3 Identifying the Shocks: Japan’s Economic Performance in the 1990s
Author: Mr. Ramana Ramaswamy and Christel Rendu1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Language:
English
Keywords:
BOOK; company; investment; bank; expansionary monetary policy; VAR estimation; nonresidential investment; asset price collapse; fiscal policy variable; Public investment spending; Private consumption; Vector autoregression; Private investment
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Abstract

The Japanese economy experienced its worst postwar recession in late 1997 and throughout 1998. Output contracted for five consecutive quarters before growth turned positive in the first quarter of 1999. The decline in activity followed a seven-year period in which the Japanese economy grew at an average of about 1½ percent a year. The tepid economic performance of recent years contrasts starkly with average growth of about 4 percent achieved during the 1980s. Japanese economic performance during the 1990s also fared unfavorably from an international perspective. Not only did output grow more slowly in Japan than in other major industrial countries, but the volatility of output in Japan rose during the 1990s, whereas it declined significantly in the other Group of Seven countries (Figure 3.1).

The Japanese economy experienced its worst postwar recession in late 1997 and throughout 1998. Output contracted for five consecutive quarters before growth turned positive in the first quarter of 1999. The decline in activity followed a seven-year period in which the Japanese economy grew at an average of about 1½ percent a year. The tepid economic performance of recent years contrasts starkly with average growth of about 4 percent achieved during the 1980s. Japanese economic performance during the 1990s also fared unfavorably from an international perspective. Not only did output grow more slowly in Japan than in other major industrial countries, but the volatility of output in Japan rose during the 1990s, whereas it declined significantly in the other Group of Seven countries (Figure 3.1).

Figure 3.1.
Figure 3.1.

Growth and Volatility Comparisons

Sources: IMF, World Economic Outlook database; and IMF staff estimates.1For Germany, data start in 1991:Q2 to exclude reunification effects.

A visible sign of the economic crisis in Japan could be seen in the banking sector. Moreover, the failure of both equity and land prices to recover from the collapse in the early 1990s, and Moody’s downgrading in November 1998 of Japan’s sovereign debt in response to the rapidly rising fiscal deficits and public debt, further heightened the unease about economic conditions in Japan. A striking and somewhat novel aspect of the crisis in Japan was the limited range of options available for using traditional macroeconomic policy tools. With the Bank of Japan’s overnight call rate close to zero during 1999, there was minimal further scope for providing support to the economy through a lowering of nominal short-term interest rates. Moreover, given the recent deterioration in public finances, and the rise in long-term bond yields, the scope for further fiscal stimulus is also seriously limited.

How did Japan get saddled with problems of this magnitude? And what policy options are available for dealing with them? The focus of recent analyses, perhaps not surprisingly, has tended to be more on what should be done to get the Japanese economy back on track, than on providing a systematic analysis of what went wrong. The “policy literature” falls into three broad groups. One view, associated prominently with the recent work of Posen (1998), and with some adherents in international policy circles, argues the case for a substantial fiscal stimulus to revive the Japanese economy. This viewpoint attributes the relative ineffectiveness of past fiscal stimulus packages both to the temporary nature of many of the measures undertaken and to the adoption of programs—such as land purchases—that have had little impact on activity, rather than to the inappropriateness of fiscal policy as an effective tool for reviving the economy.

Krugman (1998) makes the case for the continuing relevance of monetary policy in Japan, despite an apparent liquidity trap—that is, the configuration of nominal interest rates close to zero, mild deflation, and a significant output gap. The liquidity trap, however, implies that monetary policy has to be conducted primarily through injecting liquidity rather than by targeting an interest rate. Thus, the Bank of Japan ought to expand the monetary base in a sustained way to increase inflation expectations and lower real interest rates. Krugman downplays the importance of solving the banking crisis as a precondition for getting the Japanese economy moving. He argues that the interplay of adverse selection and moral hazard would have bad banks lending more, not less.

