Asset price inflation and monetary policy.

Response of the Authorities

Until December 2001, the two principal anti-recession actions by the authorities in the 1990s were, first, cutting short-term interest rates successively to virtually zero percent, and, second, implementing successive fiscal stimulus measures, as noted above. Japan's government debt currently is the largest of major industrial countries (114 percent of GDP, whereas 60 percent is the comparable U.S. figure). As of 2002, the policy responses had not succeeded in generating self-sustained recovery of private demand.

A belated attempt to deal with non-performing loans was the establishment of the Resolution and Collection Corporation in March 1998 to buy such loans from failed and healthy financial institutions. It is authorized to buy assets only at prevailing market prices, and is not allowed to lose money on its resales. (It turned a profit in 2001, but has had a net loss since its start. It transfers profits to the Deposit Insurance Corporation, its parent.) The banks have urged the agency to buy loans at book value, using taxpayer funds, but the agency's regulator has so far not acquiesced. The problem of non-performing loans remains unresolved.

The principal development in December 2001 was the Bank of Japan's announcement that it would expand the monetary base and add some financial instruments to the list of those that it customarily buys. As of mid-2002, reserve growth has expanded without much effect on broader aggregates and credit availability.

No concerted policy was directed to the problems of undercapitalized institutions, where the choices were either to shut down those beyond salvage or to inject public funds into the rest. Instead, piecemeal measures were introduced. In June 1996 685 billion yen of public funds was applied to the liquidation of failed bank-affiliated non-banks and jusen companies with non-performing loans. 1.8 trillion yen in public funds was injected into 21 major banks. In October 1998 funds appropriated for financial system stabilization were increased to 60 trillion yen, and in 1999 the government bought 7.5 trillion yen of 15 big banks preferred shares and 2.6 billion yen to shore up the capital of four regional banks. The financial services minister said any necessary capital injections would be made on a case by case basis. As of 2002, the health of Japanese banks is still in question, more than a decade since their perilous condition has been known.

Part of the delay in cleaning up banks' bad debts and determining which insolvent banks should be closed is attributable to the government's policy of sharing up the banks' weakest borrowers. Although some firm bankruptcies have risen, again much more needs to be done.

Neither of the twin weaknesses of the banks-non-performing loans and overvalued equity Holdings--has been corrected. A government-sponsored fund to buy shares from banks has not made much progress.

In a surprising move in September 2002 the Bank of Japan announced that it would buy at market prices corporate equity directly from the biggest banks with equity holdings in excess of Tier 1 capital. The seven largest ones own 25.8 trillion yen ($200 billion) worth of shares. The Bank proposes to buy $24 billion shares, the purchases to continue for up to two years. (By September 2004 equity holdings of banks must be reduced to the amount of Tier 1 capital). The Bank of Japan will hold the shares it purchases for up to ten years. It said that it would not announce the names of the banks from which it would buy. The Bank's intention apparently is to send a signal to the government that it was time for it to undertake real reform.

It is not clear how monetary policy will be affected by the purchase of equities by the Bank. Will it sterilize its purchases?. How much of its balance sheet will be damaged by the acquisition of shares of uncertain quality remains to be seen. The Bank proposes to establish a reserve fund to cover potential losses.

The Bank's initiative disturbed the Japanese bond market, which undersubscribed the government's debt auction on 18 September. The world is still in doubt whether Japan will finally eliminate bad debts from bank portfolios, restore their capital to appropriate levels, and succeed in either shutting down bankrupt borrowers or restructuring them. It is a great unknown.

Alternatives to the Authorities Response

The industry whose problems could have had the highest priority among the concerns of authorities was that of financial institutions. Instead of fixating on the foreign exchange value of the yen, and manipulating fiscal policy, they could have been focusing on the condition of banks and insurance companies.

The balance sheets of financial institutions were loaded with non-performing loans. Mori et al. [2000] defend forbearance on this problem by bank regulators when the bubble first burst, since they hoped for early recovery of the economy and the real estate market, but they argue that it was not forbearance later on that explains the regulators' behavior. Rather they waited until there was an adequate safety net before tackling writing-off non-performing loans. The result was a frozen credit supply by troubled financial institutions and distrust of the institutions by the public throughout the decade.

