Masaaki Shirakawa: Balance-sheet adjustments and the global economy
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Paris
EUROPLACE Financial Forum, Tokyo, 16 November 2009.
* * *
Introduction
Thank you for having me today at the International Financial Forum organized by Paris
EUROPLACE.
Counting the Banque de France, financial institutions, clearing systems, law firms, and
accounting offices among its members, Paris EUROPLACE is an organization with a wide
range of members with an interest in French financial markets. Communication among
market participants is important for the development of markets, but it is particularly crucial
during a period of financial crisis. I have learned that Paris EUROPLACE plays an important
role in providing the opportunities for such communication, and I salute the members of Paris
EUROPLACE for their contributions.
At this forum today, reflecting the current financial crisis, various workshops will be held to
address issues concerning financial markets and the financial system, and the workshops
will no doubt give rise to active discussions. The topic I would like to talk about today is
balance-sheet adjustments. As the governor of the central bank of a country that has
experienced the hardship brought by balance-sheet adjustments before any other advanced
economy, I believe that balance-sheet adjustments are a key factor in shaping the prospects
for the global economy following the economic crisis.
I. Global economic developments and balance-sheet adjustments
I will start by discussing recent developments in the global economy.
Following the failure of Lehman Brothers in the autumn of 2008, global financial market
conditions deteriorated significantly and economies around the world contracted
simultaneously and sharply. Recently, however, global financial markets have increasingly
been showing signs of improvement, and the global economy has started to pick up. On the
whole, Japan's economy has followed a similar trend as other advanced economies,
although both the economic contraction and the subsequent recovery were greater in Japan.
The reason is that industries that were the most severely affected by the global economic
downturn, such as automobiles, electrical machinery, and general machinery, carry a
particularly large weight in Japan.
The current pick-up in the global economy is supported by the following three factors. First,
dissipation of the panic, namely the liquidity crisis. Second, progress in inventory
adjustments. And third, the implementation of massive economic stimulus measures around
the world. However, the fundamental problem that caused the current economic crisis, that
is, the need for balance-sheet adjustments due to the bursting of the credit bubble in the
United States and Europe, remains unresolved. This means that households and firms will
have to restrain consumption and investment in order to reduce the debts accumulated when
asset prices were rising. While such debt reduction, in other words, deleveraging, is a
rational response from the perspective of individual households and firms, if they restrain
spending simultaneously in large numbers, this could cause a decline in aggregate demand
and a fall in income and profits, which provide the necessary resources for deleveraging.
Financial institutions, too, will inevitably have to reduce assets and risks, which had grown
excessively relative to their capital bases. While balance-sheet adjustments are
indispensable for the economy to return to a sustainable growth path, they will continue to
exert chronic downward pressure on the economy during the adjustment process, as Japan's
experience shows. Meanwhile, emerging and commodity-exporting economies essentially
face few balance-sheet problems of their own and have been recovering at a faster rate than
anticipated in early spring.
Given these considerations, a key issue in determining the outlook for the global economy is
how to assess the pressures from these balance-sheet adjustments in U.S. and European
economies. Comparing Japan's experience of balance-sheet adjustments in the 1990s and
the current situation in the United States may provide some important pointers in this context.
II. Balance-sheet adjustments and policy responses
The size of balance-sheet adjustments
Let me begin by comparing the size of balance-sheet adjustments necessary in Japan and
the United States. Taking as an example real estate prices in real terms - using the
consumer price index as deflator - the pace of decline in both residential and commercial
real estate prices from their peak levels has been more or less the same in the United States
and Japan, although thus far it seems to have been slightly faster in the United States. Next,
how do the two square up in a more direct comparison of the degree of excessive leverage?
One way to gauge excessive leverage is to look at the upward divergence of the
debt-toGDP ratio for the non-financial private sector from the trend of the past 20 year. Based on
this somewhat mechanical approach, we find that the level of excessive leverage is also
about the same for Japan and the United States.
