Masaaki Shirakawa: Japan's economy and monetary policy
Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Kisaragi-kai
Meeting, Tokyo, 25 July 2011.
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Introduction
I am privileged to have this opportunity to speak before such a large audience today.
Four and a half months have passed since the Great East Japan Earthquake, an
unprecedented tragic event. Immediately after the earthquake, production plunged mainly
due to the destruction of capital equipment, supply-chain disruptions, and electric power
shortages. After passing through the worst period, however, production activity has been
recovering at a faster-than-expected pace with a gradual easing of various supply-side
constraints. At the same time, there is also the harsh reality that many still bear hardships
that cause them restless days. The conduct of monetary policy is by nature mainly based on
a macroeconomic analysis. However, we recognize that the damage from the earthquake
disaster varies by area and industry. I myself visited the disaster areas and now have a
greater recognition that macroeconomic perspectives are not enough to fully describe the
true state of our economy. Even from a macroeconomic perspective, although downside risk
has been receding with respect to the supply-side constraints that emerged immediately after
the earthquake, Japan's economy is starting to confront another new problem of uncertainty
regarding electric power supply in the long run. Even before the earthquake, our economy
had faced various pressing structural problems, including the rapid aging of the population.
So, this brings us to the end of a somewhat lengthy introduction. Today I will first describe
the current state of Japan's economy and its outlook. After illustrating the challenges
confronting our economy, I will explain the Bank of Japan's conduct of monetary policy. In my
remarks, I would like to pay due attention to the time horizon by clearly delineating short-term
and medium- to long-term periods.
I. Developments in overseas economies
I will begin with developments in overseas economies, which form the basis for analyzing
those in Japan's economy. The impact of the recent earthquake has been enormous, and
recent economic debate tends to focus on the effects of the disaster. Needless to say, the
global economy and financial markets keep changing while we deal with the aftermath of the
disaster. After all, when the supply-side constraints are resolved, developments in overseas
economies will be the most significant driver of Japan's economic activity in the short run.
The U.S. economy has been growing at a slower pace since this spring. This is partly
because households' real purchasing power has declined due to the rise in gasoline prices
seen until around spring, and there have been difficulties in procuring automobile parts due
to the disaster in Japan. It should be noted, however, that gasoline prices have fallen back
somewhat since May and Japan-led supply-chain disruptions have started to be resolved.
Therefore, the view held by the U.S. authorities and economists is that the recent economic
slowdown is generally transitory, and their baseline scenario is that the pace of growth will
resume a recovery supported by the accommodative financial environment. Of course, such
an outlook entails uncertainties. The focal point is on how to assess balance-sheet
adjustment pressure. Recent data on household debt and housing prices indicate that
balance-sheet adjustment in the household sector is ongoing. The recovery in employment
has also been disappointing. Just as in the case for Japan in the 1990s, after the bursting of
the large credit bubble, the economy often continues to face a low growth rate for a
protracted period, although there are some short-term boosts reflecting the implementation of
fiscal stimulus packages or accommodative monetary policies. Having said that, it might not
be appropriate to conclude that the U.S. economy will follow a path similar to the one Japan
once experienced, taking into account the U.S. economy's distinctive flexibility and the fact
that it is a commodity-exporting country. Careful attention should be paid to how strongly
balance-sheet adjustment pressure continues to constrain growth in the U.S. economy.
The European economy as a whole continues to recover moderately, although there are
large differences in the economic growth rates between the euro area's major countries,
such as Germany, and its peripheral countries, including Greece. The German economy
maintains its robustness; for example, the latest unemployment rate is 7.0 percent, the
lowest level since the reunification of West and East Germany. On the other hand, peripheral
countries are experiencing a tough time, as witnessed by the recent Greek growth data,
which showed an 8.1 percent decline on a year-on-year basis. Regarding prospects for the
European economy, the focal point clearly is developments in the sovereign debt problem in
peripheral countries. The essence of the problem is an adverse feedback loop among fiscal
conditions, the financial system, and the real economy. This feedback loop works as follows.
