Unformatted text preview: 220 Takatoshi Ito Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting?
Takatoshi Ito1 1. Introduction By any historical or cross-sectional standard, the Japanese economic slump from 1992 to 2004 has been quite unusual. The economy that was once regarded as number one fell into a state of low growth, falling prices, and chronic banking crises for more than a decade.2 The average growth rate from 1993 to 2003 was just above 1 per cent, in contrast to the average growth rate of 4 per cent between 1975 and 1992. Slow growth was accompanied by disinflation in the first half of the 1990s and, eventually, deflation since the mid 1990s. The deflation in prices was associated with a shrinking of the Japanese economy a rare phenomenon among advanced economies. From 1997 to 2002, Japanese nominal GDP (in yen) shrank by 4 per cent, while the nominal GDP of the United States (in US dollars) increased by 25 per cent. Many factors have contributed to the stagnation of the Japanese economy since 1992. The long stagnation reflects the adverse combination of the negative wealth effects from the crash in asset prices, external shocks like the Asian currency crisis, and policy errors in bank supervision, fiscal policy, and monetary policy. In the early to mid 1990s, the burst bubble a decline of stock prices by 50 to 60 per cent and the beginning of a long slide in real estate prices meant that many corporations and households suffered from capital losses, and consumption and investment spending were curtailed. The most severely affected companies stopped interest and principal payments to banks. Non-performing loans became a serious policy problem by 1995. Large fiscal stimulus packages were implemented in the mid 1990s, and the call interest rate was lowered to an unprecedented level of 0.5 per cent in the fall of 1995. The stagnation of the Japanese economy from 1990 to 1995 can be largely explained by the extraordinary negative shocks to asset markets and the subsequent damage to the balance sheets of households and corporations. After the mid 1990s, policy errors prevented the Japanese economy from returning to a firm recovery track. The two opportunities for recovery in 1996 and in 2000 were followed by negative growth and a (near) banking crisis. After a long stagnation, the Japanese economy began to recover in 1996, partly due to
1. The author is grateful for comments by Governor Ian Macfarlane, Robert McCauley, Frederic Mishkin, Warwick McKibbin, and other participants of the conference. 2. Japan as No.1: lessons from America was the title of a book written by Ezra Vogel (1979). A comprehensive description and analysis of the Japanese economy up to 1990 is available in Ito (1992). Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting? 221 the large fiscal stimulus in 1995, and partly because of an increase in exports. As part of the 1995 tax-reduction-now, tax-increase-later package, an increase in the consumption tax in April 1997 had been planned. The expected increase in the consumption tax rate stimulated consumption in the second half of 1996 and the first quarter of 1997. It was difficult to see how much of the growth was due to a genuine recovery and how much was due to the intertemporal substitution of consumption. The planned tax rate increase was carried out and consumption decreased in the second quarter of 1997. The consumption tax rate increase and the repeal of the income tax cut in April 1997 are often regarded as a mistake, in that fiscal tightening was applied to an economy in a nascent recovery. But, in evaluating the cause of the sharp decline in Japanese economic growth in 1998, it is difficult to separate the effects of the fiscal tightening of April 1997 from those of the Asian currency crisis, from July 1997 to the spring of 1998, and the banking crisis of 19971998. The financial markets suddenly shrank due to the failure of one large bank and two securities companies (one large and one medium-sized) in November 1997. As a result of these incidents, the government undertook a capital injection for the major banks in March 1998. However, the additional capital proved insufficient, and two large banks failed in 1998. The second round of fiscal support in March 1999 put an end to the undercapitalisation and fragility of Japanese banks, but only for a few years, as it later turned out.3 From 1995 to 2000, the US economy grew strongly without inflation. The new economy was believed to be supported by the widespread use of information and communication technology (ICT), as well as growth in the ICT sector itself. This was not happening in Japan (or Europe), and one reason, I believe, is that regulatory barriers and the protection of jobs prevented the widespread use of ICT. Even without strong economic growth, ICT stock prices soared worldwide. The Japanese economy was partly helped by the stock price boom and in 2000 the economy expanded by 3 per cent. However, t...
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