Japan signals wrong recovery route

By Michael Coote

Friday 18th October 2002

In awaiting evidence of global recovery, most of the focus is on the US. Consensus has it that the US will lead and others will follow. The other two super economies Japan and Euroland with the UK are expected to lag the US rebound.

This assumption about the order in which major economies will revitalise growth is based on a "steady state" view that they will not get much worse before they improve.

The key risk to this view is deflation or year-on-year negative growth in average prices. Deflation should not be confused with disinflation. The latter entails falling but nonetheless positive price growth.

Japan has been crippled by sustained deflation. Its consumers are putting off spending today to buy more cheaply tomorrow. As a result it has been locked into 13 years of boom and bust mini-cycles involving recurrent bouts of recession and excessive reliance on the now-depressed export sector to fudge economic growth statistics.

Concerns have been raised, not least by the US Federal Reserve, that the US has an increased chance of experiencing deflation as its economy sputters along. The steady state model of the basis for recovery would be overturned if the US goes down Japan's path and gets locked into a prolonged cycle of falling prices. Should that occur, then the US will not be the engine of rapid global economic upturn.

The Fed has been studying Japan to see what might be done to avert deflation. It is not reassuring that the US central bank takes the Japanese example so seriously. It has even looked at whether it should become a buyer of last resort of US bonds and shares, much as the Bank of Japan has become in its own bailiwick (NBR, Sept 27).

The Bank of Japan is a curious model to contemplate following. Like the Fed, it allowed an asset bubble to build, particularly in shares and property. It then slammed on the brakes with higher interest rates, killing off the boom in stocks and real estate and triggering deflation.

It has since failed despite gaining independence of operations from the Japanese government, running official interest rates near zero and loosening up liquidity to refire Japan's economy. It has turned into a case study of how monetarism can break down at the margin. Small wonder the Fed, with the US sharemarket punctured and property in a bubble, is intrigued by the Bank of Japan's fate.

It recently came out with two startling adverse results. A Japanese government bond tender humiliatingly failed for want of takers. In part, the problem may have been that the Japanese government has issued far too much debt and the global market may now be saturated. Also, the credit rating of Japan's sovereign bonds has slumped to the levels of minor economies. The market indicated that Japanese sovereign paper is a junk bond.

Then Bank of Japan governor Masuru Hayami announced it would start buying shares owned by Japanese banks. On the face of it, the decision made no sense but there was a political purpose to the manoeuvre.

The bank was attempting to force the government's hand into ramming reform down the throat of the recalcitrant and probably largely insolvent Japanese banking sector.

The Bank of Japan was playing a dangerous game and on the face of it the gamble paid off. Finance minister Masajuro Shiokawa over-rode his own ministry by appearing to back Mr Hayami's proposal to consolidate banks and inject public funds. Prime Minister Junichiro Koizumi responded by firing the man in charge of bank reform, Hakuo Yanagisawa, of the Financial Services Agency, who was in denial over the need for firm action, and replaced him with Heizo Takenaka.

Mr Takenaka is believed to want a tough line on bank reform, but he lacks a power base in the ruling Liberal Democratic Party and faces endless battles with filibustering vested interests.

Read one way, the Bank of Japan has won a victory but it may be pyrrhic when the central bank enters into brinkmanship with the government and politicises its supposedly independent role. It remains to be seen if the Fed is driven to the same extreme in the US.

Either way, Japan's gathering economic crisis and the US tilt toward deflation represent twin risks to economic recovery. War with Iraq would be a mere sideshow by comparison, a disease of the global economy's skin, rather than the disease of the heart that would come from American or Japanese central bank failure to avert or reverse deflation.

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