nomura research sites: www.nomura.com/research Bloomberg: NMR
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8 June 2010
Inasmuch as Japanese currency intervention to soften the yen could have sent the global economy back to the 1930s, the strong principles of Mr. Aso and Mr. Fujii and their refusal to take the easy way out by devaluing the yen helped save the world economy. In that sense, it was extremely fortunate—both for Japan and the global economy—that these two men, with their extensive knowledge of economics and economic history, were at the controls at this pivotal moment in economic history following the Lehman collapse. * Kan’s decision saved Japanese economy in 1998 On the other hand, we should not overlook the fact that Mr. Kan’s pragmatic flexibility and his desire to do the right thing for the people—and not just for his party—once saved the Japanese economy and its financial system. In 1998 the Japanese economy was in serious trouble and faced a growing number of problems in the banking sector. Local banks were forced to pay a “Japan premium” to borrow on international capital markets, and Long-Term Credit Bank of Japan and Nippon Credit Bank went under. Meanwhile, the Hashimoto administration’s fiscal consolidation policies sparked stock market investors to “sell Japan,” which in turn pushed the yen sharply lower. This double weakness in the yen and Japanese equities served to lower the capital adequacy ratios of Japanese banks as their dollar-denominated assets grew and the unrealized gains on their cross-shareholdings fell sharply. The result was an unprecedented credit crunch. To address this situation it was essential that the government inject capital into the banking system and get banks lending again. But the opposition parties were violently opposed to this strategy—it was simply out of the question, they said, to spend the money of already suffering taxpayers to save banks and their high-earning employees. The situation grew steadily worse, and it was thought to be only a matter of time before Japan experienced large-scale bank runs. The situation was so serious that I was asked to appear on television programs every week to explain why the banking system needed a capital infusion. The ruling LDP, on the other hand, had just experienced a major defeat in the summer upper house election, draining its strength and vitality. * Kan’s idealism saved Japan’s economy It was at this point that a miracle occurred. Mr. Kan was the leader of the main opposition party, which had been violently opposed to a bailout. Yet he offered to end his opposition to the Financial Reconstruction Law if the LDP agreed to certain conditions. These conditions were not particularly onerous, and they were accepted as-is by the LDP. As a result, the Financial Reconstruction Law finally became law, and Japan managed to pull through its worst postwar financial crisis. If Mr. Kan had not changed his stance, the LDP government might well have collapsed, giving way to a DPJ administration. That, in turn, could have cast Japan’s financial sector into the abyss. But Mr. Kan gave precedence to saving the economy and financial sector and left the opportunity for his party to take power for another day. His decision effectively delayed the birth of a DPJ government by a decade. In my view, this story reflects Mr. Kan’s idealism—specifically, his view that the party’s interests should be sacrificed if necessary to save the nation and its people. His decision, on the other hand, generated a great deal of debate within the DPJ at the time. I remember speaking to a DPJ representative immediately after the Financial Reconstruction
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Law passed. When I remarked that Mr. Kan had performed a great service by choosing his country over his party, she said the situation within the party had been very difficult. In a subsequent magazine interview, Mr. Kan said Ichiro Ozawa had told him that he didn’t understand politics and had made a major mistake by not taking advantage of the party’s chance to topple the LDP. * Kan’s political philosophy likely to lead to more politically driven policy decisions In the same interview, Mr. Kan said that administrative reform is the goal of a change in government. That belief stems from his deep-seated concern that the concept of “neutrality” and “continuity” so highly valued by the bureaucrats who had traditionally governed Japan was fundamentally inconsistent with the principles of democracy. Mr. Kan believed that 70% of the policy decisions in Japan were made by bureaucrats and just 30% by the politicians. That implied that no matter which party the people elected—including the Japan Communist Party—70% of policies would not change. The principle of popular sovereignty cannot exist under such conditions, nor can we expect meaningful changes in policy based on the people’s will. The LDP had thrived in this system for half a century and was not in