Annual Report on Japan' s

Economy and Public Finance


- No Gains Without Reforms -

December 2001

Cabinet Office

Government of Japan

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   Points of Chapter
   [Section 1 From Short Recovery to Another Recession]
 The economic recovery that started in the spring of 1999 was short and the economy turned downward again: Why?
 Characteristics of the latest recovery = foreign demand driven + dependence on IT (U.S. and Asian economies were strong / degrees of dependence on IT: exports 30%, production 60%, and machinery orders 80%)
 Recovery of business investment was weak; Investments concentrated mainly on IT, No increase in capacity enhancing investment, Investment slow in non-manufacturing industries
 Sluggish consumption-weak income growth, Worsening employment situation (Mismatch of employment expanded right arrow Of the 5% unemployment rate, close to 4% is structural unemployment)
 Non-performing loans and excessive debts are a burden on the Japanese economy

   [Section 2 Advancing Deflation and Monetary Policy]
 The Japanese economy is now in a mild deflationary phase. It has been in a state of deflation since two years before in terms of the CPI and since the mid-1990s in terms of the GDP deflator. First experience of such kind since World War II for Japan and other advanced countries.
 Causes of the deflation: (a) "Supply-side structural factors" such as increase in low-priced imports, IT and other technological innovations, and the distribution revolution, (b) "Demand factors" caused by a lack of strength of the economy, (c) "Financial factors" caused by disintermediation of banking system.
 Corporations are saddled with excessive debts and banks with a large amount of non-performing loans right arrow Even if it is mild, deflation has adverse impacts on the Japanese economy.
 The "Theory of good deflation" is debatable. What is occurring is not only declines of individual prices caused by an increase in imports from China and IT (changes of "relative price" ) but also declines of "general price levels" (deflation). Deflation has adverse impacts on the economy.
 Adverse impacts of deflation right arrowDeflation restrains business investment by (a) increasing the debt burdens of corporations saddled with excessive debts and (b) raising real interest rates and real wages, and thus erodes corporations' profitability.
 Although monetary policy is not a cure-all to bring about a complete recovery of the economy, it is believed that the Bank of Japan is now in the stage where it should positively consider further measures to ease deflationary pressures.

   [Section 3 Direction of the Economy]
 Probable scenario = The Japanese economy will turn to recovery over the second half of fiscal 2002, but the recovery will be weak for some time to come.
 Triggers to recovery = (a) Recovery of exports, (b) Self recovery power (Completion of inventory adjustment, Recovery of business investment), (c) the effects of the "Front-Loaded Reform Program" and other structural reform measures
 Recovery will be weak for the time being because = The potential growth rate of the economy is low at around 1% + It will take time before the growth rates anticipated by corporations and consumers turn higher.
 Downside risks = Negative impacts of the terrorist attacks (If the recovery of the U.S. economy is drastically delayed, a recovery of the Japanese economy will not come in the second half of fiscal 2002 and the economic stagnation is likely to be prolonged.)

Chapter 1

   Preconditions to Strong Recovery of the Economy

   The Japanese economy had been recovering moderately since the spring of 1999. But the recovery turned out to be short-lived and there is a strong possibility that the recovery phase was the shortest in post-war Japan. Why was the recovery so weak and why did the economy turn downward again? In order to materialize an economic recovery in the future, it is necessary to clarify these questions and study measures to remove factors hampering growth. From this standpoint, Section 1 examines the movement of the Japanese economy since the spring of 1999, when the economy turned downward from recovery, explains its characteristics, and elucidates the mechanism that made the economic recovery weak.
   One of the outstanding characteristics of recent economic trends is advancing deflation. The Japanese economy is now in a mild deflationary phase. This is an extremely characteristic phenomenon not seen in other advanced countries since the end of World War II. Why has the deflation been caused? Is the current deflation a "good deflation" ? We also have to study monetary policies to solve the deflation. Section 2 explains various problems involved in deflation and examines monetary policies to cope with them.
   Based on detailed studies of the economic trends, Section 3 presents reference information and points that should be taken into account in forecasting economic prospects from the viewpoint of economic analysis.
   The government has declared to resolutely carry out structural reform and is now implementing various measures. Through the analyses in this chapter, it will become clear why painful structural reform has to be carried out resolutely.

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