The government lavished public funds on public works construction to revive the economy to no avail. Public funds would have been better spent to restore the financial industry to sound condition. Since the bursting of the bubble, the monetary authorities have relied on a virtual zero interest rate policy rather than on expanding the annual growth rate of monetary aggregates to promote monetary ease. Belatedly, the Bank of Japan responded in December 2001, as noted above, to the recommendation of many observers, to aggressively expand the monetary base. Its announcement in September 2002 that it would purchase excess corporate shares in bank portfolios is another belated effort to counter bank capital problems and ultimately lead them to deal with their bad loans. Perhaps monetary and financial policy reforms will finally enable Japan to emerge from its prolonged economic stagnation.

U.S. Equity Prices (1995-2002) and Monetary Policy

Since 1995 the U.S. stock market has had its biggest boom ever. The Dow Jones rose annually from 3834 at year-end 1994, to 5117, 6448, 7908, 9181, and 11,145 in 1999. The comparable end-of December figures for the Standard & Poor index are 460, 542, 670, 873, 1086, 1327, and for the Nasdaq 752, 1052, 1291, 1570, 2193, 4069.

As in other episodes, it is hard to determine the extent that fundamentals--the usual ones cited are low unemployment, low inflation, rapid productivity growth--account for equity price escalation, and the extent that herd behavior by investors has caused equity prices to overshoot their "fair" values. A more important fundamental has been the increase in corporate efficiency and profitability that the takeover movement a decade earlier generated in the 1990s.

Since the start of 2000, when market highs were reached: the Dow Jones (11723 on 14/1), the S&P 500 (1527), and the Nasdaq (4963 on 24/3), the stock market has retreated, most sharply by the Nasdaq. Rallies have been short-lived. Equity prices fell sharply after the 9/11/2001 terrorist attacks on the World Trade Center buildings, recovered somewhat in the months thereafter but fell again most drastically beginning in April 2002 as revelations of corporate accounting malfeasance shocked investor confidence. Stock market valuations by July were at lower levels than in October 1997. The Dow registered 7702, the S&P 797, and the Nasdaq 1229. In early August the Nasdaq fell even lower to 1206, and in September to 1172. The Dow also fell further in September to 7591, and in early October to 7528. Corporate malfeasance combined with the threat of war with Iraq have been more destructive to market valuations than the twin tower attack.

One question is whether the Federal Reserve has had any responsibility for stock market prices either during the upswing or the downswing as far as it has gone as of the summer of 2002. Two statements by Fed Chairman Greenspan may be cited. On 5 December 1996 he referred to "irrational exuberance" in describing the behavior of stock market investors, and the Dow Jones declined 2.3 percent. The warning was not repeated, so the Fed's position since has in essence been agnostic about what the level of stock market prices should be.

Four years later to the day, Greenspan in a speech to New York bankers hinted that the Fed might lower the fed funds rate sometime soon and the Nasdaq rose that day by 10.47 percent, the other indexes by about 3 percent, all giving up most of their gains on the following day. The objective of the chairman's speech was surely not to add to volatility of market performance. On 24 September 2002, when the market anticipated that the Fed would cut the Fed funds rate but it did not do so, the Dow and the Nasdaq fell to new lows. It is hard to fault the Fed for the market's belief that monetary policy should be guided by the price of equities.

Chairman Greenspan in a speech on 30 August 2002 at the Kansas City Fed Symposium in Jackson Hole, Wyoming, remarked that incremental policy tightening seemed incapable of deflating a bubble, and that he did not know of other options that could limit the size of bubbles without doing substantial damage in the process. I agree.

Some observers believe that monetary policy, judged from an acceleration of M2 and M3 growth rates in 1998, has been accommodative, facilitating the upswing [Fand, 1999]. That was certainly true of the 75 basis points fed funds rate reduction in 1998. Not until November 1999 did the Fed fully withdraw that easing. It then raised rates a further one percent over the next half-year ending May 2000. There is no metric by which to gauge whether these monetary actions by the Fed played a role that favored either rising equity prices before March 2000 or highly volatile equity prices thereafter. In any event, all equity prices were not uniformly affected. On balance one may conclude that the Fed has been a bystander rather than actively promoting or inhibiting the market's rise and recent fall. Had the Fed been more restrictive--how much more is an unknown--with the aim of moderating the market's rise, what would the trade-off have been? Lower economic growth, a business expansion of shorter duration?

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