Hiroshi Nakaso: Japan's economy and the Bank of Japan - yesterday,
today, and tomorrow
Speech by Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan, at the Economic
Conference to commemorate the 150th Anniversary of Diplomatic Relations between Italy and
Japan "The Economics of Italy and Japan: Historical Development and Future Policies for
Stability and Growth", co-hosted by Keio University and Bocconi University, Tokyo, 23 May
2016.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
It is a great honor to have the opportunity to speak to you today at this conference
commemorating the 150th anniversary of the establishment of diplomatic ties between Italy
and Japan. Moreover, I am grateful for the wide-ranging close relationship that has developed
between the Bank of Italy and the Bank of Japan at all layers and am very happy to be able to
speak with Senior Deputy Governor Rossi in this session. Personally, when I was a young boy,
the legend of Romulus and Remus about the founding of Rome left a lasting impression on
me, and ever since, I have been one of the many Japanese who are fascinated by Italy's
history, art, fashion, food, and football. The subtitle of today's speech - "Yesterday, Today,
and Tomorrow" - is chosen based on the title of the movie starring Sophia Loren and Marcello
Mastroianni, which won the 1965 Academy Award for Best Foreign Language Film.
Well, let me start with my speech today. As is well known, following the collapse of the bubble
economy in the early 1990s, Japan's economy suffered a prolonged period of low growth and
deflation - what has come to be called the "Lost Decades." The causes of the Lost Decades
have been the subject of active debate among policy makers and economists alike, but until
relatively recently, the associated issues were regarded as specific to Japan. However, since
the 2008 global financial crisis, the United States and Europe also have faced the threat of low
growth and deflation, giving rise to talk about a "Japanization" and renewed interest in Japan's
experience. In fact, when I glance at the economies of the euro area including Italy, I have to
say I often have a sense of deja vu.
Therefore, in my speech today, I would like to look back at Japan's experience since the
collapse of the asset bubble and the Bank of Japan's policy responses to maintain the stability
of the financial system as well as monetary policy. I will then go on to discuss the policy
challenges for Japan as well as the implications of Japan's experience for Europe today.
I. Developments in Japan's economy during the lost decades
As is well known, Japan's economy has been mired in stagnation since the 1990s. On the
other hand, what is less well known, especially abroad, is that the challenges that Japan's
economy has faced during this prolonged stagnation have differed over time. Put simply, until
the early 2000s, the main challenge consisted of dealing with the instability of the financial
system and deleveraging in the banking sector brought about by the collapse of the asset
bubble, and of resolving the so-called "three excesses" in the corporate sector, consisting of
excess debt, excess capacity, and excess employment. However, these problems were
essentially resolved by the early 2000s and a more serious challenge since the second half of
the 2000s has been the decline in Japan's growth potential and inflation expectations. The
decline in both since the 1990s has been brought to the fore by the large decline in aggregate
demand as a result of the global financial crisis. These two major challenges appeared in
succession and it is mainly for this reason that Japan's economic stagnation has been so
prolonged.
The collapse of the asset bubble, financial system instability, deleveraging, and the
"three excesses"
In the 1990s, Japan's banking sector was riddled with a mountain of nonperforming loans
resulting from the collapse of the 1980s bubble in real estate and stock prices. At the same
time, Japan's corporate sector was suffering from the "three excesses" just mentioned -
excess debt, capacity, and employment - owing to the expansion of businesses driven by
overly optimistic growth expectations. In 1997 through 1998, these problems led to the
successive failure of major financial institutions, significantly impairing the functioning of
financial intermediation and causing a sudden credit crunch (Chart 1). The economy
contracted severely and the year-on-year rate of change in the consumer price index (CPI) fell
into negative territory, marking the beginning of Japan's prolonged, though moderate, deflation
(Chart 2).
The Bank of Japan responded to this financial crisis in Japan during the 1990s by acting
extensively as lender of last resort.1 Moreover, since the safety net was underdeveloped at
that time, the Bank of Japan, in order to carry out its mission of ensuring the stability of the
financial system, played the role that essentially should have been the responsibility of the
government, had there been a robust financial safety net; specifically, in addition to supplying
liquidity, the Bank took various extraordinary measures such as injecting capital to an ailing
bank and setting up a bridge bank on its own. However, as a result, the Bank had the painful
experience of recording credit losses reaching 200 billion yen. The crisis became obvious to
everyone, and legislative steps to set up a safety net were finally taken. It was only in 1998,
almost a decade after the collapse of the bubble, that a comprehensive framework for the
temporary nationalization and the injection of capital using public funds was put in place.
