Speech of Professor Motoshige Itoh At the event organized by Thai-Japanese Association December 17, 2002 At the Bangkok Club, Bangkok, Thailand.

Speech of Professor Motoshige Itoh At the event organized by Thai-Japanese Association December 17, 2002 At the Bangkok Club, Bangkok, Thailand. Good afternoon ladies and gentleman. It s my great honor to be here to talk about Japanese economy. Please allow me to speak from the display for you. I am going to talk about 30 or 40 minutes. I would like to invite your comments or questions after that. And I hope we can have some kinds of bilateral discussion on the issue. Now as all of you know very well Japanese economy is in a big trouble. The important things are what the reason is and why it took so many years for Japanese economy to recover from the present difficulties. And also when and how it can recover from its present situation. Before I m going to the detail of Japanese economy, as a professor in university I would like just to present the two very fundamental economic theories, which are very important, I think, for the understanding of Japanese economy. One theory is what economists call the convergence theorem. The convergence theorem is just something about the long-term perspective of economic growth along the stage of economic development. For the country like Japan, says 30 years ago or for the country like Thailand or even for the country like China where the economy is in the process of catching up, it is possible to grow at the rate of 5% or 7% or even more than 10% for some period of time. It is when we can afford the importing of the best practices of technology form the frontier economies such as the United States or the Europe. And also those economies are very young just like human being. When they are young they are very active and they can just grow very rapidly. But convergence theorem says once the economy just reaches the stage of the socalled mature economy it cannot grow very rapidly. Europe is very good example. They just grow less than 2% on average. And the United States in the 1990s, maybe it is the exception. The United States could grow at sometimes 4%. But you know that was bubble. After just the crash of bubble in the beginning of 2000s, people found out that even a dynamic economy such as the United States maybe can grow at most 2% or 3% per year. That is a kind of very natural thing when the economy just hits the stage of frontier. They cannot just borrow or import the idea from some place else. They have to invest themselves and invent their own technology. Japan is in a very similar stage. So you have to make distinct between Japan in the high growth period and Japan in the future. There is another important economic theory. When the economy is in a boom for a long time it will take more time to adjust from boom to the next boom. Now in the case of Japan, we started the rapid growth probably around 1955 10 years after the end of the WWII. At that time the share of the Japanese economy in the world production was only 2%. Japan was a very small economy. Now just before the crash

of the bubble in 1990s the share of the Japanese economy in the world production was probably around 16% or 18% depend on exchange rate. As you probably know, there is no one country in the history which expanded so rapidly for so long period and just grew from the very minor economy to the second largest economy in the world only in 30 or 40 years. But that long period of growth just built in a very specific or very strange economic structure in Japan. That kind of economic structure cannot be sustained forever. The last 10 years of difficulty of Japanese economy is in the process of adjustment. Because we enjoyed more than 30 years high growth that means we need more time to adjustment. Let me just first go to the last page of my presentation. It simply summarizes the long term prospective of Japanese economy. What is the future picture of the labor market of Japanese economy? And what was the past picture of the labor market of the Japanese economy? It will move from the long-term growth or long term relation to a more mobile or liquid market. Because I am the professor of economics I have many opportunities to give seminars to business community in Japan. Sometimes the audience was more than 400 or 500 people. But always the female audiences in my seminar are less than 3%. Just the other day I had a good opportunity to talk with owners of supermarket and audiences were something like 600 and they had no female manager in that seminar. That is the kind of typical picture of the Japanese business community. As you probably know, we have a very famous so called the lifetime employment system. Many young students when they graduated from university or from high school just become a member of some company and when company grows then workers become very happy and when workers work very hard the company will just grow rapidly. That kind of mutual relationship was very important part of the dynamic growth of Japanese economy. That is one of the secrets of the growth of Japanese economy. But because of that we have utilized only 15% of population for business activities. It is surprising. We are using only 15% of population but we could grow this way. But now the situation is changing very rapidly. I am teaching at the university so I am just looking at the situation of young people. Of course 50% of good students even in my university are now becoming female students. Even the best student who get honor from my department was female student last year. These very brilliant young ladies as well as brilliant young boys are parts of business community now. These people will probably support our economy in the future. I am saying that our economy has a very bright prospective because we are going to utilize 100% of the population for business activities. In the future may be 10 years or in 15 years we will have a lot of perspectives but the problem is the adjustment. We have to change to more male and female combined society and it is very difficult process. That is one of the reasons why we just observe the increasing of unemployment rate. That is the reason why we are increasing the number of suicide because of the desperate of the future by middle age male workers. I am not just saying everything is good. That is a kind of typical picture of Japanese economy. We actually do necessary adjustment. But the magnitude of adjustment is far more than we expected 10 years ago.

