Masaaki Shirakawa: Deleveraging and growth - is the developed world
following Japan's long and winding road?
Lecture by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the London School of
Economics and Political Science, co-hosted by the Asia Research Centre and STICERD,
London School of Economics, London, 10 January 2011.
* * *
Introduction
"It was the best of times, it was the worst of times..."
Thus begins A Tale of Two Cities, by Charles Dickens, the bicentennial of whose birth we will
celebrate next month. While this famous opening sentence of the novel refers to the year
1775, it also strikes a chord with us in 2012. On the one hand, with all due respect to the
frustration vented by the Occupy protesters, the people of today's developed nations enjoy a
living standard far higher than the harsh realities of Dickensian England. One of the few
luxuries available to young David Copperfield, the alter ego of Dickens, was to take a plunge
in the cold spring water at the old Roman Bath just a few hundred yards from this hall. On the
other hand, it is also true that people feel as if the economy is in the worst possible shape.
Difficult issues in their own right, such as mounting government debts, aging of the
population and challenges brought about by globalization, are exacerbated by stagnant
growth.
These days, when people discuss the grim economic outlook for developed countries, I find
that Japan's experience is often cited. In the past twenty years, Japan's growth rate has
been very low, at 1.0 percent annually in real terms and 0.4 percent in nominal terms
(Chart 1). People ask whether their economies are going to experience a lost decade - or
more recently two lost decades - like Japan. As the governor of Japan's central bank, I have
mixed feelings when I hear Japan's experience referred to in such a negative context, and I
should also note, for the reasons I explain later, that it is not appropriate to bunch the two
decades together. Nevertheless, I cannot deny that this question also provides much food for
thought for other developed countries. Therefore, with apologies to two talented
Liverpudlians and a song that they wrote over 40 years ago, I would like to share with you
some of my thoughts today on the theme "Is the Developed World Following Japan's Long
and Winding Road?" It will be my great pleasure if my speech can be of some benefit to you.
I. Change in how Japan's experience is discussed
To me, the question of whether other developed countries will repeat Japan's experiences is
itself surprising and appears to indicate that a significant intellectual change is under way. At
various international meetings I have attended in the past ten years or so, policy makers and
academics often have not seriously discussed the issue of stagnant growth in Japan, simply
dismissing it as "an idiosyncratic failure of Japan's society and its policy makers to respond
to problems in a swift and bold manner". Even after U.S. housing prices started to decline in
the spring of 2006 this tendency remained. The following is a comment made by a U.S.
official in January 2007.1
"The financial instability that many countries experienced in the 1990s, including Japan, was
caused by bad loans that resulted from declines in commercial property prices and not
declines in home prices. ... Many have learned the wrong lesson from the Japanese
experience. The problem in Japan was not so much the bursting of the bubble but rather the
policies that followed."
What I see behind this comment is a gross underestimation of the extent of the balance
sheet repair - or deleveraging - required after a bubble bursts, as well as an overconfidence
in the effectiveness of aggressive policy measures.2 However, comparing Japan's
experiences in the early 1990s after the bubble burst to what happened in the United States,
the euro area, and the United Kingdom in the past few years, it is my impression that the
similarities far outweigh the differences. What happened in Japan was not unique to Japan.
The first similarity is economic performance. For example, the paths of real GDP since the
peak of the respective bubbles, 1990 in Japan and 2006 in the United States, are similar
(Chart 2).3 Some may say that the selection of the base year is somewhat arbitrary but the
same conclusion can be drawn if we choose as a starting point the year in which the financial
crisis occurred, 1997 for Japan and 2008 for the United States (Chart 3). Comparisons with
experiences in the euro area and the United Kingdom also show similarities, despite some
differences in degree (Chart 2 and 3 as cited above). Some interesting similarities can be
also found in other bubble-related variables. For example, the pace of decline in real estate
prices in the U.S. after its bubble burst was almost the same as in the Japanese case (Chart
4). Despite some differences among countries and regions, overall developments in
longterm interest rates were similar (Chart 5). Cross-country similarity was also evident in
developments in bank lending (Chart 6).