Under this framework, the resolution of failed banks progressed. Whereas the increase in the
number of failed financial institutions in the late 1990s occurred under circumstances in which
the underdeveloped safety net made it difficult to get the crisis under control, the spike from
2000 onward is proof of a systematic resolution of failed banks under the new framework (Chart
3). During this period, deleveraging in the banking sector and the resolution of the three
excesses in the corporate sector continued. For example, the amount outstanding of bank
lending, which stood at more than 500 trillion yen in the second half of the 1990s, fell below
400 trillion yen in the mid-2000s - a drop of more than 20 percent (Chart 1). The decline in
bank lending through this deleveraging process finally came to an end in 2006, when bank
lending rebounded. Moreover, in the same year, CPI inflation returned into positive territory,
so that deflation temporarily receded (Chart 2). Fortunately, Japan had been able to avoid a
1930s-style deflationary spiral with a rapidly deteriorating economy and falling prices. Thus, by
the mid-2000s, Japan's economy had overcome the negative legacy of the asset bubble and
appeared to have laid the foundations for renewed sustained growth.
The decline in the growth potential and inflation expectations
In fact, Japan's economy did return to a growth trajectory, benefitting from the tailwind of a
favorable global economy spurred on by rapid growth in China. However, triggered by the
outbreak of the global financial crisis in autumn 2008, circumstances changed at a stroke. In
contrast with Europe and the United States, the exposure of Japan's financial sector to
subprime mortgage-related financial products was limited and the financial system generally
remained stable; however, the real economy, as a result of the significant slowdown of the
global economy, could no longer rely on exports, the traditional engine of economic recoveries
in Japan. Against this background, the decline in the potential growth rate came to the fore as
a major economic challenge (Chart 4).2 The decline in the potential growth rate reflects a
slowdown in productivity growth since the collapse of the bubble economy, a decline in the
labor force since the late 1990s due to demographic trends, and deceleration in the pace of
capital accumulation.
Meanwhile, on the price front, CPI inflation fell back into negative territory, and inflation
expectations started to slide (Chart 2). With only little room to lower interest rates, it did not
take much time for Japan to face the zero lower bound on interest rates again and real interest
rates remained elevated. At the same time, in line with the falling potential growth rate since
the 1990s, the natural rate of interest - that is, the interest rate at which the economy neither
accelerates nor decelerates - had declined substantially (Chart 4). As a result, Japan's
economy fell into a situation in which it was difficult for the Bank of Japan to provide sufficiently
accommodative financial conditions through an extension of policies that had been employed
before. These economic difficulties were compounded by the Great East Japan Earthquake in
2011.
II. Evolution of monetary policy during the lost decades
Next, I would like to look back at monetary policies taken by the Bank of Japan from the start
of the Lost Decades until recently. As the first central bank facing the aftermath of the collapse
of a bubble and deflation, the Bank developed a range of new policy measures. These consist
mainly of two measures that correspond to the challenges that the Bank faced at different
points in time. The first measure was quantitative easing, QE for short, which concentrated on
the provision of ample liquidity, while the second was quantitative and qualitative monetary
easing, or QQE, which focused on raising inflation expectations (Chart 5).
QE, which was implemented from 2001 to 2006, proved effective in that it maintained the
stability of the financial system through the provision of ample liquidity and prevented Japan's
economy from falling into a deflationary spiral. However, it was not powerful enough to reverse
the declining trend in inflation expectations and overcome deflation. As mentioned earlier,
Japan's natural rate of interest had been falling due to the decline in the potential growth rate;
at the same time, real interest rates remained high due to the zero lower bound on nominal
short-term interest rates and the decline in inflation expectations. As a result, QE did not
provide sufficiently accommodative financial conditions. Under these circumstances, a vicious
cycle of a decline in prices, a fall in sales and profits, restraint in wages, stagnation in
consumption, and a further decline in prices took hold. This indicates that once the economy
becomes stuck in a deflationary equilibrium, it is difficult to escape from it.
From a theoretical perspective, the policy prescriptions are obvious. What is needed is to
remove, once and for all, the deflationary mindset and raise inflation expectations - that is, to
lower real interest rates - through decisive monetary easing, and to raise the potential growth
rate - that is, to raise the natural rate of interest - through a growth strategy and deregulation.
