A sluggish rate of GDP growth is the most important issue facing Japan's economy today. Low inflation, a strong trade surplus and low interest rates are signs that Japan is operating below capacity, which suggests that a deficiency in aggregate demand is the short-term culprit. In fact, it is so low, presently, that Japan seems to be caught in a "liquidity trap", an economic state that previously had only existed in theory. This is a situation in which interest rates fall so low that demand does not react. Certainly, this can be related to the structural problems that plague Japan: the country is in a liquidity trap because consumers don't have enough confidence in the system to spend their money. For example, in a country where large firms, especially banks, have historically been saved from bankruptcy by the government, more and more failed businesses have been reported. Layoffs and increasing rates of unemployment signal that lifetime employment is no longer secure. Stories of corruption at high levels in government and major corporations have shaken the faith of the populace. These problems can only be remedied by restructuring the system in the long run, however, the instability of this may exacerbate the problem in the short run. Therefore, macroeconomic policy may be the best approach for now. Through massive capital infusions, relaxing fiscal policy, and taking steps to encourage consumer spending, the government can hope to raise aggregate demand to a point where it will kick-start the rate of GDP growth. This will help raise consumer confidence such that the adjustment pains from eventual restructuring may be easier to bear.
Figure 1 - The Liquidity Trap
The economy is in a "liquidity trap" if the IS curve intersects the LM curve somewhere in this flat portion. In this case, falls in money wages may push the LM curve to the right (in our Figure 1, from LM1 to LM2), but the equilibrium level of output Y* and equilibrium interest rate, r* will remain virtually unchanged and we move nowhere nearer the full employment output level, YF. In short, the "Keynes effect" will be disabled.
To achieve the economic stability, Japan must do the daring internal restructuring through deregulation and administration reform that is stronger than ever to solve the problem. The real solution is to free up the economy, liquidate the malinvestments and cut taxes further. Also Japan in effect needs inflation, because it needs a negative real interest rate.
Keynes argued that interest rate was determined by liquidity preference and the supply of money. But the liquidity trap clearly assumes that the demand to hold money is determined by the rate of interest, meaning that this demand should vary inversely with changes in the rate of interest.
In the 1990s, macroeconomic policy options were exercised to deal with the economic bubble burst in 1991. In 1995-96, monetary policy was loosened, and a variety of two-year tax breaks was given. Subsequently, the growth rate reached 3.9% in 1996. The strength of this comeback was overestimated. In 1997, fiscal tightening (April consumption tax increase to 5%, and September increase in health care costs to the individual), which totalled about 2% of GDP, was intended to curb the growing government deficit. Concurrently, the true extent of the banking crises became known. Investment bust and government inaction led to most of the decline, as succeeding macroeconomic policies in late 1997/early 1998 were too conservative to be useful.
If immediate growth stimulation is to be seen, Posen is correct in arguing that the following measures must be taken now: permanent tax cuts to the tune of 3%of GDP, an inflationary goal of 3% in the next one to two years, and serious reform of the banking system that forces mergers, accountability, and the offering of a high degree of short-term government securities. Naturally, this will increase the government debt, which is nearing 95% of GDP. But, Japan is quickly running out of macroeconomic policy options. Posen's suggestions will buy Japan some needed time while leaders induce structural reforms in the tax system and banking/financial sectors. If progressive enough, these policy, changes may realize close to full potential, and could subsequently be followed by significant changes in the industrial sectors, where total factor productivity has much room to grow, which would in turn induce long-term, sustainable growth.
Fiscal policy has played a major role in supporting economic activities. The government launched the Policy Measures for Economic Rebirth, aiming to achieve a smooth transition from public sector-led growth to private sector-led growth and to put the Japanese economy back on the path of full-fledged recovery.
Monetary policy: Facing the severe economic situation, the Bank of Japan (BOJ) followed the "zero interest rate" policy since early 1999. Short-term interest rates were virtually zero in 1999, except for a period in which money demand rose because of the Y2K issues. The BOJ terminated the zero interest policy in 2000, and short-term interest rates have made a slight increase after that. Although the stringent corporate climate finance has been relieved not only for large firms but also for medium-sized firms, lending by financial institutions remains stagnant. Monetary policy is seemingly impotent to stimulate demand and raise spending since interest rates are already at the lowest point possible--no one would normally be willing to hold bonds with negative yields over (zero interest-bearing) money. In a liquidity trap monetary policy does not work because the markets expect the bank to revert as soon as possible to the normal practice of stabilizing prices; to make it effective, the central bank must credibly promise to be irresponsible, to maintain its expansion after the recession is past.
