Conclusion
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Conclusion
Supporting structural reform by economic analyses
The Cabinet of Prime Minister Junichiro Koizumi is actively promoting structural reform. The Council on Economic and Fiscal Policy (Chairman: Prime Minister) that was established as part of the reorganization of the central government in January 2001 plays a central role in mapping out a strategy for the structural reform. The Cabinet Office is the Secretariat of the Council on Economic and Fiscal Policy and its first report, "the Annual Report on Japan' s Economy and Public Finance" , is designed to give an analytical base on which to promote structural reform.
The following are the basic ideas that lie behind the analyses of the main issues taken up in the White Paper of this fiscal year: the relationship between bad loan problems and the economy, problems that beset Japan' s public finance, and the weak resiliency of the Japanese economy.
Relationship between the problem of bad loans and the economy
Japanese banks are still beset with a large amount of non-performing loans. The positioning of cause and effect in the relationship between the problem of non-performing loans and the prolonged stagnation of the Japanese economy is subject to debate.
Some argue that non-performing loans are a major factor that is dragging down the economy and that solving this problem is the key to extricating the Japanese economy from its prolonged stagnation. On the other hand, others argue that the problem of non-performing loans will not disappear while the economy remains in the doldrums and that non-performing loans are not the cause of the disease but rather merely one of the symptoms. According to these arguments, if non-performing loans are really an impediment to the economy, interest rates should have risen due to a credit crunch and trying to solve the problem hastily amid the current loose monetary situation will have far greater adverse effects than good effects on the economy, such as increases in bankruptcies and unemployment.
The White Paper addressed the problem of non-performing loans, one of the most important and controversial problems facing the Japanese economy. The conclusion of the White Paper that is based on detailed analyses (Chapter 2) is that although there is an interactive relationship between non-performing loans and the economic slump, it is important to radically resolve the problem of non-performing loans in order to extricate the Japanese economy from the difficult current situation in which it finds itself.
The problem of non-performing loans is seen as a burden on the Japanese economy and putting downward pressure on its growth. This is because, first of all, the role of banks as financial intermediaries is not functioning properly due to the problem of non-performing loans. With their profitability eroding and their capital depreciating due to the problem of non-performing loans, banks are not eager to take on new risks and invest in new customers or growth areas. Occupied with the backward-looking work of solving the problem of non-performing loans, banks are unable to spare enough personnel or management focus for the forward-looking work of establishing a new earnings base. Secondly, the prolonged problem of non-performing loans has preserved inefficient corporations and industries and thus lowered the productivity of Japanese industry as a whole. Thirdly, concerns about the stability of the financial system cannot be dispelled due to the problem of non-performing loans and, as a result, corporations and households have become prudent in their investment and consumption behavior, which in turn serves to block economic recovery.
Under such circumstances, the White Paper analyzes the mechanism by which the problem of non-performing loans disturbs the growth of the Japanese economy. Since financing and the economy are deeply inter-related to begin with, there are various arguments as to the relationship between the two. Since there is a close relationship, in particular, between the development of the financial sector and economic growth, there have been difficulties in identifying which is the cause of the other. These arguments are analogous to the debates regarding the relationship between the non-performing loans and the stagnation of the recent Japanese economy. Schumpeter, who is known to have emphasized the importance of innovation, stressed that development of financial intermediaries, such as banks, is important for technological and economic development, while Robinson, an influential economist, argued that the development of financing has simply followed economic development.
In fact, a study on the relationship between various financial indicators and economic growth rates by using long-term data of various countries clearly shows that they are positively correlated with each other. The question is which is the cause and which is the result. Regarding this question, substantial empirical analyses have been made during the last 10 years. They reveal that (a) sound development of the financial sector increases the rate of economic growth and (b) development of financing is effective in increasing the rate of economic growth mainly through enhancing the productivity of the economy as a whole. (See Column 2-4: "A sound development of the financial sector increases economic growth rate." ) Such research findings concerning the relationship between financing and economy suggest that, in addition to rehabilitating industries, solving various problems that beset the Japanese financial sectors, such as the bad loan problem, is important for the growth of the Japanese economy.