This, in fact, is exactly what the three arrows of Abenomics are aimed at. One can often hear
discussions as to whether monetary easing or structural reforms are more important, but I do
not see this is a particularly constructive question. Both are essential for overcoming deflation
and achieving sustainable growth. It is not a question of either monetary easing or structural
reforms - they are complementary to each other.
With regard to the first arrow, monetary policy, the Bank of Japan introduced the price stability
target in January 2013 with the aim of achieving 2 percent inflation in terms of the
year-onyear rate of change in the CPI. This was followed, in April 2013, by the introduction of QQE to
achieve the price stability target of 2 percent at the earliest possible time. The challenge for
monetary policy is how to raise inflation expectations given the limited room for lowering
shortterm interest rates. For this reason, QQE consists of two elements. The first is the Bank's
strong and clear commitment to the target. Specifically, the Bank has made clear its stance
that it seeks to achieve the price stability target at the earliest possible time, with a time horizon
of about two years, and has committed itself to pursuing QQE as long as it is necessary for
achieving the price stability target in a sustainable manner. The second element is the exertion
of downward pressure on nominal interest rates across the entire yield curve through massive
purchases of Japanese government bonds (JGBs). That is, the Bank seeks to exploit to the
greatest possible extent any remaining room for further declines in nominal interest rates. The
combination of the two elements will lower real interest rates and thereby stimulate private
demand. If people as a result see prices going up, this will raise their confidence in the Bank's
commitment, which will further reinforce this process.
In January 2016, the Bank further enhanced QQE by adding the new dimension of a negative
interest rate. "QQE with a Negative Interest Rate" aims to exert stronger downward pressure
on the entire yield curve by lowering the short end of the yield curve through a negative interest
rate applied to a certain tier of current accounts at the Bank while continuing with massive
purchases of JGBs. In designing the negative interest rate policy scheme, we were inspired by
the experience of central banks in Europe, including the ECB.
III. The effects of QQE and QQE with a negative interest rate
About three years have passed since the introduction of QQE, and the Bank judges that QQE
has been exerting its intended effects.
Let me start by considering the effects on interest rates. Since the introduction of QQE, yields
on 10-year JGBs have cumulatively fallen by about 70 basis points (Chart 6). Against this
background, bank lending rates have continued to decline, so that the average interest rate on
the stock of total bank lending has fallen to a level around 1 percent. The amount outstanding
of bank lending, including to small firms, has continued to rise, with the annual pace of increase
recently exceeding 2 percent (Chart 1). It appears that, at present, with real interest rates
substantially below the natural rate of interest, financial conditions for the real economy are
highly accommodative (Chart 4).
Given such accommodative financial conditions, the real economy has evidently improved. In
the household sector, the employment and income situation has steadily improved. Labor
market conditions have continued to tighten as seen in the fact that the unemployment rate
has declined to the range of 3.0-3.5 percent, which we think corresponds to full employment
(Chart 7). Reflecting the tight labor market conditions, base pay increases - that is,
acrossthe-board wage increases mainly reflecting inflation and decided in the annual
labormanagement wage negotiations - returned in 2014 for the first time in two decades. Base pay
increases have continued this year, marking the third consecutive year of such increases. In
the corporate sector, profits have increased to record levels, partly helped by the correction of
the excessive appreciation of the yen and the decline in energy prices. Against this
background, firms have maintained their positive stance with regard to fixed investment.
As for prices, the year-on-year rate of change in the all-item CPI excluding fresh food is about
0 percent, reflecting the decline in energy prices, but the underlying trend in inflation has
steadily improved. CPI inflation for all items excluding fresh food and energy, which had been
in the range of about minus 0.5 to minus 1.0 percent before the introduction of QQE in April
2013, has been positive for 30 consecutive months since the latter half of 2013 and in recent
months has been about 1 percent (Chart 8). This is the first time since the second half of the
1990s, when Japan's economy fell into deflation, that such sustained inflation has been
observed. Moreover, looking at price changes across all items, the share of price-increasing
items minus the share of price-decreasing items has been rising clearly since the introduction
of QQE, and is currently near its peak. This indicates that firms have maintained their
willingness to increase prices, and a virtuous cycle between a moderate rise in inflation and
wage growth has remained in place.
Meanwhile, I admit there has been a fair amount of criticism in Japan of the negative interest
rate policy adopted by the Bank in January 2016. The situation seems not dissimilar to the one
in Europe. Such criticism can be divided into two broad strands.
