Bubbles, Demographic Change
and Natural Disasters
Opening Speechby Masaaki Shirakawa,
Governor of the Bank of Japan

I. Introduction
Good morning. I am very pleased to address the Bank of Japan Annual International
Conference. On behalf of my colleagues at the Bank of Japan, I welcome all theparticipants from central banks, international organizations, and academia.
Japan was hit by an unprecedented earthquake and tsunami on March 11, the daythat was etched into our memory. The scars are yet to heal in the quake-stricken regions. In the aftermath of the disaster, however, we Japanese were not in a hopelesssituation. We have received lots of support and numerous warm messages from ourfriends abroad. I express my sincere gratitude to those whose hearts and thoughts havebeen with us since that day.
The title of this year’s conference is “Real and Financial Linkage and Monetary Policy.” Conventional macroeconomics has analyzed macroeconomic dynamics throughthe two lenses, trend growth and business cycles. While the two lenses remain important, over the past quarter-century the need to incorporate a third lens—rare but large
events including financial crises—was increasingly recognized, by policymakers andacademics alike. I myself already addressed the issue of bubbles and financial crisesin the opening remarks at the previous year’s conference.1 This year, through this thirdlens, I find myself left with no choice but to refer to the repercussions of a natural
disaster. At the other extreme compared with sharp, unanticipated shocks like financial
crises and natural disasters, I also recognize the fully anticipated development, demographic change, which the Japanese economy is undergoing, as the paramount issue.
Today, I will pick three issues, bubbles and resulting financial crises, demographic
changes, and natural disasters, as the factors driving economic dynamics and call forfurther research on them.

1. See Shirakawa (2010).
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II. A Retrospective View of the Japanese Economy in the Past
Quarter-Century and Research Agenda Going Forward
A. The Day after the Great East Japan Earthquake
Before we move on, I will brief you on how matters stand in the Japanese economy.
In the aftermath of the earthquake, production has declined very sharply due to supply
constraints caused primarily by the destruction of capital stock, disruptions in supply
chains, and a shortage of electric power (Figure 1). As a result, exports have decreased
substantially, and domestic private demand has also been weak, partly accentuated bydeterioration in business and household sentiment. Those constraints are, however, being relaxed more quickly than expected initially as a result of strenuous efforts by firms.
Looking ahead, for the time being, Japan’s economy is likely to continue to be understrong downward pressure, mainly on the production side. However, as supply-side
constraints ease and production regains traction, the economy is expected to return tothe moderate recovery path from the second half of fiscal 2011, backed by an increasein exports reflecting the high growth of the global economy and by a rise in demand forrestoring capital stock.
B. The Japanese Economy in the Past Quarter-Century
Beyond the horizons of a short-term economic outlook, the paramount issue for theJapanese economy lies in the medium- to long-term growth prospects. In this regard, areview of the economy over the past quarter-century could benefit us. With this aim in
mind, we need to underscore the following five facts.

Figure 1 Downturn in the Japanese Economy[1] Production[2] Real Exports

Sources: Ministry of Economy, Trade and Industry, “Indices of Industrial Production”; Bank ofJapan, “Real Exports and Real Imports.”

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Bubbles, Demographic Change and Natural Disasters

Figure 2 Real GDP in the G7 Countries

Notes: 1. To eliminate the effect of the financial crisis, the figures for the 2000s are the average
from 2000 to 2008.
2. The figure for Germany for the 1980s is that for West Germany, and that for the
1990s is the average from 1992 to 1999.
Source: Datastream.