The second similarity is initial responses from the authorities and economists. When a
bubble is being formed or even soon after it bursts, they underestimate the problem or deny
its very existence. In Japan, after real estate prices started to decline, people talked about a
reversal and subsequent upturn. Even after property prices continued to fall for some time,
society denied the possibility that the decline would lead to a financial crisis or stagnation of
the macro economy. In the case of the bursting of the housing bubble in the United States
and the sovereign debt crisis in Europe, the initial reaction was also underestimation of the
problem. Even at a later stage, when experts agreed on the need for public support for
financial institutions, such measures met with opposition from the general public, influenced
by the lingering effects of the underestimation, which was also seen in the case of Japan. In
particular, injecting public funds into financial institutions was universally unpopular across
countries. Likewise, the provision of financial support from core countries to peripheral
countries in the euro area is politically unpopular.
The third similarity is the policies adopted by central banks (Chart 7). In developed countries,
short-term interest rates declined to close to zero and central bank balance sheets expanded
enormously. Since the second half of the 1990s, the Bank of Japan successively introduced
various unorthodox policy measures including zero interest rates, a commitment to maintain
zero interest rates, quantitative easing, and the purchase of risk assets, including stocks held
by financial institutions. After the subprime loan problem materialized, the U.S. Federal
Reserve adopted various policy measures that were often described as innovative, but in fact
many of them are essentially similar to measures previously adopted by the Bank of Japan.
This fact demonstrates the unsurprising truth that central banks act similarly when
confronting similar problems. If there was any major difference, it was that the Bank of Japan
was a lonely forerunner and had to feel its way forward, making decisions in the uncharted
territory of unorthodox policy.
The fourth similarity is the decline of the effectiveness of monetary policy in an economy that
is deleveraging, or in other words, that needs to address the problem of balance sheet repair.
When it comes to the transmission mechanism of monetary policy, in Japan, lower interest
rates had previously induced an increase in banks' lending to small- and medium-sized firms.
This in turn increased business fixed investment by such firms, which drove economic
recovery. This mechanism did not work, however, after the bubble burst. Similarly, in the
United States, a decline in long-term government bond yields has not been fully transmitted
to a decline in the effective rates of mortgage loans because borrowers with low credit scores
have not refinanced at lower interest rates. In Europe - Spain is a prime example - bank
lending rates have risen due to higher interest rates for covered bonds, reflecting a
deterioration in the quality of real estate collateral.
I have gone through some similarities between the current state of the U.S. and European
economies and Japan's experiences. Needless to say, there are also differences.
The first difference is the fact that Japan never became the epicenter of a global financial
crisis. The most important reason for this is that the Japanese authorities did not allow the
disorderly failure of financial institutions. In this regard, the most challenging time for Japan
was 1997, when the brokerage Yamaichi Securities, with assets of 3.7 trillion yen or 19 billion
pounds at that time, collapsed. Yamaichi Securities also had sizeable presence
internationally, especially in the European capital markets. At that time, as was the case
when Lehman Brothers failed, Japan did not have a bankruptcy law that enabled the orderly
resolution of securities companies. Given such circumstances, the Bank of Japan decided to
provide an unlimited amount of liquidity to Yamaichi Securities. This measure essentially
enabled an orderly resolution by replacing all exposures to the securities company held by
market participants both domestic and overseas with exposures to the Bank of Japan and so
prevented the materialization of systemic risk. This was truly a tough decision for the Bank of
Japan. It was made without knowing whether the institution was solvent or insolvent, and
eventually resulted in some losses. I would say, however, that the benefit of preventing
systemic risk from materializing far exceeded such costs. As a result, Japan did not
experience a sharp and significant plunge in economic activity like the one that followed the
collapse of Lehman Brothers, and negative impact from financial turmoil in Japan did not
spread to the rest of the world (Chart 8).
The second difference is the length of time before the economy was exposed to acute
market pressure after the bubble burst (Chart 9). In the Japanese case, non-performing
assets were mainly loan assets, which were not marked to market. For that reason, it took
more time before unrealized losses were recognized and correspondingly it took longer for
the financial institutions involved to be exposed to acute market pressure. On the other hand,
in the recent cases of the United States and Europe, the problem started in the securitized
products market, which enabled the recognition at a relatively early stage of losses based on
mark-to-market valuation, and therefore market pressures intensified earlier than in the
Japanese case. As a result, a financial crisis materialized at an early stage and financial
system stability measures were introduced in a relatively prompt manner.
Examining these differences further, however, the plunge in output might have been limited
in the case of Japan simply because the scope of the crisis was confined within the country.
Even if financial system measures are introduced at an earlier stage, these measures do not
mark the end of deleveraging that characterizes an economy after a bubble bursts. What
happened in Japan, the United States and Europe was basically the same: the paying down
of excess debt, or deleveraging. For the purpose of considering policy responses after the
bursting of a bubble, I believe that examining similarities and differences in this way shows
that it is more constructive to focus on similarities instead of differences, and then consider
factors peculiar to each country.
