Asia’s crisis is a reflection of massive excess capacity and the accompanying deflationary pressure.
Regular readers of the Wall Street Journal editorial page may be forgiven the impression that Asia’s crises could have been avoided by rigidly pegged exchange rates. On April 15, 1998, the Journal’s editors observed: “Asia’s crisis has been primarily a currency crisis, not an explosion of economic fundamentals.”
This view is disastrously wrong. Asia’s crisis is a reflection of massive excess capacity and the accompanying deflationary pressure. Collapsing Asian currencies are a symptom, not the cause of that reality. Nowhere is this truth more evident than in Japan, which--lest the Wall Street Journal forget--produces more than 60 percent of the Asian gross domestic product. Japan’s GDP is ten times that of South Korea and twenty times that of Indonesia. Japan is the latest and largest Asian economy risking a deflationary disaster by trying to prop up its currency.
In fact, it is the widespread application in Asia of the Japanese model that led to excess capacity and deflationary pressure.
The resulting heavy pressure for currency depreciation is a symptom of the need to export the massive excess supply at the heart of the Asian crisis. The Japanese model--hard work, high savings, and the suppression of domestic demand for current goods--leads to a large flow of funds available for investment. If the government misdirects investment flows, which are probably too large for economic conditions anyway, the result is chronic excess capacity, deflationary pressure, and the general signs of huge pressure for currency depreciation, which emerged in Japan in 1995 and surfaced more broadly in Asia in 1997.
The pressure for currency depreciation is growing in Japan as misguided, tighter fiscal policy and a collapse of business and household confidence have contracted domestic demand even further. The markets have judged as grossly insufficient the modest reversal of the tight fiscal policy in Japan, announced with much fanfare early in April.
The Mounting Japanese Crisis
Within Asia’s deflationary environment of excess supply, Japan’s rising current account surplus and reserves are omens of escalating trouble, not signs of strength, as Prime Minister Ryutaro Hashimoto has claimed. The climbing current account surplus reflects increasing excess capacity in Japan and a more urgent need to export it. Domestic demand is so weak because of Japan’s crisis in the financial sector that a weaker currency and more aggressive printing of money are the only ways to shore up demand, especially in the face of weaker demand in Asia.
Demand, not supply, is the increasingly scarce component: the exact reverse of Japan’s postwar preoccupation with rebuilding its capital stock while suppressing domestic demand. Japan will not recover fully until its current account surplus disappears as aggressive deregulation creates a surge of investment opportunities that can be financed only with imported savings. A sharp currency depreciation would help to jump-start the transformation of Japan’s overregulated economy so that it could profitably absorb more domestic and foreign investment. Meanwhile, the aggressive printing of money would help to reflate domestic demand.
In the rest of Asia, where chronic excess supply also abounds, the International Monetary Fund has applied its traditional medicine of squeezing down domestic demand. Consequently, the pressure for currency depreciation has intensified. If domestic demand is squeezed, the only way to increase demand for the goods produced by excessive capacity is to have the currency collapse so that world demand is shifted onto the traded-goods sector of the country afflicted with general excess capacity. Finally, in 1998, the IMF reversed its extreme austerity prescriptions for
Thailand, Indonesia, and South Korea, but the growing condition of excess supply in Japan has persisted despite belated, insufficient efforts by the Japanese government to reverse it.
Unfortunately, Prime Minister Hashimoto and, from time to time, the G-7 have embraced the Wall Street Journal’s misguided notion that resisting the currency depreciation symptomatic of excess capacity amounts to a cure for the Asian crisis. But the misdiagnosis of the Asian crisis as a currency crisis last fall, coupled with the belief that a large stock of foreign exchange reserves is a sign of strength, led to disaster for South Korea. The government’s denial that a crisis was brewing, along with efforts to shore up its currency, provoked a collapse in its equity market, followed by a collapse in the South Korean currency. A hastily arranged and misconceived IMF program created a panic over South Korea and Asia by mid-December and forced U.S. Treasury Secretary Robert Rubin to take over management of the Asian crisis outside Japan.
The second signal of an intensifying Asian crisis appeared during November in Japan. One of Japan’s “too big to fail” city banks, the Hokkaido Takushoku Bank, did indeed fail. A week later, Japan’s fourth largest brokerage firm, Yamaichi Securities, failed as well. These failures caused a panic at the Ministry of Finance and a determination not to allow any further financial collapses. This panicky decision unfortunately bumped Japan off course in dealing with the serious problems in its financial sector.
Finally, late in November, Japan passed its version of America’s Gramm-Rudman Law, the Structural Fiscal Reform Law (SFRL), which targeted the reduction of the budget deficit to a level below 3 percent of GDP by the year 2003. This put Japan’s fiscal policy on a dangerous tightening path while excess supply was rising in Japan and in the rest of Asia.