a position to implement administrative reform. That is why it was necessary for the DPJ—which was not bound by the past—to take power and develop an administrative system capable of reflecting popular sovereignty. If this reflects the core of Mr. Kan’s underlying political philosophy, I suspect we will see more decisions made by politicians instead of bureaucrats. Mr. Kan’s appointment of ex-Itochu president Uichiro Niwa to serve as ambassador to China (as opposed to someone from the Ministry of Foreign Affairs) is part of this shift. At the same time, Mr. Kan differs from Mr. Hatoyama in having experience as a cabinet minister and, as he demonstrated in the AIDS-contaminated blood scandal, being skilled at managing bureaucrats. In that sense, I think there is a real possibility that he will bring something new to the table. That would be a welcome relief from the last eight months, which have been characterized by steady conflict and turmoil between politicians and bureaucrats with few decisions being made. * Policy views of Kan’s economic “brain,” Osaka University’s Yoshiyasu Ono Mr. Kan’s partner in the aforementioned magazine dialog was Yoshiyasu Ono, an Osaka University professor who is said to be Mr. Kan’s key advisor on economics issues and who was recently appointed cabinet consultant. The two apparently saw eye to eye from the time they met for this interview in November 1999. Strangely enough, I participated in a dialogue with Mr. Ono for the same magazine in February 2001. I remember quite well that, with one exception, our views were in perfect agreement. (All of the dialogues in this series were subsequently gathered together in Mr. Ono’s book, Reducing Spending Won’t End the Recession [Japanese]). Mr. Ono argued that during a severe recession with high unemployment, structural reforms will only create more unemployment and will not boost the economy. At such times, he argued, the government needs to engage in public works spending in order to boost demand. He was also well aware of macro- and micro-level differences. Companies, for example, can lay off staff in order to enhance efficiency, but a country cannot “lay off” citizens working at inefficient businesses. As such, he said, the kind of “efficiency” that should be pursued by companies and governments is naturally different. I concurred wholeheartedly. We also shared a taste for the term “fallacy of composition,” which arises when what is good (i.e., the right behavior) for the individual, when taken together, is
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actually counter productive for the group. Both of us had strong reservations about the simplistic argument—which was extremely popular at the time in Japan and elsewhere—that micro-level improvements via structural reforms and self-help efforts would naturally lead to improvements in the macro situation. Japan was suffering from all sorts of fallacies of composition at the time: the harder the private sector tried to improve its position—whether it was companies deleveraging or banks disposing of nonperforming loans—the sicker the economy grew and the further asset prices fell. This was clearly not the simplistic situation described in economics textbooks. * Quantity beats quality for public works spending during balance sheet recessions There was one point on which I disagreed with Mr. Ono. I felt his view that public works projects had to be useful undertakings in order to help the economy reflected a lack of understanding of the causes of the recession. My position was that the Japanese economy had fallen into a balance sheet recession, which results when the private sector seeks to minimize debt rather than maximize profit. GDP cannot be maintained in such situations unless the government steps in to borrow (and spend) the surplus savings resulting from private-sector deleveraging. The question of how the government spends the savings is of secondary importance. In a world in which damaged balance sheets leave businesses and households paying down debt and unwilling to borrow money despite zero interest rates, demand shrinks by the amount of private savings. Assuming a private savings rate of 10%, what started out as income of ¥1,000 will progressively contract to ¥900, ¥810, ¥729, and so on. If the government stands back and does nothing to stop this process, the jobs supported by the borrowing and spending of this money will be lost, and the situation will continue to deteriorate until the private-sector deleveraging process stops. If we accept that unemployment represents the worst possible allocation of economic resources, the government’s first priority under such circumstances should be to prevent the economy from falling into a deflationary spiral by borrowing and spending surplus private savings. In the example above, the government would need to borrow and spend the initial ¥100 in savings (10% of ¥1,000). When added to the ¥900 spent by the private sector, this would