MW-08 -- Is Heizo Takenaka Mr. Depression?

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 8
Wednesday, December 4, 2002
Tokyo

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Viewpoint: Is Heizo Takenaka Mr. Depression?

The Bottom Line:

o Japan's Heisei Malaise has evolved from a simple overhang of
bad debts following the bursting of the excess credit bubble
of the 1980s into a debt deflation spiral. If the government
thinks that 1 percent deflation a year is worrying, try the
25 percent implosion in consumer prices seen in the four years
prior to 1933 in the US, or the explosion of the debt-to-GDP
ratio from 1.8X in 1929 to 2.8X at the peak.

o The Hashimoto faction within the LDP is trying very hard to
portray Heizo Takenaka as "Mr. Depression," the nickname for
US president Herbert Hoover. As they tell it, not only is the
Koizumi administration refusing to aggressively stimulate the
economy by abandoning his cap on JGB issues, but Takenaka is
even worse than Hoover in trying to push the major banks into
default so that they can be nationalized, while providing no
safety net for corporations and the economy.

o Japan has already been fighting deflation through conventional
policy means for the past 10 years in terms of both monetary
policy and fiscal policy, with little favorable lasting
impact. Moreover, it is MoneyWatch's view that both Koizumi's
reform opponents and the Koizumi administration itself are
vastly under-estimating how much a real cleanup will cost. If
South Korea's case is any guide, it will cost Japan in the
neighborhood of 150 trillion yen, or over 30 percent of GDP.
It may also very well cost them a major sell-off in the bond
market and a substantial depreciation in the yen. Some
1,158 trillion yen of capital value in the property and stock
markets has already been destroyed, and it's not over yet.

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JUST EXACTLY WHAT IS THE HEISEI MALAISE?
In its recent economic analysis of Japan, the OECD states the obvious
in observing that Japan must manage a transition from a system that
once worked well but that is now ill-adapted to a rapidly changing
environment. To outside observers, Japan has a dysfunctional banking
system, widespread balance sheet problems, an ineffective monetary
policy with zero interest rates, a persistent GDP gap (where actually
GDP is well below potential GDP, i.e., there is excess capacity or
insufficient demand) and deflation. As William Pesek writing for
Bloomberg has observed, it's "a perfect financial storm."

Japan tried to avert the negative impact of a deflating asset price
bubble with classic Keynesian policies, which state that government
spending is more effective in raising aggregate demand than are tax
cuts. And while economists, political observers and market pundits
have widely criticized the Japanese government and Bank of Japan for
botching the job, a study by Federal Reserve Board economists suggests
that the Japanese government and the Bank of Japan did about as good
as they could have with imperfect information. Indeed, domestic and
foreign economists and financial market participants are in no
position to throw stones, as they also failed to forecast the slump
and the onset of deflation.

In perfect hindsight, Fed economists suggest, if the BOJ had cut rates
by 200 basis points anytime between 1991-1995, Japan might have
avoided deflation. The other suggestion was that, instead of spending
too much fiscal resources on the problem, the Japanese government may
have spent too little, as the impact of the stimulus packages only
worked to temporarily offset declines in private capital
investment.

FROM POST-BUBBLE OVERHANG TO DEBT DEFLATION
There is remarkably little economic theory devoted to deflation.
The world's central banks and certainly the BOJ were geared to
fighting the last war, which was inflation, not deflation. One
definition of deflation is that it is a pure monetary disorder, and
that adjustment for monetary deflation takes time, eventually forcing
all nominal prices to fall -- wages, assets, and goods/services.
Modern money, as it is not backed by gold, is essentially non-interest
bearing debt of the government. Deflation can be expressed as a
significant undersupply of money relative to demand and occurs when
the central bank fails to match supply and demand of money in the
marketplace. Another definition is that inflation/deflation depends
largely on the size of the output gap. If the current sustainable
level of GDP is below potential (meaning there is excess capacity),
inflation can fall and keep falling, even if the economy is growing
briskly, and until GDP rises back to potential and the negative output
gap is eliminated.

Thus deflation in and of itself is not necessarily bad. During the
last 30 years of the 19th century, consumer prices in the US fell by
almost half as the railways and technological advances brought cheaper
ways to make everything and productivity was high. Real US GDP growth
during the period was 4-plus percent. This was the sort of scenario
envisioned with the IT revolution and globalization. Increased
efficiencies would produce price declines, but the productivity gains
of the "new economy" would ostensibly produce rising real wages and
higher economic growth.

PRELUDE TO DEPRESSION
But deflation amidst excessive debt levels is another matter entirely.
Indeed, history tells us that it is the prelude to a depression. The
common prognosis for debt deflation is to print more money. However,
modern central banks and, most certainly, the Bank of Japan find such
suggestions revolting. This is because, dyed into the pinstripes of
the central bankers' suits is the notion that excessive money creation
causes an inherent inflationary bias, while written into the charters
of central banks is the notion that their marching orders are to seek
price stability as their main, if not their only, goal. Instead of an
"irresponsible" monetary policy, the BOJ instead stuck to a commitment
to stable prices and to a strong yen. It was only after conventional
monetary policy tools were clearly not working that the BOJ
reluctantly began to experiment with unconventional monetary
operations (i.e., quantitative easing).

