The Japanese economy has been in a protracted phase of deflation with a large unused production capacity despite monetary policy geared to virtually zero nominal short-term market interest rates and huge increases in the monetary base over a sustained period. Accelerated bank restructuring or further fiscal expansion alone would not correct this situation.

As pointed out by myself as OECD chief economist in the 1994-95 period of yen's sharp appreciation and argued also by some prominent US and European economists including Profs. Allan Meltzer, Jeff Sachs, Joseph Stiglitz and Lars Svensson, an effective way to jump start the economy after the burst of a bubble is aggressive easing of domestic monetary conditions to ward off a deflationary spiral; and once the zero bound to nominal interest rates is reached, it is essential for an open economy in a liquidity trap and recession to resort to another effective stimulative mechanism, namely currency depreciation with the understanding and support of its trade partners.

Between 1993 (a year or so after the burst of a bubble economy) and last year, Japan's share in world merchandise exports declined sharply from 10.0 per cent to 6.6 per cent. During the same period, US share was remarkably stable at around 11 percent and Germany's remained close to 10 percent. Japan's poor export performance in the face of weak domestic demand is largely a result of weaker international price competitiveness associated with the excessively high yen value. This export behaviour of Japan is in sharp contrast to that of countries such as the United Kingdom, Australia and Nordic countries which managed to get out of recessions and to solve balance-sheet problems resulting from sharp declines in domestic real estate and other asset market prices through export-led recovery induced by sharp currency depreciation. The role of monetary policy in many of these countries was to contain inflationary pressure associated with currency depreciation by adoption of numerical inflation targets together with fiscal tightening to improve budget positions and prevent the collapse of the government bond market.

TOP

In Japan, instead, a series of expansionary fiscal measures were introduced in vain to reflate the economy battered by the burst of a bubble and turned its fiscal position into the worst among advanced countries. Moreover, despite some short-run ups and downs in the yen exchange rate, international capital market forces, often unrelated to developments in price and wage differentials across countries, tended to exert upward pressure on the yen exchange rate and it continued to follow an uptrend. Sure, from time to time, the Bank of Japan as the agent of the ministry of finance conducted forceful intervention in the foreign exchange market in an attempt to avoid the yen's sharp upswings. But, domestic monetary policy management and foreign exchange market operations remained un-coordinated and the yen exchange rate has remained out of line with international price and wage differentials. Higher nominal wages and other production costs in Japan than in its partner countries have deterred foreign direct investment inflows into Japan and encouraged Japanese direct investment abroad with a result of "hollowing"of Japanese manufacturing industries.

In theory, at unchanged levels of nominal exchange rates, shaper wage cuts and other cost deductions in Japan than in its trade partner countries should help Japanese industries regain international competitiveness and increase foreign demands for Japanese products, inducing a rise in business investment which may in turn raise domestic consumer demand in real terms, if not in nominal terms, over time. But given a low inflation environment in a growing number of competing countries abroad and a certain degree of downward rigidity of nominal wages and prices in Japan, restoration of international competitive positions by undergoing a protracted period of sharper wage cuts and price deflation in Japan is costly. Moreover, continued deflation and lower nominal income will aggravate debtors' balance-sheet positions and increase banks' new bad loans. Currency weakening is a less costly way of adjustment in particular if supported by actions of Japan's trade partners which have room for manoeuvre of conventional macroeconomic policy instruments to offset any undesirable short-run negative demand effects of Japan's currency adjustment on their economies.

The net effects of a currency depreciation on trade and current account balances of Japan's trading partners can be very small over time with higher export growth jump-starting Japan's domestic economic recovery and later increasing its import demand. But, yen exchange adjustment can reduce export volumes and hence aggregate demands in Japan's trading partners and have adverse consequences on their external accounts at least in the short run. Therefore, they might not extend help to Japan unless they were fully convinced that Japan's new package deal included measures which would help increase their own economic benefits over the longer term.

With these basic domestic and international considerations in mind, I would propose the following set of policy actions to be jointly taken immediately by the Bank of Japan and the government of Japan.