JULY 26, 1994



Economies are not static; they perpetually change. Changes in economy cause deviations from predictions in supply and demand, and in the long run economic frameworks like institutions and customs no longer mesh with reality. In response to these changes, private enterprise, households and the government make adjustments, which then induce further changes in the economy. In this way, the real world economy continues to change, repeating the adjustment process from disequilibrium to equilibrium, and from a state with problems toward an optimal state.

The Japanese economy - since early 1993 until the middle of 1994, the main focus of this report - also underwent a variety of changes. To best capture these changes in the economy, this report is comprised of three chapters, each with 'short term', 'medium term' and 'long term' viewpoints.

Chapter 1, "The Japanese Economy in Fiscal 1993," viewed from a short-term perspective, takes up issues in the Japanese economy in fiscal 1993, and considers questions such as "Why did the expectation for economic recovery in early 1993 fail to be realized?", "How has the continued appreciation of the yen influenced each sector of the economy?"; "How was the fiscal and monetary policy to stimulate the economy implemented, and what have its effects been like?"; "Can the favorable moves observed in some areas of the economy in 1994 be viewed as signs reading toward economic recovery?"

Chapter 2, "Characteristics and Background of the Prolonged Slowdown", thoroughly ines the process of the current downturn from a medium-term viewpoint, and considers questions such as "What are the features of the current downturn?"; "Why has the downturn prolonged beyond the expectations of many people?"

Chapter 3, "Long-term Issues on the Japanese Economy under the Recession", takes up the long-term and structural issues that the Japanese economy faces. Under the prolonged downturn and the continued appreciation of the yen, questions such as the following make the future hard to predict: "Could industry and employment in Japan suffer a severe blow by further `hollowization' accompanied by the appreciation of the yen?"; "Will other industries comparable in scale to the automobile or electronics industries appear in the future?"; "and a might continuing adjustments to major changes in Japanese employment?" Chapter 3 examines these long-term issues.

Chapter 1
The Japanese Economy in Fiscal 1993

Section 1
A Stagnated Japanese Economy

The developments of the Japanese economy in fiscal 1993 can be divided into the three periods: 1) from the beginning of the year to the early spring, during which favorable movements appeared in some areas of the economy; 2) from the summer to the end of 1993, where economic stagnation was again seen; and 3) from the beginning of 1994, when favorable movements again started to appear in some areas of the economy.

The Fiscal 1993, having shown the above-described developments, can be characterized as "The year of downside risk."

Since the April-June quarter of 1991, realization of downside risks were repeated, as the economic downturn led to a worse-than-expected performance. One reason may be that past experience had little to teach: this downturn has been evolving, is unlike the ordinary cyclical process of downturn, and is further complicated by adjustments to the burst of bubbles.

In 1993, too, the Economic Planning Agency decided in June that the economy had almost "hit bottom", against a background of favorable movements from the beginning of the year to the early spring. However, those movements failed to permeate through the entire economy, and the economy continued to stagnant for fiscal 1993, resulting in realization of downside risk. The growth rate of GDP for fiscal 1993 registered 0.0% ( -0.1% for GNP), which turned out to be far lower than most forecasts (the initial government outlook was 3.3% and the average forecast by private research institutions released in the end of 1992 was roughly in the latter half of 2%, each measured on a GNP basis).

The realization of downside risk as mentioned above was largely related to the negative effects on the economy by unpredictable exogenous factors such as the continued appreciation of the yen. Furthermore, it has lead to a variety of questions including "How have the sequelae of bubbles influenced balance-sheet adjustments?", "How the stimulating fiscal and monetary policy been effective?" and "Are structural problems causing a prolongation of the economic downturn?"

Section 2
Large Deflationary Effects of Appreciation of the Yen

Rapid Appreciation of the Yen under Economic Downturn

The appreciation of the yen since early 1993 was relatively small in its rates of appreciation against the US dollar, compared with what occurred after the Plaza Accord. Nonetheless, negative influences on economic activities were more strongly recognized this time because 1) the yen appreciated against most major currencies this time while, after the Plaza Accord, only the dollar had been depreciated, 2) the appreciation of 1993 broke out under the prolonged economic downturn, and 3) petroleum prices dropped significantly during the appreciation after the Plaza Accord.

Points of Issue on Macroeconomic Impacts of Appreciation of the Yen

The impacts of the appreciation of the yen can be roughly classified into four categories: 1) "terms-of-trade effect" accompanying changes in yen-denominated export prices, 2) "volume effect" in the form of a decrease in export volume and an increase in import volume, which, in conjunction with the "terms-of-trade-effect," leads to a decrease in yen-denominated net export and in corporate profits, 3) "translation of benefits of a strong yen", implying translation of changes in import prices into domestic prices, and 4) "effect on domestic demand," such as private consumption and business equipment investment (see Figure 1-2-2(1), (2), (3) ).

Impact on Exports, Imports and Corporate Profits

The "J-curve on a yen basis" (see Figure 1-2-4 2 ) refers to a description of changes in yen-denominated net exports (SNA basis, including services transaction) due to a 10% appreciation of the yen, with a consideration of the volume effects and the terms-of-trade effects. According to this J-curve, one can understand that an appreciation of the yen continues to affect negatively on net exports from the beginning to the end. The J-curve on a yen basis is closely related with movements in corporate profits, for which the appreciation of the yen as a whole has been shown to be a negative factor.

Similarly, the "J-curve on a dollar basis" can be drawn (see Figure 1-2-4 4 ). Accordingly, dollar-denominated net exports (current surplus on a dollar basis) increase for the first year due to a rise in dollar-denominated export prices with a relative delay in a decrease in volume, but turns into a decrease from the second year due to significantly larger volume effect.

These discrepancies between the J-curve on a yen basis and that on a dollar-basis become a factor for the contrasting movements in the balance of payments."The yen-denominated surplus decreases while the dollar-denominated surplus increases after the appreciation in 1993. Few recognized that firms are pressed by a severe adjustment from the domestic side, while the Japanese current surplus does not decrease in spite of the appreciation of the yen from the overseas.

Transmission to Domestic Prices

An appreciation of the yen has the effect of reducing import costs, thereby stabilizing domestic prices. A 10% reduction in import prices roughly translates into a 1.2% reduction in domestic wholesale prices (see Figure 1-2-11 ). The lag until the attainment of this ultimate rate of reduction is three quarters. A similar estimation for consumer prices yields a 0.7% drop in approximately one year.