ensure that total spending remained at ¥1,000. Under such circumstances, I argued, it was not an option for the government to stand by and do nothing because it could not find any worthwhile projects to invest in. * “Empty” public works projects not always meaningless Although Mr. Ono agreed that Japan suffered from a severe demand shortage, he did not think the shortage would grow worse without government action. Hence he could argue that for the government to invest in empty public works projects would be tantamount to doing nothing at all. But if the government does nothing at all during a balance sheet recession, the demand contraction will spiral out of control. As a taxpayer myself, I am no happier than anyone else when my taxes are used to pay for empty projects. But at a time when private businesses are paying down debt (and thereby creating a deflationary gap) worth ¥30trn a year, or 6% of GDP, it was clearly not the time to be worrying about the quality of the projects. If the government had decided not to borrow this ¥30trn because there were no worthwhile projects available, Japan’s GDP could have shrunk by ¥30trn a year. In effect, Mr. Ono and I were in agreement that Japan’s economic problems could not be addressed by the kind of structural reforms being promoted by Prime Minister Koizumi and Heizo Takenaka and that public works projects were necessary, but we disagreed on the
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content of those projects. * Content of public works projects will greatly influence future of Japan’s economy Today the situation is very different. Japan is clearly in the final stages of its balance sheet recession. Although there has been some increase in savings and debt paydowns since the Lehman crisis, the private sector has finished repairing its balance sheet, and there is little risk of the economy falling into a deflationary spiral, unlike the situation a decade ago. On a less positive note, the US and European economies face a severe shortage of demand resulting from the collapse of the housing bubble, and Japanese output remains at the levels of 2003. And for the first time in history other economies, especially China, are giving chase to Japan. China has home-grown technology to build nuclear submarines and rockets for outer space. Its foreign reserves exceed $2trn, and it has 1bn industrious workers willing to work for a fraction of what their Japanese counterparts earn. If Japan is to stay ahead of this challenge and maintain a developed-world standard of living for its citizens, it must continue to provide the most advanced goods and services, which will require further scientific and technological advances along with training and education. The government has an essential role to play in these efforts. In summary, Japan (1) faces a shortage of demand (more accurately, a shortage of external demand) and (2) is being pursued by strong economic competitors. Under such circumstances, the government’s ability to spend money on areas with future potential is critical to the economy’s future. The kind of public works projects undertaken in the coming years, therefore, will have a major bearing on the nation’s future. When a government decides to engage in public works spending to stimulate the economy, the question of whether to focus primarily on quantity (the amount of money spent) or quality (the kinds of projects pursued) depends on the prevailing conditions in the economy. In that sense, the issue of the content of projects that Mr. Ono was talking about 10 years ago has become a critical issue today. * Japan can use debt to fund projects without raising taxes Recently, however, Mr. Ono and Mr. Kan have suggested that the government should increase public works spending even if that means raising taxes. I disagree with the second part of that argument. I suspect their view is based on the assumption that the government can no longer fund its deficits in the financial markets. This stance not only ignores the market reality but is quite dangerous. Markets exist to discover the price that equates demand with supply. In the market for government debt, that price is the price of government bonds or the inversely related yield on those bonds. Today, Japanese government bonds are priced near all-time highs, with the yield on the 10-year JGB trading at less than 1.3%. This is far less than the record low yield of 1.85% on 10-year US Treasurys during the Great Depression 70 years ago. It highlights the absence of attractive private investment opportunities at a time when corporate deleveraging and household savings have created a large surplus of savings. Contributing to this situation is an aversion to debt at Japanese companies, which spent 15 years paying back loans after the bubble collapsed. Now that they have finally emerged from this debt “hell” and cleaned up their balance sheets, many are determined never to borrow money again—even at zero interest rates.