As Japanese policymakers re-discovered first, and now the US is
beginning to realize, debt deflation is not as easy to prevent or
eradicate as first thought. Debt deflation is not easily curable by
conventional policy prescriptions such as interest rate cuts, tax
cuts or fiscal stimulus. Unlike stock prices, the aggregate level of
prices in an economy does not fall quickly and easily.

It wasn't until 1992 that the BOJ and the government realized they had
a bad debt problem, but it took even longer to grasp that this
economic cycle was different from its predecessors. Deflation raises
the real burden of debt while the value of assets mortgaged to support
the debt may have to fall even more sharply in nominal terms to return
to a fair level. The 1,158 trillion yen deflation in stock and
property values during the Heisei Malaise has caused severe balance
sheet problems. The initial decline in prices theoretically merely
allocates wealth from debtors to creditors, who seize collateral and
call in loans. In the Japanese banks' case, this didn't happen.
Instead, they practiced "forbearance lending," which is a nice term
for additional loans and eased credit conditions to keep zombie
companies alive. But continued deflation in the value of assets on
bank balance sheets (through both shrinking values of loan collateral
and falling stock prices that produced a 231 trillion yen shrinkage
for all financial institutions) began to threaten the viability of the
banks themselves.

Given the weakened condition of their balance sheets, the banks ceased
to perform their traditional economic role as money multipliers, which
in turn rendered conventional monetary policy largely ineffective and
put monetary policy in a "liquidity trap," where additional amounts of
monetary stimulus failed to produce the usual "trickle down" effects
into the real economy.

Thus the situation has deteriorated from a mere post-bubble overhang
of debt into full-fledged debt deflation territory. The negative
impact of debt deflation in Japan is already bad, but it could get a
lot worse. Price declines of 1 percent per year, even though the
declines have continued for almost eight years, is, in historical
context, not yet a deflation spiral. In the four years prior to 1933,
the US consumer price index fell by 25 percent, while real GDP fell by
30 percent. Total US debt to GDP soared from 1.8X in 1929 to 2.8X at
the peak in the early 1930s.

TURNING THE DEBT DEFLATION TIDE
To boil Japan's problems down into several key issues, Japan is
experiencing:
A) Debt deflation
B) A liquidity trap in monetary policy
C) Excess savings over investment (GDP gap)

To overcome the liquidity trap, the BOJ is being forced to venture
beyond conventional monetary policy measures that depend upon a
normally functioning, as they have already begun to do, beginning with
"quantitative easing" measures, and now direct purchases of stocks
held by the banks. This move, initially aimed at prodding the
government to more aggressively push for early liquidation of
nonperforming loans (NPLs), has evolved into demands to directly
purchase the stocks of the banks themselves. To foster a permanent
uptick in inflationary expectations, however, the BOJ ostensibly would
need to do a lot more, such as purchase significantly more Japanese
government bonds (JGBs), expand its asset purchases to property, or
even aggressively purchase foreign assets to weaken the yen.

The downside of an aggressive inflation targeting program would be
that it could very well "kill" the bond market rally that has been the
mirror image of the bear market in stocks. That would make the
problems in the banking sector much worse. Moreover, trying to
generate inflation may have little effect on consumer spending despite
the disincentives; consumers would simply try and maintain their
wealth levels by saving even more, due to continued unemployment and
wage uncertainties.

In addition, if the BOJ were an "internationally active" commercial
bank, they would have long ago gotten a call from the Financial
Services Agency. As of September 30, 2001, the BOJ's own capital
adequacy ratio fell to 7.6 percent for the first time in 12 years, or
below the 8 percent regulatory capital ratio considered as a minimum
by the Bank of International Settlements (BIS). The drop below the 8
percent level was mainly attributable to an increase in outstanding
central bank notes. Near-zero interest rates and the lifting of
blanket government deposit protection is prompting an increasing
number of individuals to withdraw money from bank accounts and keep it
in their cabinet drawers. This increased demand for BOJ notes by
10 percent from the same period last year. If the amount of
outstanding bank notes keeps increasing in the second half, the BOJ
may be forced to reduce the "dividend" paid to the nation's coffers
from the profits generated from managing assets accepted in exchange
for issuing bank notes on behalf of the government.

The capital adequacy ratio at the BOJ fell 1 percent year on year in
the first half, and the purchase of stocks from commercial banks may
lead to a fall in net income, further deteriorating the bank's capital
adequacy ratio. Moreover, to keep its capital adequacy ratio as high
as possible, the central bank decided to postpone writing off some
losses from bond and foreign exchange trading. The reserves used to
write off these losses are part of the numerator in the
ratio-computation formula.

