Japan's Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance

by Akio Mikuni, R. Taggart Murphy

Overview

"Until quite recently, the Japanese inspired a kind of puzzled awe. They had pulled themselves together from the ruin of war, built at breakneck speed a formidable array of export champions, and emerged as the world's number-two economy and largest net creditor nation. And they did it by flouting every rule of economic orthodoxy. But today only the puzzlement remains—at Japan's inability to arrest its economic decline, at its festering banking crisis, and at the dithering of its policymakers. Why can't the Japanese government find the political will to fix the country's problems? Japan's Policy Trap offers a provocative new analysis of the country's protracted economic stagnation. Japanese insider Akio Mikuni and long-term Japan resident R. Taggart Murphy contend that the country has landed in a policy trap that defies easy solution. The authors, who have together spent decades at the heart of Japanese finance, expose the deep-rooted political arrangements that have distorted Japan's monetary policy in a deflationary direction. They link Japan's economic difficulties to the Achilles' heel of the U.S. economy: the U.S. trade and current accounts deficits. For the last twenty years, Japan's dollar-denominated trade surplus has outstripped official reserves and currency in circulation. These huge accumulated surpluses have long exercised a growing and perverse influence on monetary policy, forcing Japan's authorities to support a build-up of deflationary dollars. Mikuni and Murphy trace the origins of Japan's policy trap far back into history, in the measures taken by Japan's officials to preserve their economic independence in what they saw as a hostile world. Mobilizing every resource to accumulate precious dollars, the authorities eventually found themselves coping with a hoard they could neither use nor exchange. To counteract the deflationary impact, Japanese authorities resorted to the creation of yen liabilities unrelated to production via the largest financial bubble in history. The bursting of that bubble was followed by massive public works spending that has resulted in an explosion in public sector debt. Japan's Policy Trap points to the likelihood that Japan will run out of ways to support its vast pile of dollar claims. Should the day come when those claims can no longer be supported, the world could see a horrific deflationary spiral in Japan, a crash in the global value of the dollar, or both. The effects would reach far beyond Japan's borders. Mikuni and Murphy suggest that a reduction in Japan's surplus must be accompanied by a reduction in deficits somewhere else—most obviously through far-reaching shifts in the American economy.

"

Product Details

ISBN-13:	9780815702238
Publisher:	Rowman & Littlefield Publishers, Inc.
Publication date:	11/26/2003
Edition description:	New Edition
Pages:	320
Product dimensions:	6.00(w) x 8.97(h) x 0.76(d)

About the Author

Akio Mikuni is one of the most universally respected analysts of the Japanese economy in the global financial community. He is the president and founder of Mikuni & Co. Ltd, Japan's leading independent, investor-supported bond-rating agency. Mikuni was named one of the fifty most influential individuals in Asia by "Business Week" in 1999. He also has been the subject of profiles in the Financial Times and Fortune. R. Taggart Murphy, a former investment banker, is foreign professor, College of International Studies, Tsukuba University, Japan, and a nonresident senior fellow in the Foreign Policy Studies program at the Brookings Institution. His recent books include "The Weight of the Yen: How Denial Imperils America's Future and Ruins an Alliance" (W. W. Norton, 1997) and " Ugokanu Nihon e no Shohosen" ( "Prescriptions for a Japan That Is Not Moving"), (Mainichi Shinbunsha, 1998).

Read an Excerpt

Japan's Policy Trap

Dollars, Deflation, and the Crisis of Japanese Finance

---

By Akio Mikuni

Brookings Institution Press

Copyright © 2003 Akio Mikuni
All right reserved.
ISBN: 081570223X

---

Chapter One

The Policy Trap

As Japan enters its twelfth consecutive year of economic stagnation, it has begun to dawn on the world that something peculiar is going on. The term "recession" is often trotted out, but whatever may be happening in Japan, it does not seem to be a garden-variety recession. "Recession" suggests a sharp, severe economic decline lasting a few quarters; the word carries the connotation of a common disease like the measles or mumps, with a clear-cut cause and an approved course of treatment. But while Japan's authorities appear to have administered the standard recession therapy-interest-rate cuts, easy money, and fiscal pump priming-they have little to show for it other than a staggering level of government debt.

More frightening terms are sometimes heard-depression, liquidity trap-with their deliberate echoes of the 1930s. Those words came into use back then, when economists realized that the world had fallen into something far more intractable than a recession. But except for the intractable part, they manifestly do not fit contemporary Japan. Unemployment rates and bankruptcies may have risen to historical highs, but the country does not look or feel like a country anywhere close to a depression. There are no bread lines, no signs of widespread destitution, no angry, radicalized mobs to provide easy prey for populist demagogues.

