[paper] Use the funding policy to boost demand

Andrew Smithers: Smithers & Co . Ltd. (Chairman)

Date of Birth: 21st September, 1937. Education: Winchester College 1951-1955. Clare College, Cambridge 1956-1959 (M.A. Econ.) Business Career: 1989-present Smithers & Co. Ltd. (Chairman) 1962-1989 S.G.Warburg & Co. Ltd. (Director from 1968) 1959-1962 Commonwealth Development Finance Co.

Japan's key economic problem is obviously a shortage of demand. This is clearly inadequate and, if boosted, the economy could expand for some time before supply constraints become any hindrance to growth. Furthermore the demand problem is structural rather than cyclical.

Fiscal stimulus is a sensible response to a cyclical demand problem, but not to a structural one. Large long term budget deficits cannot be used as a policy tool. Since Japan's demand problem cannot therefore be solved by increased budget deficits, it follows that another way must be found to boost demand.

Governments can stimulate demand through fiscal policy, monetary policy or funding policy. Since fiscal policy is inappropriate to solving a structural demand problem, only through monetary or funding policies can stimulus be effected. While either, if followed with sufficient rigour, could achieve a sustained recovery for Japan, the central argument of this article is that funding policy is more appropriate under current circumstances. Not only is this much more likely to achieve quick results, but it lowers the risk that an excessive rise in inflation will follow recovery.

The Use of Funding Policy

It is usual to distinguish between fiscal and monetary policy, but to ignore funding as a potential policy tool. It may therefore be helpful to set out in more detail the nature of the proposal, before considering how a change in funding policy could solve the fundamental economic issues that face Japan.

Japan has a huge budget deficit. At the moment, this is partly funded by borrowing from commercial banks, via local governments and the Trust Fund Bureau, but by far the larger part is funded by the issue of bonds. Funding policy can be changed by varying the mix between borrowing from commercial banks and borrowing from the bond market.

This could be effected most radically by ceasing to issue bonds and borrowing all the needed funds from banks. If this were done, it should result in a marked expansion of money supply. At present, money supply is not increased to the extent that the budget deficit is financed by the sale of bonds, unless those sales are made to banks. If all financing were made by direct borrowing from the banks, then the growth of money supply would accelerate.

The Bank of Japan is hoping to increase money supply by increasing the monetary base through the purchase of government bonds. Compared with direct government borrowing from the banks, this has two disadvantages. First, it is relatively ineffective and secondly, it opens up potential problems for the management of money supply, once the economy has started to expand.

When the Bank of Japan buys bonds, it adds to the assets in its balance sheet. The matching increase in liabilities is represented by higher deposits of commercial banks. If the banks use these idle balances to make loans or buy bonds, then their actions will increase money supply. In current circumstances, however, the banks may not respond at all. They may simply allow their idle balances to grow, without taking any action.

This risk is not an academic one, it has been happening. In recent years, the monetary base has expanded much faster than money supply. It was also the experience of the US in the 1930s. In the first three years of that decade, the US monetary base grew by 30% while money supply fell by 25%.

The additional advantage of the use of funding rather than monetary policy to expand money supply, is that it will render the control of the economy less difficult, once the recovery starts. If the monetary base is expanded enough, then it is probable that the banks will use their idle balances to buy bonds and increase money supply. This will then lead to the desired expansion of the economy. Once this is firmly in place, however, it will be necessary to reduce again the size of the monetary base. Otherwise, the ability of the banks to increase money supply will be almost unlimited and will create a risk that recovery could lead to uncontrolled inflation. The Bank of Japan would then, however, face a quandary. The banks would have greatly increased their holdings of government bonds and if the Bank of Japan raised interest rates to control the rise in money supply, it would risk bankrupting the commercial banks through the fall in the value of their bonds holdings.

On the other hand, if the government had borrowed directly from the commercial banks, paying interest at short term and regularly adjusted rates, the government could quickly prevent the rise in money supply from proceeding too rapidly and could do so without distressing the banks. All the government would need to do, once recovery was in progress, would be to revert to issuing bonds to cover the budget deficit. If an even slower rise in money supply was required, then the existing debt to the banks could be repaid by issuing bonds, to "over-fund" the deficit.

The Structural Savings Surplus

The need for novel measures reflects the unusual nature of Japan's problems. Structural, as distinct from cyclical demand problems are rare. In Japan's case they are the result of the country's unusual demography.