How about financial market? This is very important part of the adjustment. I am going to discuss in more detail. If I just simplify the basic feature of our financial market is now moving from the so called loan based society. We depended so heavily on banking system and we have to just move from the so called bank dominated system to more diversified financial market which means the increasing use of stock market, bond market, and other market oriented financial instruments. I m not saying bank is not necessary anymore. Bank is very important. But bank is too important for the Japanese economy. Again this is a kind of result of very high growth. When the economy is growing rapidly, just as Japan did in the past, there is always the shortage of financial resources. We have to find the way where some institutions effectively allocate the financial resources where it is needed most. Bank did a very good job through the system such as main bank system or local small enterprise financial institutions. Everything even the government has a very good postal saving system, which is used by financial institutions to provide finances to small enterprises or some kinds of infrastructure financing. This is fine when the economy is growing rapidly. But maybe we have relied too much on that kind of what Japanese called indirect financial system. That means the deposit or the loandominated system. This is a kind of change we have to actually establish. We have to utilize more stock market or bond market. But again it is very difficult because there are so many banks already there in Japan. There are so many deposits and so many loans. Some of these loans are non-performing loans. It is very difficult process of adjustment. But this is very necessary adjustment. And thirdly even in industry area, we have a kind of very specific feature of growing economy. The other day I just had a dinner with the chairman of Nissan Corporation and after that we had a serious discussion. He asked me whether I know how many automakers there are in the world. I asked him to give me the answer. According to him, there are only 2 automakers in the U.S. because Chrysler was purchased by Daimler Benz. And there are only 4 carmakers in Germany, and 2 carmakers in France. Now carmakers in UK and in Sweden were purchased by American carmakers. Then there is no domestic carmaker in UK or Sweden. And according to him the one car maker in Italy is almost diminishing. (I don t know what he means). There already one carmaker in Korea Hyundai. Other companies were just brought by American. There are 10 carmakers in Japan and 110 carmakers in China. Why 110 carmakers in China? The reason is very simple. The economy is growing rapidly so they can effort 110 carmakers in China. But probably if I ask the same question 10 year later, he probably will answer 10 or 5 or 20. Now why there are 10 carmakers in Japan? We produced only 25,000 cars in 1950s when we started production of commercial cars after the Second World War. Now in the peak it was about probably 12 or 13 years ago. Before the burst of the bubble, we manufactured almost 10 million cars in a year. It is 400 times expansion in terms of volume from 1950s to 1990s. That very rapid growth could sustain a large number of carmakers. We still continue that system so far. But what happen is, except Toyota and Honda, all other car makers are now owned their shares by some overseas companies.

There are going to be some kinds of adjustments over industries. Automobile is just only one example. If you look at each industry such as retail stores or electric appliances or banking sectors or constructions whatever industry you look at, there is a kind of adjustment that is what I call over-company over-capacity structure. That is very important because over-company over-capacity is the other side of the so-called over-borrowing or over-debt of financial market. This is a very difficult process. Sometimes there is bankruptcy of some very famous companies or sometimes there is purchase of very famous company by foreigner. And sometimes there is merger and acquisition. But if you look at just the future picture of these industries, it is also very promising picture. Although some Japanese automaker companies are not doing very well because of these adjustments but partly because of that, Toyota and Honda are becoming even stronger. And also we have many bankruptcies of very big scale retail stores but maybe because of that, the remaining several companies are now becoming even stronger. And maybe we have too many big banks in Japan that is reason why we have some problems. But again if we have some more concentration of the international banks then they will maybe do much better. These are just 3 examples labor market, financial market, and industry. I can, if it is necessary, give other 10 or 12 examples of other aspects of the economy where in the process of very difficult but very important adjustment. Since I think most of the audience here is interested in the present issue, I just again simplify what the problem of Japanese economy is. When the economy is in the process of drastic transformation from the rapidly growing economy to more mature economy the issue is not just one. Important and difficult thing is that we actually have multiple issues. I personally think that these three issues are more important. One is nonperforming loan issue or banking issue that is s very urgent issue. There is going to be some big change in the financial market probably next January or February when many people expect because our fiscal year just ends in March and new fiscal year starts in April. So everybody is looking carefully what is the market condition next January or February. This nonperforming loan issue, as all of you know, is a very important issue. I will discuss more carefully about this issue later. The second is a kind of hidden issue but this maybe more important in the future. That is government debt. Government financial problem is not fiscal issue. It is more the market issue when there is something serious happens in government bond market. Probably I think Japanese corporate sector will suffer a lot from it. We have to be very careful about the development of the government fiscal policy. The third issue is that we are in the process of a very drastic adjustment even in the population of the economy the demographic structure. In the handout I have a population pyramid of the Japanese people. This is about 4 years ago. You can easily find out that there is big peak in the middle. Please remember that we are in the Second World War before 1945 and during 1946 and 1947 there were many bombings in the land of Japan. We could not effort to have babies.

