FROM THE OFFICE OF PUBLIC AFFAIRS

It is a great pleasure for me to be here in Tokyo.  I have many friends here—colleagues in the Japanese government, in academia, and in the private sector. I am fortunate to have had a long association with the Bank of Japan, as a visiting scholar in the 1980s and as an honorary foreign adviser in the 1990s—a job that I regret I had to resign from when I joined President Bush’s Administration last year.  I lived in Tokyo for a short time in 1987—in the Aoyama neighborhood.  My wife and I chose to send our two children to the local Japanese school—Sei Nan Sho Gako.  My family will never forget the friendly welcome we received. I learned a lot about the warm hospitality of the Japanese people during that visit.

I also learned a lot about monetary policy and banking policy in Japan during that visit in 1987. Economic growth was still going strong; it averaged about 4 percent per year from 1974 to 1990, much stronger than the 1 percent since then.   Inflation was low, but positive.  Recessions were few and far between. From the vantage point of 1987, looking back over the 1970s and early 1980s, I attributed much of the responsibility for that smooth economic performance to Japanese monetary policy, and in particular to the steady growth of money, deposits, and credit at banks. This steadiness kept economic growth strong, it kept inflation in check, it avoided the boom bust cycle. 

On my return to the United States I talked a lot about the success of Japanese monetary policy with my colleagues and students, and with policy makers in Washington.  The good story, charts and all, was added to my textbook. As you know, learning from Japanese experiences is not confined to macroeconomics.  Secretary of the Treasury Paul O’Neill—another admirer of the Japanese people—talks a lot about how American manufacturing firms learned from the tough competition from Japan.

Today I would again like to talk about monetary policy and banking policy in Japan.  I came to Japan for the Financial Dialogue, part of the Economic Partnership for Growth established last year by President Bush and Prime Minister Koizumi.  The Partnership is a forum to candidly exchange views about economic policy in our two countries. I feel particularly fortunate to be able to come to Japan at this time, just after the naming of a new cabinet and the opening of the Diet session. 

Last month when President Bush and Prime Minister Koizumi met in New York they discussed the economy.  The Prime Minister told the President that he was making renewed efforts to restore economic growth in Japan by addressing problems in the banking sector.  We in the United States are greatly appreciative of these efforts.  We are encouraged by them. Higher economic growth in Japan would greatly benefit the Japanese people.  It would reduce unemployment. It would provide greater resources needed to deal with pressing problems such as maintaining security and improving the environment.  A healthy vibrant Japanese economy is critically important for the world at this time.  

I see no reason why—with the right policies—Japan could not return to the “3 percent plus” economic growth of the 1970s and 1980s. Getting monetary policy and banking policy right is essential to restoring economic growth in Japan, and that is why I want to concentrate on them today.  A theme of my talk is that neither monetary policy nor banking policy can fully succeed without the other in achieving the goals of strong economic growth.  

Monetary Policy

First, let me consider monetary policy.  To restore strong economic growth in Japan, deflation must be stopped.  Deflation wreaks havoc with business balance sheets; it discourages investment; it leads people to postpone spending.  With the consumer price index falling at about 1 percent per year, and the broader GDP deflator falling at about 2 percent per year, deflation has become persistent in Japan. Aside from an increase in 1997 when the consumption tax was raised, prices have been falling in Japan for the past 7 years.

Deflation is damaging to the operation of the banking system, and this is one of the key links between monetary policy and banking policy that I want to emphasize today.  With deflation, interest rates become very low -- very close to zero. Near-zero interest rates reduce the need for banks to deal with problem loans.  With very low interest rates, borrowers can easily meet their interest payments to the banks, and loans remain performing year after year even if the firm is struggling and needs to adjust its business operations.  Firms and banks would face these decisions at a much earlier stage if interest rates were greater than zero. As a result of the delays, failure, liquidation, and loss of jobs can be much greater than if the adjustment were made earlier.

In March of last year, the Bank of Japan made an important change in monetary policy.  It announced that it would provide ample liquidity until the inflation rate was equal to or greater than zero; that is, until deflation is ended.  In fact, in the year and a half since that announcement, the Bank of Japan has significantly increased money as measured by the monetary base—bank reserves plus currency. The monetary base is up 34 percent since the Bank of Japan began its new policy.  However, broader measures of liquidity that are more closely associated with general price increases have not grown nearly so rapidly.  The growth rate of broad money, which includes individual and business deposits at banks, has hardly increased at all.  Moreover, bank lending has not increased.  Even after adjusting for loan write-offs, bank lending is down 2.6 percent over the past year and consumer prices are still falling. 