Impacts on Domestic Demand

It is difficult to decide a priori whether the total impact of an appreciation of the yen on private consumption is positive or negative. This is because, on the one hand, there is an effect of enhancing real income through lowered prices (a 10% drop in import prices entails an approximately 0.7% increase in real disposable income in one year). On the other hand, there is the possibility of anxiety about future decreases in corporate profits and progress in employment adjustment, resulting in a decline in the propensity to consume.

As for the relationship between an appreciation of the yen and private investment, the former has the effect of restraining the latter in the short run, at least for the manufacturing sector. This is because a decrease in export volume and an increase in import volume accompanying an appreciation of the yen restrain domestic production, which work not only at the time when the appreciation occurs but also against corporate outlook in the future.

Indicators to Measure Purchasing Power

One can think of the concept of "real command GDP," which quantitatively captures a phenomenon that "purchasing power increases due to the appreciation of the yen." This is obtained by the domestic demand part of GDP, deflated by domestic demand, plus net export by import deflators, with the consideration that net exports produce funds for importing goods and services in the future. The rate of increase in real command GDP is equal to that of real GDP plus that in the purchasing power stemming from improvement of terms of trade (export prices/import prices). Looking at changes in the real command GDP (see Table 1-2-15 1), almost all of the increases in real command GDP for fiscal 1993 are attributable to improvement of terms of trade.

Similarly, for overseas stocks, one can think of the concept of "real command cumulative net export." Regarding the relationships between an appreciation of the yen, it is often pointed out that an appreciation of the yen makes overseas assets decrease. However, considering with the concept of real command cumulative net exports, such a decrease is hardly observed since the rate of appreciation of the yen approximately corresponds to the ultimate rate of decrease in import deflators.

Section 3
Stagnated Private Consumption

During this economic downturn, private consumption has generally been stagnant, yet it could not break out of the stagnation even in fiscal 1993. The stagnation of private consumption can, as a result, be explained mainly by stagnation of income. This can be also seen by the fact that the growth rates of consumption are nearly equal to those of income. In fact, real employees' income showed a further slowdown since the beginning of 1993 and registered almost zero growth on a year-on-year basis in the latter half of the year. It is natural that such relatively low rates of growth in real income result in low rates of growth in private consumption.

Incidentally, the cold summer with long rainy days in 1993 had some impact on sales of goods and services which usually sell well in summer. In the end, however they have not had a significant impact on private consumption as a whole.

Section 4
Decreased Business Equipment Investment

Private equipment investment (real, seasonally adjusted, compared with the previous quarter) has decreased for ten consecutive quarters (since Oct-Dec quarter of 1991 until Jan-Mar quarter of 1994) and is one of the major factors of stagnation of domestic demand.

Drawing a cyclical diagram of private investment in the manufacturing sector, one could observe a relationship that a decline in the rate of growth of capital stock to around 5-6% corresponded to a slowing down of the rate of decrease in investment (called a flow concept). However, although the rate of growth of capital stock declined to 4-5% in 1993 and thus stock adjustment has progressed, private investment never showed a pickup (see Figure 1-4-2 ). One of the factors of this phenomenon is that demand further dropped and a decline in utilization rates continued despite the satisfaction of prerequisites for the completion of stock adjustment, resulting in the prolongation of stock adjustment. Another factor is the possibility that firms became more pessimistic regarding the future recovery in production than extrapolated directly from the current level of production, due to continued appreciation of the yen. It can be seen that the continued appreciation in 1993 caused firms to downwardly revise their plans for investment through the expectation of future decreases in production due to the decrease in exports and to the increase in imports of competitive goods.

Section 5
High Level of Residential Investment

In this downturn, only residential investment quickly started to show a recovery and continued to be buoyant in fiscal 1993, while other private kinds of demand have been stagnant.

Looking at numbers of housing starts by relations of ownership, one can see that high growth of construction of owner-occupied houses contributed to the increase in the total number since July until October while houses for rent replaced them after November of 1993. This has resulted in a high level of housing construction throughout the fiscal year with a change in the major contributing categories.

Among these, the number of housing starts of owner-occupied houses has regressed in capacity of procuring funds (for those who purchase houses for the first time). Other contributing factors are land prices, costs of construction and number of marriages. Accordingly, an increase in capacity of procuring funds through lower interest rates and raised ceiling of public loans are the largest contributors to the huge increase in the number in 1992. In addition, the decrease in land prices made a significant contribution to developments in 1993.

Section 6
Stagnated Production Activities

Industrial production has shown a tendency of stagnation since 1991. In the beginning of 1993 inventory adjustment seemed to be finishing up and production increased temporarily. After that, however, inventory adjustment fell into a state of stasis, while production continued to be stagnant.

Inventory adjustment can be demonstrated as a clockwise locus, as in Diagram 1-6-2 where crossing the 45 degrees line in the upper-right (lower-left) area is a signal of a cyclical peak (trough). The Jan-Mar quarter of 1993 registered a rapid decrease in inventory and increase in shipment, and the Apr-Jun quarter observed a temporary crossing at the 45 degrees line. This means at that stage inventory adjustment has almost completed. After that, however, inventory did not decrease while shipment again was stagnant, thereby resulting in the continuation of the standstill until Jan-Mar quarter of 1994. The standstill of the once-seemingly completed stock adjustment was due to the more sluggish trends in actual demand than firms had expected.

As for production activities in fiscal 1993, the following conspicuous incidents are observed: 1) industrial production and shipment showed large fluctuations around the end of the fiscal year, 2) non-manufacturing sectors showed a severe stagnation and 3) cold summer and frequent rains brought severe damage to the agricultural sector.

Section 7
Decreased Corporate Profits

Corporate profits continued to decrease in fiscal 1993. To cope with this, firms are making efforts at restructuring.

Current profits for all industries in fiscal 1993 registered a decrease by 9.7% compared with the previous year, implying four consecutive years of decreases. Breaking down the changes in profits for the manufacturing sector into contributions of quantity sold, sales prices, terms of trade and fixed costs (see Figure 1-7-1 (1) (2) (3) ), the following features can be recognized: 1) while the decrease in quantity sold was the largest contributing factor to the decrease in profits in 1992, the contribution by sales prices increased in 1993; 2) a decrease in fixed costs has contributed to improved profits since 1992, suggesting effects of the progress in restructuring; 3) terms of trade continue to improve partly due to the appreciation of the yen (however, the appreciation also causes a decrease in quantity sold and in sales prices). As for the reduction in fixed costs, "other fixed costs" (so called intermediate costs) are most contributed the most. But in addition to these, depreciation costs decreased and the rate of increase in labor costs diminished in 1993.

