Interview: August 3, 2004

Let’s start with a not-so-serious question:  How did you get from Manchester to Tokyo?

That is easy. Margaret Thatcher ensured there were no practical employment opportunities in Manchester in the 1980s, unless you had a talent for playing the guitar, which I don’t. So I went to London.

In London, doing international economics in the mid-1980s it became apparent that Japan was the place to be. It seemed to be a remarkable economic success story, dominating world capital flows —suggesting some major lessons to be learned.  So looking back, it was just a horribly poor career misjudgment—another victim of the bubble.

What got you interested in Japan and its economy? Was it its dazzling “success” or its potential problems that attracted you to the subject?

The initial hook was the apparent dazzling success. That has mutated into a sort of macabre fascination—how long could the policy-makers avoid facing up to the scale of the problems.

Tell us about your PhD thesis. . .

It was an examination of regional trading blocs, trying to quantify the impact on trade and investment behavior, and on corporate activity, including a critique of the generally accepted measures that are used.

Imagine that you were asked to select three books on Japan (fictional and non-fiction) that best conveyed the feeling and depth of this country. What would those three books be? Are there any books on Japan that you feel are exceptionally well written and researched —something in the field of economic literature or the social sciences that also deserve special mention?

I liked The Ministry by Peter Hartcher. This is a good summary of the absurdities and corruption of the bubble. Edward Lincoln’s book Arthritic Japan was excellent as an antidote to the naïve reformist claims that are made all too often. Haruki Murakami’s Underground is quite remarkable, as a collection of the personal stories of various victims of the Tokyo sarin attack of 1995, followed by a similar collection from members of Aum Shinrikyo. The lack of anger among the victims is quite striking. I love Murakami’s novels too.

What is your nomination for the worst book on Japan? Why?

I cannot bring myself to read the bad books all the way through, so maybe it is unfair to select one from the many candidates. The competition for “worst” would be quite tough. I still treasure Sakakibara’s book Beyond Capitalism—not because it is a bad book, but because it seems to summarize the hubris of the bubble.

What book on Japan needs to be written? Will you be writing it?

The problem with writing a book on Japan is that nothing much has happened for the past decade. So most of the books have been written several times over, with varying degrees of success. That is probably the root of the bad books—that to say something original or provocative, you need dubious analysis.

At some point I would like to write a book on some aspect of the recent economic history, but my day job is a bit too time consuming to write it at the moment. It is a tough call between writing a serious and worthy book for a limited audience or writing an airport bookshop “Japan is back and its coming after your job”-type of trash-business book.

I think a good book would be “Hashimoto: the great reformer” as he gets bad press and he has been the only politician to make any significant progress on structural reform in the past decade...make that five decades. I cannot imagine it being a best-seller, although maybe the Japan Dental Association would buy a few copies.

What are you focusing your energies on right now? What aspect of the Japanese economy offers the most puzzling issues, but the least obvious answers from a market economist’s viewpoint?

In general I am increasingly focused on the monetary aspects of the economy, as that has been irrelevant for such a long time, but finally seems to be the key to producing an extended recovery.

There is also an interesting question of how did we get to this situation. Supposedly structural barriers, financial system distress, deflation, excessively high real interest rates, or demographics were supposed to stop the economy having a lasting recovery. Yet here we are, with solvent banks, 5% growth, deflation nearly over. I was in the camp that thought that financial system distress would prevent such a strong recovery, but it looks like that was wrong.

The Million Dollar Question: What are you reading right now?

Reading The Chess Artist by JC Hallman. Just finished Amsterdam by Ian McEwan which is beautifully written, but with a pathetic ending. Also I have finally got around to reading Heilbroner’s Teachings from the Worldly Philosophy, which I bought back in 1998 but did not get past Adam Smith that time. I have started Peter Bernstein’s Against the Gods, which is a good read, considering the complexity of the subject.

One leitmotif of your reports is your criticism of Japanese data itself. What makes the data “bad” and is this ministry-specific, nation-specific or an international dilemma?