In contrast, the credit-crunch viewpoint argues that recent reforms in the banking sector in Japan, such as the implementation of “prompt corrective action” rules, discourage banks in difficulties from lending indiscriminately. Some empirical evidence lends credence to the hypothesis of activity being dampened recently by a credit crunch.1

The above discussion suggests that there is no clear consensus on the policy measures needed for reviving the Japanese economy. This chapter aims not to make an explicit case for adopting one policy option over another, but focuses primarily on providing a systematic analysis of the factors leading up to the current conundrum in Japan. The reasons for the emphasis on what happened, rather than on what needs to be done now, are twofold. One follows from the obvious perspective that a better understanding of the recent past should help in making more reasoned choices among the different policy options. The other, as observed earlier, is driven by the relative paucity of econometric work on what went wrong in Japan in the 1990s. While some of the popular writings on recent developments in Japan have been perceptive, they have had a tendency to be either discursive or sweeping in their generalizations. It is not easy, for instance, to test empirically the role played by structural factors such as lifetime employment practices, the nature of financial intermediation, or the pursuit of implicit industrial policies in dampening growth in the 1990s. It is, however, easier to test econometrically the validity of generally held beliefs regarding the role of macroeconomic factors in inducing the stagnation of output in the 1990s.

This chapter uses a vector autoregression (VAR) model, with structural identifying restrictions, to quantify the extent to which the growth slowdown in Japan during the 1990s was driven by shocks to the different expenditure components of real GDP. VAR estimations of this type can prove useful in providing techniques for quantifying existing intuitions about, for example, whether negative shocks to private investment were more important than negative shocks to private consumption in dampening activity in the 1990s. Moreover, the results of such estimations may motivate the questioning of existing priors—such as whether developments in international trade did play an important role—and also uncover new stylized facts that explain the slowdown in activity. Further, as discussed below, the VAR approach can be useful in providing benchmarks for evaluating the effectiveness of macro policies—that is, for providing a counterfactual scenario of whether the economy would have been better or worse off in the absence of the monetary and fiscal policies that were actually pursued.

The main conclusions of this chapter are:

  • negative shocks to both residential and nonresidential private investment contributed importantly to the marked deceleration of output in the 1990s;

  • despite the collapse of both equity and land prices in the 1990s, there has not been a large buildup of negative shocks to private consumption;

  • significant negative shocks to public consumption, rather surprisingly, are also shown to have played a role in dampening activity in the 1990s—an explanation that figures prominently in the VAR estimations, but one that appears to have been neglected in most recent analyses of Japan;

  • despite the strong appreciation of the yen during the first half of the 1990s, the external sector does not appear to have been a major drag on growth; and

  • the VAR estimations do not provide supporting evidence for the counterfactual conjecture that activity would have been significantly weaker in the absence of the expansionary shift in the stance of fiscal policy in the 1990s.

Trends in the Main Economic Indicators

This section provides a brief overview of the trends in the main economic indicators in the 1990s as a precursor to the VAR estimations. A snapshot of aggregate demand developments—captured in Figure 3.2—reveals the following broad trends. The decline in private investment—both residential and nonresidential—was precipitous following the collapse in asset prices. After what proved to be a transient pickup in 1996, related in part to new opportunities created by deregulation, private investment declined sharply yet again. Public investment, which has served as the main ingredient of countercyclical fiscal policy in the 1990s, filled in to a considerable extent the slack left by private investment. Private consumption grew more slowly in the aftermath of the collapse of asset prices; significant declines in the level of private consumption have, however, been a more recent phenomenon, occurring mainly during 1997–98. The external sector’s contribution to growth (both positive and negative) has been under 1 percentage point during the 1990s, except in 1997, when it contributed about 1½ percentage points to growth.

Figure 3.2.
Figure 3.2.

Japanese GDP at 1990 Prices, 1990–99

Sources: Nikkei Telecom; WEFA; and IMF staff estimates.