Why has the increase in the growth rate of the monetary base not resulted in higher growth of loans and deposits at banks or a rise in prices?   One reason may be that the increase in the monetary base has not been sustained for long enough.  So, it is important not to reverse the policy of the last year and a half, not let the growth of the monetary base decline.  This will eventually require increases in reserve balances banks hold at the Bank of Japan -- a key component of the monetary base.  Can we say how much of an increase will be needed?  It has been some time since a major country has had to overcome persistent deflation.  But experience in other countries—for example, Sweden during the 1930’s—suggests that larger increases in the monetary base, sustained over time, are necessary to break deflation’s grip.  

There is another important reason why the increase in the monetary base has not yet worked, and that is non-performing loans in the banking sector.  To put it simply, funds loaned by commercial banks and spent by the borrower create deposits at other banks that can then be lent out to other borrowers.  This is the way that an increase in the monetary base leads to an increase in the amount of broad money and higher prices.  But banks that are burdened by non-performing loans do not seek out new, profitable loan opportunities, even when they have excess reserves.  Hence, a change in banking policy that effectively deals with the non-performing loan problem will lead to more banks and more businesses seeking out new opportunities and creating new loans.  It would significantly increase the ability of the Bank of Japan to increase broad money, increase lending, and raise the price level.  And this brings me to banking policy.

Banking Policy

The recent report by the Bank of Japan highlights the nature of the non-performing loan problem. The report effectively argues that non-performing loans are not simply the legacy of the old bubble days, but reflect continuing problems in the banking sector. There is growing recognition that the problem must be quickly addressed.

Problem loans exert a heavy toll on banks. Heavily burdened banks lose the ability to focus on new lending and new business opportunities.  A banking system that is weighed down by bad loans can’t fulfill its role of gauging risk and return and channeling savings to the most profitable investments.

Banking problems also exert a heavy toll on the economy. Borrowers who are not servicing non-performing loans are frequently the owners of assets—property, buildings, capital equipment—that are not being used productively or profitably.   Unresolved loans freeze these assets in place and prevent them from moving to more profitable activities.  In industries where there is excess capacity, failure to deal with non-performing loans locks in the excess capacity, worsening deflationary pressures.

If this were simply a matter of reducing debt, the problem would be easy to solve.  Over-indebted borrowers are almost always over-extended businesses—having expanded into activities with little economic return.  Addressing the problems of the borrowers usually requires substantial restructuring in order to identify a profitable business core, and in some cases liquidation of the borrower is the only alternative.

For the ¥44 trillion in loans classified by banks as bankrupt or in danger of bankruptcy, these harsh choices are clear.   But a more corrosive problem arises with loans that are performing, but owed by companies that are barely able to keep afloat, have little prospect for long-term survival, and no possibility of ever paying back the loan.  As I discussed earlier, these firms may be able, in Japan’s low interest rate environment, to scrape together their required interest payments. 

How many of the roughly ¥100 trillion in “need attention” loans fall into this category and are likely to become non-performing loans is at the heart of the dispute about the size of Japan’s bad loan problem. Dealing with these firms—before they spiral into bankruptcy, and while there is still value and employment that can be salvaged—is a critical issue. 

One should not underestimate the costs of addressing the bad loan problem, and recent discussions of providing a safety net for workers who are unemployed are welcome.  But the longer Japan takes to resolve the problem the greater these costs will be.  It is also important to emphasize the gains from removing the heavy weight that the wounded banking system represents.  Other countries that addressed severe banking crises – Sweden, Finland, and others – saw initial rises in unemployment but then the resumption of more rapid growth that restored employment.  At the same time, failure to address the non-performing loan problem has not spared Japan the pain of unemployment.  If Japan could restore the average unemployment rate of the 1980’s it would mean millions of additional, permanent jobs.

There are already some visible successes.  The turnaround at Nissan is a striking example. The activity in the BIC camera store, formerly a branch of the Sogo Department Store, is visible to anyone who walks through Yurakucho. Another example is Victoria Sportswear.  Jafco—Nomura’s private equity group—organized a leveraged buyout to rescue a profitable ski and sportswear operation from a company that had failed under a load of over $1 billion in property-related debt.  And a debtor rehabilitation plan for the apparel manufacturer, Liberal, was able to create a profitable reborn company.

