Negative Interest Rate Japan Essay

Japan

On January 29th, 2016, the Japanese government instituted a negative interest rate for the first time in history. The stated objective of this policy is to "encourage banks to lend, business to invest and savers to spend," but the policy has come under heavy criticism. It is, ultimately, a high-risk policy that essentially takes Japan into uncharted waters (Reuters, 2016). To suggest that this policy is unorthodox is an understatement, but it highlights the rather unique position that Japan is in with respect to its economy. Economists in particular will be observing what happens with this policy closely, because it is a new situation, and the impacts can only be theorized at this point. This paper will outline the context for this decision, and analyze whether it not this is a good move by the Bank of Japan.

Background on the Japanese Economy, 1940s to 1980s

Understanding how this move came about requires an understanding of the Japanese economic context. After World War Two, Japan began a program of industrialization in order to modernize its economy. In part, this was the result of losing in the war, where America's technological superiority was clear to Japanese leadership as the cause for the outcome in the Pacific theater. The nature of industrialization in Japan was highly-centralized. It was, for many years, the only industrialized nation not to follow the Western model of industrial development. The Japanese model relied on the keiretsu concept. In this concept, companies are grouped in mutually-beneficial alliances. At the heart of each group is a major bank, and this bank enables the other members of the group to obtain financing, often on favorable terms. Multiple industrial concerns will out the keiretsu, encompassing different major industries. Many of these companies would grow to become conglomerates. The central government, through the Bank of Japan, exercised control over the keiretsu via the major banks at the heart of these groups. In a given keiretsu, directors would sit on the boards of the other companies, so that corporate governance was designed that each company within the keiretsu would hold the other companies accountable (Twomey, 2016).

The keiretsu allowed companies to flourish with new businesses, investing in capacity because they could all but guarantee a certain amount of demand. As such, this system was ideal for growing industrial capacity rapidly. It served Japan well through the 1980s, when some of the faults in the system began to show through. The relative lack of competition was starting to hurt the ability of keiretsu to compete on the global markets, with the emergence of South Korea and other Asian nations. The Japanese economy, which had been growing rapidly for a few decades to that point, began to slow down. The keiretsu model, which included some other facets that constrained the ability of its companies to compete, was no longer an engine for growth, but was too strong to be undone easily.

At the heart of the Japanese growth story was technological development. The major industrial companies were well-run, and enjoyed successes because they were able to capitalize on the Japanese education system and on their preferential access to capital. However, some other facets of the system were of questionable value. Major companies in Japan provided, for example, lifetime employment, and promotions were based on tenure, moving up through the hierarchy. Ultimately, this would prove to be a problem, because managers were not incentivized to excel, knowing that not only would they not be fired, but that they probably would be promoted anyway, to some extent regardless of performance. Inefficiencies like this would eventually pose a challenge, at such point in time as Japanese companies could no longer compete strictly on technological superiority. As global markets began to open up, many Japanese products were no longer competitive.

The Japanese economy grew rapidly in the 1960s, but then slowed in the 70s, only to roar back to life in the 1980s, in particular as Japan began exporting automobiles around the world, as well as with growth in personal electronics. The problem for Japan is that this was not sustainable. The country relied on high tariffs to protect its own markets, but as the major trading nations moved to start lowering trade barriers, this policy would eventually hurt Japan two ways. First, its domestic companies, because they did not have to be competitive, were not. Second, some Japanese markets had to be opened, and this allowed for foreign products to enter Japan.

Another issue with the Japanese economy is that unlike most other industrialized nations, Japan does not have a growing population. Most industrialized nations have birth rates that are below replenishment levels, and rely on immigration for most of their population growth. Economic growth, basically since the dawn of industrialization, relies on two things. One is growing population, as the world's population has increased rapidly since industrialization. The other is resource exploitation. Japan lacks much in the way of natural resources, so was never going to grow that way. The domestic market, even when it is protected, is a no-growth market. So Japanese companies were always going to rely on exporting in order to achieve growth. If their products became less competitive globally, the country would experience economic stagnation. In the early 90s, that is exactly what happened.

Background on the Japanese Economy, The 1990s

In the early 1990s, the Japanese economy faced a no growth scenario. Coming on the heels of the 1980s boom, this was a shock and resulted in significant restructuring of the Japanese economy. This period was known as the "lost decade." The Japanese economy had at that point caught up to the other industrialized nations. With little incremental natural resources to exploit, and a flatlined population, Japan would only have been able to increase its GDP with another technological boom cycle, or increases in productivity (Smith, 2012). The keiretsu system, as noted, was an impediment to productivity increases. As it turned out, Japan was not at the fore of the next major technological cycle, which instead was driven by the U.S. with the Internet.

The country has come under considerable criticism for its macroeconomic policies during the lost decade. Appendix A shows the real GDP growth for Japan, the U.S. and the Eurozone, as a means of highlighting the country's output gap. In addition to Japan losing its edge in technology, and its stagnant population, the country also suffered from a high savings rate. At the end of the 80s, the country faced a financial crisis. For the first time, Japanese people felt apprehension about their future, as mass layoffs took their toll on the national psyche. The savings rate increased, to the point where by the late 2000s Japan had by far the highest savings rate in the G7. Massive amounts of wealth were held by the country's elderly. Again, though, this is attributable to macroeconomic policy. Savings passed down to children were taxed as regular income, which discouraged the elderly from passing that wealth down at all, and if they did they would wait until the child was retired, to minimize the negative impact of that taxation (The Economist, 2009).

Another policy response in the 1990s was massive fiscal stimulus. After the stock market and real estate bubbles burst at the end of the 1980s, Japan faced massive financial shock. The government's response was as series of stimulus initiatives, both in terms of public works spending and loan programs. These efforts did not do much for the Japanese economy, in part because the works projects often added little real value to the country (Yang, 2009). Interest rates were dropped to rock bottom as well.

This policy put Japan into the realm of the liquidity trap. Essentially, the Japanese central bank lowered its rates rapidly in response to the bursting of the 80s bubble. . Then it added the various stimulus programs, but those were ill-conceived. Moreover, it quickly became apparent that Japan was no longer technologically superior and would need to restructure its economy. This process would take years. As the 90s dragged on, there were elements of this restructuring. By the mid-90s there was a slight uptick in the economy, and the government promptly raised its consumption tax (Yang, 2009). This of course crushed consumer spending. The economy now lapsed back to recession, the government had already kept its interest rates at the zero bound, so it had no power to stimulate the economy by lowering rates further -- they could not be lowered past zero (Krugman, 1998).

The restructuring of the economy was required, however. Fiscal policy would be insufficient to prop up Japan during this period, and with monetary policy already used up, more or less, Japan's recession dragged into the lost decade. Critical time had been lost before the government adopted the needed measures to address the bad debt that was holding Japan back, bad debt that was a hangover from the real estate and stock market bubbles (Kobayashi, 2009).

Others have argued that the…