II. Facts about low growth in Japan
In order to explain these similarities and differences, I would like to comment on Japan's
economy in a little more detail. Specifically, I will explain some facts about economic growth
in Japan by looking at three different time horizons.
Economic growth in Japan: long-term, medium-term, and short-term
First, examining the long-term growth trend, Japan is known as a country which once
recorded surprisingly high growth rates, just like China has done in recent years. The peak
period of Japan's high-growth era was the 15 years from 1956 to 1970, during which real
GDP grew at 9.7 percent annually (Chart 10). Incidentally, this growth rate is exactly the
same as that recorded by China in the period starting in the early 1990s. However, the good
times inevitably come to an end, sooner or later, for any country enjoying such high growth.
This is because some of the conditions that support high growth, especially the labor supply
from rural areas to cities and the high rate of increase in labor force, will eventually reach
their peak.4
Second is the medium-term time horizon. Although Japan's high-growth period ended in the
1970s, its rate of economic growth continued to be much higher than in other developed
countries. Since the 1990s, however, Japan has ceased to be a high-growth economy, even
in a relative sense. In the past twenty years, Japan's growth rate has been very low, at
1.0 percent annually in real terms and 0.4 percent in nominal terms. That is why the past
twenty years are sometimes called "Japan's two lost decades" (Chart 1 as cited above).5
Third is very short-term growth developments. Japan's economic activity plunged after the
tragic earthquake and tsunami on March 11 last year, but recovery proceeded at a
higherthan-expected pace thanks to the efforts made by companies, individuals, and the public
sector. Although Japan's economy is not immune to a slowdown in the global economy,
compared to the United States and Europe, the stability of Japan's financial system and
financial markets is notable, as evidenced by the risk spreads observed in funding markets
and corporate bond markets (Chart 11).
Reasons for low growth over medium term
Of the three time horizons that I have just explained, hereafter I will focus on medium-term
economic developments. Although I have used the phrase "the two lost decades", the causes
of low growth in Japan in the 1990s and 2000s were different and it is somewhat misleading
to discuss the two periods together. In the 1990s, low growth was mainly brought about by
the deleveraging associated with the unprecedented bursting of the bubble. In the 2000s and
thereafter, the major causes of low growth in Japan have been rapid population aging and
population decline.
Regarding the impact of the bursting of the bubble in the first half of the two periods in
question, I do not have much to add to what I have already explained. If I can point out one
difference, the rise in the unemployment rate in Japan was relatively limited (Chart 12).
Japan's unemployment rate peaked at 5.4 percent, significantly lower than the double digit
figures reached in the United States and major European countries. This is attributable to the
fact that wage levels were adjusted in a reasonably flexible manner, reflecting society's
preference to prioritize employment. That people's jobs were preserved was a positive in
terms of social stability. At the same time, it also had a negative consequence. Wage levels
were adjusted but not sufficiently for the magnitude of the shock to the economy, and a
situation arose in which effectively unemployed people retained their jobs at companies. This
delayed the necessary reallocation of resources to respond to demand and cost changes
after the bubble burst. The decline in wage levels also contributed to deflation through a
decline in the prices of services which are labor intensive. In fact, a significant portion of the
inflation differential between Japan and the United States reflects changes in service prices
rather than goods prices.
As for the second of the two lost decades, low growth was mainly attributable to
demographics, or more specifically, a rapid aging of the population. Japan's real GDP growth
rate has declined and growth has been subdued compared to other developed countries.
However, comparing the average real GDP growth rate per capita over the past ten years,
Japan's growth rate is almost the same as other developed countries. Moreover, Japan is
highest in terms of real GDP growth rate per working-age population (Chart 13). As indicated
by these figures, the most significant challenge confronting Japan is how to adjust to a rapid
demographic change that is unprecedented in developed countries (Chart 14). To a
significant extent, the decline in growth rates and deterioration in fiscal conditions are
attributable to a failure to adjust to the rapid change in demographics. Although forecasts by
economists almost always involve a large margin of error, demographic trends are one of the
few economic variables that can be projected with relatively high accuracy. The implications
of population aging and decline are also very profound, as they contribute to a decline in
growth potential, a deterioration in the fiscal balance, and a fall in housing prices. Given that
other developed countries will face the same problems despite some differences in timing
and magnitude, the economic effects of demographics deserve further study.
