Failure of Macroeconomic Policy and Decade Long Stagnation - Case Study Example

Running Head: JAPANESE ECONOMY 1990S Failure of Macroeconomic Policy and Decade Long Stagnation [The [The ofthe Institution] Failure of Macroeconomic Policy and Decade Long Stagnation This paper will discuss and evaluate the lost economic decade for Japan. It will address the issues pertaining to the failure of macroeconomic policy ands how this policy failed to help out Japan from the decade long stagnation. Introduction While the world economy underwent sluggish growth in the 1970s and the 1980s, the performance of the Japanese economy was somewhat successful. Nevertheless, "Japan's Miracle" ended in the beginning of the 1990s. Since then, the Japanese economy has fallen into an acute and long slump and has entered into a new transition phase. Since 1990 Japan has experienced over a decade of slow growth in real economic activity. Between 1990 and 2000 per capita output raised at an annual rate of 0.68 percent, per capita investment dropped at the rate of 1.4 percent per annum and weekly hours per adult worker declined by 1.18 percent per annum. This period has come to be referred to as "the lost decade." During the same period the inflation rate, as measured by the growth rate of the GDP deflator, fell from 2.3 percent to -1.8 percent and the nominal interest rate fell from 7.4 percent to 0.1 percent. Japan's current experience of sluggish growth coupled by deflation and zero nominal interest rates raises questions about the role of monetary policy in times of deflation. Should monetary policy take actions to avoid the zero nominal interest rate bound and if so, what policies can avoid it and/or ameliorate its negative ejects This paper deals with a model that accounts for the real and nominal facts from the 1990s and makes use of this model to answer the two questions posed above. We consider an expensive price adjustment model along the lines of Rotemberg (1996) and expand it to allow for capital accumulation. In this economy monopolistically competitive firms face convex costs of adjusting prices. Households own the capital stock and are subject to convex costs of adjustment. The economy experiences exogenous shocks to technology and government purchases and the monetary authority follows an interest rate targeting rule that assigns weight to current output deviations from trend and current deviations of inflation from its target level. Solving for the equilibrium is complicated by the likelihood of a zero nominal interest rate limitation. An algorithm for computing perfect foresight equilibria is developed in situations where the nominal interest rate is zero over some period of time. The model is then solved and replicated using a parameterization that is standardized to Japanese data. An impulse response analysis is used to answer the first question. We find that the dynamic response of the economy to shocks in technology and government purchases is very di.erent depending on whether the zero nominal interest rate constraint binds. When the constraint is not binding output and investment rise in response to improvements in technology under the interest rate targeting rule we mull over. Nevertheless, when the constraint binds, monetary policy cannot respond and output and investment all drop in response to positive technology shocks. A binding constraint also exacerbates the contractionary e.ects of negative government purchase shocks on these same variables. Overview of the Study First, I will analyze what is extent of stagnation and what are its evidences and proofs from economic conditions of the country. Besides this, what went wrong in demand side Second, I will examine the components of GDP which have been stagnant with reference to relevant theories. Third, I will explore the weaknesses of supply side and its relevant issue will be discussed. Background of the study From the beginning of the 1950s to the early 1970s, the Japanese economy experienced dramatic growth. Several institutional structures sustained this rapid growth. First, the stable international environment hastened Japan's economic growth. Pax Americana, and especially the IMF dollar system, encouraged and sustained fast growth in Japan. Contrary to the interwar phase, the United States fulfilled its responsibilities as the key currency country by distributing dollar funds on a huge scale under the Marshall Plan to assist in the resurgence of Europe after World War II. The vast level of "special procurement" income raised the ceiling of the Japanese balance of payments and helped to recover its economy. The development in world trade was the main factor in the growth of Japan's exports during this period. Because all foreign currency earned from exports was spent on imports to expand production and achieve high growth, the increase in exports made rapid growth possible. [e.g., Nakamura 1995, 45, 64, 68]. Second, the stable financial system maintained speedy growth. In those days, the corporate sector demonstrated an enormous scarcity of funds, which was made up by the surplus in the household sector. During periods of economic growth, the Bank of Japan provided funds through loans and open market operations, which spurred rapid growth. On the other hand, when economic booms led to balance of payments' deficits, which decreased foreign exchange reserves, tight monetary policies were effective in restricting fund supplies, suppressing domestic demand, and wiping out those deficits. 