If confidence in the government declines due to the expansion of fiscal deficits, the
government bond rate increases and the creditworthiness of financial institutions
deteriorates. An overall increase in interest rates could cause further fiscal deterioration
because an associated economic downturn reduces tax revenue. As a result, interest rates,
including those on government bonds, could increase further. Such an adverse feedback
loop among fiscal conditions, the financial system, and the real economy is the inherent
nature of the sovereign debt problem. If the sovereign debt problem in Europe triggers
instability in global financial markets, it will exert an adverse impact on the global economy
as a whole. To address the problem, further efforts in the following two areas are
indispensable. One is strenuous efforts by Greece and other problem-stricken countries to
reduce their fiscal deficits and to advance a structural reform to strengthen competitiveness.
The other is to "buy time." The European Union (EU) and the International Monetary Fund
(IMF) need to work together to provide financial support to the problem-stricken countries
until those countries' efforts produce noticeable outcomes. In this regard, Greece, the EU,
and the IMF have been taking necessary steps. The Bank has been monitoring the situation
carefully.
The growth rates in emerging and commodity-exporting economies are still at high levels, but
these have recently been slowing somewhat mainly due to the heightened inflationary
pressures and associated monetary tightening. In China, the year-on-year rate of increase in
the consumer price index (CPI) was 6.4 percent in June 2011, up substantially from the
2.9 percent exhibited a year ago. In response, the People's Bank of China has raised the
renminbi benchmark rates five times since October 2010. Other emerging economies have
also raised interest rates, but in many cases the real short-term interest rate, which subtracts
the inflation rate from the nominal interest rate, is significantly below the long-term trend of
the economic growth rate. In any case, deceleration in growth is inevitable and necessary for
emerging and commodity-exporting economies to achieve sustainable growth. Yet, there is a
considerable degree of uncertainty as to whether these economies will be able to make a
soft landing by achieving price stability and economic growth at the same time.
I have explained the current state of the economy, the baseline scenario of the outlook, and
associated risks by region - namely, the United States, Europe, and emerging economies.
The Bank projects that the global economy as a whole is likely to continue realizing relatively
high growth led by growth in emerging and commodity-exporting economies. The forecasts
by the IMF released in June represent an upbeat projection for the growth rate of the global
economy, with growth of 4.3 percent in 2011 and 4.5 percent in 2012. For reference, the
average annual growth rate of the global economy over the 30 years since 1980 was
3.3 percent and that over the 10 years to 2007, which includes the period of the global credit
bubble, was 4.0 percent. This suggests that the projected growth rates this year and next
year are at a historically high level. Therefore, the global economy as a whole is likely to
continue realizing relatively high growth; however, as I mentioned earlier, when considered
by region, such an outlook entails uncertainties and various risks warrant sustained attention.
II. The current situation of Japan's economy and the bank's baseline scenario
Based on the outlook for overseas economies, now I would like to explain the current state of
and outlook for Japan's economy.
As I mentioned at the beginning, production plunged immediately after the earthquake as the
economy abruptly faced supply-side constraints. Although the initial problem was supply-side
constraints, private consumption also weakened because the combination of increased
uncertainties about the future and voluntary restraint by consumers led to a deterioration in
household sentiment. As a result, in March, industrial production registered the largest
month-to-month drop on record, surpassing the decline following the Lehman shock. It
should be noted, however, that the economic plunge after the earthquake was different from
the one following the Lehman shock. The recent plunge was mainly caused by the supply
shock, while it was the "evaporation of demand" after the Lehman shock that took corporate
activity into a downward spiral of contraction. Therefore, unlike the time after the Lehman
shock, we were able to make a reasonable projection at an early stage that production would
recover once the supply-side constraints eased.
In fact, production is recovering quickly as progress in the restoration of supply-chain
disruptions has been made at a faster-than-expected pace. This recovery is led by the
automobile industry, which experienced an especially sharp downturn. At least for this
summer, it seems the electric power shortages are not constraining economic activity as
significantly as projected immediately after the earthquake, reflecting a strengthening of
supply capacity by electric power companies and successful efforts to conserve energy and
level out demand. Based on an overall judgment, taking into account the information from our
business contacts, production is expected to recover to the pre-earthquake level sometime
during July to September. Household sentiment is also improving somewhat. With regard to
business sentiment, we are carefully monitoring business fixed investment plans. In this
regard, business sentiment is becoming firm, as evidenced by the June Tankan (Short-Term
Economic Survey of Enterprises in Japan), in which business fixed investment plans were
revised upward from the March Tankan.
