investment expenditures, thus causing a downward kink (or shift) in the path of capital accumulation, which inevitably has serious negative long-term implications. _16_ A set of indicative regression analyses was conducted to investigate the extent of the negative effects of the stock of nonperforming loans on new credit creation by the banking sector - its central role as a financial intermediary. The results of these analyses, tabulated in Table 11, show that the ratio of bad debt to total credit extended had a negative correlation with the bank's lending activities. Judging from the size of the estimated coefficients and their statistical significance attached to this factor in lending operations, the dampening effects of the bad debts on new lending activities seem to have been much larger in smaller financial institutions (regional banks) than in the 21 major institutions with larger net worth (city banks, long-term credit banks, and trust banks). Thus, the disappointingly low growth in banks' credit creation and the high lending rates seem to have their roots in the mounting bad loans.

An interest rate is thought to have two functions in the market economy. An interest rate in real terms directs an inter-temporal (vertical) resource allocation - i.e., a time preference. An interest rate in nominal terms guides liquidity preference, a horizontal resource allocation. Although the Bank of Japan continued to supply enough high-powered money to satisfy liquidity needs in the economy (the second function), the real interest rate did not decline enough to move the capital/earning ratio to stimulate current investment expenditures (the first function). A quasiliquidity trap may have happened during this period due to ongoing stock adjustments, delays in interest rate cuts, and disinflationary pressure caused largely by international trade, as analyzed in a previous section.

The negative effects of widened interest spread were simulated in an report by Japan's Economic Planning Agency (EPA). Assuming that a long-term interest rate relevant for consumption, housing investment, and plant/equipment investment decisions rises in line with the postulated increase in the banks' lending rate, it was shown that an increase in spread of _0.5_ percentage point lowered real GDP by 0.14 percent compared to the base case in the first year and by 0.41 percent by the third year. 7 16 Not only a credit crunch, but also a distortion in income distribution might have occurred under such a situation. Assuming that there are three agents in the economy - household, financial institutions, and nonfinancial enterprises -a decline in the deposit rate means an income transfer from household to financial institutions and to nonfinancial enterprises. Additionally, assuming that a loan rate does not decline as much as a deposit rate (thus increasing the lending spread), the transfer from households (saving agent) to nonfinancial enterprises (investment agent) will disappear or be significantly reduced, manifested as a social loss, in the process of financial intermediation.

17 See Economic Planning Agency, _State of Japanese Economy-Review and Issues of Japanese Economy in 1995,_ December 1995.

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