Japan’s Tax Cut
Events in November that should clearly have signaled that Asia’s crisis was far more than a currency crisis spilled over into December. In Japan, the panic resulting from the closure of two large financial institutions along with rapidly deteriorating financial conditions forced Prime Minister Hashimoto to reconsider the fiscal stringency implied by the SFRL less than a month after it was passed. On December 17, against the backdrop of the deepening Asian crisis outside Japan, Hashimoto announced a weak stimulus package featuring 2 trillion yen (about 0.4 percent of GDP) of special tax cuts.
The immediate market reaction was to sell yen. In an unfortunate attempt to simulate confidence in the plan, the Bank of Japan immediately and aggressively sold dollars, pushing the yen price of dollars from 131 to 126. The Japanese government apparently believed that if the market’s judgment on a misguided policy move was negative, the reality could be concealed by currency market intervention. Perhaps policy makers had been reading the Wall Street Journal and believed that their crisis, like Asia’s, really was just a currency crisis.
Japan’s 2 trillion yen tax cut was an offensive in two dimensions, and it failed in both. First, it was an attempt to support the lagging economy and to offset the loss of consumer confidence resulting from the bank failures and the closure of Yamaichi Securities the month before. The measure involved injecting virtually all the tax cut directly into household paychecks by canceling Japan’s federal taxes during the month of February 1998.
The December tax cut was also an experiment to see if Japanese households could be induced to spend more. The cut amounted to a tax rebate of about $300 for every household in Japan. Unfortunately, data published in January and February along with March’s disastrous Tankan survey of company attitudes revealed Japan’s December experiment as a failure. February chain store sales fell by 5 percent, recording the largest single monthly decline since 1993. Department store sales fell by 6 percent on a year-over-year basis while recording the largest single drop ever for the month of February.
Deteriorating Picture for Business and Banking
The collapse in demand was enough to frighten Japan’s producers. February industrial production fell by 3.9 percent, while projections for the next two months suggested that production would be falling at an annual rate approaching 40 percent over the three months from February through April 1998. Meanwhile, February inventories rose rapidly, and the inventory-to-sales ratio reached the highest level since May 1975, when Japan’s economy collapsed after the oil crisis.
The precipitous decline in Japan’s economy during the first quarter of 1998 was underscored by the Bank of Japan’s Tankan survey released April 2. The survey showed a heightened deterioration in the business situation since December, even more acute than anticipated. Inventory buildups were larger than expected. The business outlook for large and small firms was worse than predicted. Investment plans for large and small firms were revised to larger negative numbers, and the credit crunch, especially for small and medium-sized firms, intensified.
Paralleling the acute distress of Japan’s economy during the first quarter of 1998, the crisis in the banking system intensified. The exposure of Japanese banks to Asian debtors at $271 billion meant further deterioration of Japan’s bank balance sheets. Most objective estimates of the total bad debt on Japan’s bank balance sheets run close to $1 trillion, or about one-fifth of the total assets of Japanese banks. This accounts for the rapid shrinkage of Japanese bank balance sheets as they struggle to meet international standards for adequate reserves.
The Japanese government assembled a package of 30 trillion yen for possible use in shoring up the banking system; 13 trillion yen was earmarked for capital injections to Japan’s banks while 17 trillion yen was set aside to prop up Japan’s empty deposit insurance fund. Unfortunately, the 13 trillion yen was made available to all Japanese banks rather than used to reinforce strong banks while weak banks were allowed to close. Given the stigma attached to the government funds, since they would suggest that a bank might desperately need credit, less than 2 trillion yen was initially used. Meanwhile, the 17 trillion yen remains an awkward reminder that the former finance minister’s declaration in early December that there would be no more bank failures may prove untrue. While a substantial amount, the 30 trillion yen does not add to aggregate demand and is far too little to deal with a $1 trillion, or approximately 130 trillion yen, problem in Japan’s banking system.
As if Japan’s problems were not bad enough, on April 3, Moody’s Investor Service changed its rating outlook for Japan from stable to negative. This move, while leaving Japan’s triple-A rating intact for the time being, reminded markets that Japan’s cumulative 70 trillion yen effort to shore up its economy with fiscal packages over the past seven years had considerably damaged government finances. Aside from the waste entailed by huge public works expenditures included in the 70 trillion yen, Japan’s debt-to-GDP ratio has risen to more than 90 percent, based on the usual calculations, while its deficit is running well above 6 percent of GDP once the prefectural government outlays are included.
Japan’s debt-to-GDP ratio is probably worse than the official figures show. First, the unfunded liabilities in Japan’s pension funds could be as high as $500 trillion. Beyond that, the 130 trillion yen hole in the balance sheets of Japan’s banks will ultimately have to be filled by the government; this represents a prospective major liability of Japan’s government that should be recognized on a comprehensive balance sheet. Just including the cumulative losses to Japan’s banks in the total of government liabilities takes the debt-to-GDP ratio close to 110 percent; it could rise higher if a comprehensive evaluation of the Japanese government’s liabilities is undertaken. Little wonder that the Japanese government felt compelled last November to pass the Structural Fiscal Reform Law.
