OECD Economies Week 2 Michaelmas Term

1. 19/10/10 Rebick - OECD Week 2 1 OECD EconomiesWeek 2Michaelmas Term Lecture 2: Japan: The Lost Decade Dr Mark Rebick

2. 19/10/10 Rebick - OECD Week 2 2 Outline of Lecture The �bubble� and aftermath Demand-side issues Supply-side issues Lessons for the current economic crisis?

3. 19/10/10 Rebick - OECD Week 2 3 The Bubble The Plaza accord and yen appreciation after 1985 Loose monetary policy and financial deregulation Asset prices rise steeply after 1987 but inflation low. Should asset prices be considered by Central Bank authorities? BOJ raises rate sharply to 6% during 1989 Stock Market crashes, followed shortly by real-estate market � note difference in order of events with recent crisis in the United States

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5. 19/10/10 Rebick - OECD Week 2 5 The Lost Decade 1992-2002 Not a period of prolonged negative growth, but three episodes of negative growth Overall an average growth rate of 1% per annum Unemployment rates rise slowly, more rapidly after 1998, peaking at around 5 � percent in 2002. Deflation took hold midway through the decade and has persisted ever since

6. Causes of the Lost Decade Principal cause is the collapse of the bubble and the drop in investment demand as a result of overinvestment in the 1980s A mix of policy errors and external factors complicate the picture Some economists, however, believe that the supply side was more important and point to low TFP growth as the chief culprit in Japan�s sluggish performance 19/10/10 Rebick - OECD Week 2 6

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8. Demand-side factors End of the bubble brings on a huge loss in asset value -- 1500 trillion yen or 3 years of GDP wiped out. Stock and land prices declined by 85% by end of decade 19/10/10 Rebick - OECD Week 2 8

9. Consumption effects Pigou effects from the drop in property values did not have so much of an effect as most house owners not selling their homes � mobility rates low in Japan However, eventually job losses and the fear of job losses would have a dampening effect on consumption. This does not show up in savings rates, however. Savings rates actually fall through the 1990s, continuing a long-running trend Ageing of population an important factor Declining incomes at the bottom of the income distribution make saving impossible 19/10/10 Rebick - OECD Week 2 9

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11. Consumption effects Fall in stock market prices had an effect on prospects for private pensions from life-insurance companies Towards the end of the period the increased national debt may have affected consumer behaviour. 19/10/10 Rebick - OECD Week 2 11

12. Investment demand The Bubble period had also been a period of overinvestment in physical capital leading to much excess capacity Companies (not just financial) were left technically insolvent and were mainly concerned about paying down their debt This process took more than 10 years Richard Koo�s �balance-sheet recession� 19/10/10 Rebick - OECD Week 2 12

13. 19/10/10 Rebick - OECD Week 2 13 External factors affecting demand Yen appreciation in 2004-5 Asian Financial Crisis of 1997 End of the dotcom boom in 2000 All of these affected export demand and thus the overall economy

14. 19/10/10 Rebick - OECD Week 2 14 Policy Errors of the 1990s Failure of monetary policy � central bank too slow to react to downturn? After interest rates reached 0, policy becomes more difficult Inconsistent fiscal policy � e.g. stimulus in 1995 led to growth in 1996, but then tax increases in 1997 helped stall growth. Stimulus mainly aimed at public works which could be wasteful and have low multiplier effect.

15. Policy debates Disagreement about the efficacy of fiscal policy � extremes of opinion Expenditure was often wasteful and driven by political issues and regional economic problems Posen, Koo and others argue that without the stimulus packages recession would have been much worse Others, however, are much more sceptical and some econometric studies suggest that fiscal policy had no effect Krugman argues that Japan was in a liquidity trap, but doesn�t believe that Japan should try to spend its way out under deflation Instead he argues that the Bank of Japan should adopt a high inflation target to try to raise expectations of inflation 19/10/10 Rebick - OECD Week 2 15

16. Bank of Japan policy Generally conservative due to bad experiences with inflation in the 1970s Bank was made independent in 1998 and in 2001 seemed to raise interest rates prematurely just to prove this Eventually adopted a policy of �quantitative easing�, essentially monetising the debt Exchange-rate intervention in the early 2000s -- John Taylor calls it the great intervention and claims that this is what brought about recovery 19/10/10 Rebick - OECD Week 2 16

17. 19/10/10 Rebick - OECD Week 2 17 Supply side problems Problems in the banking sector � huge problem of non-performing loans, perhaps 100 trillion yen due to collapse of bubble and continuing losses Low productivity growth in non-traded goods sector Regulations Problems with competition policy Lack of inward investment Labour market problems

18. Banking sector Reluctance of government (i.e. Ministry of Finance) to deal with the problem until banks failed Banks showed forbearance on debt and the MOF did not push them to clear up the problem Eventually regulation of banks moved to a Financial Services Agency and the government recapitalises the banks Problems not completely resolved for 10 years (or more in the case of smaller regional banks) � other countries have managed banking crises more rapidly Kashyap and Hoshi argue that the banking sector is too big for Japan�s needs today � most large corporations raise funds through stocks and bonds 19/10/10 Rebick - OECD Week 2 18

19. Credit crunch? Although banking sector problems were serious, there does not appear to be a credit crunch except in 1998. Interest rates remain low Lack of demand from firms rather than lack of ability to lend appears to be the problem If the banks were not providing credit, then we should have seen lending by foreign banks 19/10/10 Rebick - OECD Week 2 19

20. 19/10/10 Rebick - OECD Week 2 20 Low productivity growth A number of critics (Porter and Takeuchi; Hayashi and Prescott) argue that the main cause of the slowdown is on the supply side The Prescott-Hayashi argument is partly based on the fact that the number of hours worked per worker fell during this period --- however this could easily be due to demand problems The Porter-Takeuchi argument points to the low productivity of many sectors in Japan. This viewpoint emphasises the numerous impediments to competition including government regulations and direct interference, bid-rigging cartels and other forms of protection for vested interests There is also a problem in the education sector � critics argue that Japanese education produces high standards of knowledge but is not as good at fostering creativity Japanese universities research environment is poor and not used sufficiently in R&D � (this is changing gradually)

21. An example � computer software In Japan, different hardware manufacturers such as Toshiba or NEC developed software that was tied to the specific characteristics of the machine � bundled software Japanese anti-trust law too weak to stop this, unlike US Keiretsu organisation may have provided captive markets for some of these firms 19/10/10 Rebick - OECD Week 2 21

22. Software (continued) Employment system and status attached to working for large companies inhibited the movement of labour to small start-ups Venture capital market undeveloped Weak protection of intellectual property rights Lack of competition held back development except in games sector Eventually Microsoft and Apple were allowed into the market as the poor state of software was affecting users competitiveness 19/10/10 Rebick - OECD Week 2 22

23. Supply or demand? The main argument against the supply-side explanation is that problems did not suddenly develop after 1992. However, it could account for some of the decline in TFP growth The �varieties of capitalism� literature suggests that Japan (and Germany) may have economic systems that are good for some industries, while the US would be good at others There has been a drive to reform Japanese institutions including changes to labour law, corporate governance, anti-trust law, privatisation. 19/10/10 Rebick - OECD Week 2 23

24. Lessons for the future Don�t postpone recapitalisation of banking sector � this lesson appears to have been learned by the authorities in the US and UK in recent financial crisis If a recession is triggered by the collapse of an asset-price bubble, working off debt may take time and government stimulus is necessary Don�t attempt a fiscal consolidation too quickly after such a shock 19/10/10 Rebick - OECD Week 2 24