After overcoming the supply-side constraints, which has been the most serious cause of
concern, the short-term prospects for Japan's economy will rely on demand-side
developments. In this regard, there are two important factors. First, it seems that the
economy can count on exports, which are likely to continue increasing on the back of strong
growth in overseas economies. Second, demand arising from the rebuilding of capital stock
that was damaged by the earthquake, or the so-called "rebuilding demand," is expected to
increase gradually. Although we have seen only a limited amount of rebuilding demand so
far, such demand will become more noticeable as we get a clear overall picture of rebuilding
in the coming period. Furthermore, although it might be slightly different from the rebuilding
demand, private consumption data in the Tohoku region shows that there has been a large
increase in the so-called "rebuilding-related consumption" - namely, consumption for the
purpose of rebuilding daily lives, including the purchase of new durable consumer goods
such as cars and electrical appliances.
Based on the various information as I just described, Japan's economy is expected to return
to a moderate recovery path from the second half of fiscal 2011. The Bank published the
Outlook for Economic Activity and Prices (hereafter the Outlook Report) in late April and
made an interim assessment in July. Looking at the median of individual Policy Board
members' forecasts in the interim assessment, the year-on-year rate of increase in real GDP
for fiscal 2011 is 0.4 percent. The figure is somewhat of a downward revision from the April
2011 Outlook Report. This is mainly attributable to a smaller carry-over effect from fiscal
2010 on GDP growth for fiscal 2011, reflecting the fact that the earthquake disaster resulted
in significant negative growth in the January-March quarter of 2011. The forecast for the
year-on-year rate of increase in real GDP for fiscal 2012 is 2.9 percent, broadly unchanged
from the relatively high growth projected in the April 2011 Outlook Report.
Let me turn to price developments. The pace of decline in the CPI has moderated steadily
reflecting the improvement in the aggregate supply and demand balance. In April 2011, the
year-on-year rate of change in the CPI turned positive for the first time in two years and four
months since December 2008, and in May of this year it marked an increase of 0.6 percent.
With regard to the outlook for price developments, the projection of international commodity
prices is one key factor. The Bank projects that international commodity prices will continue
to increase moderately along with strong growth in emerging economies. Another key factor
is medium- to long-term expected rates of inflation. Based on forecasts made by economists,
such rates remain stable at around 1 percent. The Bank has released the "understanding of
medium- to long-term price stability" (hereafter the "understanding") - that is, the level of
inflation that each Policy Board member understands, when conducting monetary policy, as
being consistent with price stability over the medium to long term. Members' "understanding"
centers at around 1 percent, which is the same as the medium- to long-term expected rates
of inflation forecasted by economists. We expect that medium- to long-term expected rates of
inflation are likely to remain stable going forward. In this situation, the year-on-year rate of
change in the CPI is expected to remain slightly positive with the aggregate supply and
demand balance improving as a trend amid economic recovery. In the July interim
assessment of the April 2011 Outlook Report, the median of Policy Board members' CPI
forecasts was an increase of 0.7 percent both for fiscal 2011 and 2012.
It should be noted, however, that the base year of the CPI is revised every five years in
Japan. As the Bank has explained on various occasions, there will be a downward revision to
the year-on-year rate of increase in the CPI to be released in mid-August this year, based on
the new base year. While rather technical, based on the methodology currently employed to
compile the CPI in Japan, the CPI basket that comprises the goods the consumers would
purchase is fixed. Therefore, as a longer period of time has elapsed since the base year, it
becomes increasingly difficult for the CPI to fully reflect the impact of substantial price
declines for some goods for which the volume of purchases has increased due to a price
decline. This is the so-called "Laspeyres bias." Typical examples of such bias are found in
the prices of goods such as personal computers and televisions. As a result, after almost five
years from the previous base-year revision, the recent figures for the year-on-year rate of
increase in the CPI have a somewhat large upward bias, and therefore are likely to be
revised downward all at once in the scheduled base-year revision. Although some
economists make public their estimates, it is difficult to accurately project the specific degree
of downward revision in advance. This is because, in addition to the easy-to-estimate
Laspeyres bias, the revision will be affected by the composition of a new basket and the
methodology of measuring prices of individual items. Firms and households make their
day-to-day decisions on production and spending on the basis of the observed prices of
individual goods. Therefore, the underlying trend of prices and people's economic activity will
not be affected by the base-year change of the price index, which is a technical revision in
statistics. Nevertheless, the Bank will examine how this revision will be made, as well as its
implications.
