by John H. Makin
AEI Economic Outlook
While there is plenty of argument about where the U.S. economy is headed next year, the argument about Japan’s economy is over. During 2001, Japan passed from a prolonged and serious recession into outright depression. The bad news is that a depression in the world’s second-largest economy will make it more difficult for the world economy to recover in 2002. The (not very) good news is that depressions as acute as the one that has emerged in Japan do not usually last very long. However, Japan’s exiting its depression will require a large write-down of an unsustainable debt burden either through reflation or outright default.
Japan Chooses the Road to Default
Japan appears poised to follow the passive route of outright default rather than the more active route of reflation. Reflation, even if it leads beyond price stability to some inflation, is a better strategy than default because moving from deflation to rising prices taxes evenly the holders of government debt as rising prices push up interest rates and push down the value of the debt. The default approach toward which Japan is heading will be more abrupt, arbitrary, and disruptive to Japanese and global markets. Beyond financial market turmoil, abrupt default entails a significant additional risk that jeopardizes further employment and growth in Japan and worldwide. Japan’s deflation and debt crisis now constitute systemic risk to the global economy.
Japan’s efforts to reflate have failed essentially because such efforts have been pursued along normal monetary channels that are appropriate for an economy with a functioning banking system. Japan’s banking system is insolvent. Efforts by the Bank of Japan to boost economic activity and to reflate by increasing reserves in the banking system and cutting short-term interest rates virtually to zero amount to beating harder a dead horse. The dead horse is the Japanese banking system, which by virtue of its insolvency is unable to act as a financial intermediary borrowing short from the central bank and lending to Japan’s private sector. Rather, Japan’s banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up an additional 15 or 20 basis points of yield on those government notes.
The Bank of Japan’s unsuccessful efforts to stimulate the economy by providing more liquidity to the banking system have essentially amounted to underwriting ever-rising government debt and a continuation of wasteful government programs, exactly what Bank of Japan governor Masaru Hayami has said he wants to prevent. In this process, Japan’s banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks.
The Lesser of Evils
The large acquisition by Japanese banks of Japanese government securities has, of course, created a dilemma for the government and the Bank of Japan. Successful efforts to stimulate the economy or reflate would result in higher interest rates and a collapse in the value of the low-interest rate government bonds acquired by the banks. This “dilemma” has caused the government to pause in its efforts to encourage reflation by the Bank of Japan.
An economy in depression, as Japan’s is, presents its government with no attractive alternatives. Rather, the government must choose the least bad alternative, and that is to reflate, either proactively or reactively, to reduce the rising burden of debt that is being compounded by prolonged heavy government borrowing and by accelerating deflation. The alternative, to do nothing, simply ensures that the problem will get worse and the pain caused by a transition from deflation to reflation will be greater.
Time and again, the Japanese government and the Bank of Japan have demonstrated a preference for passivity with respect to the need to reflate. The inevitable outcome will be the failure of one or several large banks that ultimately precipitates the failure of the banking system. By failure I mean simply that depositors, convinced that the liabilities of Japan’s banks far exceed their assets, will continue to withdraw funds from the Japanese banking system. There will be a full-scale “run” on the banks. Concern over this outcome is already evident in Japan’s stock market, where bank stocks through early December were down 44 percent on the year against the overall stock market decline of 24 percent. Meanwhile, the market prices of some money market funds, which are supposed to be safe assets, have fallen below par by virtue of their questionable holdings.
The problem with the collapse of Japan’s already dead banking system will be especially acute for depositors. Bank shareholders have long since seen the positive equity value, or net worth, of Japan’s banks disappear. But as the banking system collapses, the Japanese government will face the need to avoid additional losses by household and business depositors in the banks.
Specifically, the negative net worth of the Japanese banking system is somewhere above the yen-equivalent of $1 trillion. When the banking system collapses, in order to avoid compound losses by Japan’s households, the Bank of Japan will need to inject at least $1 trillion into the banks to protect depositors from losses that would constitute a further setback for the Japanese financial system and economy.