Importance of economic analyses of Japan' s public finance
Japan' s public finance is in a severe condition. It is obvious that public finance is one of the important sectors of an economy. The condition of public finance is a mirror that shows the condition of an economy and how it is managed has a far-reaching impact on the performance of that economy.
When we say "government' s finance," we have to clearly define the scope of the government. In the National Accounts that cover total economic activities, including public finance, the broadest concept of government is "general government." The finance of a general government includes (a) national (central government) finance, (b) local government finance, and (c) social security funds (public pension, medical insurance, etc.).
Finances of national government, local governments, and social security funds are under the jurisdiction of the respective authorities (the Ministry of Finance, the Ministry of Public Management, Home Affairs, Posts and Telecommunications, the Ministry of Health, Labour and Welfare, and local governments, etc.). Since each system is complicated, it is hard for outsiders to understand the actual state of its finances. Worse still, since the finance of one sector is closely inter-related with another, we cannot understand the actual state of our country' s finance simply by looking at the financial condition of each sector individually.
In national finance, we usually focus only upon the revenues and expenditures of the general account. However, since the national finance includes many special accounts, it is hard to understand the condition of national finance simply by looking at the general account. Moreover, local finances are closely related to the national finance and, as was described in Chapter 3, their dependence on the central government has increased, especially since the 1990s. Social security funds, which are managed with premium revenues such as pension premiums, are also closely related to the national finance as seen from the fact that one-third of the annual payments of pension benefit to basic pensions (part of public pensions) are financed by tax revenues of the national government. Unless we look at the national finance and social security funds together, we cannot correctly assess the impact that the aging of the population is expected to have on the nation' s finance.
Although not classified as part of the government sector in the National Accounts, the financial condition of public corporations (special corporations) also have a major impact on the national and local finances. Some of the special corporations have received subsidies or investment from the national government. In the event of the financial ruin of such corporations, disposal of its cumulative deficits would become a heavy burden on the national finance. A recent example of this was the collapse of the Japan National Railways (special corporation), which was placed under private management. In fiscal 1998, the national government assumed obligations of 24 trillion yen from the Japan National Railways and eventually had to dispose of the cumulative debts by using tax revenues.
In order to correctly understand what is happening with regards to the country' s finances and to objectively assess the impact of economic development and the aging population on these finances or, conversely, the impact of these finances on the economy, it is extremely important to study and evaluate the national finances, local finances, social security funds and public corporations in a comprehensive manner from the viewpoint of economic analysis. Since the financial situation of the country has a far-reaching impact on the life of the people, it is also important not only for financial experts but also for people in general to have correct understanding of the current condition of the national finance and its future developments. To this end, it is important for the government to provide the results of the analyses as clearly as possible.
The analysis of the White Paper (Chapter 3) is one step toward that end.
Break away from the thinking: "Increase demand because demand is lacking."
The economic recovery that began in the spring of 1999, the second recovery in the 1990s, was weak and did not even last two years and the Japanese economy has entered a downward cycle again. Why is the Japanese economy' s potential for recovery so weak? How long will it remain in the doldrums? Answering these questions is one of the main themes of the White Paper.
Economic performance is sometimes robust and sometimes weak. One of the typical diagnoses when the economy is in a slump is as follows: "The economy is in bad shape because overall demand is weak and because demand is lacking as compared with overall supply. When demand is lacking, the government should create additional demand by such means as public investment, as the private sector is unable to get back on its feet through its own efforts."
In fact, the Japanese government created additional demand throughout the 1990s by repeatedly implementing economic measures. However, these economic measures sometimes drew criticism as being exaggerated and triggered debate over the mamizu (real water) content, as they included the expansion of credit by public financial institutions simply to replace private-sector financing. But, as a matter of fact, the mamizu, or the proportion of additional government spending which directly contributed to economic growth came to a huge amount. Such additional spending, coupled with a decrease in tax revenues, drastically increased the fiscal deficits of the national and local governments. But, the weakness of the economy remained unchanged. The thinking that "We had better create demand, because the economic slump is due to the lack of demand" is based on Keynesian economics. The basis on which Keynesian economics stands is that it takes time for prices (including wages) to adjust in response to a change in demand and that prices are typically sticky on the downside (downward rigidity). Therefore, once the economy falls into a shortage-of-demand phase, the shortage stays as it is for a long time and the economy remains in the doldrums due to weak adjustment of prices. If the government expands its spending and creates demand, then, according to the theory, the economy can get out of the doldrums.