III. Risk factors for the outlook
I have explained the baseline scenario of the outlook for economic activity and prices that the
Bank considers most likely. As the outlook is always subject to uncertainties, we should
acknowledge the risk that the economy will deviate from the baseline scenario.
Risks regarding overseas economies
The first risk factor concerns prospects for overseas economies. I will not go into detail on
this point, as I already covered this earlier, but I emphasize that there are respective risks in
the United States, Europe, and emerging and commodity-exporting economies. In relation to
the risk regarding overseas economies, attention should also be paid to developments in the
foreign exchange markets. If uncertainties about the prospects for the global economy
heighten, investors increasingly become risk averse and upward pressures tend to be
exerted to those currencies perceived as relatively safe. In terms of changes in the nominal
effective exchange rate of advanced economies after the earthquake, the Swiss franc has
appreciated most followed by the Japanese yen. Although the appreciation of the yen has
some benefit of reducing the cost of imported energy and raw materials, it could have
adverse effects on the economy as a whole through a decline in exports and corporate
profits, as well as a deterioration in business sentiment, when the appreciation is caused by
increased uncertainties about overseas economies. Careful monitoring is warranted in this
regard.
Risks regarding the effects of the earthquake disaster
The second risk factor regarding the outlook for economic activity and prices concerns the
medium- to long-term effects stemming from the recent earthquake disaster. The focal point
of the effects of the disaster keeps changing as time passes. The risks that became apparent
immediately after the earthquake - such as a delay in the restoration of supply-chain
disruptions and electric power shortages in this summer - have receded. However, I must
say that the somewhat improved household sentiment is still weak compared with the
pre-earthquake level, and recovery in some components of private consumption such as
eating out and travel expenses has been slow. Therefore, developments in private
consumption for the time being warrant careful examination.
Recently, uncertainty has increased with regard to electricity supply constraints, which will
occur when more nuclear power plants fail to resume operations following their regular
inspections. In that case, it will probably be difficult for some time to completely cover a
reduction in electricity supply by other measures. Even if various efforts are made, the
economy will likely continue to suffer from electric power shortages, mainly in summer and
winter, in the coming years. Moreover, we are likely to bear higher costs anyway, either when
some of the electricity generated through nuclear power is replaced by thermal power, or
when the use of nuclear power plants is maintained after strengthening safety measures. In
either case, a rise in electricity costs will oppress corporate profits and households' real
purchasing power, which could in turn restrain business fixed investment and private
consumption. Furthermore, from a longer-term perspective, we should recognize the risk that
the electricity supply problem will dampen the medium- to long-term growth potential of
Japan's economy. The recent experience of supply-chain disruptions has renewed
awareness that domestic production is exposed to the risk of earthquake disasters. In
addition, if high uncertainties continue with regard to electric power supply, both in terms of
stability and costs, we cannot ignore the risk that the shift to overseas production will be
accelerated.
IV. The strengthening of medium- to long-term growth potential of Japan's
economy
I have discussed the outlook for Japan's economy with emphasis on the impact of the
earthquake and developments in overseas economies. After long deliberation on the issue of
rebuilding the economy after the earthquake disaster, I am increasingly convinced that we
need to make renewed decisive efforts to tackle the challenge of strengthening medium- to
long-term growth potential, which Japan's economy had faced even before the disaster. I will
now describe measures to strengthen Japan's growth potential.
Need to strengthen the growth potential
In order to ascertain a specific prescription, we need to make an accurate assessment of the
confronting problems. Although political and social difficulties are often pointed to as
obstacles, I think that implementation of the correct prescription is also hampered by
insufficient recognition of the bottom line for Japan's economic problems and the causes of
declines in the growth rate.