Another Stimulus Package
Against this backdrop of the worsening Japanese economy and a reminder from Moody’s (the first ever applied to a G-5 country) that Japan’s fiscal situation needed watching, Japan’s beleaguered Prime Minister Hashimoto “announced” yet another fiscal stimulus package April 9. But the prime minister only outlined a vague package that was headlined at 16 trillion yen but said to contain 10 trillion yen of actual stimulus. The market verdict once again was “too little, too late.”
Shortly after the Hashimoto announcement, the yen sold off sharply from about 131.50 to more than 133. The sell-off reflected the market’s concern about the general outline of the package, which included a headline number of 4 trillion yen in tax cuts and 6 trillion yen in public works spending. The 4 trillion yen in tax cuts, however, was really for two years, suggesting that the annual tax cut would more likely be 2 trillion yen. No details were given about the supposed 6 trillion yen in public works spending.
Currency traders who sold the yen after the announcement were mindful of a few salient facts. First, 2 trillion yen of the 6 trillion was necessary just to bring government spending for fiscal 1998 back to its 1997 level. That left a prospective 4 trillion yen in public works spending. But since the annual total public works budget is 10 trillion yen, it was difficult to see how a 40 percent increase in the budget would be possible even if 2 trillion yen of the 4 trillion yen had been expected. About two-thirds of the 6 trillion yen package would have to be appropriated and spent by prefectural governments, whose fiscal picture is even worse than Japan’s central government. The Tokyo prefectural government--Japan’s largest--already indicated that it was not prepared to undertake additional spending in FY 1998.
In short, Prime Minister Hashimoto’s announcement of a 16 trillion yen fiscal stimulus package actually offered considerably less real stimulus and marked the end of Japan’s ability to stave off disaster with additional packages. Moody’s had reminded investors that the Japanese government’s fiscal picture would not permit another package unless the actual net spending was considerably less than advertised. The negative experience with Japan’s 2 trillion yen tax cut announced in December and administered in February suggested that Japanese taxpayers would not spend anyway since they were fearful about the future for the economy and they knew Japan’s fiscal picture well enough to realize that any tax cuts now would only be reversed.
Hashimoto’s announcement underlined this fact by outlining a total of 4 trillion yen in tax cuts during calendar year 1998, the 2 trillion yen in February, and probably another 2 trillion yen in June, to be followed by another 2 trillion yen sometime in 1999. The clear implication was that tax cuts had to be temporary and would later be replaced by higher taxes. Therefore, why would Japanese households with shrinking incomes and a bleak outlook choose to spend a tax cut?
Japan’s tax cut of 2 trillion yen this year will probably be injected into household paychecks in June, just in time for the July 12 upper house election. The tax cut is not likely to be spent, and any net stimulus will have to come from increases in government spending programs. The increased spending during the current fiscal year will probably lag well below the 6 trillion yen publicized, approaching only 2-3 trillion yen. Therefore, of an announced 16 trillion yen package, the net stimulus (even assuming that some of the tax cut will be spent) will be about 4 trillion yen, or 0.8 percent of GDP, hardly enough to do anything but nudge the growth forecast for Japan in 1998 from minus 1 percent to minus 0.6 percent. Little wonder that traders sold the yen upon Prime Minister Hashimoto’s announcement.
Currency Solutions?
Unfortunately, instead of developing a sound approach to solving Japan’s and Asia’s serious problems of excess capacity, the G-7 and even Treasury Secretary Robert Rubin appear to be flirting with the notion that treating the symptoms of the Asian crisis by supporting currencies will help to solve the problem. After the sell-off of the Japanese yen on the morning of April 9, the Federal Reserve entered the market selling dollars on behalf of the Bank of Japan although that action was not immediately clear. The delay in recognition was important because traders did not know whether the Fed’s sales of dollars represented a fundamental change in the sound U.S. dollar policy or the Federal Reserve was undertaking sales on behalf of the Bank of Japan. The latter proved true, but some press reports suggest that the Fed and the Bank of Japan joined in the April 9 dollar-selling exercise.
On the night of April 9 (April 10 in Tokyo), foreign exchange markets virtually closed in anticipation of the joint Easter-Passover holiday weekend. At that time, the Bank of Japan chose to enter the market to sell dollars aggressively, probably selling about $15 billion into a market where most traders had departed for the holiday. This effort pushed the dollar down from 131 to about 126 yen at its lowest in thin holiday market conditions.