Can this thinking be applied to the current state of the Japanese economy? Given the following reasons, the argument based on Keynesian economics in its simplest form is not persuasive.
First, the price rigidity (or slow adjustment speed of prices) on which Keynesian economics is based is valid only for a short period of time. The prolonged slump of the Japanese economy that spans a period as long as 10 years cannot be explained by the lack of demand stemming from price rigidity.
Second, under the current conditions of the Japanese economy, various prices have actually been declining due to the advance of deflation. As was analyzed in Chapter 1, wages have been adjusted quite flexibly in line with a decrease in bonus payments and an increase in employment of low-waged part-time workers. In view of these facts, it is difficult to say that adjustment of prices takes several years, although, admittedly, its speed is slow.
Third, as was described earlier, although the government has carried out measures to create a huge amount of demand, the Japanese economy still remains in the doldrums. On this point, some may argue that it is because the government had made public investments that were low in productivity and wasteful. However, in terms of creating demand, whether they were wasteful or not does not make any difference. Keynes himself said that even such a totally wasteful project as "digging a hole and filling it again" is useful as an economic measure.
It is true that the Japanese economy as it stands is lacking demand. The GDP gap, one of the indicators to gauge the lack of demand, is estimated to stand at 3~4%. However, despite the long period of slow growth, the GDP gap has not expanded sharply over the last 10 years. This could be attributed to the fact that Japan' s supply potential has decreased. The potential growth rate, which shows the growth of the supply potential, has now declined to about 1%. The analysis in the White Paper (Chapter 2) shows the mechanism whereby the "negative legacy" of 10 years of slow growth has been dragging down the potential growth ability of the Japanese economy.
In order for the Japanese economy to extricate itself from the prolonged stagnation and get back on a growth path, it is necessary to raise the potential growth rate of the economy. Merely creating demand by expanding government spending as the government has done in the past will not solve the problem. The potential growth rate can be raised by proceeding with structural reform.
Key to economic recovery
In order to ensure future economic growth, it is above all necessary to resolve at an early date the problems of non-performing loans and excessive debts that have been dragging down the Japanese economy. By resolving the problem of non-performing loans, banks will be able to take forward-looking, aggressive management policies, such as the establishment of new business models, and their lending to new customers and new fields will become active. In other words, the "blood" circulation, which has failed to function properly, will be normalized. The final disposal of non-performing loans will make it possible to reallocate the resources, such as labor and capital, that have remained unused in low-profit corporations that are unable to pay off their debts, to fields of high profitability.
Restoration of banks' financial intermediary function through early resolution of the bad loan problem and easy-monetary policies to ease deflationary pressures will work together to remove the fragility in the Japanese financial system. The Bank of Japan is now at a stage where it has to positively consider further measures to ease deflationary pressures.
We cannot achieve a rebirth of the Japanese economy simply by removing the bad loan problem. We also have to increase the productivity of the Japanese economy by promoting structural reform, including deregulation, fiscal reform, reform of pension and medical insurance systems, and promotion of start-up ventures, science and technology. As to government spending, including public investment, it is particularly important to make well-organized, focused distribution of funds to fields with high social needs and to fields that are effective in increasing employment and spurring private demand, not from the standpoint of "creating demand" but from the standpoint of "increasing growth potential." Steadily implementing structural reform in a tangible way will be effective in dispelling the concerns held by corporations and households about their future and in brightening their future prospects (expected growth rate). It will also enable the Japanese economy to extricate itself from the vicious circle of "depression causing bearish mood and bearish mood causing depression."
Structural reform will enhance the growth potential of the Japanese economy as it shifts Japan' s precious economic resources, such as labor, management resources, capital and land, to fields of higher productivity. The structural reform that will enhance the supply potential of the Japanese economy will also be accompanied by a sustainable expansion of private demand. This is because it increases private investment in highly profitable fields and because it brightens consumers' future prospects and thus results in a sustainable recovery of consumption. We cannot get out of this economic difficulty simply by creating demand through public investment. The key to the recovery of the Japanese economy is structural reform that will increase a growth potential that has declined during 10 years of economic stagnation and that will spur a sustainable expansion of private demand.