1 Research by Storesletten et al. (2004b) fairly effectively explicates the US data by adopting the preventive savings model and linear income process estimated by the US Panel Study of Income Dynamics. Nevertheless, as demonstrated in the previous section, the variances of Japanese or Taiwanese consumption grow increasingly in middle age. In the buer stock saving model with linear permanent shock process, as in Figure 8, the corresponding variances profile of age-consumption becomes a concave function over the age.29;30 Therefore, Storesletten et al. (2004b)'s estimation is likely to perform poorly if we apply the same estimation to the Japanese economy. Although they clarify the shape of the age-consumption disparity in the United States, they fail to explain the "level" of variances of logarithms of consumption; as a result Storesletten et al. (2004b) concluded that the social security system is vital for understanding the level of fit. In Storesletten et al. (2004b), the relative risk aversion is fixed to be 2. Our approach exhibits a sharp contrast. Using a partial equilibrium model, we standardized the replacement rate from the public pension system in Japan, and projected the relative risk aversion that is consistent with the Japanese data's shape and level. Using theResearch by Storesletten et al. (2004b) quite successfully explains the US data by adopting the precautionary savings model and linear income process estimated by the US Panel Study of Income Dynamics. Nevertheless, as showed in the previous section, the variances of Japanese or Taiwanese consumption grow more and more in middle age. In the buer stock saving model with linear permanent shock process, as in Figure 8, the corresponding variances profile of age-consumption becomes a concave function over the age.29;30 Therefore, Storesletten et al. (2004b)'s assessment is likely to do badly if we apply the same estimation to the Japanese economy. Although they explain the shape of the age-consumption disparity in the United States, they fail to explain the "level" of variances of logarithms of consumption; as a result Storesletten et al. (2004b) concluded that the social security system is essential for understanding the level of fit. In Storesletten et al. (2004b), the virtual risk aversion is fixed to be 2. Our approach shows a marked difference. Using a partial equilibrium model, we standardized the replacement rate from the public pension system in Japan, and assessed the relative risk aversion that is consistent with the Japanese data's shape and level. Using the nonlinear stochastic income process, we are able to duplicate the consumption disparity with a reasonable risk aversion. In the meantime, if we presume the variances of permanent shocks to be constant over age, the risk aversion that enhances the log-likelihood has a value that is incongruously large (Table 10). Furthermore, at least for the Japanese economy, Vuong's test shows that the nonlinear income process model is superior to the model with linear regression. The "Lost Decade" Macroeconomic Policy Failure Through the 1980s and early 1990s, the Japanese presence in the international political economy expanded to the degree that it appeared to be a challenge to the existing hegemonic structure. The Japanese populace also enjoyed a rise in economic power via the expansion of consumer spending. Consumerism in Japan reached maturity in the mid-1980s, and the bubble economy in the late 1980s and early 1990s that resulted from rocketing prices of land and shares certainly contributed to luxury spending for some strata, though not all, in Japanese society. In the mid-1990s, however, there was another twist, and the requirement for further transitions overwhelmed the Japanese political economy. The bubble economy finally burst in the early 1990s, and the Japanese economy has since been stuck in serious stagnation. Many large corporations that had previously represented the momentum of the Japanese economy abroad collapsed, and major banks and key economic institutions were crippled by non-performing loans created during the bubble economy. Simultaneously, the process of globalization started to have a visible impact on the economy, and the idea of 'global standard' was used to pose some questions regarding conventional economic ideas and practices. The problems and transitions in the performance of the Japanese economy resulted in the downsizing of companies (in Japanese 'risutorakucharingu' (restructuring) or 'risutora' in short), pushing the unemployment rate to its highest level in the postwar period. The downsizing also generated anxieties over everyday life. As mentioned earlier, the majority of the 1990s in Japan was experienced as the 'lost decade', in which the national economy had to struggle to cope with an enduring recession. Many large corporations