Rx for the Japanese (and World) Economy

The Japanese economy, second largest and envy of the world in the 1980s, is now stuck in the 8th year of its worst depression since World War II, with no recovery in sight. Their famed "lifetime employment" is a bitter casualty. Some fear Japan may be prophetic for the rest of the world if solutions aren't found soon.

Micro vs Macro.  Like other economies that are now performing poorly, Japan would quite probably benefit from some of the banking and other "structural reforms" now being so widely recommended. But the Keiretsu system of interlocking corporate control and finances, mutual support and close government relations also existed during the 1980s boom. While there may be stronger motivation for making such reforms today, actually carrying them out would obviously be much easier in a prosperous full-employment economy.

Price-depressing "excessive capacity" in a depressed economy tends to rapidly disappear in a vigorous recovery. The U.S. Resolution Trust Corporation's liquidation of failed savings & loans became much less painful and less costly than expected during the ensuing rapid growth of the economy. Thus, the most critical need today is for more systematic coordination of macroeconomic policies to get the economy back on a credible, initially-fast but "soft-landing," recovery track.

The web of credit and macro policy.  As the present crises illustrates so well, credit relationships tend to form an intricate interdependent chain -- or web. Consumers, business firms and governments that are quite capable of servicing their debts in a prosperous, full-employment economic environment may become unable to do so in a depression -- even a mild one. This puts financial pressure on their immediate creditors, which puts pressure on banks and reduces general finanical confidence, in a vicious cycle. Breaking into this credit vicious cycle is an important key to recovery -- and a primary responsibility of macroeconomic policy. "A rising tide lifts all boats, if they are not already sunk."

The disarray of economic "science" and economic accounts.  Unfortnately, traditional macroeconomic "science" is now in such shameful disarray that it often gives conflicting and inappropriate policy advice. Although not so generally realized, this disarray is itself due largely to the conceptually handicapped and functionally unintegrated condition of our present macroeconomic accounting systems, which keeps them from providing the empirical data needed for effective economic management.

The National Income and Product Accounts (NIPA), which are unble to deal with money and credit, leave a financial gap between financial saving and credit-financed GDP investment. The Flow of Funds Accounts (FOFA) have their own conceptual flaws which prevent them from filling the NIPA financial gap with reliable data, and they are also unable to deal empirically with the key relationship between money growth and economic growth.

These data weaknesses are compounded because traditional Keynesian theory is based largely on the NIPA accounts, and traditional (Friedmanite) "monetarist" theory does not even have a precise and consistent definition of money. The result has been that the traditional Keynesian and monetarist "economic stimulus" policies such as those tried in Japan are empirically ad hoc and uncoordinated, with monetary and fiscal policies considered alternative rather than complementary.

What has long been needed is a conceptual framework which can "complete the Keynesian Revolution" by making possible effective functional integration of the FOFA and NIPA, as a reliable empirical basis for systematic coordination of macroeconomic policy. The IDMF conceptual framework attempts to fill this need.

 
2. The Integrating Dynamic Money Flow (IDMF) Conceptual Framework

Please click here now  for a brief but essential IDMF summary before continuing.

 
3. The basic financial imbalance
 
Japanese short-term market interest rates remain close to zero, and half of the $10 trillion of household financial assets are in bank deposits yielding less than 1%. This is clear evidence that the economy’s total demand for credit (Primary Borrowing) does not provide sufficient outlets into credit-financed GDP spending for both the economy's total Primary Financial Saving, and also the amount of bank-loan-created New Money needed (in a credit-money financial system) to grow the economy at an appropriate recovery rate. [2]

Several reported Japanese tendencies tend to exacerbate this financial imbalance, through either the National Credit Balance or M1 money growth, or both:

1. Households, fearful of unemployment and retirement income, and/or expecting lower prices from systemic deflation, are tending to spend less -- particularly on big-ticket credit-financed items -- and to save more.
2. Housing.  Inappropriate government regulations may also be unduly restricting private borrowing to finance needed housing construction -- which, in the U.S., tends to be the largest user of private Primary Credit.
3. Industrial companies with widespread excess capacity and declining profits have little incentive to borrow the cheap credit to finance new investment.

4. Banks, with their equity capital reduced by depressed stock and real estate prices, and with huge amounts of bad debt, are fearful of making more potentially non-performing loans -- even loans which would be quite sound in a prosperous economy.
5. Households, fearful of bank failures, withdraw checkable deposits in order to hold their money in the form of currency (at very low interest-opportunity cost), thus enlarging the "inactive" part of the already inadequate money stock and increasing the Money Demand Ratio. In a fractional reserve banking system, this also tends to reduce the banks’ reserve balances and their effective ability to make even profitable loans.
 

6. The Bank of Japan, with short-term interest rates already near zero (as in the U.S. in 1932) is reluctant to pump more reserves into the banking system for fear of reducing the exchange rate and further destabilizing other Asian economies.[3]
7. The Government, trying to "stimulate" the economy by traditional NIPA-based Keynesian policies, uses increased government public works spending (which is inefficient and inappropriate for a flexible stabilization policy), and ad hoc tax cuts. Without a reliable empirical measure of the National Credit Balance (which IDMF-based integrated national accounts could produce), and no clear distinction between the Policy and Stabilization components of the federal deficit, it may have no clear idea of whether there is actually a Policy Deficit, or the magnitude of the Stabilization Deficit actually needed to facilitate the needed money growth.