The first is that the negative interest rate policy may have an adverse impact on economic
activity and prices by squeezing banks' profits, which could hamper the functioning of financial
intermediation. However, in the case of Japan, the concern that the negative interest rate policy
will undermine financial intermediation is unfounded, at least at this moment. First, as I
explained, the process of deleveraging in Japan was completed by the mid-2000s, and
financial institutions now have a strong capital base, partly helped by the fact that the impact
of the global financial crisis on them was limited. Second, despite the current low interest rate
environment, the profits of both major banks and regional banks are close to record levels,
mainly reflecting the significant decline in credit costs due to the steady economic recovery.
And third, when the Bank introduced the negative interest rate policy, it designed the policy so
as not to excessively squeeze banks' profits. Specifically, the Bank designed the policy
framework such that a negative interest rate is applied only on the margin by dividing the
current account balances that financial institutions hold at the Bank into three tiers. As the
Bank continues to purchase JGBs, the current account balances will increase accordingly;
however, since the tier will be adjusted at the same time, the balances subject to a negative
interest rate will remain relatively small, between around 10 and 30 trillion yen. Needless to
say, the Bank will closely monitor the effects on financial institutions' earnings, and will examine
and evaluate those effects in the Financial System Report. The importance of banks'
functioning as financial intermediaries in the transmission of monetary policy cannot be
overemphasized.3 That is exactly why, since the outbreak of the financial crisis in the 1990s,
the Bank of Japan has consistently acted as the guardian of financial intermediation. I assure
you this shall not change in the future.
The second criticism is that the general public will not really feel the benefits of the negative
interest rate policy. While the public understand that their deposits will not diminish as a result
of the negative interest rate policy, we are aware that, for example, households that do not
have a mortgage will not necessarily feel any specific benefits. Particularly those who rely on
their savings, such as pensioners and the elderly, may think that the negative interest rate
policy has an adverse effect, since their interest income further decreases. The Bank's
negative interest rate policy can be understood as an extension of QQE in that its transmission
channel is to maintain real interest rates well below the natural rate of interest, but I cannot
deny that some aspects of this policy may be counterintuitive to the public. Therefore, we need
to carefully listen to criticisms. At the same time, we need to clearly explain that the effects of
monetary policy should not be assessed only in terms of households' and firms' direct profits
and losses in transactions with banks, but in terms of the macroeconomic effects such as the
benefits from an increase in employment and a rise in wages. In other words, it is essential to
explain more persuasively that these policy measures are necessary for the economy to revert
to a sustainable growth path. This seems to be a challenge the Bank of Japan and the ECB
have in common.
At any rate, I will keep a watchful eye on how the negative interest rate policy, through the
further decline in interest rates following its introduction, will work through the economy.
IV. Central banks' lender of last resort function: lessons from the global financial
crisis
So far, I have outlined the challenges facing Japan's economy in the past and present and
how the Bank of Japan has responded. Now, looking into the future, I would like to touch upon
two issues which I believe are important from the perspective of central banks.
First, we need to work on the development of an international financial safety net and discuss,
from a global perspective, central banks' lender of last resort function. Domestically in Japan,
our financial safety net has been strengthened based on the lessons learned during Japan's
financial crisis in the 1990s and the role of the Bank of Japan's lender of last resort function
has become quite clear. The global financial crisis has raised new challenges for central banks'
role as lender of last resort, especially in the case of a temporary liquidity crisis of a systemically
important financial institution operating in multiple jurisdictions and currencies. Issues include
how central banks should share information and how responsibilities should be allocated in
such circumstances. Moreover, it is also possible that different countries and jurisdictions treat
banks and non-bank differently under their individual safety nets. The Bank of Japan actually
has experience in some aspects of such cross-border challenges, since Yamaichi Securities,
which failed in 1997 and to which the Bank provided liquidity, had overseas bank subsidiaries.
In addition, partly as a result of lessons learned during the global financial crisis, the use of
central counterparties (CCPs) to centrally clear transactions is being promoted to reduce
settlement risks. This raises additional issues, such as how liquidity shortages at cross-border
CCPs dealing with multiple currencies should be addressed, and how central banks should
contribute to resolving such issues.4
Central banks are responsible for the stability of their respective domestic financial systems.
However, in order to fulfill their responsibilities, they need to ever more closely monitor and
engage with the global financial system. There is also a growing importance of further
strengthening cooperation among central banks. I believe the Bank of Japan, based on its
wealth of experience, should take a leading role in the discussions in this area.