Sectors that require balance-sheet adjustments
Another difference between Japan and the United States is the sectors requiring
balancesheet adjustments. In the case of Japan, it was the corporate sector that mainly faced
excessive debt within the non-financial private sector. The excess of investment over savings
reached more than 10 percent of GDP in 1990. Amid the rise in asset prices, firms had made
aggressive real-estate investments and, at the same time, increased business fixed
investment by borrowing from banks using real estate that had gone up in value as collateral.
After the bubble burst, economic activity deteriorated together with the fall in asset prices,
and the corporate sector was confronted with excesses in debt, production capacity, and
employment.
In contrast, in the current situation in the United States, it is the household sector that needs
to make balance-sheet adjustments. As seen in the subprime mortgage problem, against the
background of rising home prices, households' borrowing against homes as collateral
increased substantially, which in turn led to excessive consumption.
Policy responses amid balance-sheet adjustments
Next, I would like to look at differences in the policy responses in Japan and the United
States.
The first aspect in this regard is the timing and scale of policy responses. Starting with
monetary policy, both the Bank of Japan and the Federal Reserve undertook the first policy
rate reduction about one year after real estate prices in major cities had reached their peak.
Therefore, the time it took for the Bank of Japan and the Federal Reserve to start lowering
interest rates was about the same. On the other hand, the pace of policy interest rate
reductions was faster in the United States than in Japan, reflecting the difference in the
sequence in which impaired asset problems arose, as described later. In Japan, the policy
rate reached 0.5 percent after four years from the start of rate reductions, while in the United
States, it was after only 15 months. With regard to the scale of injections of public capital into
the financial sector, which are a key to the restoration of the functioning of financial
intermediation, the size of public capital injections relative to GDP was approximately 2.5
percent in Japan, while it was 1.5 percent in the United States. The relative size of injections
was slightly larger in Japan, but injections were undertaken considerably earlier in the United
States. In the United States, because the bursting of the bubble started with a fall in market
prices of securitized products, financial institutions' capital shortages were revealed at an
early stage by market forces. In contrast, in the case of Japan, it took time before financial
institutions' capital shortages were recognized and public capital was injected. The reason is
that financial institutions' impaired assets consisted mainly of loans and it was more difficult
to gauge the decline in their value. It should, however, be noted that currently in the United
States, commercial real estate prices continue to fall and the quality of consumer loans
continues to deteriorate, and therefore the sequence in which the problems related to
impaired assets arise is different in the United States from that in Japan. Meanwhile, in terms
of financial market stability, which is key to avoiding a sharp economic contraction, the
degree of instability seems to have been relatively smaller in Japan reflecting partly the Bank
of Japan's active stance as the lender of last resort.
The balance-sheet adjustment process and the effectiveness of monetary policy
The second aspect with regard to the policy response concerns the effectiveness of
monetary policy. As Japan's experience shows, the effectiveness of accommodative
monetary policy through policy rate reductions declines substantially in an economy that is
undergoing balance-sheet adjustments. This, of course, does not mean that monetary easing
is ineffective. Monetary easing encourages spending and risk-taking activity by entities that
are not suffering from excessive debt and supports aggregate spending and income.
Monetary easing also enhances debt reduction through a decline in interest payments and
accelerates balance-sheet repairs by supporting asset prices.
One of the distinct differences between Japan and the United States in terms of the conduct
of monetary policy amid balance-sheet adjustments concerns the income transfer effects
between economic entities. Needless to say, in the economy as a whole, for economic
entities with excess debt there will correspondingly be entities with excess savings. In Japan,
as a result of the reduction in the policy rate, there was a large income transfer from the
household sector, which held large amounts of assets, to the heavily indebted corporate
sector. However, in terms of income distribution, I believe that in the final analysis, the policy
rate reductions supported household sector income: although they lowered households'
interest income, thereby restraining consumption to some extent, the policy rate reductions
facilitated the adjustment process in the corporate sector and supported economic activity
overall, thereby propping up household sector income from employment and hence the
economy.