Section 8
Increased Severity in the Employment Situation

Under the prolonged economic downturn, the employment situation get tougher and tougher. Namely, overtime hours are still decreasing, in addition to a declining trend since the peak of March of 1991 in the actual job offers-to-seekers ratio. Furthermore, the rate of growth of the number of employees has become sluggish since 1992, and turned into a decline for the manufacturing sector since the beginning of 1993. Since the end of the 1992, unemployment rate has been rising.

Amid these developments, "severity" tends to focus on some part of the labor market. The first labor market consists of those who have already been unemployed. The second group includes those who, especially the middle-aged or elderly, who hold managerial or clerical jobs. Firms are increasingly feeling over-employment in those jobs. Once having left a firm, it will probably be difficult for those people to find new jobs, especially since markets for managerial jobs have little flexibility. The third group is comprised of females, whose unemployment rate registered a historically high level. This is the appearance of (once-hidden) "discouraged workers" who unwillingly exit from the labor market since 1993.They have been facing a severe employment situation since 1993.

Section 9
The Decreased Current Account Surplus

Decreased Export Volume, Increased Import Volume

Reviewing the developments in exports in fiscal 1993, export volume tended to decrease. Export prices declined on a yen basis yet rose on a dollar basis, partly due to the appreciation of the yen. Reflecting these movements, nominal exports turned into a rapid decrease on a yen basis while continuing to increase on a dollar basis. Import volume increased overall, as import prices declined both on a yen and a dollar basis, and nominal imports decreased on a yen basis while increased on a dollar basis. In particular, a huge increase in import volume - mainly of manufactured goods - was conspicuous.

Figure 1-9-6(1) (2) (3) shows a break down of the growth of aggregate supply into domestic shipments and imports. According to the diagram, it is conspicuous that supply by imports increased while aggregate supply declined sharply, though there were some periods where contribution of imports was large. From the standpoint of the level of domestic production, this implies that domestic production might be more suppressed by import substitution at this time, different from a history in which domestic production and imports increased in tandem.

Classified by type of goods, an increase in imports was especially large for consumer goods, among which the contribution of imported goods for nondurable consumer goods such as textiles exceeds the rate of growth of the aggregate supply, implying the replacement of all the increments in aggregate supply by import.

The Decreased Current Account Surplus on a Yen Basis

Reflecting the above-mentioned developments in exports and imports, the current account surplus decreased on a yen basis and increased on a dollar basis, a salient feature of 1993. The current surplus - GDP ratio declined from 3.4% (fiscal 1992) to 3.0% (fiscal 1993).

Japan's Not Unusual Trade Structure

The U.S. Annual Report of the Council for Economic Advisers (1994) points out that the trade structure of Japan is unusual. For example, it states that "Japan's ratio of imports of manufactured goods to domestic consumption is low." In fact, Japan's manufactured import/nominal GDP remains low relative to other industrial countries and has not shown a conspicuous increase for the past twenty. However, this indicator has a drawback: the effect of increased import volume is canceled by a decline in the yen-denominated import prices. Therefore, measured by "real manufactured import/real GDP," Japan's ratio rapidly increased after the Plaza Accord of 1985, and also registered a huge increase in 1993 (see Figure 1-9-11 ).

Section 10
Fiscal and Monetary Policy toward Economic Recovery

Actively Managed Fiscal Policy

Fiscal and monetary policy in fiscal 1993 has been managed in a timely manner toward economic recovery. It includes a budget tailored to the economic situation, repeated compilation and implementation of an economic package and supplementary budget, and a cut of the Official Discount Rate to a historically low level.

Despite the compilation of a budget tailored to the economic situation, the economy failed to recover quickly. First, the steady implementation of the public works budget has been called into question. But viewed throughout the fiscal year, public investment was generally steady.

Secondly, if the effects of supporting the economy through the permeation of public investment into private activities (see Figure 1-10-7 ) did not sufficiently work, it is a fact that there was not much evidence of this in the real world. However, it is too soon to conclude that public investment has had little effect. It may be the case that without the increase in public investment, construction-related materials would have fared poorly, suggesting a further decline in private demand. Actually, the continued stagnation of construction-related materials was due not to weak public demand but to a huge decline in private demand (see Figure 1-10-4 ).

More Eased Monetary Policy

Although the monetary policy in fiscal 1993 was continuously eased against the background of the prolongation of the economic downturn, money supply as well as loans extended were still low.

Since the real economy continued to be stagnant despite progress in monetary easing, it is sometimes pointed out that "the reason is because the effects of monetary policy are disappearing." However, monetary easing has contributed toward corporate profits, thereby leading to the improvement of investment environment toward recovery.

Regarding the lower interest rates, common opinion says that although nominal interest rates are declining, real rates remain high, which hinders recovery. However, measuring real rates is not easy: it is difficult to judge the effects of monetary policy, and it is possible to think that a rapidly declining nominal rate at least shows the realization of the effects of monetary policy.

Section 11
Current Position and Prospects of the Japanese Economy

Looking at the movements of the GDP gap from the viewpoint of the "level of economic activities," it expanded in 1993, implying a very low level of activities (see Figure 1-11-1(1), (2) ).

However, since the beginning of 1994, favorable movements are appearing in some areas of the economy, which is still generally stagnant. First, on the demand side, while public investment is steady and residential construction remains at high levels, a slight movement of a pickup in private consumption is appearing, as seen in the movement toward recovery in some areas of consumer durables. Although private investment is still decreasing, the electronics such as semiconductors have already shown a signs of increase. Exports show recently displayed movements of one step forward, one step back thanks to the recovery of the overseas economy. Second, on the supply side, since the beginning of the year, production and shipment increased while inventory decreased, resulting in a sharp decline in inventory-shipment ratio. Third, on the financial side, stock prices remain steady. Fourth, consumer and corporate confidence is improving faster than the actual economic situation.

Will these favorable movements lead to a recovery, or, as experienced in 1993, will they turn out to be temporary and adverse risk?

In fact, there are movements in the background of the favorable movements yet to be translated into the recovery. First, the pressure on stock adjustment is gradually weakening. Second, overseas economies are improving. Third, supporting effects of stimulating measures are expected. Fourth, as for the impacts of the appreciation of the yen initiated in 1993, while its deflationary effects are gradually disappearing, the merit of stabilizing consumer prices is expected to continue to exert favorable effects on private consumption.

Based on the above analysis, the favorable movements currently observed have certain driving forces in their background.

However, it should be noted that the trends in exchange rates and the delay in the balance-sheets adjustment remain downside risks. Therefore, fostering the currently observable favorable trends, by avoiding realization of these downside risks and making an effort of appropriate and flexible economic management including, the steady implementation of the Comprehensive Package, will allow us to bring the economy toward the path of recovery.