First, Japan’s real GDP growth rate has steadily decreased. Back in the 1980s, Japan
was a frontrunner in terms of GDP growth among G7 countries, while it continued tolose momentum during the 1990s and remained in the most lackluster subgroup in the
2000s (Figure 2).
Second, Japan’s per capita GDP continued to grow at a high pace comparable toother G7 economies in the 2000s, although significantly slowed compared with the
1980s. Japan’s per-worker GDP growth, in particular, remained in the top subgroup,
and in fact it was only slightly less than that of the United States (Figure 3).
Third, after the burst of the bubble, the Japanese economy took a long time to resume its expansion (Figure 4). The protracted period of economic underperformance is
now known as the “lost decade.” The Japanese economy resumed its expansion finallyin 2004. Incidentally, it could be noted that after the burst of the bubble in the 1990s, thedecline in Japan’s growth rate was relatively moderate compared with the declines experienced by the United States and European countries after the collapse of the global
credit bubbles in the mid-2000s.
Fourth, the Japanese economy was precipitated into a sharp contraction in the wakeof instabilities in financial systems. One occasion was the failure of Yamaichi Securities
in 1997, and the other was the Lehman shock. In the latter case, the contraction was
more acute than the first case (Figure 5).

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Figure 3 Real GDP per Worker in the G7 Countries

Notes: 1. To eliminate the effect of the financial crisis, the figures for the 2000s are the average
from 2000 to 2008.
2. The figure for Germany for the 1980s is that for West Germany, and that for the
1990s is the average from 1992 to 1999.
Source: Datastream.
Figure 4 Economic Underperformance in Japan

Note: Shaded areas indicate periods of recession.
Sources: Bank of Japan, “Short-Term Economic Survey of Enterprises in Japan”; Cabinet
Office, “National Accounts.”

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Bubbles, Demographic Change and Natural Disasters

Figure 5 Contraction in Economic Activity[1] Real GDP in Japan[2] Real GDP during the Recent Crisis

Sources: Cabinet Office, “National Accounts”; U.S. Department of Commerce.

Fifth, Japan is facing another sharp decline in economic activity triggered by theGreat East Japan Earthquake.
C. Research Agenda Going Forward
Admittedly, the global financial crisis in the late 2000s together with the aforementioned
five facts left us with no choice but to realize how little we knew about macroeconomic
dynamics. Against the backdrop, I put a bubble and a resultant financial crisis at the topof the research agenda. Beyond a variety of discussions prompted by the global financial
crises, we need to make further progress on this front. The second issue is economic andsocial consequences of sizeable demographic changes, such as a declining population
and ageing. The third issue is repercussions of natural disasters on economic activity.
The second and third issues may look remote from financial systems and monetary policy, but that is a prima facie impression, as I will flesh out later. A declining population
gives rise to an outright reduction in the natural rate of interest and this could constrain
monetary policy via the zero lower bound. If the guaranteed return of pension policies
did not adequately reflect the anticipated decline in the natural rate of interest due toa decline in the population, the misalignment could spur the search for yield, which
would sow the seeds of a bubble.

III. Bubbles and Financial Crises
I will start with the first issue on the agenda, that is, bubbles and financial crises. We
have commonly observed across countries that economic contractions following the23

Figure 6 Real GDP Growth and Inflation (Japan and the United States)[1] Real GDP[2] Consumer Prices

Note: Consumer prices are core CPI. The core CPI in Japan is computed by excluding
perishables from headline CPI.
Sources: Cabinet Office, “National Accounts”; U.S. Department of Commerce; Ministry ofInternal Affairs and Communications, “Consumer Price Index”; U.S. Departmentof Labor.

burst of a bubble tend to be protracted, and subsequently the economies are hobbled
at an early phase of recovery.2 In the aftermath of the two bubbles, namely, one in the
United States in the late 2000s and the other in Japan in the 1990s, both the GDP growthrate and inflation show similar trajectories across the two cases (Figure 6).
The crippled balance sheets can be detected as the primary factors that impede theeconomic recoveries, while we also need to underscore the linkage of low productivity
growth and the inefficient resource allocations resultant from the malfunctioning credit
intermediation. In fact, to promote economic growth, it is crucially important to maintain the economic metabolism by smoothly reallocating economic resources toward thesectors with higher growth potential. In this regard, economists at the Bank of Japanestimated that the distortion in factor markets can account for one-seventh of the total
3.6 percent decline in the GDP growth rate during the six years in the aftermath of
the bursting of the bubble.3 More research would be called for in an attempt to further
elaborate on the effects of the deterioration of banks’ balance sheets and the protracted
zero interest rates on the efficiency of the resource allocations.
In this context, I would highlight the subtle distinction between money and credit
in a period of deflation. Professor Milton Friedman once noted that inflation is always
2. See Reinhart and Reinhart (2010).
3. See Nakakuki, Otani, and Shiratsuka (2004).