Temporarily [5] reduce the most easily adjustable withholding or sales tax rate enough to increase the total federal budget deficit enough to increase real interest rates to their long-term norms (which, in Japan, are very low by world standards). [6] This could be done most precisely and efficiently by the FASTA (Formula-Administered Stabilization Tax Adjustment) fiscal policy tool.

If economic uncertainty causes the public to save part of the tax cut rather than spend it, the FASTA policy tool would merely continue cutting the tax rate and increasing government borrowing until the supply and demand for credit is re-balanced at normal interest rates. Establishing this credit balance, so as to permit Monetary Policy to finance a suitable recovery rate of money growth, should be the primary consideration in fiscal policy, no matter how high the Stabilization Deficit goes. An economic crisis of this severity should be considered the moral equivalent of war, and wars tend to be financed very largely by government deficits.

This tax cut would undoubtedly be popular with most of the public, and would thus offer political support for the less palatable structural reforms.

This method of raising interest rates to reduce capital flight would tend to be more effective, and cause fewer bankruptcies and less unemployment, than trying to do it by restrictive monetary policy.

Monetary Policy

Determine the current trend value of the Money-Demand Ratio (MDR) growth rate as soon as possible, because it is likely to be significantly distorted by the current excessively low interest rates and financial fears. Then make sure that bank reserves are increased enough to enable the banks to buy enough of the increased treasury securities (and enough private sector loans that would be economically sound in the anticipated better financial environment) so that the M1 money supply can be increased according to the Monetary Policy Formula.

If these two crucial policy tools had been in place during the 1980s, it is highly likely that the "bubble economy" would not have developed.

 
5. Likely immediate effects
 
These precise and systematically coordinated macroeconomic policies, based on generally understandable formulas, [7] rather than ad hoc analytical judgments and political decisions, would tend to greatly improve the general economic environment, with the following specific effects:

1. Dramatically increase confidence  among Japanese businesses, consumers and international investors.
 

2. Increase consumer spending.  The FASTA-induced tax reductions would directly increase consumer after-tax incomes and spending, [8] which would increase employment, and thus further increase incomes and spending, in a continuing "virtuous" recovery spiral. If consumers believe that the accompanying rapid money growth will cause inflation, that would further increase their spending, to beat price increases. But because total spending would be controlled by the coordinataed monetary/fiscal policy, these fears would not actually cause inflation.
3. Increase credit liquidity.  The New-Money-financed increase in the total supply of credit would lubricate the economic gears by injecting more "liquidity" into the interdependent chain of credit relationships to provide a "virtuous" credit chain reaction.
 

4. Make possible a healthy adjustment of bank and business balance sheets.  Putting general economic recovery first would make possible a more appropriate evaluation of bank and business assets. Instead of writing down the value of assets to their present severely depressed market levels, they could be adjusted gradually upward to levels that would be economically sound in a prosperous (but not boom) economy. This would greatly reduce the extent of "needed" bankruptcies, make it easier to sell off foreclosed property, and reduce the discount-cost to the government of liquidating those banks which actually need to be liquidated. [9]
5. Increase banks' ability and willingness to lend.  Immediate reversal of the downward spiral, and adoption of a credible, comprehensive, integrated recovery program, would cause a rebound in stock market and property values, thus increasing the banks' equity capital ratios, and thus their ability lend. The accompanying improvement in their customers' credit-worthiness and reduction in non-performing loans would increase their willingness to lend. Moreover, a rise in interest rates is generally helpful to banks.
6. Increase the political acceptability of temporarily subsidized government loans.  The government is able to take a longer-run view of a business’s credit-worthiness because the government, unlike a private bank, can engineer the economic recovery that will make the loans more viable.
7. Increase the Yen exchange rate.  The higher interest rates and increased confidence would directly tend to reduce investment capital outflow and stimulate more inflow, which would further strengthen the Yen. A stable, credible macroeconomic policy would also tend to minimize speculative fluctuations.
8. Shift the focus of recovery policy from trying to increase exports -- in competition with other countries’ efforts to do the same thing -- to increasing Japanese domestic demand.
9. Help other Asian countries recover.  The rising Yen exchange rate would reduce competitive pressure on China and other Asian countries to further devalue their currencies. Since Japanese recovery would also tend to stimulate these other economies by increased exports to Japan, it would help to reduce their debt problems and the incentive of foreign investors to further withdraw capital.
10. Improve international coordination of monetary and fiscal policies.  If this formula-based coordination of monetary and fiscal policy works successfully for Japan, it will serve as a model for other countries, and also for international coordination of national monetary and fiscal policies, particularly in the new Euroland. It would also probably suggest a further reduction of the U.S. Policy Deficit (excluding Social Security Trust Fund surpluses) and resulting reduction of the still-high US real interest rates, which would be helpful to Japan.
11. Provide a conceptual framework for coordinating macro and micro economic policies.  If the IDMF conceptual framework, which systematically nets out intermediate credit flows, were applied to individual Japanese business accounts it could simplify the problem of determining where in the credit-chain would be the most strategically useful places to provide additional government financing to complement the macroeconomic policies.