attempted to survive this crisis by further rationalizing their personnel policies. While lay-offs, downsizing and early retirement became common practices, eroding the expectation of lifetime employment among white-collar workers and their families in the name of the 'restructuring' of companies, the number of non-regular workers rapidly increased from 8.81 million in 1990 to 12.25 million in 1999. This example suggests that civil movements that pursue 'protection of everyday life' act in accordance with the logic of the advanced capitalist state of efficiency and economy in order to attain the objectives of the movements. Japan's Success in Maintaining Economic Growth In the start of the 1970s, stable economic growth in developed countries finished. First, international institutions became unsteady because of the decline in Pax Americana. The fixed exchange rate system suffered a debacle, and the price of crude oil rose considerably. The floating exchange rate system was one of the main factors of the international economic and financial uncertainties. The rise in the crude oil price created a severe condition for oil-importing countries. Second, many developed countries had to face the grave problem that we had never experienced before - "stagflation." Japan, however, succeeded in keeping a better economic performance than any other developed country during the second half of the 1970s and through the first half of the 1980s. Why could Japan get over the "Nixon shock" and two "oil crises" Why could Japan deal effectively with "stagflation" The most important factor causing the Japanese economic success in this period was the flexibility of the Japanese corporate system. Following the first oil crisis, the Japanese economy encountered a serious trilemma: inflation, balance of payments' deficits, and stagnation. The Japanese government was forced to adopt restrictive monetary and fiscal policies to restrain inflation for two years. These anti-inflation policies were accompanied by huge sacrifices. The firms' profits fell considerably owing to a decrease in demand and a rise in costs. Japanese firms reduced numbers of employees and minimized labor costs. First of all, they dismissed their temporary female workers and their part-time workers, who were mainly housewives. As most of them did not remain in the labor market but returned to the home, they were not counted as "completely unemployed." In addition, Japanese firms avoided large reductions in their work forces by dismissing specific workers in order to maintain their traditionally good labor-management relations. They tried to employ every conceivable device to decrease employment without dismissal - from leaving positions of retiring employees unfilled to reshuffling personnel; transferring employees to other companies; and calling for voluntary resignation. Private Consumption Stagnation As this comment shows, when the Everyday Life Improvement Movement began, there was a clear recognition on the side of the designers of national policy that state management targeted creating 'a rich country', which required homes managed and developed in better ways. Importantly, when Tanahashi mentioned 'the expansion of the state's fortune', he referred to it not only in a militaristic sense but also in an economic sense - a clear manifestation of the link between reproduction and developmentalism. According to him, reforms in everyday life by saving time, controlling consumption, and rationalizing other details of everyday life resulted in a strengthening of the state. This was because 'in order to win in the economic war undertaken in peace time, which can be expected to be extremely severe in the future, we must enrich and strengthen the state's power by first eradicating waste through reforming everyday life, and then re-allocating the spare time and energy from reforms to more productive projects' They also made efforts to economise on labor-related expenses. They switched from male to female employees, especially, low-wage part-time workers. Moreover, management gained the cooperation of company labor unions in order to hold down annual wage increases to a level only somewhat more than the rate of rise in the consumer price index. All in all, Japanese industrial firms were able to decrease employment, trim their total wage costs without a rise in the unemployment rate, and shun social conflict. Consequently, the Japanese government did not have to adopt growth-promoting policy until 1977, when the anticipation of inflation stopped. The second reason for the Japanese success in economic growth in the 1970s and the 1980s was the expansion in exports. The increase in net exports expanded the real GDP by around 1-2 percent during the period between 1974 and 1977. The U.S. government adopted growth-promoting monetary and fiscal policies and provided the spur for a world economic recovery as an engine of world economic growth. The expansion in exports backed economic growth again in the first half of the 1980s. The rise in net exports helped the Japanese economy pick up from the recession of 1980-1982 [Bank of Japan 1997]. Fiscal Policy in the last decade There have been a