"Stagnation" comes closer, since Japan's economy has neither seen much growth in the past ten years nor really shrunk. But while the label works well enough, it does not help us to get a grip on the situation, partly because there is no useful precedent. No one has ever really thought about what it means to muddle along year after year with no improvement and no crash. True, much of the world was in the grip of stagnation twenty-five years ago-"stagflation" they called it, since it combined anemic growth with high inflation. It bothered economists at the time because they had never seen anything quite like it. But again, Japan's problems today do not seem to resemble at all the difficulties faced by the developed world in the mid 1970s. Inflation is nowhere to be seen, the currency is reasonably strong, and the country continues to run high trade and current account surpluses -an economic picture that is the opposite of that in the United States and much of Europe back then.

This is not the first time, of course, that Japan has puzzled the world. Indeed, the country has been something of an enigma ever since the "little land of topsy-turvy" emerged out of a rosy mist of geishas and cherry blossoms to crush the Russian navy in 1905. In more recent times the country posted the most phenomenal record of economic growth in history while violating virtually every single tenet of Western economic orthodoxy. Policy analysts sputtered helplessly about "fairness" and "free rides" while defensive neoclassical economists were reduced to remarking that Japan could have recorded even higher levels of growth if only its government had gotten "out of the way."

The onset of Japan's economic difficulties has led, naturally, to a good deal of "I told you so" crowing from such quarters as well as more reasoned attempts to analyze the "souring" of policy ingredients that are said to have once worked well enough but no longer do. The schadenfreude is, however, more muted than one might expect given the threat to conventional economic wisdom that Japan seemed to pose a decade ago. For if the West could not understand how a war-devastated Japan could build the world's premiere industrial machine from scratch in less than twenty years, the onset of Japan's difficulties did not clear up the myriad enigmas enveloping economic and political reality there. There is talk of policy errors by the central bank and grumbling over a succession of weak prime ministers. But those "explanations" do not go very far in helping us grasp how a country can stagger along year after year at close to zero growth with its banking system in a shambles and all the while avoid anything that looks like a real recessionary shakeout.

The Goals of Policymaking

Much of the difficulty in analyzing Japan in both its high-growth and its stagnation phases can be traced to mistaken assumptions about the nature of policymaking in Japan and the objectives of Tokyo's policymakers. Western observers tend, understandably, to assume that these men-they are all men-want prosperity for Japan and that they measure prosperity by the usual yardsticks: employment rates, living standards, per capita gross domestic product (GDP), corporate earnings, productivity growth, and the vibrancy of the markets for money, equities, real estate, and goods. Now, Japan's policymakers have nothing against prosperity as the West defines it, provided that it does not undermine their control of economic and political outcomes. And they understand that the world expects them to discuss their achievements and shortcomings with reference to the commonly employed yardsticks. But they have goals that transcend prosperity.

Japan's decisionmakers have run their country for well over a century now with three objectives: independence, survival, and control-the independence of their country from foreign domination, their own survival as a ruling elite, and their continued control of key economic and political levers. Their historical memory taught them to secure those goals by maximizing production capacity and mastering and controlling important upstream industrial technologies. And they did, but their aim was not to purchase prosperity for Japanese citizens; it was to buy protection in what they saw as a hostile world. They believed that the only sure route to the control of production and technology lay in aggressive, centrally directed capital spending, and they measured their success by the technological and manufacturing prowess of Japanese companies and the size of Japan's trade and current account surpluses.

That remains true to this day. Perhaps nothing more astonishes educated opinion in the West than Japan's obsession with its trade and current account surpluses. There is no doubt that the obsession exists; a decline in the current account surplus that began in the spring of 2001 gave rise to a veritable orgy of doomsday pieces in Japan's media in which commentators went to the extreme of making off-the-wall comparisons of Japan with Indonesia. Agitation of that kind seems to betray basic economic illiteracy, and comments such as that by Ito Takatoshi, a former official of the Ministry of Finance (MOF)-"If nothing is done [about the deterioration of Japan's trade surplus], the yen will eventually drop and Japanese won't be wealthy anymore"-suggests that Japanese educated opinion is still in thrall to the crassest sort of mercantilism. For not only does Japan enjoy the world's largest pile of claims on foreigners-claims that can be used to buy all the imports Japan could possibly need for years to come-it still boasts a panoply of world-beating industries and companies. Real wealth, as economists since the days of Adam Smith and David Hume have understood, comes not from piles of gold or their modern equivalent-a huge and unnecessary buildup of international reserves produced by an unbroken string of current account surpluses-but from the skills and productivity of a country's citizens, with which Japan is exceptionally well endowed.

