Liquidity, Monetary Policy and the Japanese Economy: An Evaluation of the 1990s in Japan.

The Japanese economy presents many interesting problems for macro economists, and it is clear that they have not been solved. The National Institute forecast published in October 2001, for instance, projects two further years of declining output and price deflation. Unemployment is expected to continue to rise, and government debt will rise further. The 1990s might be seen as a lost decade, although an economist should be cautious in describing any period as that. Japanese growth may have been disappointing by historical standards, but on average over the last decade it has been low, but not markedly so as compared to an economy such as Italy. However, the emergence of spare capacity, the increase in unemployment and the significant decline in inflation clearly mark the economy out as different. In this paper we look at policies in the last decade and attempt to re-run history. We first look at the four years from 1992 to 1995. The economy had to face the collapse of asset prices after the bubble of the late 1980s. There was a sharp yen appreciation and in the wake of this the economy suffered from near zero growth. We analyse an early introduction of the zero interest rate policy. From 1995 to 1997 stronger investment led to faster rates of economic growth, and the worsening fiscal situation led to a fiscal tightening. The East Asian crisis from the end of 1997 caused serious financial problems in Japan, and the combination of a tight fiscal policy and an increase in the equity premium caused the economy to slow down. We use our model, NiGEM to analyse the possibility of a loosening of monetary and fiscal policy in early 1998 to see if the slowdown we saw could have been prevented. It was only in 1999 that the zero interest rate policy was introduced, and this may have been rather late, and was not operated with great enthusiasm. We look at the effects of a more aggressive monetary expansion in 2001. We then finally stack three policies together, and argue that if policy had been better set in the 1990s, a monetary expansion now would not be needed. In each case where we analyse it, a loosening of monetary policy of say X percent, has an associated devaluation of the exchange rate of approximately the same size, and the economy expands for a significant period, although the long run equilibrium is essentially unchanged. The policy initiatives produce a price level that is about Z percent higher that it would otherwise have been, although the process is very slow in feeding through. A ten percent devaluation takes up to ten years to produce 10 percent higher prices. Although this is slow as compared to the US in particular, even there we observe inertia in the wage price system, but significantly less than we see in Japan. In all cases we have to accept that there are problems with our analysis. It is difficult for us to model debt deflation, and it is also hard for us analyse shocks that have a permanent effect on the level of output unless they stem from a supply side change.