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Bubbles, Demographic Change and Natural Disasters

and everywhere a monetary phenomenon, Friedman’s well-known proposition on inflation.4 Given my respect for Friedman, whose last class I took at the University of
Chicago, I would suggest asking whether the proposition holds if we replace the term
“inflation” by “deflation” in the proposition. Elaborating on the validity of this seemingly symmetrical proposition would provide a clue to better understanding how a financial crisis interacts with deflation. You may argue that replacing inflation by deflation
would simply flip a plus to a minus, but the issue is not as simple as it appears. Whether
this deflation version of Friedman’s proposition holds or not would depend on how weinterpret it.
The proposition holds if the proposition means that destabilized financial systems
shrink money stock noticeably, thereby resulting in deflation. In retrospect, we canreaffirm that severe deflation was accompanied by financial crises.5 Friedman pointed
out in his own work, A Monetary History of the United States, that during the periodof 1929–33, money stock shrank by 31 percent and the price level declined by 25 percent primarily because the Fed failed to act as the lender of last resort. In sharp contrast
to the U.S. experience in the 1930s, helped by such lessons from history, the Bank ofJapan acted very aggressively as the lender of last resort. As a result, contraction ofmoney stock was forestalled and the price level dipped by only 0.5 percent per annum
at the maximum. It could also be noted that since 1998, the price level has dropped
slightly larger than 3 percent, which is quite different from the U.S. experience in the
1930s (Figure 7). In sum, the experiences of the United States and Japan confirm thatthe proposition holds in line with the aforementioned interpretation.
On the other hand, if we interpret the proposition in a way such that central banks
can raise the price level at will by flooding the economy with the monetary base, theproposition is, at least, not compatible with the recent experiences in Japan as well as
in the United States. In Japan, between 1997 and 2010, the monetary base soared by
90 percent while money stock increased by 30 percent. Likewise, the U.S. experience
between 2008 and 2010 clearly shows that the monetary base soared by 140 percent
while, by contrast, money stock increased by only 10 percent. Despite the flooding
monetary base, Japan’s consumer price level dipped by 3.7 percent in the 13 years
by the end of 2010. The U.S. core CPI inflation rate has decreased by more than
1 percent despite the increase in the monetary base. To sum up, significant increases
in the monetary base gave rise to neither an equally significant rise in money stock
nor inflation, let alone proportional increases. Financial systems would provide a key
to better understanding the proposition. In light of the Japanese experiences, I agreewith Chairman Bernanke on his remark in his scholarly work, “I doubt that it [money]
completely explains the financial sector-aggregate output connection.”6 Without morein-depth understanding of the subtle intricacy underlying financial systems and credit
markets, we would remain less informed of macroeconomy and transmission channelsof monetary policy. Against the backdrop, I am hoping for more research to proceedon this front.

4. See Friedman (1970).
5. See Bordo and Filardo (2005).
6. See Bernanke (1983).

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Figure 7 The Need for Central Banks to Take Aggressive Policy Actions[1] Japan[2] United States

Note: Figures for Japan are adjusted for the changes in the consumption tax rate from
3 percent to 5 percent in April 1997.
Sources: Ministry of Internal Affairs and Communications, “Consumer Price Index”; U.S.
Department of Labor; Bank of Japan, “Money Stock,” “Monetary Base”; Balke andGordon (1986).

