In Search of a Prescription for the Japanese Economy

1. In Search of a Prescription for the Japanese Economy Joseph E. Stiglitz Keynote Address April 14, 2003Tokyo

2. Symptoms of an underlying problem • Slow growth for more than a decade, slipping in and out of recession • Rising unemployment –but still low by international standards • Overall: under performing potential, a sense of malaise

3. Competing Diagnoses (I) • Lack of aggregate demand • Structural problems

4. Competing Diagnoses (II) • Both are present, and the two are intertwined • Much harder to solve structural problems when economy is in recession • Much harder to solve aggregate demand problems, given the structural problems • But structural problems relate to economy’s long run productivity growth

5. Competing Diagnoses (III) • There is a short run aggregate demand problem, and this needs to be addressed much before much progress can be made on structural issues • Attacking some of the structural problems (e.g. in finance) in the wrong way could exacerbate aggregate demand problems and be self-defeating

6. Competing theories of lack of aggregate demand (I) • Keynes: downward price and wage rigidities • Fisher: debt-deflation theory • ‘Updated’ by modern theory of capital markets, based on asymmetric information and incomplete contracts, by Greenwald and Stiglitz • Focuses on balance sheet effects on households, banks, and firms resulting from inflation and large changes in asset prices (breaking of bubble) • Ability and willingness of firms to invest and banks to lend are both affected

7. Competing theories of lack of aggregate demand (II) • Helps explain why some structural reforms can worsen aggregate demand problem: attempts to ‘clean up’ banks can lead to reduced credit supply (as in US), exacerbating economic downturn –and making bank balance sheets even worse • Even redistributive changes (some people gain, some people lose) can have large real effects • Falling prices implies that even with low nominal interest rates, real interest rates are high DEBT DEFLATION THEORIES PROVIDE A BETTER DESCRIPTION OF JAPAN’S SITUATION, AND MANY OTHERS

8. Prescription (I) • Theory suggests focus on balance sheets • Shifting from deflation to inflation may help balance sheets –undoing damage that deflation has done in increasing real value of debt • But some institutions with a maturity mismatch may find their balance sheet hurt –may need to have inflation or interest rate puts • Shifting from deflation to inflation may lead to lower real interest rates

9. Prescription (II) • On average, devaluation will also improve Japan’s balance sheet, given its large creditor status • And will help to reduce deflation • This is in addition to normal trade benefits from devaluation • Conventional way of correcting bank balance sheet shifts problem from banks to government • But there are unconventional ways which provide as accurate a picture of the true change in government’s position as conventional method

10. Specific policies: limited efficacy of standard keynesian instruments (I) • Income tax cuts may be ineffective, if individuals think they are temporary • Or even if they are believed to be permanent, they may simply be used to ‘restore’ balance sheet • Temporary consumption tax cut more likely to be effective, since the fact that it is temporary is more incredible than the claim that the income tax is permanent, and such a tax has an intertemporal substitution effect • But still may have limited effect

11. Specific policies: limited efficacy of standard keynesian instruments (II) • Spending financed by borrowing stimulates the economy • But leaves the country in debt • Worsening government’s balance sheet • Could set in motion bad dynamic • Households may worry about the future tax increases

12. Key Questions • How to devalue, how to reverse deflation? • Possible solution: Financing some of deficit spending by printing money • No evidence of discontinuity: moderate amount will not set off rampant inflation • Advantage over debt finance: not treated as a liability • Can be used to help recapitalize banks, enabling them to lend more • Strategy was tried in Sweden in Great Depression - worked

13. Important Lesson • Even if this prescription works, it will not address Japan’s longer run problems • Failure to use innovations in manufacturing elsewhere in the economy, especially in the service sector • Unless, however, Japan does something about the continuing short run lack of aggregate demand, there is a real risk of exacerbating long run problem, as financial problems mount and investments in new technology wane.