The main purpose, for which people save, is to have a decent standard of living when they have retired. The normal pattern, therefore, is for savings to take place during working years and for those savings to be run down in retirement. This pattern will not only be reflected in the actions of individuals, but will take place indirectly through pension funds and life insurance arrangements. Japan today has a most unusual demographic structure. It has an unusually high proportion of its population in the high savings ages and, as yet, relatively few who have retired. As a result, Japan is and is likely to remain for a decade or more, a country with a naturally high savings rate.

Another profound influence on demand arises from the relatively small number of young people in an economy. This means that, unless the pattern is changed by migration, the workforce of Japan will be falling at around 0.6% p.a. for at least the next 20 years.

Until about 1990, Japan's economy was still catching-up with those of other developed countries. Japanese labour productivity was able to grow rapidly and, in the process, the economy was able to absorb a great deal of new capital equipment.

Now that Japan is a mature economy improvements in labour productivity are unlikely to be significantly better than those in other mature economies. Indeed over the past decade, labour productivity has fallen behind that of the US. Without exceptional growth in productivity, Japan's ability to absorb investment will decline with the fall in its workforce. For example, the US economy has a workforce that is growing at over 1 % p.a., while Japan's is shrinking at 0.6% p.a. If the improvement in labour productivity in the two countries is the same, then the Japanese economy will grow at nearly 2% p.a. slower than the US and its ability to absorb investment will be similarly restricted. At present Japan invests more of its GDP than the US. If this investment is to be adequately profitable, then in the future the level of investment must shrink to well below the US level.

Japan's demography thus produces a population with a naturally high savings rate and an economy with a limited ability to absorb these savings.

Unless impeded by imperfectly working capital and foreign exchange markets or the threat of political interference, the natural result is for Japan to run a very large external current account surplus for the next decade or so. In time, the situation will reverse, as the age structure of the population changes.

In two decades from now, Japan's pensioners should be partly living off the country's accumulated external savings. This will be very important, as otherwise the burden to pay the pensions of a vastly increased number of elderly people, will impose an unacceptable burden on the shrinking number of Japanese who will then be of working age.

Discomfort and Denial

The structural nature of Japan's demand problem raises political difficulties. There are two fundamental ways in which it could be tackled. The first is through a large current account surplus, the second is through immigration.

Each of solutions, however, creates political discomfort. There is the fear that a greatly increased current account surplus for Japan will be unwelcome in Washington, while massive immigration raises concerns in Tokyo.

This produces a tendency to avoid the issues. Discomfort, as so often, produces denial rather than discussion. This is a major barrier to solving Japan's economic problems. Recognising the existence of a problem is usually an essential first step to a solution. A common form of denial is to discuss structural improvements in the economy which, while generally desirable, are irrelevant to the problem of inadequate demand. By ignoring the key problem, the supporters of reformaremaking the achieving of their aims less likely. If the only apparent results of the drive for reform are mounting unemployment and falling output, the public support for it is likely to melt away.

Some supporters of reform wrongly believe that it will lead to increased demand. They correctly recognise that the low return on capital is a key problem for Japan and then, wrongly, conclude that this can be cured by cost cutting. This leads to the hope that the return on capital can be raised without cutting investment.

This argument involves a fallacy of composition. While cost cutting by one company will normally result in higher profits, cost cutting by all will result in lower output and falling profits. The essential point is that one company's costs are the income of its employees and suppliers. The impact of cost cutting on the economy is not therefore the same as the apparent effect on a single company multiplied many times over.

In economic terms the problem can be resolved by separating the return on capital into two parts. Profitability is the ratio of profits to capital employed. This in turn is determined by the amount of capital it takes to produce a unit of output, and by the proportion of output that goes to profits. This ratio, which is known as the capital income share, has the important quality that it is stable in mature economies. This means that higher returns on capital, for the corporate sector in aggregate, cannot be obtained by cost cutting but only by an improvement in the efficiency of capital.

Looking ahead, therefore, large falls are needed, not only in the budget deficit but also in investment. The resulting shortfall in demand cannot be offset solely by a rise in consumption arising from a fall in the household savings rate. A major rise in the external current account surplus is thus essential for Japan's recovery.

The Problem of Excessive Debt

There is another major problem, in that the level of debt is excessive In the private as well as the public sector. This is often discussed as if it were a problem purely for the banks, but the problem lies much deeper. By emphasising the banking aspect, the full extent of the problem tends to be ignored and thus unresolved. The fundamental issue is not just that the banks are bankrupt, but that so many of the banks' customers are.

From 1950 to 1990, Japan was a "catch-up" economy. It's standard of living was rising much faster than that of Western Europe or the United States.This was, of course, only possible because of a relatively rapid advance in labour productivity. Productivity does not, however, grow evenly throughout an economy and the economists Bela Belassa and Paul Samuelson have shown that this has an important impact on exchange rates. As productivity grows most rapidly in the production of traded goods, the cost of producing such goods in rapidly growing countries falls faster than other countries. To offset this, a country with rapid growth must have a rising real exchange rate.