Commenting on Prime Minister Hashimoto’s stimulus package and the aggressive Japanese intervention in the currency markets, Treasury Secretary Rubin issued an ambiguous statement:
One could suspect that Mr. Rubin wished to see a stronger yen. It might be more accurate to say that Secretary Rubin thinks that both a stronger yen and a stronger dollar are good. Unfortunately, both things cannot happen at once. Rubin is being beguiled by the misconception that supporting the yen is the answer to problems in the Asian crisis. This erroneous interpretation reiterates the misreading, emphasized over and over on the editorial page of the Wall Street Journal, that the Asian crisis is a currency crisis.
If the Asian crisis is a currency crisis and a stable or weaker dollar-yen exchange rate would solve the problem, then Japan ought to raise interest rates while the United States cuts interest rates to stabilize the yen at current levels. Clearly, left to itself, the yen will continue to depreciate. It reached 135 by early April before all efforts to stem its fall through intervention and the Japanese fiscal package.
Rubin and Hashimoto would do well to reread John Maynard Keynes’s 1928 commentary on the French devaluation:
One blames politicians not for inconsistency but for obstinacy. They are the interpreters not the masters of our fate. It is their job, in short, to register the fait accompli. In this spirit we all applaud M. Poincare for not allowing himself to be hampered by inconsistency. After declaring for years that it would be an act of national bankruptcy and shame to devalue the franc, he has fixed it at about one fifth its pre-war gold value, and has retorted it with threats of resignation against anyone who would hinder him in so good a deed.
Of course, Keynes was writing about the long-delayed French devaluation in the rampantly deflationary late 1920s. Japan, seventy years later, has experienced a return to deflationary pressure since the onset of the Asian crisis. Japan’s wholesale price index is falling at an annual rate of more than 2 percent, adjusting for last year’s one-time, two percentage point rise in the value-added tax. It is hard to see how a tighter money stance implied by pushing up the yen against the other currencies will help to deal with the Asian crisis or Japan’s crisis.
The proximate reason given by the policy makers is that further depreciation of the yen will increase the sharp downward pressure on other Asian countries. But that if the yen is not permitted to depreciate further, a deflationary crisis will engulf Japan and the rest of Asia—and will be even worse than the current one. Asia basically needs an increase in demand, not a game whereby demand for Japanese goods is reduced by a stronger yen in hopes of avoiding devaluation elsewhere in Asia. Japan cannot afford to be so generous.
The Value of Shock Therapy
Japan and Asia need shock therapy, and the shock therapy must start with Japan. Japan must somehow reflate while simultaneously enticing foreigners to buy its stocks and companies. Printing money can help reflation while devaluation of its currency makes its real assets a more attractive investment. A devaluation of the Japanese yen to a level somewhere between 160 and 180 yen per dollar would be a preemptive move to a level that markets will achieve anyway. As such, the devaluation would be a reflationary shock that would help to set in motion much needed capital inflows to Japan. With a devalued currency, Japan’s assets would be put up for sale at attractive prices to international investors. These investors would be anxious to buy many of Japan’s cash-rich, high-cost, poorly run banks, financial institutions, and manufacturing firms and transform them into efficient, competitive institutions comparable to those in the United States.
This said, such a reflationary measure clearly will not be undertaken. Japan is not about to put its redundant and poorly managed capital stock on sale for foreigners to buy and repair. Japan is not prepared for that kind of transformation to a global economy, the Big Bang and other discussion about deregulation notwithstanding. Instead, we will probably muddle through with the yen grinding lower and with the risk of a global deflationary accident on the order of the one in 1929-1930 hanging over the world economy.
The reality remains that the Asian crisis is not a currency crisis, and treating it as one by defending overvalued currencies such as those of Japan and other Asian countries has proved disastrous. The official reaction to pressures on Japan’s currency is much like the ill-advised reaction to the initial attack on the Thai baht in June 1997. The government of the affected country and the official global financial community hotly deny that any devaluation is necessary. The stock market begins to drop rapidly. In Japan’s case, the government has spent trillions of yen propping up the stock market, again by attempting to peg a price and by entertaining an illusion rather than trying to fix the problem. The denial that an exchange rate adjustment is needed only increases the cost of the crisis and leads, ex post, to the claim that the crisis is a currency crisis. The fact that currencies grow weaker when real economic problems, such as chronic excess supply, are ignored is hardly a justification that the crisis is a currency crisis.
Japan’s misplaced obsession with trying to strengthen its currency in a deflationary environment is reminiscent of Britain’s disastrous effort to overvalue sterling by repegging it to gold in April 1925 at its prewar exchange rate. The result was a deflationary effort to maintain sterling at an overvalued level that, in turn, contributed to the onset of the Great Depression. There is no reason to risk even the slightest chance of that outcome as we leave the twentieth century.
John H. Makin is a resident scholar at the American Enterprise Institute.
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Sunday, November 22, 2009
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