In the long run, Japan's economic growth rate has been on a declining trend: the average
annual growth rate was 5 percent in the 1970s, around 4.5 percent in the 1980s, around
1.5 percent in the 1990s, and less than 1 percent in the 2000s. After making a successful
take-off to high growth, every economy will sooner or later shift into stable growth. Japan was
no exception, but abruptly got trapped in the financial bubble that was formed in the process
of shifting to stable growth. After declining sharply in the 1990s on the impact of the bursting
of the bubble, we have not managed to change the declining trend of Japan's growth rate. In
the time horizon of two to three years, a growth rate is dominated by changes in demand,
except in periods following supply-side shocks such as earthquakes. However, in terms of an
average growth rate in the time horizon of 10 to 20 years - namely, the medium- to long-term
growth potential - it is natural to consider that key determinants are supply-side factors. Real
GDP can be expressed as a product of "the number of workers" and "real GDP per worker."
As a corollary, the real GDP growth rate can be understood as the sum of the rate of
increase in the number of workers and the labor productivity growth rate. Using these simple
figures, I would like to highlight the following facts.
The first is that the impact of declines in the number of workers on Japan's growth rate has
been gradually increasing in the 1990s and the 2000s. After peaking around 1995, the
working-age population started to decline and the pace of decline accelerated in the 2000s.
The working-age population plays a core role in production activity, and such a decline will
constrain economic growth from the supply side through a reduction in the number of
workers. The working-age population is also a major driver of private consumption and
significantly contributes to tax revenue. Therefore, even from the demand side, a decline in
the working-age population will lower growth potential unless necessary measures are taken.
Such measures include deregulation in the areas of health care and nursing care services for
the elderly to meet rising demand from the aging population, as well as measures to offset a
rising fiscal burden on the working-age population.
The second fact is that, despite some declines in recent years, Japan is still in the group of
advanced countries with the highest labor productivity growth rate, along with the United
States. The labor productivity growth rate is an important determinant of growth potential of
the economy. As I will explain later, I think it is necessary to continue making efforts to raise
the labor productivity growth rate, and there are good prospects for such efforts to bear fruit.
At the same time, it is not realistic to expect that the labor productivity growth rate, which has
been at around 1 percent on average, will rise by 1 or 2 percentage points at once. There is
no significant difference in the productivity growth rate among countries that have already
gone through a high growth period. While we must make the utmost efforts, we also need to
be cool-headed and recognize that the already matured economy cannot expect to see a
dramatic increase in its growth potential.
So, what is the bottom line for Japan's economic problems? In my view, the most serious
problem is that, if we maintain the current situation, it becomes difficult for Japanese people
to sustain the current relatively high level of living standards on an international comparison.
Speaking of which, the level of real GDP per capita in Japan is still high on an international
basis. In addition, the fact that the average lifespan of Japanese people is extremely long
indicates that the country has achieved a significantly high standard of health on an
international comparison. Health is an important condition for people's happiness and cannot
be measured by GDP statistics. The question is whether our children and grandchildren can
sustain such a high standard of living, and I am afraid it is not possible if we choose to keep
the status quo. The key word is "sustainability." We can make a simple interpretation of a
country's economic activity as follows. The working-age population earns income through
production activity and raises their children, the future workforce. The elderly, who once
earned income as part of the workforce, now make their living by relying on their
accumulated savings and the social security system, which is supported by the working-age
population. In this way, human society continues to raise the standard of living through
generational change. What is important here is a smooth transition to the next generations.
In this regard, unless measures are taken to review existing institutions and customs to
adjust to objective changes in the environment such as a rapidly aging and declining
population, the sustainability of the economy will be threatened. In the following, I will explain
the necessary measures to ensure sustainability.
Encouraging labor participation
First, we should make efforts not to reduce but rather increase the number of workers by
raising the labor participation rate of women. By age group, this rate displays an M-shaped
curve, with a dip in the age group of those aged in their 30s. This feature makes Japan
different from other advanced countries, indicating that Japan is not a friendly society for
working women raising children. Efforts to improve the environment for women, such that
they can handle both a career and raising children, are meaningful not only for economic
growth but for the society. Moreover, we should not overlook the fact that Japanese people
are living longer and the number of the elderly blessed with good health and physical
strength is increasing. There is research showing that the physical conditions of elderly
people have improved and those who can work vigorously have increased. Building a society
where elderly people who have the will and capability to work are able to actually do so,
depending on their situation, will not only have a positive impact on economic growth but also
lead to enriching people's lives.