V. Strengthening Japan's growth potential
The second issue is the need to redouble efforts to raise the growth rate. In order to return
Japan's economy to a sustainable growth path, it is also important to strengthen the dynamism
of the corporate sector and raise the economy's growth potential. In this respect, the
government's growth strategy plays a major role. If the growth strategy bears fruit, the natural
rate of interest will rise in line with the potential growth rate. The shape of the yield curve will
gradually return to normality as upward pressure is exerted on the longer end.
A key characteristic of the government's growth strategy is that it will take a while before its
effects become visible. Nonetheless, we are starting to see some tangible results. Let me give
you one example: raising the labor participation of women (Chart 9). As in Italy, the female labor
force participation rate in Japan has historically been low and raising it is a long-term challenge.
Specifically, a major issue is that women in their prime of life have to interrupt their career for
child rearing. Against this background, one of the pillars of the Abe administration's aim to
achieve the "Dynamic Engagement of All Citizens" is to boost support for child rearing. In fact,
the labor participation rate of women has already started to increase through measures such
as the expansion of childcare facilities. If such tangible results were to spread, this would build
further public support for the growth strategy and help to drive it forward.
Of course, the problems Japan needs to address span a wide range of areas. As mentioned,
the decline in Japan's potential growth rate is due partly to the deceleration in productivity
growth. To give you one example, it appears that there is substantial room for productivity
improvements in IT-related sectors. Both in IT-producing and IT-using sectors, productivity
growth is lower than in the United States (Chart 10). In this context, a survey on firms in the
United States and Japan provides instructive results: compared to firms in the United States,
fewer firms in Japan attach importance to IT investment or have a chief information officer
(CIO). These results suggest that strengthening Japan's growth potential is not something that
can be achieved through the government's growth strategy alone; what is also needed are
greater efforts on the part of the private sector to strengthen competitiveness.
VI. Lessons for Europe
Finally, I would like to make a few comparisons between Japan's Lost Decades and Europe
since the global financial crisis. What is worth noting is that in Europe the policy response has
been quick and decisive. In addition to innovative policy measures such as the coordinated
provision of dollar funds by the major central banks through swap arrangements, financial
system instability was warded off through the provision of ample liquidity, preventing the
financial crisis from turning into a global panic. Moreover, on the institutional front, the Single
Supervisory Mechanism (SSM) for the supervision of banks became operational. Further, I
expect that efforts to deal with remaining issues such as the full operation of the Single
Resolution Mechanism (SRM) charged with the resolution of failed financial institutions and
the expeditious recapitalization of undercapitalized banks will make good progress.
Meanwhile, on the monetary policy front, the ECB has stressed from an early stage the risks
associated with a potential decline in inflation expectations. In fact, the ECB has responded
very proactively, being the first among major central banks to introduce a negative interest rate
policy and combining it with asset purchases.
There is also perceived to be a need to redouble efforts to drive ahead with structural reforms
to raise the potential growth rate. However, this too is clearly recognized, as indicated in
President Draghi's observation that low interest rates are not the consequence of monetary
policy but a symptom of low growth and low inflation. I am convinced that the risk of a
Japanization of the euro economy is small, given that European policy makers are aware of
the issues and are responding appropriately.
Conclusion
In my speech today I tried to look back at Japan's Lost Decades and consider potential lessons
for the current economic situation in Italy and Europe. Naturally, there are many other aspects
in which Japan and Italy can learn from each other, not only with regard to finance and the
economy. Looking at the OECD's Better Life Index, which measures happiness across
countries based on various indicators such as education and the living environment, both
Japan and Italy rank in the middle of OECD countries; interestingly, however, individual
indicators suggest that whereas Japan ranks favorably in terms of labor market conditions and
education, Italy ranks highly in terms of work-life balance and health (Chart 11).
It is said that Japan became widely known in Europe when the Venetian-born merchant Marco
Polo in his 13th century travel diary introduced Japan as "Zipangu, the Land of Gold." Since
then, as countries with a long history and long traditions, Italy and Japan have continued to
learn from each other. Let me close this speech by saying that although our two countries are
currently facing a number of similar problems, I am convinced that by overcoming these
problems through cooperation, our bonds will continue to grow over the next 150 years and
bring a golden future for our two countries, even without the Zipangu's gold.
Thank you.
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