Now after the War finished maybe one or two years and then suddenly just boom of making babies. These people when they born in 1947 or 1948 are probably now 50 or 53 years old. It is a kind of very special feature of Japanese economy. The magnitude of the baby boom is very big. According to the life-time saving hypothesis, young people do not save much because they can just enjoy spending. But when you become the age of 50, the person must think about his retirement life so the normal people starts saving a lot until they retire. They utilize that retirement by using the saving they did before. But if you look at the macro economy when demographic structure is stable, there is no problem because there is some generation who save and some generation who consume. But problem with Japan is that the large population is now in the period of saving, if the average of retirement is 60. This is the structural problem. Whenever I was asked by Japanese people when Japanese consumption will start increasing, I always answer that in 10 years when we have these people just go to retirement age. But you cannot expect the future of economy. The economy is very complicated feature. Maybe these people at the age of 58 just start thinking that in 2 years they never care about their retirement and start spending for saving Japanese economy, then we may have a boom of consumption. But it is very difficult to imagine. This is very serious problem. The way we consume is the past result of the business cycle or depression. But more fundamentally we also have a very serious structure effect. This is a kind of issue we are having. Then how we can get out of these difficulties? The one is nonperforming loan issue. Nonperforming loan is not the cause of the whole issue. It is just the result of some more fundamental causes. The most important cause is over-borrowing feature. I just show between 1970 and 2000 the amount of loans given by banking sector to Japanese economy, which has a peak of something like 500 trillion yens. 500 trillion yen is actually GDP of Japanese economy. So that the ratio of the bank loan over GDP has a peak of about 100%. Just after the crash of the bubble if we look at the data, it is just stable below 60% for long period. Also I could not get data before 1970. I just think that the situation is not so different even before 1970s. There is something wrong in 1980s. It was a rapid increase of bank loans. I think you are very familiar with this kind of phenomena even in your country just has very similar experience. The economy no longer cannot support 100% loan-gdp ratio. So we have a gradual decrease of loan-gdp ratio. Although I have data up to year 2000, there is a more drastic fall of this ratio over the last 2 years. And now presently bank loan-gdp ratio is something around 82-83%. How we have this adjustment of bank loan? There are 4 mechanisms of adjusting. One is bankruptcy of borrower companies. The second is collapse of some major banks. When bank becomes bankruptcy, then loans decrease. The third is some kind of restrictions of additional lending by banking sector to the corporate sector. It is what is known in Japanese as doing many dirty tricks to decrease lending. The forth is even when company is doing very well which normally they will utilize the profit for future investment, but instead they try to just return theirs borrowings to banking sector.

So bankruptcy by borrowing sector or bankruptcy by banking sector or restrictions of additional lending and also the speeding up of returning the loan just work to decrease the so called over-borrowing position of the economy. Do you think this adjustment is a good thing or bad thing? If you look at these phenomena of adjustment from the viewpoint of the banking market, it is a good thing because we are going to the right direction. But if you look at the issues from the viewpoint of the economic activities, it is a bad thing because this is the cause of economic weakening or depression. The very pessimistic thing is that we are in the process of adjustment. We are almost in half-way and we have to do the same thing for another maybe 5 or 10 years. I have to say it takes some time. It is not just the adjustment of banking. More important it is the adjustment of borrowing companies. But we ask again if we are moving into the right direction. Again the bank issue is very difficult thing. As you probably know we have reshuffling of the cabinet and Mr. Takenaka becomes not only the minister of economic affairs or the finance minister, but he is also an old friend of mind for maybe more than 20 years. He just gave me a phone call maybe every week. So I do not want to say anything bad about him. But you have to understand that he is in a very difficult position. We need very drastic measures such as what Takenaka is trying to do. He is in a kind of position of doctor who is doing a surgery of cancer. If he has a wrong way of cutting, then that patient cannot survive. If you look at the detail of his policy, there are many things that we probably criticize. I also do not have agreement with some of his policies. We are now in the process of speeding up the non-performing loan issue. That means re-evaluation of bank assets. The second is capital injection. That means giving more capital to banking sector so that the financial market is stabilized more. And the third is more controversial issue the corporate governance issue. That means just firing the executives of some problematic banks. It is very difficult politically. But you can just observe the development of these issues by looking at these ways when capital is injected, when the government announced which and which bank has some problems and when the political decision is made to just fire some top executives of banking sector. So far it is very difficult process of adjustment of the political conflict and so forth. The speed of Mr.Takenaka s policy seems to become slower. But you have to understand the other mechanisms, which may change the speed of this mechanism. That is market mechanism. Already share prices of some banks become lower and lower. So even though some politicians or some business communities try to just slow down the process of adjustment, maybe the market mechanism will force the process. It is very difficult what is going to be the situation of banking sector in the next 3 or 6 months. I do not take risk to predict. But you just observe the development by looking at the development of next 3 to 6 months. Speeding up of the non-performing loan is only one part of the issue. The more important thing is how to stop deflation. This is very similar to the situation of the surgery of the cancer patient in hospital. If you do not do anything to take care of the body like injecting more energy or blood or what ever, if you do not do anything of anti-deflation policy, and just do the cutting the body to just remove the cancer, then