large number of fiscal packages over the last 10 years, and as the chart shows, the overall deficit has risen as a proportion of GDP over the decade. These packages were often insufficient and contained few measures with a direct effect on activity (Posen, 1998). Many tax reductions were fleeting and had little effect in boosting consumers expenditures. In addition, many of the fiscal packages involved programs such as land purchases that have little impact on economic activity. While the different fiscal stimulus packages were greatly weighted in favour of public investment, projects were often of poor quality and did little to lift potential output. There have been incessant apprehensions about the level of debt, and even on conservative measures of overall public debt, as published by the OECD, the debt stock is now well over 120 percent of GDP, as can be seen from the chart. As a result no fiscal stimulus has been sustained, and the absence of a bold and steady fiscal spur has been cited as one of the main contributory factors to the extended slump. The evidence on the efficacy of fiscal policy is varied. Bayoumi (2001) finds, using a VAR approach, that fiscal policy was effective in contributing to the small minirevival in 1996. Government investment was sharply increased in the September 1995 stimulus package, and this had beneficial effects on output in 1996. The following reversal in public investment helps to enlighten the slowdown the subsequent year. "Japan's Miracle" End in the 1990s Before analyzing the reasons why "Japan's miracle" ended in the 1990s, we will have to see the features of the boom in the late 1980s. Economic growth began in December 1986 and ended in January 1991. This 50-month "Heisei" period boom was longer than the "Iwato boom" (1959-61) and a little shorter than the "Izanagi boom" (the second half of the 1960s). The major factor that backed and hastened the "Heisei boom" was the rise in domestic private demand and especially, fixed business investment and consumption of durable goods. Additionally, an increase in stock and land prices spurred an increase in private debt, which hastened private demand for investment and consumption. GDP Components The growth rate of the Japanese GDP started to decline in the second quarter of 1991 and became negative in the second, third, and fourth quarters of 1992 [Bank of Japan 1997]. The main factors that terminated the "Heisei boom" were declines in rental housing construction, consumption of durable goods, and fixed business investment in small- and medium-sised non-manufacturing firms. The reasons for this decline were tight monetary policy and the drop of stock and land prices. After the Japanese economy fell into slump in the early 1990s, a strong recovery has not started to date. The factors of this recession were: 1. A drop in fixed business investment was considerable in 1992 and 1993. A factor of this decline was a drop in capacity utilise. Another factor in this decline in fixed business investment was a drop in present profit to sales ratio. A third factor in this slump in fixed business investment was worsening in the financial position of the corporate business sector. Particularly, the financial position of small- and medium-sised enterprises in the non-manufacturing industries was tight in the first half of the 1990s, as the lending attitude of financial institutions remained limiting [Bank of Japan 1997]. 2. The contribution of private consumption to the real GDP became negative in 1992. Especially, the decline of consumer durables' expenditures rose in 1992. The factors of this decline were a decrease in the growth rate of employees' earnings and capital losses in stocks and lands in 1992. 3. Public demand, and fixed investment in particular, supported domestic demand in fiscal years 1991, 1992, 1993, and 1995. In addition, a reduction in the personal income tax in fiscal years 1994, 1995, and 1996 and an increase in treasury investment and loans in fiscal years 1992 and 1993 prevented the Japanese economy from worsening. As a result, the ratio of public deficits to the GDP rose rapidly and exceeded these ratios in the United States and EU countries. In spring 1997, the government increased the sales tax from 3 percent to 5 percent and terminated a special personal income tax cut in order to reduce government deficits. As a consequence, there has been a negative impact on the Japanese economy since the second quarter of 1997. 