III. Is the developed world following Japan's long and winding road?
Now I would like to focus on the key question which I posed at the start of my speech. Is the
developed world following Japan's long and winding road? Of course, this is not the kind of
question that can be answered with a simple yes or no. Policy measures are shaped by not
only economic factors but also the response of society and the political world. Every country
has its own unique complexity, both in social and political terms, of which outside observers
have only a limited knowledge. Therefore, instead of providing a direct answer to the
question, I would like to list three factors that define the length of time necessary for
adjustment.
The first factor is the size of excess debt accumulated before a crisis. And if we simply look
at rough estimates of excess debt, it appears that a lengthy period of adjustment is inevitably
required. The scale of the global credit bubble formed toward the middle of the 2000s was
indeed gigantic.
The second factor is growth potential. In the end, whether the amount of debt assumed by an
economy is excessive or not can be judged by considering it in proportion to the economy's
size. For two economies with the same amount of debt, the one with higher growth potential
can lighten the burden of excess debt faster. Having said that, growth potential is not fixed
and can change as a result of policy measures and the response of the society after a bubble
bursts. In that sense, avoiding collateral damage from the bursting of a bubble becomes
extremely important.
Collateral damage could materialize in various ways. For example, in a low-growth economy
that is in the process of deleveraging, social stress tends to intensify and is more likely to
result in a rise in protectionism and excessive government intervention. When lending to
nonviable firms continues for political or social reasons, the resultant decline in productivity
growth will lower growth potential.
Furthermore, monetary policy can also distort economic incentives. Low interest rates and
abundant liquidity are necessary but if they continue for a long time, they may lower
productivity by keeping inefficient firms alive. Necessary adjustment will also be delayed if
low interest rates discourage the government from making efforts to restore fiscal balance.
Population decline will also prolong the adjustment of excess debt by lowering growth
potential. Although these are common problems for the developed world, the decline in
population growth and aging of the population profile are most serious in Japan. The rate of
population growth is lower in Japan than in the United States, the euro area, and the United
Kingdom. More importantly, the fast pace of decline in the population growth rate has been
placing burden on Japan's economy and society. Also, compared to Japan, the contribution
to population growth from immigration is significant in the United States and many European
countries. However, this contribution from immigration could diminish if the stagnation of
economic activity is prolonged (Charts 15 and 16).
The third factor is the growth rate of the global economy. Since the early 2000s, Japan's
economy gradually overcame the post-bubble effects of deleveraging. However, Japan was
also greatly helped by the high growth in the global economy at that time, growth that was
almost unprecedented in the past several decades (Chart 17 and 18). In retrospect, during
that period, the global economy was in the very process of creating a global credit bubble
and also led by strong performance of emerging economies. Given that growth rates in
developed countries are currently restrained by post-bubble deleveraging effects, it is now of
prime importance that emerging economies continue growing without causing inflation or
bubbles of their own.
Of these three factors that define the length of time needed for deleveraging, the first one
- the initial size of excess debt - is a given once a bubble bursts, but we can still influence
the remaining two factors: the growth potential of individual economies and growth
momentum in the global economy as a whole. After the bubble burst, the priority is to
maintain the stability of the financial system. At the same time, it is also important to adapt
the economy to a new environment and resist to pressures that would lead to collateral
damage. This requires strong will and determination.
IV. The role of Central Banks
Given the limited time remaining, I would like to wind up my remarks by briefly explaining my
thoughts on the role of central banks in this difficult period.
In addition to the aforementioned four similarities, there is another similarity between Japan,
the United States and European countries after the bursting of their respective bubbles. That
is, opinions are sharply divided with regard to the roles central banks should play. In the
United States, criticism of aggressive central bank measures seems to prevail, as evidenced
by negative reactions by politicians to the QE2 measures. In other developed countries,
however, central banks apparently face rising expectations and demands to deal with the
situation against a background of sluggish growth. The recent discussion about the
responses to the sovereign debt crisis in Europe confirms this point. Maintaining price
stability and financial system stability are important goals of central banks, but central banks
are not able to solve all problems, especially in an economy characterized by zero interest
rates and deleveraging. Central bank governors including myself have made this point clear
recently.6 I would like to concur with the assessment of my respected colleague, Sir Mervyn,
who said that "There's a limit to what monetary policy can hope to achieve".7
What can be accomplished by central banks? Or, what are central banks expected to
accomplish? Conversely, what cannot be accomplished by central banks? Looking back at
the process of how bubbles form and burst, and the financial crises that ensue, I would like to
make the following four points.