Chapter 2
Characteristics and Background of Long lasting Recession

Section 1
An Overview of the Last Recession

In terms of duration and depth, the last recession was relatively severer than other post-war recessions. The last recession was, also, completely different from other post-war recessions in the sense that it was accompanied by the "burst of bubbles". Those factors seem to have brought about uncertainty for the future among business sectors.

Regarding the severity of this recession, although it is not clear when the bottom hit, the last recession starting from mid 1991 was relatively longer and the deepest since the first oil crisis in the post-war period.

Three factors can be illustrated regarding this: 1) weak business investment in non-manufacturing sectors, which had been stable during past recessions, 2) repeated down side risk regarding business forecasts and confidence, 3) slower increase in nominal economic activities.

The slower increase in nominal economic activities can be confirmed by comparing nominal economic indicators with real ones. In the context of the nominal economy, the last recession was the deepest among the post-war recessions, as last nominal economy, like real economy, has shown slowdown reflecting the slower price increases.

In addition, Japan's last recession can be interpreted as one amid world wide simultaneous recessions. From a world wide view, the recession started in the following order: English-speaking countries -> Continental Europe -> Japan. The recovery, similarly, can be observed in the same order.

Section 2
Prolonged Stock Adjustments

The last recession, from a cyclical perspective, results from the longer stock adjustments in consumer durables, business plants and equipments than expected.

1 Stock Adjustments in Consumer Durables

Regarding the development of stocks in consumer durables, cars showed a remarkable increase, and household electrical appliances also registered a gradual increase in the latter half of 1980's.

This increase of stocks seemed to bring about huge stock adjustments, which led to the decline in consumption for consumer durables along with negative wealth effects and decreases in real income afterward.

Stock adjustments, however, have progressed significantly since 1992, and stocks have turned downwards. It will indicate that the extent of the decline in consumer durables consumption will become smaller. The recovery in consumption among some household electrical appliances during 1994 seems to be evidence of improved stock adjustments.

The larger stock adjustments in cars than that in electrical appliances is partly due to the fact that demand for cars rapidly increased during bubble era. That is, car users with long purchase cycles of 6 or 7 years, as well as typical car users who have a 3 or 5 years' purchase cycle, rushed into the car market in the latter half of 1980's against the background of enhanced income conditions and wealth effects.

2 Stock Adjustments in Fixed Business Investment.

During the last stock adjustments in fixed business investment, longer adjustments were observed as fixed business investment remained weak despite the low growth in capital stock, at which fixed business investment had recovered fairly quickly.

This continued weakness in business investment reflects the following factors. First, stock adjustments in the manufacturing sector have been prolonged. This is mainly due to the unimprovement of capacity utilization, as final demand has remained weak despite the low growth in capital stock.

That factor can be confirmed by the fact that the ratio of capital stock to final demand (capital/output ratio) has risen, mainly reflecting the weaker final demand (see Figure 2-2-6(1), (2) ).

Second, business investments in the non-manufacturing sector, especially among retailing, service and commercial real estate, have not shown recovery owing to longer stock adjustments. This seems to be one of the characteristics in this recession, taking into consideration that business investments in non-manufacturing sector tended to support overall investments during past recessions.

Third, capital stock in construction increased remarkably, leading to longer stock adjustments. Stock adjustments in construction seem to have prolonged overall stock adjustments, as the duration of stock adjustments in construction is longer than that in equipment. In fact, capital stock in construction, still, has remained relatively high. On the other hand, capital stock in equipment has decreased significantly by 1992 (see Figure 2-2-12(1), (2), (3), (4) ).

In addition, lower asset profitability than usual seems to have played a role in worsening investment conditions. This lower profitability is mainly due to a slowdown in the economy. There is also a possibility that freer judgement about investment as seen in the bubble era made investments with lower profitability possible. Therefore, stocks with lower profitability were accumulated.

Section 3
The Influence of the Bubble on the Economy

The last recession differs most greatly from other past recessions in the sense that the adjustment phase was accompanied by the burst of bubbles.

Magnitude to the Japanese Economy and Current Asset Prices.

With respect to development of capital gains or losses in land and stock prices, massive capital gains, equivalent to nominal GDP, emerged during the bubble era. Huge capital losses, however, emerged in stock prices since 1990 and in land prices since 1991 in line with the burst of bubbles (see Table 2-3-1).

Regarding the current asset prices, several indicators, like the ratio of asset prices to nominal GDP and theoretical land prices, will indicate that bubble is likely to cease in both stock prices and land prices.

Mechanism of the Influence of the Bubble on the Economy

This section examines the influence of the bubble on the last business cycle from a view point of "risk taking capability" (see Figure 2-3-8). "Risk taking capability" can be defined as the extent to which corporations and banks can actively take additional risks.

As asset prices rose during the bubble boom, "risk taking capability" in business sectors rose, as the latent property, regarded as a buffer for management risk, increased. This rise in "risk taking capability" is thought to have had influence on economic activities through the following ways. First, enhanced "risk taking capability" made business sectors invest more. Banks, also, became aggressive about extending credit. Second, business sectors could raise the ratio of debt to assets as they would not worry about "default risk".

As the bubble burst, the decline in "risk taking capability", in contrast, seems to have restrained economic activities through the following ways.

The first is "simultaneous effects" such as the "negative wealth effect" which is affected by asset price fluctuation. The second is the "lagging effects", which mean the existing influence on the economy even after the cease of bubbles. In this sense, "lagging effects" can be interpreted as a balance-sheet adjustment and huge excess stock in office buildings.

Balance-Sheet Adjustment

Balance-sheet adjustment was brought about amid a background of the worsened balance sheets of corporations and increased non-performing loans in banks. Under that phase, the decline in "risk taking capability" is likely to have restrained investment.

With respect to the development of balance-sheet adjustment, it will take some time to complete the adjustment, especially in non-manufacturing sectors, although progress can be observed in the downward trend among the ratio of debt to assets (see Figure 2-3-10 2 ).

Worsened balance sheets seem to have restrained economic activities through weaker business investment and the cautious attitude of banks toward lending. In other words, corporations that tend to prioritize the reduction of debt, have been cautious about taking additional business risk such as new fixed investments. Banks, also, may have had some negative impact on business investment, especially in the bank-dependent non-manufacturing sectors, as banks have become cautious about extending credit reflecting declined "risk taking capability" as well as decrease in the value of collateral. The result of cross-sectional analysis indicates that banks with more non-performing loans or less capital have tendency to reduce loans (see Table 2-3-19).

