UCSC Currents online

Front Page
Classified Ads
In Memoriam
Making the News
Take Note

July 17, 2000


Ease Japan's credit crunch and economic growth will follow

By Michael Hutchison

Since the early 1990s, rising unemployment, price deflation, sluggish growth, and recession have beleaguered Japan.

Michael Hutchison
The country's central bank has responded by lowering interest rates to stimulate demand. Short-term rates were gradually lowered from 8.3 percent in early 1991 to virtually zero by early 1999 and have stood at that level for more than a year.

With interest rates at historic lows, why is the Japanese economy still in a slump? One explanation, put forward by economist Paul Krugman, is that traditional monetary policy instruments are powerless to provide effective stimulus to the economy because Japan is in a "liquidity trap." A liquidity trap is characterized by a situation--similar to that in Japan today--where interest rates are at or near zero.

Monetary policy is seemingly impotent to stimulate demand and raise spending since interest rates are already at the lowest point possible. Krugman draws on two bits of empirical evidence to support the liquidity trap argument.

First, he points to the fact that short-term interest rates have reached a minimum point, virtually zero.

Second, Krugman points out that injections of liquidity by the central bank have not been very effective in raising the growth rate of the broader money aggregates.

He shows the monetary base grew 25 percent from 1994 to 1997, but that the broader monetary aggregate (M2 + CDs) grew only 11 percent. Bank credit grew not at all.

More recent statistics indicated "money hoarding" continued to be evident in 1998-99, as an expansion of the monetary base in the range of 8 percent to 10 percent resulted in only about 3 percent growth in M2 + CDs.

Moreover, low interest rates and expansion in the monetary base had not helped increase aggregate demand--the economy continued in recession.

The main alternative explanation for the ineffectiveness of monetary policy to stimulate the economy is the "credit crunch" view. This explanation focuses on the contraction of the supply of bank credit (credit crunch) caused by massive nonperforming loans accumulating in the financial system. This argument has two parts.

The first focuses on the decline in bank capital due to the accumulation of bad loans held by Japanese banks. The capital asset ratio of the 20 largest financial institutions in Japan fell significantly between 1994 and the end of 1998.

Less-than-candid reporting both by banks and by the ministry of finance about the magnitude of the nonperforming loan problem made it difficult for banks to raise capital in domestic and international financial markets.

They therefore responded by reducing the amount of loans. Japanese financial institutions have attempted to raise capital-asset ratios, in part in response to recently tightened international capital standards, as well as in response to pressure from the markets and the government.

But building capital-asset ratios by restraining lending takes a long time. It induces a credit squeeze in the process--the origins of the credit crunch in Japan.

The second part of the credit crunch explanation focuses on the cautious lending attitude of Japanese banks following their recent experience with bankruptcies, nonperforming loans, and recession.

Liabilities associated with bankruptcies hit an all-time high of 2.7 trillion yen in October 1997, and a trend line shows a sustained rise to the highest point in the postwar period toward the end of the decade.

These circumstances make firms less desirable potential borrowers than they used to be, from the banks' point of view. They also have the self-reinforcing effect of tightening credit conditions and worsening the recession.

Evidence of a credit crunch also is suggested by the Bank of Japan's survey known as tankan. This survey asks companies their views of the "lending attitude of financial institutions." Despite the low interest rate environment, the survey indicates a sharp tightening of credit conditions in Japan since mid-1997 facing both large and small enterprises.

These lending attitudes, at least from the borrower perspective, have become much more stringent. A credit crunch implies injections of liquidity (base and narrow money expansion) do not increase credit and aggregate lending.

This is exactly what has occurred in Japan. Base and narrow money have increased at a robust pace in 1997-99, but the broader money aggregates most directly related to spending in the economy grew modestly.

Most disturbing is that aggregate lending by banks has decreased sharply, the flip side of which is the tightening of credit conditions faced by enterprises in Japan.

The balance of evidence seems to support the credit crunch explanation. To address the banking and credit crunch problems, public funds totaling 60 trillion yen (12 percent of GDP) finally were set aside in 1998-99 to recapitalize banks.

In principle, this should ease the credit squeeze and induce banks--particularly with further injections of liquidity into the banking system--to increase lending.

Long-delayed capital injections and restructuring of the banking system should finally help push Japan's economy into an expansion. The analysis here suggests bank recapitalization should ease the credit crunch, and if the Bank of Japan keeps interest rates low, economic growth will soon follow.

Michael Hutchison is a professor of economics at UCSC and a visiting scholar at the Federal Reserve Bank of San Francisco, which published a longer version of this in its Economic Letter.
  Maintained by pioweb@cats