For economic growth to increase in any country it is necessary for productivity growth to increase.  Productivity is the amount of goods and services that workers can produce in a fixed period of time such as a day or year.  Productivity growth is driven by the ability to move productive resources – labor and capital equipment – from low productivity activities to high productivity activities.  Here the Japanese economy is striking.  It combines industries where productivity is the highest in the world, with industries that lag behind their counterparts in other countries.  In no other major country are the differences between leading and lagging sectors as large, or the potential productivity gains so great from closing the gaps.

Consider food processing, an industry that employs 11% of Japan’s manufacturing workforce.  If one could raise productivity in Japanese food processing to the level of France—a country with equal attention to quality, freshness, and presentation—then productivity in the Japanese economy as a whole would rise by 1.64%.  

The Japanese government is developing measures to deal with the non-performing loan problem.  Financial Services Minister Takenaka has already described principles that will guide their approach to banking policy.  The first is assuring that banks accurately classify their loans and that they hold sufficient provisions against losses.  The second is assuring that banks are adequately capitalized.  And the third is improving the corporate governance of banks, to assure that they operate both effectively and profitably.

These goals make great sense to me.  Accurate loan classification and provisioning means that banks recognize likely losses immediately, eliminating the incentive to postpone losses by postponing action. Adequately capitalized banks risk their shareholders’ money, and have strong incentives to operate prudently.  

Much of the current debate in Japan has centered on the use of public funds to strengthen the banking system.  Major banking crises almost always result in a cost to the taxpayer.  Japan has already used public funds to try to strengthen its banking system, and more may be required.  But I agree strongly with statements made by the Japanese government that public funds are not a solution in themselves.  Effective banking reform can be aided by the use of public funds.   But using public funds without condition is a recipe for moral hazard and delay.

The Broader Context of Economic and Foreign Policy

 I have concentrated on monetary policy and banking policy today because I feel they are so essential right now. To be sure, there are other economic reform issues. As in any other country, a sound fiscal policy, an efficient tax system with low marginal tax rates, and free and open trade are also important parts of an economic plan.   It is good to hear that tax reform, structural reform, and regulatory reform are part of the long term agenda in Japan.  The deregulation of Japan’s cellular telephone industry provides a vivid example of a good reform.  

There is also an important foreign policy context for my remarks.  One of the great pleasures I have had on my job at the U.S. Treasury is interacting with my Japanese colleagues in areas of foreign policy and, in particular, the area of reducing poverty in the poor countries.  In this regard, the enormous help from Japan in the reconstruction of Afghanistan is important to recognize. Japan has been a co-chair of the Afghanistan Reconstruction Steering Group along with the United States, the European Union, and Saudi Arabia. The government of Japan hosted a major donors’ conference in Tokyo in January of this year, where President Koizumi gave truly inspiring remarks.  And Japan pledged $500 million to that effort. Japan is now working with the United States on a major road building effort and has helped bring the Asian Development Bank into the reconstruction effort. And I have recently been working closely with Ambassador Nishimura, the coordinator for Afghan reconstruction in Japan, to find ways to better fund the operating budget of the new government of Afghanistan.  I have appreciated how flexible Japan has been in finding the badly needed resources. 

But what is the relevance of reconstruction in Afghanistan for my talk today?   It is simply that large financial resources like this, which are so important for peace and security around the world, require strong economies in donor countries.  Funding to provide these resources comes from tax revenues paid the Japanese people as they produce and earn wages and profits.  If economic growth continues to falter then these tax revenues will not grow; in fact, tax revenues have fallen off as the economy has grown slowly in recent years. 

So a strong Japanese economy is not simply a matter of economics.  A healthy, vibrant Japan is a Japan that can take its proper place on the world stage – a critical factor in the security of this region and the world.

Concluding Remarks

In conclusion, let me briefly summarize.  Monetary policy actions and banking policy actions—together, not separately—are essential to end deflation and restore sustained economic growth in Japan. 

Regarding monetary policy, the Bank of Japan has taken steps since March of last year to increase the monetary base; it is important to sustain this higher growth rate, especially if past experiences with ending deflation are a guide.

Regarding banking policy, non-performing loans problems at the banks are still a serious problem and must be quickly addressed.  We welcome the emphasis that the government of Japan has placed on this problem.  These non-performing loans limit the ability of monetary policy to end deflation. And, perhaps most important, the non-performing loans are now preventing higher growth rates directly by discouraging productivity enhancing changes in the Japanese economy.