Raising labor productivity
Second, efforts are needed to raise labor productivity. The phrase "raising productivity" is
often used to mean improving efficiency and streamlining. But I would like to emphasize the
other aspect of higher productivity, which is that it leads to an expanded equilibrium, in that
individual workers can generate higher added value. Added value is a source of funds that
ultimately will be allocated as corporate profits and wages. Therefore, increasing added
value is the same as saying that firms boost profits while expanding wages to be paid. To
this end, firms need to increase their profits by exploring new markets, not solely relying on
cost reductions. In what follows, I will highlight three strategies for exploring new markets.
First of all, it is all the more important to actively capture global demand amid the world
economy's continuing strong growth. In this regard, the expansion of firms' overseas bases
would likely have a positive impact on Japan's economy if it is motivated by the aspiration for
growth to strengthen their global strategies, instead of the passive choice of giving up on
Japan. The share of Japanese firms' overseas production, which is currently a little less than
20 percent, has been increasing in inverse proportion to the gradual decline in Japan's share
in global GDP. In other words, as emerging economies have grown and Japan's relative
share in global GDP has declined, overseas production by Japanese firms has expanded to
capture the demand for the increasing consumption of locally made products. In the process
of continuous expansion of overseas production, domestic offices and factories have always
constituted an integral part of international division of labor by changing their role.
Specifically, they have started to assume the function of a global headquarters and to focus
on advanced research and development while increasing exports of intermediate goods to
overseas bases.
For Japanese firms to be winners in the rapidly changing global markets, mergers and
acquisitions have acquired increasing importance. In this regard, although Japan is
experiencing declining growth potential in terms of flow, it still has strengths in terms of
economic stock, such as abundant financial assets and technological competitiveness. In
fact, an increasing number of firms, taking advantage of their ample funds, have recently
concluded vigorous investment deals to purchase overseas firms with growth potential.
Capturing global demand is not limited to the areas of monozukuri, or manufacturing. Efforts
to further enhance Japan's attractiveness as a tourist destination will generate a significant
outcome in the medium to long run. As I have illustrated, Japan should pursue global
strategies in a wide range of areas and in a variety of ways. In order to make the best use of
Japan's potential, it is extremely important to steadily enhance the framework of free trade
agreements and economic partnership agreements.
To raise labor productivity, it is also important to promote technological innovation and
explore potential demand in areas related to the natural environment and energy. The
earthquake disaster is expected to further heighten the need for technological innovation in
these areas. Having nurtured sophisticated technologies for years, Japan is well placed to
raise its growth potential by pursuing the following three strategies together: "saving energy,"
to conserve energy through the wider use of LED lighting; "creating energy," through the use
of solar power; and "storing energy," through the improvement of batteries in terms of
efficiency and capacity.
Furthermore, efforts are needed to further explore domestic markets and thereby generate
added value by discovering potential demand. I often hear the pessimistic view that domestic
markets will shrink steadily because of the declining and aging population. However, even in
an aging society, people's potential needs are diverse and unlimited, and continuously
exploring such needs is a significant source of added value.
V. Efforts toward fiscal consolidation
I have talked about efforts to encourage labor participation and raise labor productivity as
necessary measures to ensure the sustainability of the economy. In this regard, there is
another policy goal of extreme importance that requires further efforts - namely, fiscal
consolidation. As government debt outstanding has already reached a tremendous level in
Japan, an increasingly aging population will act to exert pressure to further deteriorate fiscal
balance. Deterioration in fiscal balance has adverse effects on economic activity through two
channels. First, an increased burden on the part of the working-age population would
constrain consumer spending. Second, as I explained earlier by taking the example of the
sovereign debt problem in Europe, if confidence in the government's debt repayment ability
is undermined, there would be an adverse feedback loop among fiscal condi