For the current account is simply that-an accounting entry that captures current cash flows (trade settlements, dividends, interest, transfers) to and from the outside world while plugging the gap between savings and investment in an economy. A poor developing country without a convertible currency might need to monitor its current account to ensure that it has adequate foreign exchange to purchase needed imports. But Japan is one of the world's richest, most highly developed countries. For policymakers in such a place to concern themselves with the ups and downs of the current account can remind economically literate Westerners of grownups still haunted by childhood fears of being picked on in the sandbox.

But this comparison ignores Japan's single-minded concern with the maximization of production capacity and exports. For those charged with carrying out the policies, the current account serves as the most critical indicator of economic well-being. To them, a current account deficit flashes dire distress signals: of excessive imports, of poor export performance, and, above all, of savings inadequate to finance investments in production capacity without dangerous reliance on foreigners. Meanwhile, a constant string of surpluses reassures policymakers that they are following the right course: that savings and exports are sufficient to provide Japan with a protective cocoon of claims on other countries. The importance of the current account surplus is so embedded in the thinking of Japan's decisionmakers that to secure it they have been willing to sacrifice much of the prosperity that could otherwise have been theirs. They have seen to it that the surplus was not consumed domestically; instead, they have invested it overseas, where it finances the deficits of trading partners. But unlike King Midas, gloating over gold he would not spend, the Japanese have accepted payment for their export earnings and returns from their investments abroad not in precious metals or their own currency but in dollars-the fiat currency of another country, a currency that has lost two-thirds of its purchasing power over the past three decades.

Part of Japan's obsession with its current account and the level of its exports reflects the inordinate sway of the bureaucracy over political and economic life in Japan, a matter we will consider more closely in chapter 2. Free of any requirement for political accountability, the Japanese bureaucracy, like bureaucracies everywhere, operates on a kind of inherited autopilot, fighting, in a manner of speaking, the last war. The bureaucracy assumed untrammeled control of economic policymaking in Japan during the late 1940s, a time when officials had to be concerned about the hoarding and rationing of precious foreign exchange. With nothing to change it, that mentality has persisted to this day. But it also reflects the underlying bureaucratic drive to retain control of economic outcomes rather than ceding control to markets or to foreigners. That, in turn, spells maximization of production capacity financed by domestic savings. Unlike other industrialized nations, Japan has built and maintained an industrial capacity that far exceeds its domestic requirements, a capacity that takes financial form as a current account surplus.

To induce and sustain a current account surplus, Japan's policymakers have allocated purchasing power preferentially, to manufacturers on the one hand and to exporters of financial capital on the other. They chose a centralized banking system as the most effective way of doing this. Manufacturers and exporters of capital were given to understand that their task in the system was to play their respective roles in maximizing production capacity. Profits, the sine qua non of viability in market economies, were incidental. Manufacturers and banks were never expected to pay attention to profits; Japan's governing bureaucracy did that for them. The bureaucrats ensured the viability of important players by controlling key prices in the economy and by socializing risks that in market economies are borne by individual enterprises. Banks lent without credit risk; major companies produced without market and supply risks. Both were thereby made responsive to bureaucratic directive, not to the greed of profit-seeking shareholders. Western analysts often wonder at the lack of corporate governance in Japan, but the absence of outside investors to bring pressure for profit and return has enabled Japan's governing bureaucracy to allocate managerial resources to targeted industries without any distractions.

By their own lights, Japan's policymakers have been successful. They have run current account surpluses now for more than thirty years (figure 1-1 shows these surpluses as a percentage of GDP). The surpluses have accumulated to the point that Japan's claims on other countries have made Japan far and away the world's number-one net creditor nation; in other words, the net claims of Japanese institutions on foreigners-the bonds and equity that they hold, the loans that they have made, and the factories, buildings, and companies that they own abroad, less foreign ownership of Japanese domestic assets-far exceed those of any other country. Meanwhile, Japanese companies dominate a wide range of industrial processes, upstream components, and key technologies, enabling Japan to rack up current account surpluses for as far into the future as the eye can see.

The rest of the world, of course, views things in a different light. Japan's huge surpluses seem less a mark of industrial strength than a system-straining imbalance, a sign that both the Japanese economy and global trade and financial systems are out of kilter. For example, C. Fred Bergsten, the head of a prominent Washington think tank, doubted as far back as 1986 whether "the world will sustain external surpluses on the part of Japan on the order of $50 billion or so for the rest of the decade." Japan's surpluses, which are now more than twice that size, are being sustained into their second decade beyond the one in which Bergsten made his prediction, but his comment was not in the least exceptional. For Japan's imbalances-and their counterparts, the swollen current account deficits of the United States-were not supposed to be possible in today's world. The floating exchange rate system, heralded at its birth in 1973 as an automatic adjustment mechanism that would prevent the accumulation of such payment imbalances, has seen the opposite happen. Payment imbalances reached levels never witnessed under a fixed-rate system, a matter that monetarist cheerleaders for floating rates have never satisfactorily explained.