Meanwhile, since the United States, unlike Japan, is a net debtor country, the reduction in
policy interest rates will reduce interest payments to creditors overseas, resulting in an
income transfer from overseas sectors to the United States. In other words, in terms of
balance-sheet adjustments, the United States has the advantage that policy interest rate
reductions bring about income transfers that are favorable to the country. However, there are
also risks involved in continued low interest rates. If the continuation of low interest rates
leads to a substantial rise in long-term interest rates by raising inflation expectations or by
generating expectations for a weak dollar, this may give rise to another problem, namely that
the fiscal burden increases and in turn the need for adjustments in the government's
balance-sheet arises.
Effects resulting from different sectors making balance-sheet adjustments
The difference between the United States and Japan in terms of what sectors have to or had
to make balance-sheet adjustments can result in considerable differences not only in income
transfer effects, but also in the adjustment process. In the case of Japan, since it was mainly
the corporate sector that had to make balance-sheet adjustments, progress in the adjustment
process for the economy overall was achieved through an increase in exports owing to high
global economic growth. However, at present, it is difficult for the United States to expect
similar help from a substantial rise in its exports, because other advanced economies are
also, to a greater or lesser extent, undergoing balance-sheet adjustments. An additional
problem is that employees' income has declined more substantially than in previous
recessions in the United States. While this may help the recovery in corporate profits, it at the
same time entails the risk of a delay in balance-sheet adjustments by households.
Having said that, I must hastily add that there are elements in the structure of the U.S.
economy that will encourage rapid progress in balance-sheet adjustments. The size of
necessary balance-sheet adjustments depends on the size of the excess in supply capacity
in the overall economy relative to the long-term equilibrium growth rate - that is, the potential
growth rate. If expectations for economic growth are high, pressures for balance-sheet
adjustments will be small. In this context, the United States has the significant advantage of
having a flexible economic structure. If labor and capital shift swiftly from low-productivity
sectors to high-productivity sectors, this should sustain high productivity growth in the
economy overall. In contrast, reflecting population aging and a falling birth rate, the growth
rate of Japan's working-age population first declined and then turned negative during the
1990s. Moreover, labor and capital mobility was relatively low, which was partly responsible
for the gradual decline in productivity growth in the economy overall. As a result, Japan's
potential growth rate after the bubble burst declined, which protracted the duration of balance
sheet adjustments.
III. Balance-sheet adjustments and the global economy
Lastly, I will broaden my perspective and touch upon the relationship between balance-sheet
adjustments and the global economy. What is important in this context is the relationship
between developments in emerging and advanced economies. Currently, large-scale
economic stimulus measures are being implemented around the world. Although emerging
economies did not face pressure for balance-sheet adjustments, given the decrease in global
demand they nevertheless implemented large-scale economic stimulus measures. In
addition, monetary easing in advanced economies has stimulated capital inflows to emerging
economies, boosting economic activity there. On top of that, the effects of monetary easing
have been magnified by foreign exchange interventions by emerging economies to contain
the appreciation of their currencies. In these circumstances, economic activity in emerging
economies has been recovering at a faster rate than anticipated in early spring, contributing
to the recovery of the global economy overall. However, we also need to be aware of the risk
that if the difference in the pace of recovery in emerging and advanced economies does not
diminish, and if capital inflows from advanced economies continue for a protracted period,
emerging economies might overheat and experience financial turmoil, triggering a recession.
Although this may be stating the obvious, given the growing interconnectedness between
economies around the world, what is important for the global economy is that advanced and
emerging economies grow in a sustained and well-balanced manner. Therefore, it is
necessary to pay attention to the relationship between developments in advanced and
emerging economies and especially to capital flows from advanced to emerging economies.
Closing remarks
In my speech today, using Japan's experience in the 1990s for comparison, I highlighted a
number of issues concerning balance-sheet adjustments that will play an important role in
shaping the outlook for the global economy. As a policymaker, I believe it is important to be
aware of the issues I discussed today and, keeping duly in mind that the past is not
necessarily a good guide to the future, to continue to carefully assess economic
developments without any prejudgment. Thank you.