Huge Excess Stock in Office Buildings

A number of office buildings were planned for construction during the bubble era, which consequently has led to huge excess stock. Huge excess stock in office buildings, which tends to take longer to adjust, has continued to have negative impact on economic activities even after the burst of bubbles. Actually, a huge number of office buildings, equivalent to that supplied in the bubble era, is being planned between 1993 and 2001. Consequently, huge excess stock in office buildings could be one of factors that extend capital stock adjustment.

Section 4
Permeation of Disinflation

One of the characteristic features of this recession is disinflation, in which price increase and nominal growth rate are getting lower.

The reasons behind the lower price increase is more disputable, though this phenomenon caused by weak demand was usually observed during past recessions, are mainly due to the following: 1) consumer attitude about price-oriented consumption has been spreading, 2) price of some products is declining significantly, and 3) various impacts are expected to influence the overall economy.

Disinflation and Slower Increase in Nominal Growth Rate

Permeation of disinflation can be observed in the current development of price indexes: a decline in the Wholesale Price Index(WPI) and a slower increase in the Consumer Price Index(CPI).

Also, there are disputes on the slower increase in CPI compared with the remarkable decline in WPI, like "Can price be lower than CPI?" or "Is CPI inconsistent with consumer attitudes?".

A slower increase in CPI is evident if we compare purchase price (which is taken from purchase into expenditures) and CPI. This comparison would suggest that purchase price is becoming lower than CPI (see Table 2-4-3).

However, it should be noted that the differentials between purchase price and CPI were observed during past recessions. Moreover, with respect to compiling statistics, CPI is taken from the same qualified subjects and at the same shops. Purchase price, in contrast, is taken on an ad hoc basis. As a result, the differentials are likely to indicate the fact that households are seeking cheaper goods amid a background of smaller income. Business sectors, also, are providing households with cheaper goods.

In addition, the permeation of disinflation brought about a huge decline in the nominal economy, accompanied by sluggish weak real economy (see Figure 2-4-5 ).

Background of Disinflation

A clear definition of disinflation is both useful and necessary. The origin of its cause (at home or abroad) distinguishes between "home-oriented" and "import-oriented". "Import-oriented" disinflation may increase real income, while "home-oriented" disinflation may keep real income unchanged. Disinflation caused by temporary factors or by permanent factors can be distinguished as "cyclical" and "uncyclical". "Cyclical" disinflation should be brought by a slowdown of the economy and is expected to weaken in line with recovery of business conditions."Uncyclical" disinflation, on the other hand, is expected to remain in the long run, accompanied by an increase in real income.

From the above perspective, disinflation seems to reflect the following factors (see Figure 2-4-8(1), (2) ).

The first is cyclical and home-oriented disinflation. It has been brought about by stable prices, mainly due to expanded capacity utilization and slower increases in wages caused by decline in profit of corporations and a worsened labor market.

The second is cyclical and import-oriented disinflation. It has been brought about by stable prices mainly due to the decline in import prices, reflecting the appreciated yen.

The third is uncyclical and home-oriented disinflation. It has been brought about by an attempt of distributors to try to make the distribution system more efficient, which is called "price destruction". This change will reflect the prevailing price-oriented consumption in households.

The forth is uncyclical and import-oriented disinflation. It has been brought about by the increase in cheaper imports, especially manufactured goods amid a background of integrated economic cooperation with South east Asia. In fact, the WPI of electricities and textile goods has declined remarkably in line with increase in imports (see Figure 2-4-10 ).

Relationship between Disinflation and the Economy

In the context of the influence of disinflation on economic activities, permeation of disinflation will be accompanied by not only positive effects (improved terms of trade in business sectors and increased real income in households) but also negative influences (increased real outstanding debt and worsened business confidence). As a result, it is not easy to assess which is bigger.

What is needed now is not to discuss the merits and demerits of disinflation, but to enhance the above positive effects in order to support the pick up of final demand.

As for the business sector, disinflation has become severer due to the following factors.

Firstly, the business sector has been in an adjustment phase for huge capacity utilization. Disinflation has resulted from that adjustment. In this case, smaller profits with more sales tends to make that adjustment more difficult.

Secondly, it has been in an adjustment phase for worsened balance sheets. Disinflation tends to make that adjustment severer as well.

Thirdly, it has been in an adjustment phase for structural reform. It has to improve the distribution system more efficiently and deal with prevailing price-oriented consumption in households. As above, disinflation tends to make that adjustment severer.

Although business sectors may feel severe during those three adjustment phases, they have to overcome those three phases in order to achieve well-balanced and stable growth. The three phases with disinflation are expected to increase real income, which will lead to the pick up of final demand.

In sum, price should fluctuate according to economic activities. In the last recession, severe adjustment phases have been mirrored into slower increases in price; that is disinflation.

Chapter 3
Long-term Issues on the Japanese Economy amid Recession

Long-term and structural issues on the Japanese economy have been more and more focused as the recession has continued. The important point in judging the current situation of the Japanese economy is how we see the interaction between cyclical problems and structural ones, since structural as well as cycle issues have made firms and households feel more pessimistic and uncertain toward the future.

There are two questions concerning the relationship between the short term cyclical issues and the long term structural ones.

First, why are the structural issues more focused at present? It is not because the structural issues suddenly appeared recently, but because the sluggish economy has made the structural issues, which were masked by the domestic-oriented high growth during the bubble era, stand out more sharply.

The second question is how we should understand the relationship between measures to deal with both the long and short-term issues. Measures which are intended to solve long term issues are not necessarily appropriate for short term issues. However, it is very important to understand the long term issues more deeply and to reform the structure of the Japanese economy regardless of the cyclical movements in the economy.

In chapter 3, the long term issues are divided into four parts: 1) issues on the external relationship with the Japanese economy including the effect of a strong yen, "hollowization", and price disparity internationally and at home; 2) issues on the Japanese-type economic system including the employment system; 3) issues on institutional aspects including public regulation; and 4) issues on the future course of the Japanese economy.

Section 1
Changes in Industries under the Strong Yen and Long Lasting Recession

Arguments on Hollowization

As the yen value has been appreciating, we have often heard the pessimistic view that the Japanese economy will "hollow out". Hollowization of the economy is closely related to the movement in exchange rates. Because the appreciation of the exchange rate will lead to the substitution of imports for domestic production, the substitution of overseas production for domestic production, and the shift in resource allocation from production of tradable goods to production of nontradable goods.

Concerning overseas production, the type of direct investment expected to increase by yen's appreciation is electronics in Asian countries(1%increase in the yen value will lead to 1.6% increase in direct investment by manufacturing in Asian countries, see Table 3-1-8). Direct investment in Asian countries is intended to utilize the cost advantage by specializing in labor-intensive production processes. On the other hand, direct investment in North America and Europe is largely the production base for local sales, which falls under the influence of cyclical movements in the economy. When the domestic and external demands in the future are uncertain, investment for expanding the existing production base rather than building new production bases is easily implemented.