I think poor quality data is a reflection of the nature of the bureaucratic system. Each ministry collects data and produces related releases. Even when a release is erratic, there rarely seems to be pressure for reform. Setting up a statistical office to manage the quality and process would seem sensible, but would offend too many interests.

The greatest problem is in measurement of consumer spending, where all of the official releases seem seriously flawed. I have constructed my own measures of consumer activity from other sources that seem more reliable, but it is always tough to convince people when the headline data releases are showing random behavior.

In general I don’t think the data is manipulated for political gain, which is an accusation that you sometimes see. And to be fair, the Cabinet Office has been trying to improve the quality of the releases, especially GDP.

“Mr. Five Percent”…that’s what they called you. In one of your most famous reports, “5% in 2000” (ING Barings, August 1999), you posited that a cyclical recovery is underway…”5% GDP growth in 2000 is now a realistic outcome.”   In hindsight, what went wrong? Do you feel that there will ever be a chance for that kind of GDP growth in the future?

Well, I never actually had 5% as a central forecast, but it seemed like a decent “best case” scenario for a while. In the end the crash in IT investment sent the economy back down again.

But that “5% in 2000” report helped to shock the consensus out of its complacency. When I wrote it the consensus forecast for GDP in CY00 was just 0.6% (my forecast was 2.4%). In the end growth was 2.8% (and 3.0% in FY00). It was a very simple argument that if you give a large demand stimulus to a country with a lot of excess capacity then you can enjoy a period of rapid growth— and that is just what happened.

Could we ever see 5% growth? We are seeing 5% growth. If you believe the official GDP figures then YoY growth in 1Q04 was 5.9% and 2Q04 was 4.2%, so 1H CY04 was 5.0%. Not that I believe the official numbers and I think the economy is probably growing more like 3-4% at the moment, as the weak deflator leads to an exaggeration of the real growth figures.

Corporate bankruptcies have fallen year-on-year for 17 consecutive months and the Financial Services Agency (FSA) has reported a sizeable reduction in the banks’  official nonperforming loans (NPLs) for three consecutive years. Both factors seem to be coinciding with the relative strength of the banking sector. Tell us: is this yet another short-lived cyclical rebound with market “noise” or has the banking sector really turned a long-term (fundamental) corner this time?

I think the banking system is solvent and the bad loan problem is largely over. One clue is that rational behavior for insolvent banks in an environment of regulatory forbearance is to lend more money to distressed borrowers, to keep them in business—evergreening. This allows the banks to avoid taking the correct level of provisions and allows them to continue to claim they are solvent. It is a question of not allowing the accounting version of the situation meet with the underlying economic reality behind the balance sheet. This was the story of the 1990s. In recent years, banks have started to behave in a way that is rational for solvent institutions. That is, they no longer lend more money to zombie borrowers. The economy is partly to thank, and regulatory scrutiny has increased, but it is a major development. It means the banks are no longer writing new loans that will quickly turn bad.

We do some other number crunching on likely corporate failures yet to come and arrive at the same conclusion—that the system is solvent.

There is always the risk that if the economy collapses and deflation resumes then some banks could find themselves in trouble, but that does not seem too likely at the moment.

Aside from declining bankruptcies, it is interesting to note that the credit rating agencies are starting to report more upgrades than downgrades.

It could all become a virtuous cycle for the banks. Their improved health helps the economy to recover, which in turn improves their earnings and strengthens their balance sheets.

The recent merger plans of the major banks suggest they think the bad debt problem is over and they are trying to build plans for future income growth.

None of the above means that the banking system is particularly efficient, but fixing the stock problem of bad loans is a necessary first step to fixing the flow problems of poor profitability.

Deflation, as measured by a negative decline in the aggregate price level, appears to be at a crossroads. The consumer price index (CPI) is barely within negative territory, while the GDP deflator for the first quarter still records a -2.6% qoy decline. What’s causing this recent divergence of the indexes and which is the more realistic inflationary metric that we should be following?

Much has been written on the gap between the different measures of inflation and I do not have too much original to add. It comes down to factors such as the type of index used. Comparing the CPI with the GDP deflator is not that sensible, but you have a similar result compared to the deflator on private consumption, which fell 1.6% YoY in 2Q04.