the economy will die. We have to, at the same time, do something to revitalize the economy just because we are going to speeding up the non-performing loan issue. I personally think that Japanese government policy is not enough. It is very cosmetic. I mean, they have mentioned many policies on the list but if you look at each item very carefully, no one can expect we can get away from the deflation. There is going to be more and more discussions about the policy. Now how we can get way from the deflation? Again I want to go back to the economic theory. There are only 2 major policies you can utilize to recover from the deflation. One is fiscal policy and the other is monetary policy. There might be some other minor policies such as supply-side policy, but there are not effective. Now Japan is in very difficult position. We cannot utilize fiscal policy much because of huge amount of government debt already. Additional fiscal expansion means we have more government debt which means increase future tax burdens. There is very famous economic theory saying that in that kind of economy just fiscal expansion will not work because people just expect there is going to be more tax in the future. This is what is called the Ricardian theory. Fiscal policy is the exchange of the present expansion of the government expenditure with the future increase tax burdens. That is very difficult to stimulate Japanese economy. Then how is monetary policy? Monetary policy, if we simply say, is just the exchange of the security in the market to the money. When the Bank of Japan tries to increase the money, what the Bank of Japan can do is buying something form the market either the government bond or corporate equity or maybe foreign money. Whatever the Bank of Japan buys from the market means an increase of the reserve of the banking sector or eventually an increase of cash. That is monetary policy. In ordinary economy, it works because when the central bank buys more and more government bond from the market and issues money that will decrease the interest rate and just stimulate the economy. But do you know what the Japanese interest rate is now? It is zero, short-term interest rate. That is what Mr. John Menard Keynes said liquidity trap. And long term government bonds for 10 years is just around 1%. It is very low. If the interest rate is very low, people do not care whether they just buy government bond or whether they have deposit or they have cash because they are also equivalent. Even thought the Bank of Japan tries to expand the market by buying more government bond and giving more money to the market, it is the exchange of the government bonds to money by people and does not do anything. As Mr. Keynes said under the liquidity trap, it is very difficult to stimulate the economy by monetary policy. So we cannot utilize fiscal policy and we cannot utilize monetary policy. How we can get out from deflation? There is only one remain policy using both. That is what economists call the helicopter money. This is just the way of explanation. We charter a lot of helicopters in Japan and just spread 1 trillion yen every month for the next 60 months or 5 years. How do you think people will behave?

