What can we learn from Japan’s last decade for today dilemmas in fiscal and monetary policies – that’s the challenge of the IMF working paper “Lost Decade in Translation: What Japan’s Crisis could portend about recovery from the Great Recession”, co-authored by Murtaza Syed, Kenneth Kang and Kiichi Tokuoka.
Truly sensitive in the economic field are the risks in 2010 of a recession double-dip. It’s very hot the political pression for an exit strategy, due to the high costs of stimulus policies and monetary interventions of the last two years.
The Japanese experience was like a “lab”, where we can visualize the wrong steps and the good policies, the delays and its bad results, the opportunities Japan didn’t miss and the external shocks that take the country by surprise, showing its vulnerabilities, particularly in the financial system.
That’s the subject of the following conversation with the three co-authors.
. “An enduring recovery was ultimately possible only when financial and corporate sector problems at the heart of the crisis were addressed, allowing a resumption of policy stimulus and a favorable external environment to reinvigorate private demand.”
. “We must also remember that as the crisis unfolded, Japan faced a set of circumstances that had not been experienced by a major economy since the Second World War. Operating in virtually uncharted territory, the Japanese authorities deserve high marks for their successes in stabilizing the economy. “
. “However, we would argue that the distinguishing feature of the third recovery episode was not just the favorable external environment but a comprehensive strategy for addressing underlying problems in the financial and corporate sectors.”
. “In advanced economies that find themselves at the center of the Great Recession, this would suggest that a robust private-led recovery may not take hold until household debt levels fall back toward more normal levels and banks are sufficiently strengthened.”
.”One of the key lessons from Japan’s experience is that outlining a concrete and credible medium-term fiscal consolidation could help balance supporting growth and ensuring medium-term fiscal sustainability.”
INTERVIEW by Jorge Nascimento Rodrigues ©2010, Janelanaweb.com
Q: The Japanese “crisis lab” in the last two decades has two double-dips so far. Which were the main causes of those two double-dips?
Murtaza Syed: Contrary to popular perception, Japan’s lost decade was not an uninterrupted period of economic decline, but involved three distinct phases. Twice, green shoots of recovery emerged, allowing macroeconomic stimulus to be withdrawn. However, on both occasions, the external environment subsequently deteriorated dramatically—first during the Asian financial crisis in 1997 and then the IT bubble collapse in 2000—and the shock to the economy was amplified by a still-fragile financial system. Each time, a more severe downturn ensued, necessitating even more aggressive stimulus to support real activity. Crucially, private demand was on a relatively weak footing in both cases. An enduring recovery was ultimately possible only when financial and corporate sector problems at the heart of the crisis were addressed, allowing a resumption of policy stimulus and a favorable external environment to reinvigorate private demand.
Kenneth Kang: We must also remember that as the crisis unfolded, Japan faced a set of circumstances that had not been experienced by a major economy since the Second World War. Operating in virtually uncharted territory, the Japanese authorities deserve high marks for their successes in stabilizing the economy, placing it back on the path of sustained growth and orchestrating a relatively smooth exit from many of their policy interventions. Together with some of their early difficulties, these experiences have provided many important lessons for economies grappling with the current global crisis, and continue to do so.
Q: The third recovery episode in the Japanese long depression cycle was successful because of China’s emergence as a great geoeconomic power? Rephrasing the question: The Japanese has just pure luck because a strong “external” opportunity in the region emerged, more than their economic and financial policies in the 2000s?
Kiichi Tokuoka: There is some element of truth in your question, but it is far from the whole story. It is true that favorable global conditions, led by China, benefited Japan’s eventual recovery—between 2003 and 2007, net exports accounted for around a third of Japan’s growth. However, we would argue that the distinguishing feature of the third recovery episode was not just the favorable external environment but a comprehensive strategy for addressing underlying problems in the financial and corporate sectors. This allowed spillovers from robust exports to reinvigorate private domestic demand and sustain the recovery. There were two main elements to the strategy. First, a more aggressive approach to dealing with problem loans and capital shortages in the banking system was adopted, helping to restore confidence in the banking system. Second, corporates—helped by a push to restructure distressed assets—made significant progress in shedding the “triple excesses” of debt, capacity, and labor from the pre-crisis bubble period. These twin problems lay at the heart of Japan’s crisis and it was only when they were resolved that spillovers from sizeable macroeconomic stimulus and a favorable external environment were able to reinvigorate private demand and sustain the recovery. Without such comprehensive measures, we saw in the previous two recovery attempts that the economy was not able to benefit fully from a favorable external environment. In both those cases, exports were also growing strongly but there was little spillover to the domestic economy.
Q: If the Japanese long crisis is any guide, the worldwide Great Recession of the last three years could still be in an uncertain end? Governments must have caution? Why?
Murtaza Syed: At the current stage of the Great Recession, there are three main questions: First, has the global economy reached a true turning point? Second, should policy support be reversed anytime soon? And third, how should policymakers design and communicate exit strategies to minimize longer-term legacies of the crisis? We think there are four main lessons from Japan’s experiences that may be relevant for answering these questions.