IV. Demographic Changes and Policy Response
A. Keynes’ Perspective
We move on to the second issue on the agenda, demographic changes. In 1937, John
Maynard Keynes gave a lecture titled “Some Economic Consequences of a Declining
Population.” He noted that “in an era of a declining population, . . . demand tends tobe below what was expected and a state of over-supply is less easily corrected. Thusa pessimistic atmosphere may ensue.”7 By suggesting these views, he questioned the
traditional Malthusian view that warns against a population explosion. Neoclassicalgrowth theories tend to focus on per capita economic variables, such as per capita
GDP and per capita capital stock. This means that the very challenges that Japan iscurrently faced with are left outside the scope of their analysis at the outset. Looking
ahead, Japan is heading into a demographic vortex, by which I mean rapid ageing anda declining working-age population. To deal with the present and forthcoming challenges for Japan, we may need to rely more on the perspective offered by Keynes,
who tried to elaborate on the size of population itself and changes in its composition.
It is fairly certain that not only advanced economies, but also a number of emerging
economies are, sooner or later, expected to face a similar challenge as we proceed down
the road (Figure 8).8

7. See Keynes (1937).
8. See Shirakawa (2011).

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Bubbles, Demographic Change and Natural Disasters

Figure 8 Working-Age Population[1] Working-Age Population in Japan[2] Share of Working-Age Population

Note: The working age is from 15 to 64 years old.
Source: United Nations, “World Population Prospects: The 2010 Revision.”

B. Demography and Aggregate Demand
Demographic changes affect economic growth through a variety of channels. To start
with, in a country facing a diminishing population, like Japan, a declining working-age
population would rein in growth momentum on the supply side. Admittedly, because
we need to take demographic factors as given for the time being, we should pursue
higher labor force participation rates of female workers and the aged people. On topof this, attempts to enhance the quality of the labor force by improving education andvocational training systems are warranted as well.
We may need to recognize the complex fallout of a demographic vortex on aggregate demand. A shrinking working-age population could be an outright factor that
reduces aggregate consumption. On the other hand, the life-cycle model of consumption predicts that the ageing of society would spur the consumption of the elderly as
they reduce their savings. In fact, a common observation across economies is that, as a
general pattern, the elderly tend to cut their spending on durable goods while they increase demand for services to maintain their quality of life, such as medical and nursing services. We may need to bear in mind, however, that provision of these services
tends to be subject to intensive government regulations. If the supply that can meetthe demand of aged people would be hampered by misaligned regulations that do notreflect the changes in society and technology progress, potential consumption demand
would not materialize.
The foregoing argument reaffirms the importance of the flexibility of the social andeconomic systems that can ensure their own sustainability in the face of a demographic
vortex. We could also bear in mind how the ageing of voters affects the social choicesreflecting their preferences (Figure 9).

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Figure 9 Median Age in Japan

Source: National Institute of Population and Social Security Research.

C. Demography and Business Cycles
As I mentioned at the outset, the third lens suggests that boom-bust cycles and demographic changes could interact with each other. For example, the spending wave
hypothesis suggests a possible linkage between the two. This simple-looking hypothesis argues that peaks of business cycle and asset market booms tend to coincide withthe years when baby boomers pass their peak spending years, presuming that theirconsumption reaches its highest in their late 40s. As my colleague, Deputy Governor
Nishimura, points out, the inverse dependency ratio, which indicates workers per nonworking population, appears to be positively correlated with real estate market fluctuations both in the United States and in Japan9 (Figure 10). Similar studies predict that
real estate booms could be driven by increasing young generations when they comeinto markets as home buyers.10 All those arguments suggest that demographic factors
should not be taken lightly in analyzing bubbles and financial crises.

9. See Nishimura (2011).
10. See Sterling and Waite (1998).

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Bubbles, Demographic Change and Natural Disasters

Figure 10 Inverse Dependency Ratio and Real Estate Market Fluctuations[1] Japan[2] United States

Note: The inverse dependency ratio is the ratio of workers to non-workers.
Sources: Nishimura (2011).