4. Foreign demand, which was a positive factor in 1990-92, turned negative after 1993 due to an appreciation of yen exchange rates [Bank of Japan 1997]. Stacking the Shocks We could certainly 'stack' the shocks - if we did the two money shocks in 1993 and 1997 could have been much smaller, and Japan would not now have an output gap, and therefore a third money shock would be superfluous. The following charts give some results Our first shock is a change in the insignificant GDP target (JPNOMT) 15% up in 1993Q4, whilst our second shock is a shift in the nominal GDP target (JPNOMT) 15% up and target government balance % of GDP (JPGBRT) 2% point down (-2%) in 1997Q4. Our third shock, which we argue would have been superfluous, is a shift in the nominal GDP target (JPNOMT) 10% up in 2001Q3. The results of stacking simulation with shocks (1) and (2) are given in the charts below, with the lower line being our base, the middle line being the first shock and the top line being the two shocks stacked together. The results of stacking replications with all the shocks (1), (2), and (3) are given below, with the line with triangle dots showing the results of baseline, the line with rectangle dots the results of the simulation with shock (1), the line with circle dots the results of the stacking simulation with shocks (1) and (2), and the line with cross dots showing the results of the stacking simulation with all the shocks (1), (2) and (3). We would contend that raising the inflation rate to 5 percent, which our third shock would do, gives a lucid signal that our model suggest that the two previous shocks would have taken the Japanese economy to around its equilibrium level of output. None of these shocks can alter the equilibrium (except possibly through their effects on real interest rates, but in an open economy this should be small). Nevertheless, the redundancy of a monetary expansion in 2001-2002 given no problems appear up until then highlights the previous policy failures rather than the lack of need for a monetary expansion now. Even I a zero interest rate world monetary policy can be used to expand demand by affecting the exchange rate. The problems of debt deflation and the exchange rate in Japan Over this period we saw a important rise in the equity market, both in real and nominal terms, and although equity prices are well below the levels seen at the end of the 1980s they remain high in real terms, at least in an historical perspective. Although debt deflation has been destructive, there may be additional falls in real equity prices that may be needed. However, these can be managed either through a fall in equity prices with a stable price level or by a rising price level with a stable equity price. The latter would be much easier to administer, and at minimum a policy that insured that debt overhang problems were not deteriorated by a declining price level would be prudent to apply. When the asset price bubble burst in the early 1990s, the high indebtedness of the private sector was a severe problem. Many banks had lent large amounts of money to firms using land as collateral, encouraged by rising prices. When prices started falling, many of these loans had to be written off. The problem was worsened by the fact that many banks with large shareholdings had their capital gravely battered by the collapse of the Japanese stock market, as a result of which bank capital proved inadequate and the financial sector faced a major crisis. Slack accounting rules and a lenient regulatory environment allowed banks to survive, but with only limited ability to lend to companies due to the competing needs of writing-off bad loans and maintaining capital adequacy ratios. Bayoumi (2001) uses a VAR approach to gauge the impact of bank lending and other factors on economic activity. He finds that the largest impact on output comes from land prices. There are also essential interactions between stock prices, land prices and bank lending, reflecting the use of land as guarantee for loans and the importance of shares for bank capital. The interaction of these factors in the upturn of the 1980s and their implications for the stability of the economy help explain the path of bank lending when this process went into reverse in the 1990s when under capitalised banks responded to falling asset prices by restraining lending to maintain capital adequacy standards. The manifestation of a premium in August 1995 on Japanese bank borrowing the interbank market relative to US and UK counterparts is an indication of the problems Japan had to face in the last few years. It reflects investors' apprehension about the capacity of Japanese banks to repay loans, and Peek and Rosengren (2001) examine its determinants and find that the largest movements in the risk premium have been linked with the pronouncement of large and previously undisclosed losses. Banks with extensively reported losses that closed barely affected the sise of the premium, but bank failures that were unexpected caused large increases in the premium. Infusions of Government capital, reducing the likelihood of future failures, lowered the premium, whilst tighter regulations and strengthening of supervision raised it. Official estimates put the value of non-performing loans at 6 per cent of GDP, but unofficial estimates are much higher, and bad loans could be as high as 63 trillion yen (12 per cent of GDP). The total value of bank loans to borrowers whose financial condition "needs attention" or who are either bankrupt or close to bankruptcy may amount to 111 trillion yen (22 per cent of GDP). The government has thus far been reluctant to give in to pressure for large government support to the banking sector, as that could engender ethical hazard problems. Conclusion In conclusion, the most crucial factor of the Japanese depression in the 1990s was debt deflation, 2 which also was a major