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Monday, July 16, 2001

LITMUS TEST FOR ECONOMY JULY 29

Japan must escape from liquidity trap by ripping out unproductive, old roots


After raising the banner "No economic recovery without reforms," what awaits Prime Minister Junichiro Koizumi after his trip to the United States, Britain and France earlier this month and this week's Group of Eight summit in Genoa, Italy, is the House of Councilors election on July 29.

As symbolized by comments from the prime minister stating that his entrance on political center stage is tantamount to governmental change, opposition from those attempting to protect vested interests within both the central and local governments remains strong.

I would like to sort out the issues of the "liquidity trap" our country has fallen into and thus assist voters in deciding how to cast their ballots in the upcoming election.

A liquidity trap, simply put, is a situation in which interest rates do not react to an increase in money supply, thus causing the latter to fail in boosting economic growth.

The current situation, in which interest rates have been hovering near zero while the economy refuses to recover despite the huge flows of money pumped into it, is a classic example.

By the way, the amount of money the central bank has been channeling into the market the past five years (base money) has been rising at an annual pace of about 8 percent.

Deposits (categorized as M2 plus certificates of deposit), however, have risen less than 4 percent while commercial bank lending, in contrast, has shrunk 0.4 percent, indicating that domestic demand -- a key requirement for self-sustained recovery -- has basically remained unchanged.

If we were to imagine Japan as a tree planted in a large pot, the current situation can be described as one in which huge amounts of water, or money, are raining down on the tree but refusing to enter the soil. The money just accumulates and flows over the rim, failing to help it grow.

The reason this happens is because the tree's old, inefficient roots are slowing productivity and strangling new growth.

The aim of Koizumi's structural reforms is to chop away at the old roots to encourage the growth of new ones. But let us clarify some points of caution that should be heeded when undertaking such reforms.

First, growth in money supply gives those with assets more options to select from when picking out assets that have the greatest amount of liquidity. It does not, however, boost the amount of assets as a whole.

While low interest rates and high liquidity are indeed factors that would help support stock prices, those with assets have opted to drop them into deposits and other forms of savings in an effort to maintain their value and circumvent the risk of fluctuating stock prices. The grim lessons learned during and after the asset-inflated bubble era of the 1980s only reinforce this tendency.

If we are to increase the number of people willing to take risks, it is indeed imperative to review the capital gains taxes. However, the basic fact is that stock prices will not rise unless there are better and stronger roots in the pot.

Second, prices in Japan remain high compared with those in other countries. This was confirmed in a recently released Cabinet Office survey. Some people appear to be of the opinion that further monetary easing is necessary because deflation is gripping the country, but the current decline in prices stems from the collapse of the bubble economy and liberalization. This is not deflation, but disinflation, and adjustment toward international price levels.

The decline in domestic prices is certainly a head wind for suppliers, but for consumers who cannot hope for a substantial rise in wages due to intensifying global competition, the price drop is a tail wind. This country definitely needs to shift its paradigms in favor of the consumer.

Third, the Japanese economy has already matured, with per capita income attaining high levels. Against the backdrop of the bubble's collapse and the need to deal with the negative factors left behind, as well as Japan's environmental problems and shrinking population, we are now faced with circumstances under which it will be difficult for the pot itself to expand at the pace it did during the postwar high-growth years. If the pot does not get larger and prices fall, people will be able to get by with less funds. It is no wonder, therefore, that money is spilling out of the pot. Thus, the yardstick for measuring the state of the economy and the progress of reforms should not be gross domestic product, but per capita productivity.

Fourth, there are concerns over the decline in exports, which have so far supplemented the lackluster performance of domestic demand. However, we should note that the shift away from an external demand-led economy to a domestic demand-led one is one of the goals of structural reform.

A reduction in the current account surplus should be positively interpreted as a sign of the increasing possibility that, rather than saving up U.S. dollars, the resources used for export are instead being used internally.

The theoretical way to escape from a liquidity trap is to reduce liquidity and accelerate the pruning of bad roots. Roots with high productivity should be able to withstand higher interest rates. That is the pain of reform, and it is essential to minimize such pain because unemployment is bound to stem from the implementation of reforms.

However, this does not mean that we should condone the continuation of public works spending, which has only served to keep the weak roots alive.

Japan's productivity in the 1990s rose by 9.5 percent over all. But if we look at this figure more closely, we can see that while productivity rose by 22 percent in the manufacturing sector, it shrank by 30 percent in the construction sector.

The continuous pumping of government funds into an unproductive root has failed to contribute to economic revitalization and has only served to expand the nation's outstanding debt. This, coupled with the collapse of the bubble, has led to the so-called lost decade.

The walls of vested interests in the circles of politics, the bureaucracy, and the private sector must be knocked down in order to fully implement reforms, and the litmus test for this will be the Upper House elections later this month.

The Koizumi administration was born amid much soul-searching over the lost decade. Voters must learn not to repeat past mistakes.

Teruhiko Mano is an adviser to Tokyo Research International Ltd.


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