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Japan in Depression
By John H. Makin

While there is plenty of argument about where the U.S. economy is headed next year, the argument about Japan's economy is over. During 2001, Japan passed from a prolonged and serious recession into outright depression. The bad news is that a depression in the world's second-largest economy will make it more difficult for the world economy to recover in 2002. The (not very) good news is that depressions as acute as the one that has emerged in Japan do not usually last very long. However, Japan's exiting its depression will require a large write-down of an unsustainable debt burden either through reflation or outright default.

Japan Chooses the Road to Default

Japan appears poised to follow the passive route of outright default rather than the more active route of reflation. Reflation, even if it leads beyond price stability to some inflation, is a better strategy than default because moving from deflation to rising prices taxes evenly the holders of government debt as rising prices push up interest rates and push down the value of the debt. The default approach toward which Japan is heading will be more abrupt, arbitrary, and disruptive to Japanese and global markets. Beyond financial market turmoil, abrupt default entails a significant additional risk that jeopardizes further employment and growth in Japan and worldwide. Japan's deflation and debt crisis now constitute systemic risk to the global economy.

Japan's efforts to reflate have failed essentially because such efforts have been pursued along normal monetary channels that are appropriate for an economy with a functioning banking system. Japan's banking system is insolvent. Efforts by the Bank of Japan to boost economic activity and to reflate by increasing reserves in the banking system and cutting short-term interest rates virtually to zero amount to beating harder a dead horse. The dead horse is the Japanese banking system, which by virtue of its insolvency is unable to act as a financial intermediary borrowing short from the central bank and lending to Japan's private sector. Rather, Japan's banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up an additional 15 or 20 basis points of yield on those government notes.

The Bank of Japan's unsuccessful efforts to stimulate the economy by providing more liquidity to the banking system have essentially amounted to underwriting ever-rising government debt and a continuation of wasteful government programs, exactly what Bank of Japan governor Masaru Hayami has said he wants to prevent. In this process, Japan's banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks.

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