1) First, green shoots do not guarantee a recovery, implying a need to be cautious about the outlook today. In our paper, we constructed recovery heat maps and found that, qualitatively, the patterns in leading indicators over the last year in advanced economies resemble those in the lead-up to Japan’s incipient recovery attempts. Much as in those two episodes, indicators related to trade and financial markets are showing signs of recovery supported by aggressive stimulus and inventory adjustments, but private domestic demand—which was a key ingredient for Japan’s lasting recovery— still appears weak. In particular, spending is subdued and labor market conditions extremely weak.
2) Second, financial fragilities can leave an economy vulnerable to adverse shocks and should be resolved for a durable recovery. As noted earlier, on two occasions in Japan, adverse external shocks were amplified by a weak banking system, pushing the economy back into stagnation. Today, given downside risks and the still strained nature of financial systems and household balance sheets in advanced economies, the possibility of a double dip cannot be discounted altogether. A lasting recovery is likely to depend on concerted efforts to resolve financial sector and debtor imbalances. In Japan, it was only when corporate debt had returned to prebubble levels and banks had disposed of their distressed loans and been adequately recapitalized that the benefits from policy stimulus and a favorable external environment could spill over and reinvigorate private domestic demand. In advanced economies that find themselves at the center of the Great Recession, this would suggest that a robust private-led recovery may not take hold until household debt levels fall back toward more normal levels and banks are sufficiently strengthened.
3) Third, well-calibrated macroeconomic stimulus can facilitate this adjustment, but carries increasing costs. As in Japan, stimulus could facilitate needed restructuring by giving banks and households in advanced economies time to rebuild their balance sheets. It could also lay down firmer foundations for renewed growth. At the same time, however, sustained fiscal stimulus and unconventional monetary policies can have costly side-effects in terms of public debt and market discipline, and are ultimately not a substitute for balance sheet restructuring. In Japan, stimulus was necessary but not a panacea, and over time its effectiveness waned. A properly functioning financial system and healthy borrowers were needed to transmit the benefits of macroeconomic loosening to the broader economy. In advanced economies at the heart of the present crisis, this places a premium on timely steps to restructure bank and household balance sheets, which would stimulate private credit and reinvigorate activity while creating a plausible exit strategy from policy interventions.
4) And fourth, while judging the best time to exit from policy support is difficult, clear medium-term plans may help. As illustrated in Japan, calibrating the timing of actual exit will be challenging under extreme uncertainty about the underlying strength of the economy and financial vulnerabilities. In particular, policymakers will need to navigate skillfully between avoiding a withdrawal of stimulus before underlying imbalances are redressed, and maintaining support for too long at the expense of longer-run outcomes. This time around, the global scale of the crisis also makes it important that exit strategies are well-coordinated across economies. Japan’s experiences suggest that clear and credible exit strategies can help anchor expectations and reinforce confidence. In particular, exit from unconventional monetary policy was skilful and did not result in the kind of inflationary blow-out that many fear in the current episode. Nevertheless, the crisis did leave some long-term scars—manifested in persistently lower investment, weak price pressures and a significant rise in public debt—highlighting the risk that global economic conditions could look markedly different once the dust settles on the Great Recession.
Q: What can the Japanese experience and learning teach us for a double strategy of maintaining stimulus and began with fiscal consolidation?
Kiichi Tokuoka: One of the key lessons from Japan’s experience is that outlining a concrete and credible medium-term fiscal consolidation could help balance supporting growth and ensuring medium-term fiscal sustainability. In Japan, the delay in formulating a medium-term strategy saw the income tax cut introduced in the late 1990s only fully lifted in 2007, contributing to persistently large fiscal deficits during the economic expansion between 2003-2007. That said, Japan’s experience also highlights that it is particularly challenging to identify the right timing of fiscal unwinding. For example, in 1997, Japan formulated a law to reduce deficits over the medium-term, but was quickly forced to scrap the law in light of the sharp economic contraction following the Asian crisis.
Q: The Keynesian multiplier is one of the main arguments for the public spending in investment projects, particularly big anchor projects. What can the Japanese teach us about the rigor in using multipliers and in prioritizing spending public projects?
Kenneth Kang: While estimated fiscal multipliers cover a wide range, empirical evidence shows that in Japan they declined during the 1990s. This suggests that successful stimulus requires identifying spending with higher multipliers. On public investment, a priority should be given to projects that are more likely to stimulus private demand. On social measures, such as income transfers, spending should be targeted to low-income households with higher marginal propensity to consume. At the same time, restoring the credit function of the financial sector sector can help maximize the impact of fiscal stimulus. The effects of fiscal stimulus are likely to be short-lived unless financial system problems are resolved. In particular, without sound capital buffers in the banking system, fiscal stimulus may prove ineffective in generating a sustained recovery on its own, as was the case in Japan.