The important point to understand regarding movements in the exchange rates is whether or not the actual exchange rates deviate from the "equilibrium exchange rates" or not. When the actual exchange rates deviate from the "equilibrium exchange rates," their effects on the real economy will be great. According to the movements in the "equilibrium yen/dollar rate," which is obtained from the purchasing power parity of tradable goods from Japan and the United States, the yen's appreciation in the 1980s was in the process of returning to the "equilibrium yen/dollar rate." On the other hand, the rapid appreciation in the yen's value after 1993 can not be explained by the movement in the "equilibrium yen/dollar rate." As a result, the yen's appreciation at this time had a large impact on the Japanese economy and created the fear of hollowization.

Growing Interdependence with Asian Countries and Developments in Dynamic Intra-industry Trade

Issues on hollowization, as seen in the context of the growing division of labor within Asian countries, should be understood from a more global and dynamic perspective.

First, we emphasize the growing interdependence with other Asian countries. The high growth, mainly led by exports and business investment, has depended on imports of capital and intermediate goods from Japan. When exports of Asian NIEs and ASEAN increased, we forward that imports of capital and intermediate goods, especially from Japan, also increased. We also see the same relationship between business investment and imports of capital goods (see Figure 3-1-12(1), (2) ).

Second, we emphasize the development in dynamic intra-industry trade with Asian countries. The coefficient of trade specialization rises and falls in order of Japan, Asian NIEs, ASEAN, and China. This order holds as well for non-durable consumer goods, durable consumer goods and capital goods by goods (see Figure 3-1-13(1), (2), (3) ). We can trace development in dynamic intra-industry trade, by these following countries have changed their comparative advantage dynamically and shifted their economic resources to more value-added sectors. There are also trade patterns in which Japan exports high value-added goods and Asian countries export low value-added goods.

Let us reexamine the argument on hollowization of the Japanese economy. It is true that the transfer of the manufacturing production base abroad will reduce domestic production, employment and investment opportunities in the zero-sum situation of no economic expansion. In the short term, the adjustment to increases in imports and overseas production might be painful in some industries.

However, economic efficiency and expansion will be promoted if we can shift economic resources freed by the increase in direct investment to more value-added sectors. Therefore, it is important to deepen the interdependence with Asian countries and to make the trade and industrial structure more value-added.

Decreasing Price Disparity between Japan and the World

Issues on price disparity between Japan and the World can be examined from macro and micro aspects.

The short-term macro factor, which changes international price disparity, is movements in exchange rates. Appreciation in the exchange rate will lead to a relative increase in the price level in Japan compared with that of abroad. In the case of tradable goods, arbitrage by trade will shorten the price disparity. But, in the case of nontradable goods, as arbitrage by trade is not effective, the price disparity will remain. As a result, the aggregate price level, reflecting the average price level of tradable and nontradable goods, tends to be higher. This type of the price disparity will not disappear even if a decrease in import prices is completely transmitted to domestic prices.

In the long term, the aggregate price level is proportional to the per capita income level. Countries with high per capita GDP have high price levels (see Figure 3-1-19(1), (2), (3) ). In 1950, Japan had the lowest income level and the lowest price level among developed countries. As its income and price levels increased, Japan, by 1992, come to have the highest income and price levels.

It is possible to some extent to explain the international price disparity by macro factors, including income levels. However, this does not mean that the price disparity of each item is natural. Comparing the international price levels by items, the price level of electrical goods is comparable to that in the U.S.. But, the price levels of housing, construction, clothing and food is consistently higher than those in other countries (see Table 3-1-21(1), (2) ). The price disparity of these items cannot be explained by macro factors. Therefore, it is important to improve the productivity and efficiency of those sectors and lower price levels by self-efforts and deregulation, including the improvement of efficiency of the distribution system and import promotion.

Section 2
Long Term Issues Concerning Employment

The stability of employment is one of Japan's most important policy goals. Employment is necessary to utilize human capital as well as being a source of household income. Moreover, the labor market is the place where individuals participate in society and realize their own goals.

Characteristics of Japanese Employment System

The Japanese employment system has functioned stably and admirably in the Japanese economy. It should be noted that the lifetime employment and seniority-based wage system is not as inflexible as is generally thought, and that the characteristics and functions of the Japanese employment system can be explained by economic reasons. They are not "special."

In the Japanese employment system, long-term employment has promoted cooperative behavior among workers and smooth accumulation of human capital, which lead to efficiency and innovation among firms. Moreover, the steepness in the wage profile curve and the slow promotion system have helped prevent problems of morale among workers, which are easily caused by the stability in employment in the long term.

On the other hand, the Japanese employment system also has demerits, including long working hours, fewer holidays taken, and difficulty in changing jobs.

The stability in employment under external shocks and cyclical movements in the economy shows the flexibility in the Japanese labor market. There are four types of flexibility.

First, adjustments in labor input are made mainly by changing working hours. The degree of quantity adjustment in employees is relatively small. This type of employment adjustment does not involve large costs with respect to unemployment.

Second, the existence of the labor market of non-regular workers with high mobility makes the flexibility of the labor market compatible with long-term employment among regular workers.

Third, real wages tend to change flexibly. And finally, the reallocation of the labor force has been made effectively.

Recent Changes in Employment System

When we look at the employment system in the future, we must distinguish between cyclical changes and structural changes. In this case, the idea of "complementarity," meaning that the behavior of each economic agent complements that of other agents. Concerning the complementarity of the employment system, as the share of firms with lifetime employment gross, employees and employers have incentives to keep the lifetime employment system. And the employment system is also reinforced by other sub-systems including interlocking share holdings aimed at the stability in management.

There have been a tide of changes in the employment system. Concretely, there have been changes in macro conditions supporting the Japanese employment system, including labor shortages in the future, changes in values, and developments in innovation and globalization. It is necessary to construct a new employment system, which can adjust to new situations and can utilize the flexibility of labor market and the accumulation of human capital.

The following aspects on the future of the employment system should be pointed out.

First, it is hoped that long-term employment will be maintained. However, changes in age structure of firms and sense of values of workers has led to the increased importance on merit rating and the introduction of pay based on skill. According the survey research, the share of firms which think that they cannot maintain the seniority rating system is 78%. On the other hand, the share of firms which think that the lifetime employment system will collapse, is 21.4% (see Figure 3-2-17 1 ).