The CPI is probably over-measuring inflation, but seems to be closer to the truth. Moreover, the BOJ has said that this is the measure they are watching when deciding when to end the current policy of quantitative easing.

The BOJ “experiment” on base money growth began over three years ago. Yet money multipliers of base money don’t seem to be “multiplying” at any of the larger aggregates (e.g., M2+CD) as theory would suggest.  Can (and should) the BOJ take credit for the current economic recovery, despite a failure in the monetary transmission mechanism? If so, why?

I think the theory would suggest that once interest rates are zero and there is no credible expectation that the central bank will leave the liquidity in place in the longer term, then base money growth should not “multiply”.

The BOJ has never made a serious attempt to overcome the problems for monetary policy implied by zero interest rates and a distressed financial system. There seems to be a remarkably degree of consensus among monetary economists worldwide that policy remains potentially effective, even when interest rates hit zero. The BOJ seems to be an outlier in its refusal to accept the possibilities. I don’t view Governor Fukui as being significantly different from his predecessor Hayami, as from very early on in his term he argued that monetary policy tools had been exhausted. He is better in that he does not appear to view 0% inflation as being equivalent to price stability.

I also think that it follows that if the BOJ has been overly cautious (and has argued it cannot use monetary policy to beat deflation), then it cannot take credit for the economic recovery.

You could argue the BOJ has injected liquidity to prevent financial system instability, but that part of a central bank’s job should be taken for granted.

Some market economists claim that the current economic recovery is the natural outcome of structural reform. Yet, the Koizumi Cabinet and Liberal Democratic Party (LDP), the so-called avatars of reform, suffered a terrible blow at the hands of the Democratic Party of Japan (DPJ) in the House of Councilors (Upper House) election in July 2004.  How do you interpret the results of the latter in terms of the former—good or bad?

There is a beautiful reverse logic being applied in some quarters. Koizumi said “no recovery without reform”. We can see there is a recovery, so that shows the reform has been successful. Total nonsense of course, but you can’t blame them for trying.

As far as I can see there has been no economic reform since Koizumi took over. It is just that Koizumi got lucky with a recovery in exports and a surprising drop in the household savings rate that have gone on for long enough to allow the banking system to nurse itself back to health. Tax reform? Regulatory reform? Reform of government enterprises? Financial system reform? It all seems to be in the mind of the prime minister. The only real success seems to have been cuts to public works spending and a) that was going on before Koizumi took over and b) the motivations appear to be political (cut away the pork barrel) not economic.

To me, Koizumi is the worst possible prime minister in terms of economic reform. He is the best candidate to preserve the status quo. Anyone more obviously conservative than Koizumi would struggle to produce such good election results, which could lead to LDP defeat and thereby produce a more reformist government. Or if the LDP substituted a genuine reformer for Koizumi (if they have one, that is) then there could be change.

The only significant reform of the past decade has been financial system deregulation (takes us back to Hashimoto, the great reformer). And generally, I think that the best you can hope for from the Japanese politicians or bureaucracy is that they do not foul things up. I cannot see how any of the vested interests have an incentive to promote change, so I conclude that there will be very little policy-led change. There seems to be some interesting reform at the corporate level, but that largely seems to be due to capital markets pressure.

When economic historians look back on the Lost Decade, who do you think will receive the largest share of the blame pie—MOF, BOJ, LDP, MITI, major banks, or an apathetic Japanese public? Why?

You have to start by assigning blame for the bubble, so you can point at the politicians, MOF, BOJ and the bankers. Failure to fix it is natural, because that would involve assigning blame. You can blame the politicians for doing nothing, or MOF for clumsy fiscal policy, or the financial regulators for letting the banking crisis drag on, or the BOJ for being about the only people who think they have no monetary policy options left once interest rates hit zero. Probably MOF wins by a neck.

In the end you have to blame the public for re-electing the same characters (so maybe blame media collusion as well). Most post-bubble collapses involve a change of government as part of the turnaround.

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