Japan has been an admirable example of this theory working in practice. Over the past 40 years, the yen has risen against the dollar by nearly 3% p.a. in real, as well as in nominal terms.

There is an important corollary to this. A country with a rising real exchange rate will have a much lower return on capital. For example, if the return on capital in America was 8% and that in Japan was only 5%, then there will still be no incentive for investors to shift money from one country to another. An American investor would have had the choice of receiving 8% in his home market or 5%, plus a 3% rise in the exchange rate, if he had invested in Japan. Equally for a Japanese investor the higher return in the US will have been offset by the loss on the exchange rate.

Now, however, Japan is all too obviously a mature economy. The result is that neither can the real exchange rate continue to rise, nor can the return on capital remain below that in other mature economies.

This has important consequences for both new investment and the existing stock of capital. A fall in the rate of investment is needed to allow the return on new capital to rise. This, however, produces no benefit for the existing stock of capital. In order to raise the return on existing capital, it is necessary to write-down its value.

If Japanese corporations had been largely financed by equity, then a large write-down in the value of their assets would merely be unpleasant for the stock market. Japanese corporations are, however, highly leveraged and the required write-down of assets would mean that around \ 120 trillion of loans would become valueless.

The problem of debt is thus fundamentally a problem for companies, rather than just for banks. The outstanding amount of bank loans in the economy is shrinking, but this is not because the banks are unwilling to lend, it is because their customers are in no position to borrow. If this were not the case, then foreign banks, who do not have balance sheet problems, would take over the lending role.

At the moment, Japanese companies are choosing to repay debt rather than invest, both because much of their existing plant capacity is unutilised, and because their debt burden is excessive. So long as this continues, loans will fall and money supply will only grow through increases in the bank's bond portfolios. As the proportion of bonds to other assets rises, the banks are increasingly exposed to the risk that a rise in interest rates will bankrupt them. Thus, as their ownership of bonds rises, so the risks to the banks rise also. Prudence will therefore dictate that they should start to reduce their new purchases. If this happens before the banks' customers have been refinanced, then money supply will be unable to rise and the economy will decline.

Solving the debt problem is thus not just a case of refinancing the banks, it needs the radical refinancing of their customers.

Solving the Debt Problem

It is often said that Japanese are a wealthy people because they have such huge amounts of money on deposit. This of course simply reflects the huge debts of those that have borrowed the money. The fact that one half of Japan owes vast sums to the other half, that it can never hope to repay, does not make the country wealthy.

The real position is that Japan has more debt than the economy can sustain. This debt has to be reduced, without defaulting on the deposits, as this would cause a major collapse in the economy. This could be prevented by a massive injection of tax payers money, but it would only shift the debt from the private sector to the public sector, where it is already excessive. It has the additional disadvantage that even after major debt forgiveness, the private sector will wish to improve its balance sheet by continuing to run down debt.

The third course open to Japan is to have a one off rise in the price level. This would raise the value of assets to debt in the economy and thus effectively provide an injection of equity into the corporate sector and into the housing market. Such an injection of equity is vital to improving balance sheets to the point where debt repayment ceases to take priority over spending for both companies and households.

One Solution to Two Problems

The solution both to Japan's demand shortage, resulting from its structural savings surplus, and to its excess debt, thus lies in monetary expansion. Provided this is adequate, it should achieve both a rise in the general price level, and sufficient yen weakness to allow exports to expand. A large fall in the exchange rate is needed, however, since it must be sufficient to achieve two ends.

First there must be a decline in the real exchange rate, so that exports are competitive and the current account surplus can expand. Second there must be an additional fall in the nominal rate, to allow and offset the rise in the price level which is needed to reduce the excess level of debt in the economy and effect an injection of equity into the real value of corporate balance sheets.

To increase the quantity of money sufficiently to achieve these policy objectives will not be easy. The conventional approach of lowering interest rates has already been exhausted. The Bank of Japan has now, albeit reluctantly, moved to a policy of increasing the monetary base. The experience of the US in the 1930s, suggests however, that changes in the monetary base may need to be massive in order to be sufficient to restore growth. Combined with the central banks' reluctance, this renders the success of the policy doubtful.

The alternative of increasing money supply through a change in funding policy has a much greater chance of success. Furthermore, once successful the policy will be much easier to reverse. The policy of monetary easing induced through the expansion of the monetary base carries with it the problem that it will result in another banking sector crisis, once it needs to be reversed.