Secondly, the internal labor market will be divided into two parts, one in which long-term employment and seniority-based wage will be maintained, and the other in which non-regular workers, whose labor mobility is high, are rated by their merits. These two parts will coexist in the same firm. According to our survey analysis, the share of firms which maintain the life time employment system is about 80%. The share of firms which think that can coexist with workers under the lifetime employment system and non regular workers who are not guaranteed the life time employment, is 13.0% (see Figure 3-2-17 1 ).

Section 3
Deregulation Needed for the Japanese Economy

There are growing needs for deregulation, under the view that public regulation makes the economy less flexible and hinders its future developments. Of the value-added base in 1990, 42% of the total economy is under public regulation (see Table 3-3-1(1), (2) ).

Deregulation is expected to play an important role in vitalizing domestic demand by expanding business opportunities and consumer choice, in shortening the international price disparity by introducing competition in the non-manufacturing sector with low productivity, and in increasing telecommunication sector is expect to faster the multimedia industry and to expand domestic demand by creating new businesses.

There are many reasons why deregulation is necessary.

First, regulations can change according to the situation. The necessity and the content of regulation should be always reexamined and reformed in order to maintain regulations compatible with the current circumstances.

Second, we must realize how large the economic costs of keeping unnecessary regulation are. Excessive regulation in market entrance and price tends to lead to monopolic rents in the regulated firm, rent-seeking for allocation of rents, and protection of firms with low productivity from competition.

Third, public regulation has no mechanism for flexibly adjusting to the changes in circumstances. Reexamination of unnecessary regulations will expand selection of quality and price by consumers and will shift economic resources from unproductive activities to more productive ones.

Section 4
New Frontiers of the Japanese Economy

View on Potential Growth

In order to understand the potential growth of the economy from the supply side, let us divide the real growth rate into the contribution of labor, capital and TFP (total factor productivity) (see Table 3-4-3(1), (2) ). The contribution of TFP to the growth rate is the highest in Japan and Europe. Therefore, the growth rate in the medium and long term depends on TFP, which is determined largely by innovation. The key to economic growth is sustainable innovation, which is created by R&D and human capital investment. Steady efforts to accumulate R&D and human capital investment will create the opportunities to develop during future periods of recession, and lead to new frontiers in the Japanese economy.

Are Leading Industries Indispensable for the Japanese Economy ?

Leading industries, which have large share and transmission effects and enhance the productivity of the total economy by their own innovation, will promote the development of the economy from the domestic point of view. However, leading industries, which can compete globally with high productivity, have not been necessary to the catch-up process of the Japanese economy. Moreover, it has been difficult for the national economy to maintain extraordinarily high competitiveness of specific industries under the convergence in the productivity of developed countries and the rapid catching-up of Asian countries.

It is difficult for us to specify future leading industries a priori. However, sincere efforts for innovation within each industry will consequently create new leading industries.

Concluding Remarks

Finally, to conclude this report, we will repeat the problems which the Japanese economy faces, and review the above discussion.

The Three Adjustment Phases

In this report, we analyzed the economic condition in Japan from short-term, medium-term, and long-term perspectives. From the analysis, the Japanese economy in 1993 can be interpreted as a phase in which it has progressed adjustments in the following gaps.

First, the Japanese economy has faced a gap between expectations and results, which has led to down side risk for the future. Repeated down side risk, in line with the continued appreciation of the yen, seems to have restrained consumption in households as well as business investment in corporations, and have forced them to step up restructuring.

Second, the Japanese economy has encountered a gap between demand and supply reflecting stock adjustment in consumer durables and fixed business investment accompanied by the burst of bubbles. In this case, each economic sector has progressed balance-sheet adjustments or reduced product price to enhance final demand.

Third, the Japanese economy has faced a structural gap. We have recognized the problem of whether the economic structure in its present state can survive in the future amid a background of an expanded gap between prices at home and abroad, etc.

As a result, these three gaps together in 1993 seem to have increased uncertainty toward the future and compelled each economic sector to seriously deal with them.

Repeated Down Side Risk and Influence of the Appreciated Yen

From a short-term perspective, partial recovery of the economy was observed in the first half of 1993. However, it did not lead to the recovery of the overall economy, and the economy remained stagnant. The background of the above risks is as follows: 1) the influence of both stock adjustments and the burst of bubbles on the economy remained, 2) the yen has appreciated unexpectedly this summer, and tended to depress economic activities.

The appreciated yen, from a short-term perspective, seems to have had an impact on economic activities through the following two ways.

First, negative impacts which affect the economy by squeezing the profits of corporations, are thought to take place in the following order: 1) a rise in export price at foreign currency base, and a decline in import price at yen base -> 2) a decrease in export and an increase in import -> 3) a decrease in current account surplus at yen base, and an increase in current account surplus at foreign currency base.

Second, positive impacts, such as a decline in import price and increased cheaper imports, are expected to support real income by keeping prices stable. Under those circumstances, industrial production has remained sluggish and labor conditions are getting worse.

Background of the Prolonged Slowdown

From a medium-term perspective, the last recession was relatively severer than other post-war recessions in terms of duration and depth.

Prolonged and worsened slowdown is mainly due to the following two factors. First, from a cyclical perspective, stock adjustments in consumer durables and fixed business investment have continued. Regarding consumer durables, huge stock adjustments centering on cars have been observed. Meanwhile, prolonged stock adjustments in fixed business investment are mainly due to the unimprovement of capacity utilization in the manufacturing sector, as final demand has remained weak despite the low growth in capital stock. In addition, stock adjustments have been also observed in both the non-manufacturing sector and the construction sector.

Second, lagging effects caused by the burst of bubbles have continued to exert influence on the economy. Although the bubble among asset prices is likely to cease by 1993, lagging effects are still evident after the cease of bubbles and have restrained economic activities.

Lagging effects can be interpreted as balance-sheet adjustments and huge excess stock in office buildings.

Balance-sheet adjustments were brought about mainly by the worsened balance sheets of corporations and non-performing loans in banks. Under the phase of balance-sheet adjustments, "risk taking capability" (the extent to which economics sectors can actively take additional risk) declined. In this case, corporations that tend to prioritize the reduction of debt, have been cautious about making additional fixed business investments. Banks, also, may have had a negative impact on business investments, as banks have become cautious about extending credit, reflecting declined "risk taking capability" as well as a decrease in the value of collateral.

Huge excess stock in office buildings, the other lagging effect, has continued to have a negative impact on economic activities even after the decrease in demand for new office space. That is mainly due to the longer time needed for the completion of office buildings.

Prospects for Economic Recovery

With respect to the economic outlook from the above short and medium-term perspectives, an increasing number of economic indicators have improved or ceased to worsen since 1994.

