The policies being debated in the US and Europe today are almost identical to those that played out in Japan a decade or so ago. Japan experienced the collapse of its colossal property bubble in 1990 and then a series of crises as major banks and securities companies were overwhelmed by rapidly rising non-performing debts. The conventional wisdom among economists and politicians throughout the 1990s was that massive public expenditure and extraordinary monetary easing would give the necessary boost to market sentiments and prompt an economic recovery. Public opinion in the US and Europe today seems to be the same.
And indeed, throughout the 1990s, Japan did introduce major public works projects and tax cuts, yet the economy failed to stabilise, asset prices continued to fall, and the volume of non-performing debts continued to climb. Far from being dispelled, the sense of insecurity that had permeated the markets actually increased throughout the 1990s, ultimately leading to the collapse of several major financial institutions in 1997 and sparking an outbreak of panic.
Even after this, recovery efforts continued to be channelled through large-scale public expenditure, while the disposal of non-performing debts became bogged down. Only around 2001 did Japanese public opinion finally turn away from the belief that reductions in bad debt and financial system stability would follow an economy recovery. The public came to understand that the financial system had to be stabilised and market insecurity dispelled before any recovery could occur. Special inspections were conducted repeatedly by financial regulators and Japanese megabanks were forced to accept massive capital increases and a new round of mergers. Meanwhile, the Resolution and Collection Corporation and the Industrial Revitalisation Corporation of Japan restructured companies that had collapsed under enormous debt burdens and finally broke the back of the non-performing debt problem. This sparked a recovery of market confidence, and Japan enjoyed a period of economic expansion from 2002 to 2007.
Mainstream opinion in the US and other countries today appears to be similar to the thinking that dominated Japan during the 1990s. The general public, for the most part, have not bought into the theory that stabilising the financial system through means such as temporarily nationalising banks and rehabilitating debt-ridden borrowers is a necessary prerequisite for achieving an economic recovery. In a VoxEU column published on 1 April, I emphasised that there is a danger in expecting too much from fiscal policy. Rehabilitating the US financial system through the disposal of non-performing assets is essential for a global economic recovery. Princeton University Professor Paul Krugman commented on my column at his New York Times blog, claiming that the belief that stabilising the financial system is a necessary precondition for economic recovery is questionable. He said that if bank reform were the major factor in Japan’s economic recovery, capital investment should have increased, yet the Japanese data shows no increase in capital investment during the recovery period. My response is that stabilising the financial system alleviated the funding constraints that were making it difficult for companies to meet their working capital needs. As several recent studies show (see, for example, Chari, Kehoe and McGrattan 2007), loosening financial constraints on working capital causes productivity to rise and enables an increase in output and employment, but it does not necessarily result in higher capital investment. There is no contradiction between the Japanese data showing non-increasing capital investment and the hypothesis that stabilising the financial system was a factor behind Japan's economic recovery.
The challenge for macroeconomics
The essence of the debate is whether economic recovery and stabilisation of the financial system are two distinct and unconnected events. The prevailing view is something like – the framework within which we need to engineer a global economic recovery is macroeconomics. Since current macroeconomic theory deals only with Keynesian policy (fiscal and monetary policy), the only tools we have are fiscal and monetary expansion. The disposal of non-performing assets and injection of capital are necessary steps in stabilising the financial system, but to the best of our knowledge there is no clear link between this and a macroeconomic recovery. However, if we achieve an economic recovery through fiscal and monetary policy, the volume of non-performing assets will ease, eliminating the need for policies specifically designed to dispose of bad assets.
The experience of Japan in the 1990s would seem to indicate that these expectations are misplaced. Further evidence is provided by Sweden, which experienced its own asset bubble collapse around the same time that Japan did, but recovered much more quickly after Swedish policymakers designed a surgical bad-asset restructuring.
Signs of economic recovery are now emerging and fears of the crisis overwhelming the world economy are starting to fade. Yet if the policy responses of US and European governments toward the disposal of non-performing assets begin to falter, the financial systems of Europe and the US will once again be vulnerable to recurring financial crises, which Japan experienced repeatedly in the 1990s.
There have been those who have recognised that cleaning up banks’ balance sheets and rehabilitating debtors are necessary preconditions for an economic recovery, but this recognition has been based purely on empirical principles. The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context. For example, in the standard New Keynesian or Neoclassical macroeconomic models, the economic agents are the household, corporate, and government sectors, and the financial sector is simply treated as an innocuous veil between these three sectors. The issue of non-performing assets is invariably viewed as a microeconomic issue related to the banking industry.
In fact, the crisis we are currently experiencing may call for a change in the theoretical structure of macroeconomics. In my view, a macroeconomic approach that encompasses financial intermediaries and places them at the centre of its models is necessary. The new approach should satisfy three requirements:
- The focus should be on the function of financial institutions as media of exchange and the conditions that might cause payment intermediation to malfunction. Perhaps this kind of macro model can be built on the framework of the monetary theory of Lagos and Wright (2005), which explicitly considers the role of money as a medium of exchange.
- The new macroeconomic approach should provide a unified framework for discussing the cost and effectiveness of various policy responses to the current global crisis in an integrated context, in which fiscal policy, monetary policy, and bad asset disposal can be compared and relative weightings can be given to all three.
- To provide a unified framework for policy analysis, the new approach should make it easy to embed a model of financial crises into the standard business cycle models (i.e., the dynamic stochastic general equilibrium models).
I have elsewhere attempted to construct a theoretical model that satisfies these requirements, in which I assume that assets such as real estate now function as media of exchange given the development of liquid asset markets but are unable to fulfil this function during a financial crisis (see Kobayashi 2009a). With a model like this, we can regard a financial crisis as the disappearance of media of exchange, which triggers a sharp fall in aggregate demand. In this case, both macroeconomic policy (fiscal and monetary policy) and bad asset disposals can be understood as responses targeting the same goal – restoring the amounts of media of exchange (inside and outside monies). Thus we can compare and analyse these policies in an integrated context.
Bad asset disposal should not be left to financial community insiders
If macroeconomic policy and financial stabilisation through bad asset disposals are designed to eradicate the same externality, financial stabilisation is not just a problem for the financial community – it is crucial for the recovery of the overall economy. Therefore, the design and execution of policies capable of disposing of non-performing assets are not tasks that should be left to financial community insiders. We need to openly discuss what financial stabilisation policies should look like (for practical lessons on the policy package from Japan’s experience, see Kobayashi 2008, 2009b). Bad asset disposals including capital injections for financial institutions (or temporary nationalisation) and the rehabilitation of debt-ridden borrowers must be considered alongside fiscal stimuli and monetary easing, with a new awareness that they also constitute macroeconomic policies. Perhaps, we need to adopt a new paradigm of economic thought.
Chari, V. V., P. J. Kehoe, and E. R. McGrattan (2007). "Business Cycle Accounting," Econometrica, vol. 75(3), pages 781-836, 05.
Kobayashi, K. (2008). “Financial Crisis Management: Lesson from Japan’s Failure.” VoxEU.org, 27 October 2008.
Kobayashi, K. (2009a). “Financial Crises and Assets as Media of Exchange.” Mimeo.
Kobayashi, K. (2009b). “Some Reasons Why a New Crisis Needs a New Paradigm of Economic Thought.” RIETI Report No.108 July 31, 2009
Lagos, R., and R. Wright (2005). “A unified framework for monetary theory and policy analysis.” Journal of Political Economy 113 (3): 463–484.