Theoretically, an imbalanced current account should, at some point, correct itself. Current account surpluses ultimately derive from sales made by a country's companies in foreign markets, sales that then are translated into cash within the country and thus into credit in its own currency. That credit should in the normal course of things find its way into consumption and housing investments, stimulating economic activity and bringing on rising prices. Economic activity creates additional demand for credit. Banks, seeing more profits, raise their interest rates. Eventually, rising prices and rising interest rates erode the competitiveness of the country's exports while making imports cheaper. The current account surplus falls, and equilibrium is restored to the country's balance of payments.

Continues...

Continues...

---

Excerpted from Japan's Policy Trap by Akio Mikuni Copyright © 2003 by Akio Mikuni. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

---

Table of Contents

	Foreword	ix
	Preface	xi
1	The Policy Trap	1
2	The Preservation of Bureaucratic Power	38
3	Monetary Policy and Mercantilism	67
4	Hoarding Gold, Hoarding Dollars	96
5	Experimenting with Bubbles	125
6	Of a Great Bubble and Its Collapse	145
7	The Downward Spiral	171
8	The Policy Trap Revisited	189
9	The Anomalies of Contemporary Japan	214
10	The End of the Japanese System?	240
	Notes	263
	Index	279
	Figures
1-1.	Japan's Current Account Surplus (Deficit) as a Percentage of Nominal GDP	7
1-2.	M2 plus CDs as a Multiple of High-Powered Money	10
1-3.	Yen/Dollar Rate since 1955	12
1-4.	Japan's Gross External Assets and Liabilities	14
1-5.	Japan's Gross External Assets and Liabilities as Percentages of Nominal GDP	17
1-6.	Japan's Accumulated Current Account Surpluses, Official Foreign Exchange Reserves, and Currency in Circulation as Percentages of Nominal GDP during the Postwar Period	18
1-7.	Movement of the Wholesale Price Index and the Consumer Price Index in the Postwar Period (Base Year 1970)	23
1-8.	Exports as a Percentage of Japan's Gross External Assets	25
1-9.	Money Supply Less Accumulated Current Account Surplus	27
1-10.	Year-on-Year Growth Rates of City Bank Loans and Nominal GDP	33
2-1.	Total Liabilities of Japanese Companies in Bankruptcy, Manufacturing versus Nonmanufacturing Sectors	63
2-2.	Ratio of Sales to Net Property, Plant and Equipment	65
3-1.	Household Savings as a Percentage of Disposable Income	68
3-2.	Year-on-Year Growth Rates of the Money Supply (M2 + CDs) and Nominal GDP	80
3-3.	Net Sales/Purchases of Land by Enterprises, Governments, and Households (Absolute Amounts and as Percentages of Nominal GDP)	83
3-4.	Total Market Value of Land in the Tokyo Metropolitan Area, Kansai Area, and the Rest of Japan, 1969-99	84
3-5.	Year-on-Year Growth Rates of Wages and City Bank Loans	86
3-6.	Bank of Japan's Assets Compared with Japan's Net Creditor Position	94
4-1.	Japan's Private Capital Spending	110
4-2.	Buildup of Dollar Reserves in the FESA	121
4-3.	Ratio of Values of Official Foreign Exchange Reserves and Monthly Imports	122
6-1.	Total Assets, Breakdown of Assets, and Deposits + CDs at the Foreign Branches of the City Banks	151
6-2.	Short-Term External Assets and Liabilities of Banks and Other Financial Institutions	153
6-3.	City Bank Spreads	157
6-4.	Average Annual Increases in Domestic Credit Extended by Banks, Including the Bank of Japan	162
8-1.	Equity and Land Prices	198
8-2.	Shares Owned by Financial Institutions as a Percentage of Total Shares Listed on the Tokyo Stock Exchange	199
8-3.	Central and Local Government Indebtedness as a Percentage of Nominal GDP	204
	Table
6-1.	Japan's Balance of Payments	158

Editorial Reviews

.".. a provocative new book." --John Thornhill, "Financial Times", 11/18/2002

"many astute and sometimes provocative observations about the Japanese economic and political system." -- "Foreign Affairs"

"[The book has] many astute... observations about the Japanese economic and political system." --Richard N. Cooper, "Foreign Affairs", 5/1/2003

"An important new book..." --Hugo Restall, "The Asian Wall Street Journal", 10/25/2002

"Winner, 2002 Association of American Publishers Professional and Scholarly Publishing Award for Economics" -- "Award"

From the Publisher