V. Managing Disaster Risks
Finally, I take up the last issue in the agenda, management of natural disaster risk in thecontext of economic activity. Natural disasters are universal risks against which humanbeings have been fighting since the dawn of history (Figure 11). The tangible capitalstock lost in the Great East Japan Earthquake is estimated at 5 percent of GDP by theJapanese government.
I will highlight, inter alia, specific aspects of the issue, that is, how much extra
cost firms should bear to forestall a vast disruption in production. To this end, twoissues immediately come to mind, inventory management and risk concentration. The
Japanese manufacturing firms have been enhancing their competitiveness through constant efforts to minimize inventory of intermediate goods, by developing the sophisticated logistics network known as the just-in-time system. The efforts can be confirmedby the downward trend of the inventory-to-GDP ratio (Figure 12). Being faced with
disruptions in the production process precipitated by the natural disaster, firms with aminimum level of intermediate goods inventory were left with no choice but to sharply
scale back their production. In the wake of the earthquake, as discussed earlier, theensuing disruption of the supply-chain revealed the risk of the reduced inventory, which
may be described as a dilemma, namely, just-in-time versus just-in-case.

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Figure 11 Frequency of National Disasters

Notes: 1. The damage caused by the Great East Japan Earthquake is estimated by the
Cabinet Office. It is converted into U.S. dollars at the exchange rate at the end of
March 2011 (US$1 ¥82.84).
2. Damage includes the damage to infrastructure, agricultural crops, and buildings.
Source: Center for Research on the Epidemiology of Disasters, Université Catholique deLouvain, “Emergency Events Database (EM-DAT).”
Figure 12 Ratio of Inventory to GDP

Sources: Cabinet Office, “National Accounts”; U.S. Department of Commerce.

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Bubbles, Demographic Change and Natural Disasters

While the level of inventory should remain as an important issue, the earthquake
uncovered concentration risks as the linchpin for further assessment. The concentration risks that have been deeply buried under the complicated supply chain were due tooverreliance on particular plants located in the particular regions.
There is no free lunch: you need to bear some additional cost in either case, to raise
inventory or to diversify procurement. In a related context, Professor Barro pointed
out in his paper that the insurance premium that households need to bear at normal
times to compensate for the disaster risks would be considerably high.11 This question
regarding the disaster risks needs to be considered at a national level as well as a
firm level. For instance, over-concentration of a nation’s business activities in particular plants located in a particular region would run a significant risk while its cost ofsuch over-concentration could be hardly internalized by highly competitive markets.
As a result, tail risks may be inadvertently elevated. In sum, economists, together withpractitioners and policymakers, need to strive for a better design of broadly defined
public risk-sharing systems against disaster risks.

VI. Concluding Remarks
So far, I have discussed the challenges that the Japanese economy is faced with. I would
call for further research on tail risks, such as financial crises and natural disasters,
which have been given relatively short shrift in the existing macroeconomics. The consequences of demographic changes are yet to be explored. We could make a stronger
case to revamp the present social and economic systems. Those outdated systems, which
are not in line with the ongoing demographic changes, could sow the seeds of anotherbubble because, for example, they could prompt the search for yield under the low
natural rate of interest. Now is the time to explore all these issues. With that perspectivein mind, I am convinced that this year’s conference will catalyze dialogues between
policymakers and academics. Thank you.

11. See Barro (2009).

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Working Paper No. 1999, National Bureau of Economic Research, 1986.
Barro, R. J., “Rare Disasters, Asset Prices, and Welfare Costs,” American Economic Review,
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Bernanke, B. S., “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression,” American Economic Review, 73 (3), 1983, pp. 257–276.
Bordo, M., and A. Filardo, “Deflation in a Historical Perspective,” BIS Working Paper No. 186, Bankfor International Settlements, 2005.
Friedman, M., “The Counter-Revolution in Monetary Theory: First Wincott Memorial Lecture, Delivered at Senate House, University of London, 16 September, 1970,” Institute of Economic
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