Those improved indicators suggest that: 1) personal consumption is bottoming out, 2) industrial production has increased along with the progression of inventory adjustment, and 3) confidence among consumers and corporations has ceased to worsen.

Improved business conditions reflect: 1) progressed stock adjustments in consumer durables and fixed business investment, 2) prevailing world wide economic recovery in developed countries as well as high growth in Asian economies, 3) the permeation of stimulative effects of monetary and fiscal policies to date, including the reduction in personal income taxes.

Downside risks exist, however, in the context of prospects for economic recovery. They may possibly limit the scope of recovery through: 1) weaker income conditions and temporary production increases in the first quarter 1994 caused by the temporary sales promotions of corporations towards the fiscal year end, 2) balance-sheet adjustment pressures in corporations and banks, 3) exchange market movements.

What is needed now is to enhance the above signs of economic recovery in order to lead to overall recovery, avoiding the emergence of downside risk.

Interaction Between Business Cycles and Structural Problems

In order to understand the current problems the Japanese economy faces, and to tackle them, the important point is how we understand the interaction between problems concerning business cycles and those on structural adjustments.

On these issues, there is an argument about "structural recession," which implies that structural problems have led to a longer recession. Without solving these problem, the Japanese economy will not be able to recover. For example, "saturated consumer demands cause sluggishness in household consumption." "Prototype fiscal and monetary policies have lost their effectiveness." "There is no strategic industry which leads the Japanese economy, outside of the automobile and electrical machinery industries. These arguments, important in themselves, are not always relevant in explaining the longer recession. It is easily understood that a new change in the economy must be a structural one. However, many things which cannot be explained are often treated as structural issues.

The interaction between business cycles and structural problems is important, because it is in a recession that structural issues emerge, and sincere efforts to adjust to new situations are made with a growing sense of crisis.

The Japanese economy will finally be on the track of recovery because of the developments in capital stock adjustment and the effects of government's economic measures. However, the recovery of the economy will not solve the structural problems. That is why the division between cyclical and structural problems is important. Therefore, whether the Japanese economy will continue its good performance, while improving the quality of life, depends on how we treat the growing opportunity for making structural reforms in order to solve long-term issues.

Issues the Japanese Economy Must Overcome in the Long Term

The Japanese economy is expected to realize sustainable and domestic-oriented growth, along with importants in quality of life. It is necessary to steer the economy toward the track of a recovery and to reform structural impediments to the domestic-oriented growth and the improvement of quality of life. The long-term issues, emerging under the strong yen and the long lasting recession, are as follows.

First, the development of the Japanese economy and the world economy must be well balanced. Hollowization and the growing price disparity between Japan and the rest of the world reveal some of the hurdles which the Japanese economy must overcome in the long term.

Hollowization is related to how Japanese manufacturing constructs the network of international production bases and division of labor. The transfer of production bases to overseas, along with increases in direct investment abroad, (which are considered as hollowization,) will bring with them some painful friction through production and employment adjustment. But, in the long-run, by allocating resources freed from the transfer of production bases to more valued-added sectors, and by promoting economic developments in both Japan and Asian countries through intra-industry trade, hollowization can be considered as a new driving force of development.

Price disparity between Japan and the world shows the existence of sectors, in which output price levels are higher, due not only to macro factors including exchange rates and income levels, but also to internal factors. It is necessary for sectors with large price disparity to improve their productivity and efficiency and lower their prices through their own efforts, deregulation, a more efficient distribution system and import promotion.

Second, the existing economic system should be reformed to adjust to necessary changes, by reexamining the Japanese-type employment system and the promotion of deregulation.

The Japanese-type employment system, characterized by lifetime employment and seniority-based wage, has promoted cooperation among workers, accumulation of human capital, and the stabilization of employment. However, aging, globalization, and a changing sense of values of workers might shake the basis of this employment system. While keeping the merits of flexibility in the labor market and the accumulation of human capital, a new system should be constructed by the fusion of the part of long-term employment featured by an internal labor market, and the part with more labor mobility found in external labor markets.

One of the most important policy agendas for the Japanese economy is to reexamine public regulation depending on circumstances. The Japanese government has made every effort to implement deregulation according to its schedule. The effect of deregulation is as follows: 1) it will promote domestic demand-oriented growth by expanding opportunities of business and consumer choice; 2) it will reduce the price disparity between Japan and the world by introducing competitive pressure in industries with low-productivity; and 3) it will make the economic system more transparent from an international perspectives.

Regulation should be reexamined according to changes in innovation, consumer choice and globalization. Regulation, once introduced, cannot change flexibly according to the situation. This is due to vested interests and tends to protect low-productivity sectors. The reexamination of unnecessary regulation will expand the availability of consumer choice for price and quality and make the economy more efficient by reallocating resources from unproductive activities to more productive ones.

Third, It is important to promote growth in the Japanese economy and its labor productivity from long-term points of view. Arguments on potential growth and leading industries are related to these issues.

Improvements in productivity and economic efficiency, which lead to sustainable economic growth, are the most fundamental requirements in solving almost all economic issues. The reason is that improvement in real income and quality of life can be possible only by improvement in productivity and economic efficiency. The key to economic growth is sustainable innovation, which is created by R&D and human capital investment. Steady efforts to accumulate R&D and human capital investment will create opportunities to develop during future recession, and lead to new frontiers in the Japanese economy.

Leading industries, which have large transmission effects and enhance the productivity of the total economy, will promote the development of the economy from the domestic point of view. However, leading industries, which can compete globally with high productivity, have not been necessary to the catch-up process of the Japanese economy. Moreover, it has been difficult for the national economy to maintain extraordinarily high competitiveness in specific industries under the integrated world economy.

It is difficult for us to specify future leading industries a priori. However, there must be large potential demand for the improvement of quality of life in the domestic economy. Therefore, there must be a lot of opportunities for leading industries to emerge in the future.

Policy stance in the severe adjustment process

Fortunately, so called "structural pessimism," repeatedly argued when oil shocks and a strong yen hit the Japanese economy, has proven false not because it was wrong but because the corporate, household and government sectors made every effort to adjust to the critical situations and changed the assumptions of "structural pessimism." We hope that continuing efforts toward adjustment to new situations will change the economy and will form new frameworks for new development.

The adjustment process which the Japanese economy has experienced recently has been severe, but is also a kind of gestation period that will a new era of the Japanese economy. It is necessary to make every effort to induce the economy to the track of steady recovery as soon as possible by implementing fiscal and monetary policies flexibly, while paying attention to the downside risks of the economy from the short and medium-term points of view. On the other hand, it is important to promote structural reforms, including deregulation regardless of business cycles, with a growing sense of crisis in this harsh adjustment process, from a long term perspective.