It is indispensable to create strong demand, leading to inflation to produce negative real interest rates to get out of the trap. The foolproof way is to announce (1) an upward-sloping price-level target path to be achieved. The price-level target path provides the best nominal anchor and also an exit strategy for the temporary peg. It should start above the current price level, by the “price gap” to be undone. (2) a depreciation and a temporary peg of the yen, the initial depreciation of the yen should be so large that it results in a real depreciation relative to any conceivable long-run equilibrium real exchange rate and (3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. The expected future real appreciation of the yen will induce a desirable fall in the long real interest rate in Japan. This fall in the long real rate in Japan can also be seen as the result of the increased inflation expectations noted above. Then, the BOJ and the MOF just have to behave accordingly.
CONCLUSION
Although Japan's economy faces some serious structural problems, the focus should be on macroeconomic questions and solutions in order to stimulate growth.
One critical structural problem is Japan's financial system. For instance, banks are not competitive enough and do not fully evaluate risks. Another structural problem involves the dual economy in which protected domestic industries are not forced to compete on an international level due to the fact that imports are kept low. Both these and other structural problems must be corrected in the future. Currently, the most crucial problem is the lack of aggregate demand. In the era of catch-up growth, huge savings were absorbed by investment. However, as investment has naturally waned, consumption has not stepped up to absorb investment, thus leading to low aggregate demand. The government could spend more, in the form of public works projects, for example, but running huge budget deficits is not sustainable. Moreover, maintaining large trade surpluses, which could also stimulate aggregate demand, is not feasible in the long run either. The best solution involves a mixture of monetary and fiscal stimulus. As Posen argues, an inflation target of approximately three percent per year combined with permanent income tax cuts will help stimulate aggregate demand and allow Japan's economy to grow again.
APPENTIX
REAL GDP
INFLATION % INTEREST RATE % UNEMPLOYMENT % billions of Yen
1980 9.21 1980 7.79 1980 2.0 1980 290706.9
1981 4.80 1981 8.66 1981 2.2 1981 299737.7
1982 2.80 1982 8.02 1982 2.4 1982 308768.5
1983 1.93 1983 7.42 1983 2.6 1983 316079.2
1984 2.23 1984 6.80 1984 2.7 1984 328550.4
1985 1.96 1985 6.34 1985 2.6 1985 343171.7
1986 0.64 1986 4.60 1986 2.8 1986 353062.6
1987 0.11 1987 4.21 1987 2.8 1987 367684.0
1988 0.74 1988 4.27 1988 2.5 1988 390476.1
1989 2.21 1989 5.05 1989 2.3 1989 409397.8
1990 3.09 1990 7.36 1990 2.1 1990 430039.8
1991 3.30 1991 6.52 1991 2.1 1991 446381.3
1992 1.74 1992 4.94 1992 2.2 1992 451111.7
1993 1.24 1993 3.69 1993 2.5 1993 452401.8
1994 0.66 1994 3.71 1994 2.9 1994 455412.1
1995 -0.09 1995 2.53 1995 3.1 1995 461862.7
1996 0.19 1996 2.22 1996 3.4 1996 479924.4
1997 1.68 1997 1.69 1997 3.4 1997 484224.8
1998 0.62 1998 1.10 1998 4.1 1998 470033.5
1999 -0.29 1999 0 1999 4.7 1999 464012.9
2000 -0.70 2000 2000 4.9 2000 466163.1
References:
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Sato, K (1999) “The transformation of the Japanese economy”, UK: MG Sharpe Inc.
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“Japan” http:/www.eia.doe.gov/emeu/cabs/japan.html
- “ Japan still trapped”,
http:/web.mit.edu/krugman/www/japtrap2.html
4) Japan and the liquidity trap: another Keynesian fallacy. http://www.newaus.com.au/econ74japan.html
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The Hicks- Hansen IS –LM Model http://cepa.newschool.edu/het/essays/keynes/hickshansen.htm