From the onset of the Heisei Malaise, the Japanese government has been
attempting to close the excess savings over investment gap (GDP gap)
with government spending in the form of successive public works
expenditures. Over the past 10 years, it has implemented 12 stimulus
packages and has nominally spent some 130 trillion yen, the effect of
which has essentially been to prevent the Japanese economy from
falling into depression. Koizumi may be repeating the same mistake
with his 30 trillion yen cap on new bond issuance that Hashimoto made
with his decision to push through a value-added-tax (VAT) in an effort
to rein in the spiraling government deficit while trying to keep
Japan's economy afloat. Japan's national debt at 140 percent of GDP is
projected to continue rising rapidly, and is behind the successive
downgrades in sovereign credit ratings. But as was seen in the US
during the 1930s, Japan's national debt burden may increase even more
sharply than current projections given a serious, coordinated effort
to turn the debt deflation tide.

Some pundits say Japan should pursue structural reforms that eliminate
the savings-investment gap. This view holds that consumers are saving
excessively due to anticipation that future output will fall as the
population ages, and because of current financial sector and corporate
sector uncertainties, consumers are holding back to a greater degree
than is otherwise assumed. The government thus needs to reduce
uncertainty by tackling the problems that corporations face. To break
the vicious circle, the government needs to recapitalize the financial
institutions and prevent another possible credit crunch. The longer
such policies are delayed, the more costly they will be. Further
consolidation within the banking industry and an acceptance of
government funds to write off bad loans is thus essential to turning
the deflation tide.

KEYNESIANS VERSUS REFORMISTS
The debate among Japan's dyed-in-the wool old-school Keynesians and
the new reformists wages on, amid heavy overtones of political
infighting. "Reform" Koizumi came into office promising "pain
before gain." The biggest bone of contention now is whether the bad
debt problem at the banks should be solved before, after or in
conjunction with full-fledged deflation fighting measures, and Heizo
Takenaka is epitomized as the main "pain before gain" proponent.
Japan has already been fighting deflation through conventional policy
means for the past 10 years, in terms of both monetary policy and
fiscal policy, with little favorable lasting impact. The Keynesians
believe that more fiscal stimulus and a "go easy" approach to the
banks for the time being is the only way out. Moreover, they believe
that in coming down hard on the banks, Takenaka is playing fast
and loose with the future fate of Japan as regards a possible
depression. They believe that putting the banks in
"retrench" mode would make them even more dysfunctional as financial
intermediaries, render monetary policy even more ineffective and
preclude any multiplier effect from fiscal stimulus while pushing the
economy into a depression through a rush of bankruptcies and
unemployment.

In particular, the Hashimoto faction within the LDP is trying its best
to portray Takenaka as Japan's "Mr. Depression," as Herbert
Hoover, the US president from 1929 to 1933, was nicknamed. In fact,
they are pushing hard to get him ousted before the end of this year.

ALL ROADS LEAD TO A WEAK YEN
The fact that Japan led the West in the current debt deflation trend
makes MoneyWatch uncomfortable, because it follows a similar sequence
of events in the 1920s, when Japan's depression and deflation began
before that of the US. DeAnne Julius, a former member of the Bank of
England's monetary policy committee, argued in a recent speech that
there is a one-in-three risk of a significant deflationary period in
the main economies between now and 2005. What also makes MoneyWatch
uncomfortable is the fact that economists and academics are
still arguing today about what actually caused the Great Depression in
the US in the 1920s, and, more importantly, what fixed it, which
implies they have no hard and fast prognosis to fix Japan's current
debt deflation.

MoneyWatch, like many overseas investors, is convinced that the yen
will eventually have to depreciate, either as a consequence of an
implicit policy to depreciate it with radical monetary policies, or
more likely as the consequence of a banking sector cleanup and
full-fledged efforts to reflate Japan's economy, which inevitably
would involve further declines in the stock market, a sell-off in the
bond market and soaring government debt.To give an indication of the
scale of government debt that would be required for a thorough
cleanup, one can refer to Japan's neighbor, South Korea. In Korea's
cleanup, the government used 155.3 trillion won in public funds (some
30 percent of GDP) to recapitalize the banks and purchase NPLs through
a government-run asset management company. In the process of the
cleanup, South Korea's GDP plunged 6.7 percent and unemployment soared
from 2.6 percent to 6.8 percent. In the process, the Korean won
depreciated by 58 percent.

Whether Takenaka goes down in history as Japan's Mr. Depression
remains to be seen. It does appear, however, that both the reformists
and the Keynesians continue to under-estimate the cost of the
cleanup. If South Korea's case is any guide, Japan could
end up spending another 150 trillion yen in the cleanup, on top of the
1,158 trillion yen already lost in equity and property values during
the period and the 130 trillion yen already spent on fiscal stimulus.

-- Darrel Whitten

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