My first point concerns the role of central banks in providing liquidity to banks as "a lender of
last resort", which is extremely important in maintaining financial system stability. If there is a
sharp financial contraction, it becomes more likely that the economy will experience an
abrupt and significant downturn in a short period of time. Given the current circumstances
where the European sovereign debt crisis has been worsening, this lesson is particularly
important to all of us. At the same time, we need to bear in mind that providing liquidity as "a
lender of last resort" is, in essence, a policy to "buy time". It is essential that the necessary
structural reforms take place while time is being bought, as the time that we can buy
becomes progressively more expensive.
My second point concerns the conduct of monetary policy after a bubble bursts. Monetary
easing can affect the economy either through bringing forward future demand or bringing in
overseas demand. In the former case, available future demand gradually decreases as
monetary easing is prolonged. In the latter case, when economic growth in developed
countries is generally weak, monetary easing in individual countries aiming at bringing in
overseas demand may increasingly lead to a zero-sum game, which is not desirable for the
sustainable growth of the global economy as a whole. Such diminishing returns, however, do
not release responsible central banks from the need to act. That is why, at the present time
when short-term interest rates in major economies have declined to almost zero, central
banks, including the Bank of Japan, have been making efforts to generate monetary easing
effects by implementing various unorthodox measures to lower long-term interest rates and
credit spreads. While central banks are buying time with these measures, it is still essential
to pursue the necessary structural reforms.
My third point concerns the paradox of success in the conduct of monetary policy. The goal
of monetary policy is to achieve sustainable growth with price stability. This is a
wellestablished principle that is shared in Japan, the United Kingdom and globally, regardless of
whether an inflation targeting framework is adopted. The more successful the conduct of
monetary policy is, however, the more stable prices become and the less volatility is seen in
economic activity and financial markets. When the expectation prevails that a stable
economic and financial environment will continue for a long period of time, it is likely to
encourage leverage and maturity mismatches between the assets and liabilities of financial
institutions. The greater the leverage and maturity mismatches are, the more exposed the
economy is to a possible unwinding triggered by a given event, so the more fragile it
becomes. The bursting of bubbles is the materialization of such fragility. Before the global
financial crisis, there was a debate over how to deal with bubbles, with one camp stressing
ex-ante prevention and another emphasizing the importance of ex-post measures to resolve
the situation in the aftermath. Following the global financial crisis, however, all now appear to
agree that the cost of a bubble bursting is unbearably enormous. Most past bubbles were
formed while economies enjoyed low inflation rates. Focusing obsessively on the short-term
stability of the consumer price index as a way to ensure economic stability will actually have
the opposite effect of increasing instability. Needless to say, bubbles are not caused by low
interest rates alone. However, when the expectation prevails that low interest rates will
continue for a long period of time, it is likely to encourage leverage and maturity mismatching
between the assets and liabilities of financial institutions. In that sense, I believe that in the
conduct of monetary policy central banks also need to be attentive to the accumulation of
financial imbalances.
My final point concerns the regulatory and supervisory framework. Looking back at how
bubbles are formed, the bottom line is that it comes down to aggressive activity by both
borrowers and lenders. Financial institutions' activities are influenced not only by the
expectation that a stable environment will continue but also by incentives created by the
regulatory and supervisory framework. As for the background to such aggressive activities by
financial institutions, almost without exception regulation and supervision did not prevent
them from getting involved in risky lending, which was, in retrospect, an attempt to improve
their low profitability. This was the case in the Japanese bubble period and European
financial institutions did the same thing during the formation of the global credit bubble in the
middle of the 2000s. Central banks and the regulatory and supervisory authorities in
individual jurisdictions are currently working to reform the regulatory and supervisory
frameworks. One important issue in this regard is how to find the right balance between two
important tasks: restraining excessive risk taking and securing the profitability of financial
institutions.
Closing words
The recent financial crisis has certainly left not one, as the Beatles song said, but many a
pool of tears. As a result, if I may return to the Dickens quote, it feels for many of us like the
worst of times. It may be a bit of a stretch to say that we are in the best of times, but it is too
early to despair. Our economies have the resources, not only money but also the intellectual
and institutional capabilities, to resolve the issues we face. If we can adapt the economy to a
new environment and resist pressures that would lead to collateral damage, even after the
bursting of the bubble, we should still be able to find a path leading to renewed growth. What
we need is the determination and will. Ultimately, if we have this determination and will, we
can shorten the long and winding road.
Thank you for your attention.
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