cause of the Great Depression in the United States [Shibata 1997]. Assumption in stocks and land enhanced asset value and made the financial position of the corporate business and the personal sector better. Their approving financial positions encouraged their borrowing in order to augment fixed business investment, residential construction and using up of durable goods. Nevertheless, once asset values dropped, their financial positions degenerated. This degeneration caused a decrease in residential construction, fixed business investment, and consumption of durable goods. A rise in bad assets limited the financial intermediary function of commercial banks. The main reason for this debt deflation was the instability of the Japanese financial system in the 1980s. The institutional structure of the Japanese financial system has changed since the 1970s. In the second half of this decade, three remarkable changes occurred in the savings-investment balance. First, the dearth of savings in the corporate sector decreased noticeably as firms began to cut back on fixed investment and reorganize their operations. Second, the scarcity of general government savings increased abruptly. Third, the deficit in the overseas sector expanded. In the 1980s, while the scarcity of general government savings declined owing to the reconstruction of public finance, the deficit in the overseas sector rose. The funds from the personal sector that went to the corporate sector in the 1950s and the 1960s were aimed into the United States in the latter half of the 1980s. Deregulation and internationalise in the Japanese financial market supported this change [e.g., Shibata 1993, 47]. At the end of the 1980s, though, the deficit in the overseas sector reduced, while the scarcity of savings in the corporate sector expanded again. Foreign securities investment in the United States started to get down after 1987, because of the rise in risk premium on foreign investment in the U.S. securities market because of the stable downward propensity in the value of the dollar [Shibata 1993, 58-60]. Consequently, the Bank of Japan had to buy the dollar in the foreign exchange market and maintain an easy money policy in order to maintain the dollar exchange rate against the yen until May 1989. This policy encouraged assumption in stocks and lands. Non-financial firms expanded their responsibilities not only to raise fixed investment, but also to engage in speculation. Briefly, the uneven institutional structure of the financial system is the most important cause of the Japanese depression in the 1990s. Japanese financial institutions amassed an enormous amount of bad assets and encountered a decline in capital asset ratio owing to the depreciation of stocks and land. Consequently, the deterioration of the financial intermediary function produced bad effects on the real economy. Additionally, the unsteady institutional structure of the international monetary system is the second factor of the Japanese depression. The appreciation of the dollar exchange rates after 1995 had adverse effects on the Asian countries that pegged their exchange rates to the dollar. In 1997, a financial crisis in the Asian markets produced bad effects on the Japanese financial market. Third, the Japanese-style corporate system, especially cross-shareholding among corporations, hastened the assumption in stocks by the end of the 1980s. Once the bubble exploded, the decrease of stock values deteriorated the cross-shareholding system. Fourth, the Japanese government failed to cope with financial slump. The Ministry of Finance hid the real financial positions of the Japanese banks and delayed the disposal of their bad assets. Additionally, the Japanese government cannot bank upon bold fiscal policy, as it is thought that it has the liability to lessen the accumulated public debts. We need a striking evolution of these wobbly institutional structures to revitalize the Japanese economy. It is obvious form our discussion that a monetary expansion in 2001-2002 would help solve current problems., and over between November 2001 and January 2002 there has been a lucid intention on the part of the Bank of Japan to swell liquidity and devalue the yen in order to expand demand. They now recognise that a zero interest rate world leaves a lot of room for monetary policy. Even if today's rate for the current 3 months has been pushed to zero the Bank can push other rates down. The 3 month rate for the period 3 to 6 months ahead is a presently visible and manipulatable variable. Buying 6 month government (and commercial) paper will push that rate down, and convince the markets that the yen will drop a little. The rate between 6 months and 9 months is also an evident, and can be pushed to zero. The same can be assumed for any forward rate that is market traded, and if the Bank wants a lower yen it should work along the yield curve, growing liquidity by buying bills and bonds. It can indicate obviously where it wants the yen to be, and as long as it provides enough liquidity in the right way, it will get there. References Storesletten, K., C. Telmer and A. 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