Because we are now in deflation, when people just get money from helicopters, do you think they just save that cash in their safe in their house? No. They know that there will be more and more money coming in the future which means the price will increase eventually. The rational person, if they observe helicopter money, will start spending. It is obvious if the government just starts helicopter money for the next 5 years continues increase of the spreading of the money, say about 1 trillion yen every month. We can obviously get away from the deflation. Now the question is, can we do this in more sophisticated way? Helicopter money is just using combination of monetary policy and fiscal policy. It is monetary policy because it is an increase in money supply. It is fiscal policy because it provides purchasing power to the consumer. In the very similar way we can do helicopter money just by giving income tax reduction, for example of the order of 1 trillion yen every month. That means 10 trillion yen a year. But in order to do just tax reduction, usually if we do the fiscal policy we have to issue more government bonds. That is not a good thing. So we should ask the central bank to buy that government bonds. Then there is no additional issuance of the government bond. There is an increase in money supply. There is more purchasing power of the consumer. And it has to be the increase of the price. But people may not understand government is now doing helicopter money. The government has to let the people know that the government is doing the helicopter money and what it is it is inflation targeting. If the central bank announces inflation targeting means that they do not stop this policy until the economy will get way from the deflation. Inflation targeting is very important because if they set the ceiling on inflation, say, the bottom is 1% and the top is 3%. It gives the announcement of the commitment that government will stop helicopter money when inflation rate is becoming more than certain level. I just recommended this kind of policy 3 or 4 years ago and no one listened to my theory. But if you look at the present position of the government policy, the actual policy is moving toward this direction. Bank of Japan has already announced to purchase 1.2 trillion yen of government bond every month. So we already have the one-half of helicopter money. Minister of Finance is still very conservative to expand the fiscal policy. Also I just used the example of the tax reduction but it can be an increasing in public investment or public expenditure. Because of the difficult position of the economy, there is going to be more pressure to the government to just expand the fiscal policy. What we need is more aggressive fiscal expansion and also the announcement of helicopter policy that is inflation targeting. Can we have more aggressive fiscal expansion? Can we announce to the public that this is inflation targeting? These are the most controversial policy issues. It still seems to be very far away. But remember the governor of the central bank of Japan is changing next April. It is very important who is going his successor. And

also, as I said before, the difficult of the Japanese economy is to have strong pressure to start the fiscal policy. I don t know if we can get away from deflation by this way or not. We have just observe whether Japanese government or the central bank is clever enough to introduce more realistic policy or they are just very conservative and continue the past policy issue. Macro economy policy is very important and depending on whether the government is doing appropriate practical policy or just sticking to the previous policy, will affect future prospect of Japanese economy for the next 2 or 4 years. But you have to understand this is medium term problem. As I said in the beginning, our economy is moving to the right direction. So the question is whether we are going to the right direction in the smooth way or whether we have many bumps until we reach to the good position. It depends on the policy. Now let me just mention very briefly about another concern about the Japanese economy. That is banking sector. If you look at the size of the government debt. the debt over GDP, it is increasing. According to my diagram the government debt over GDP ratio is below 100%. I am not sure if the database that I am using is the same or not if you go to the website of the ministry of finance of Japanese government you will recognize the total value of the government debt is something like 675 trillion yen which is about 130% or 140% of GDP. It just increases more. It is surprising that the economy can sustain that large amount of deficit. And that is one of the weaknesses and strong points of Japanese economy. Because people are saving a lot, most of the government bond is owned by Japanese citizen. So what is the prospect of this? The interest rate of government bond is only 1%. That is historically low interest rate. That means historically high value of the price of the government debt. That is called debt-bubble. The bubble eventually will crash. What will happen when the bubble crashes? Obviously if the government debt price falls many long term interest rates start increasing from, say, the level of 1% to 2% to 3% to 4%. Is it good or bad thing? Again it is very difficult. It is very bad thing because then many companies will have difficulty if they have borrowed a large amount of money. Do you think Toyota will have difficulty? The answer is no because it does not have any debt. It is just a loss of asset. They will probably gain more income from higher interest rate. But how about the other for example one of the largest retail stores in Japan? They will be a lot of problems because they have borrowed huge amount of money. So 1% of increasing of interest rate means they cannot pay interest rate. Actually the adjustment of interest rate caused by this government bond is a kind of very strong medicine for the transformation of Japanese economy. Good company will become much stronger and weak company will not be able to survive. Again it is very difficult process but again once we just go through the process that implies the so-called over-adjustment, over-company, over-capacity of Japanese industry would be adjusted.

If I am asked if I am optimistic or pessimistic about Japanese economy, I should say I am very optimistic for the future maybe in 5 years or 10 years. And whether I can be optimistic or pessimistic in 2 or 3 years, it depends on whether the government is clever enough to introduce appropriate policy or not. If the government is very clever to introduce the appropriate policy then we will not suffer very much from the process although the adjustment process is very difficult. If I am given the opportunity again to speak in this event in the next 2 or 3 years I hope I can give you much more optimistic picture. I want to say the final remarks. Japan is a kind of very natural process of the adjustment from rapidly catching-up economy to more mature and more stable economy. Because Japan has a very long period of the high growth, the length of the period makes it is more difficult to adjust quickly. And maybe in next 5 or 10 years, we will observe the kind of process of adjustment as I said before. That will change the picture of not only the Japanese economy, but also our economic situation in this region. Thank you very much. *******************