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At a time when the private sector continues to be characterized by a massive surplus of savings, I find it hard to understand the argument that the government needs to raise money via taxes. It does not. * Tax hike would depress economy even if proceeds were spent on public works Economics has a concept called a balanced budget multiplier, which says that public works spending will still provide a stimulus to the economy even if it is funded with a tax hike. According to this concept, some of the money collected through higher taxes represents money that the private sector would otherwise have saved. By spending that money, the government can stimulate the economy while maintaining a balanced budget. But today’s world is a far cry from that described in the economics textbooks. Ten-year government bond yields of less than 1.3% imply that private loan demand is virtually nonexistent. If the government were to tax more and issue less debt, the private sector would not step in to borrow the money that the government had stopped borrowing. That money would then drop out of the economy’s income cycle, creating a new deflationary gap. If the resulting hit to the economy exceeded the stimulus from (tax hike-funded) public works spending, the economy would suffer on balance. I think the possibility of that happening is quite large under current conditions. * Taxes can be hiked after private loan demand normalizes To be more precise, if the kinds of promising public works projects envisioned by Mr. Kan and Mr. Ono are implemented in addition to existing projects, I think the overall economic impact will be positive even if the additional spending is financed by a tax increase. But if the new projects are simply substituted for existing projects and funding for them is shifted from debt issuance to a tax increase, the private sector will have less money to spend for the same the government outlays, weighing on the economy. For the past decade Japanese government bonds have traded at record prices, and the government has experienced absolutely no problems in financing its deficits. The greater concern, in my view, is that businesses and households remain averse to debt, as happened in the US following the Great Depression, and private loan demand refuses to recover, leaving interest rates anchored at low levels. The government’s first priority should be to tackle this issue and create an environment conducive to higher private-sector investment. Once private loan demand has recovered, then we can discuss the issue of whether to finance remaining projects with higher taxes. * Instead of worrying about spike in interest rates, we should be asking why rates remain low On recent trips to the US and Sweden, I spoke with people in both financial and academic circles. Many continued to argue that countries, including Japan, should engage in fiscal consolidation now because, while bond yields may be low today, there is no telling when they might spike higher. “Look at what happened in Greece,” they said. But people have been saying the same thing about Japan for 15 years, and their concerns have never been realized. When someone is wrong for 15 years running, his time would be better spent asking why he has been so wrong for so long than predicting the same outcome for the 16th year. From that perspective, the last 15 years in Japan—and more recent periods in the US and Europe—have with few exceptions (one of which was Greece) been characterized by a sharp increase in private savings and debt paydowns. The government has effectively become the sole remaining borrower in these economies. In other words, there is plenty of excess private sector savings to finance government debt.
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Germany has completely disregarded this surplus of private savings and is not only pursuing fiscal consolidation on its own but is trying to force the entire eurozone to do so. This is not only a major policy blunder but also an extremely dangerous one. If Europe follows Germany’s lead despite its private savings surplus, its economic slump and market turmoil will only grow worse. * Premature fiscal consolidation is a threat to democracy Pushing ahead with these misguided policies risks a collapse of social and economic foundations and could even threaten the survival of democratic structures. A good example is prewar Germany’s Brüning cabinet, which insisted on fiscal retrenchment and allowed the emergence of Hitler in the 1930s. The risk is especially high in Central and Southern European countries, which have a relatively short history of democracy. Ultimately, I think the reason so many academics and pundits do not trust current low yields on government debt and expect them to rise suddenly is that they do not trust the market economy. When a price level set by the market persists for many years, we need to realize that there is an underlying economic structure supporting those prices. What governments—including Japan’s new administration—should be thinking about is how to find promising public works projects and implement them in order to offset the deflationary pressures from private-sector deleveraging and provide the private sector with a sense of direction. When private loan demand is nonexistent, the government must do whatever is necessary to find and carry out promising public works projects (including education and environment-related projects) without worrying about tax hikes.
Richard Koo’s next article is scheduled for release on 15 June 2010.
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