Despite the significant slowing of the Japanese economy in the 1990s, unemployment remained low until early 1998, and has increased sharply only recently. The average rate of unemployment between 1991–97 was less than 3 percent, just slightly higher than the average unemployment rate during the boom years of the 1980s. Unemployment increased sharply to a record high of 4.9 percent in June 1999, however, as many large firms that were the main practitioners of lifetime employment practices perceived the need to change existing labor market practices as part of efforts to restructure, and have been shedding labor. Consumer price inflation fell sharply in the immediate aftermath of the collapse in asset prices, but it has remained broadly flat thereafter.

The VAR Model

A VAR essentially consists of any system of equations in which each variable in the system is determined by its own lagged values and the lags on all other variables of that system. The VAR approach is useful when the intention is to analyze a phenomenon without necessarily having any strong priors about competing explanations of it. The method allows the regularities found in the data to tell the story. Given that such an approach does not impose a prior theoretical structure on the data, however, it is important to combine the results coming out of the VAR estimations with explanations of why they should make intuitive sense. This paper attempts such a juxtaposition in discussing the types of shocks that the Japanese economy was subject to in the 1990s, and draws conclusions about the effectiveness of the policies pursued during this period.

The VAR model adopted for analyzing economic developments in the 1990s in Japan focuses on the different components of the national accounts, and is sequenced in two stages.2 The first-stage, eight-variable VAR, is composed of private consumption, private nonresidential fixed investment, private residential fixed investment, public investment, public consumption, exports, imports, and inventories, all measured in constant 1990 prices. The data span the period 1973:Q1 to 1998:Q2. Unit root tests (Table 3.1) indicate that the levels of these variables are nonstationary. Accordingly, all variables except inventories are estimated in first difference logs.3 Inventories are entered into the model as a ratio of GDP (and this ratio is stationary). GDP is derived as an auxiliary equation given that it is the sum of the components in the VAR. The system is estimated with the smallest number of lags necessary to obtain white-noise residuals in all equations of the system; in this case two lags were found to be sufficient. Using this criterion as a basis for choosing the optimal lag length makes sense in large systems where parsimony becomes an issue; moreover, the results were relatively stable when experimented with three and four lags.

Table 3.1.

Unit Root Tests

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Notes: ADF and PP tests. Specification mentions the best specification possible based on the residual properties (Q-statistic). C stands for constant, t for trend. ** (*) indicates that the unit root test is rejected at the 1% (5%) significance level.

The first-stage VAR is estimated to obtain an indication of what the residuals of each of the expenditure equations look like. The residuals of each of the equations of the VAR provide us with a potential benchmark for judging whether the behavior of a variable in any given period deviates markedly from the previous history of the system. For example, when a large residual is obtained for private consumption, it indicates a change in the pattern of private consumption expenditure that is neither explained by the past history of the pattern of private consumption expenditure nor by the history of changes in the other components of the VAR system.

The problem with focusing on the residuals of the VAR system is that they do not represent the “true” shocks to each of the expenditure components. VAR residuals, as is well known, are generally correlated across equations, because of their joint dependence on common underlying trends and also due to the direct contemporaneous dependence of the variables on each other. To get a measure of the uncorrelated shocks to each of the demand components—that is, to make a judgment about how much the behavior of any given variable has truly changed in relation to the performance that can be expected on the basis of past behavior—we need some identifying restrictions. We choose two identifying assumptions to orthogonalize the shocks.4 First, we assume that within each quarter, the residuals of the VAR equations are related to each other only through their common dependence on activity. For example, we assumed that the residuals of the private consumption equation depend on private fixed investment residuals only through their common dependence on GDP. While this assumption is somewhat restrictive, it is not unduly so, since the feedback effects among these variables tend to take longer than one quarter to occur. The second identifying assumption is that public consumption and gross exports are contemporaneously exogenous, and hence can be used as instruments for GDP.5

By including these identifying restrictions in the first-stage VAR, we can purge the residuals of each of the expenditure components of shocks originating from the other expenditure components. For instance, one way of purging private consumption residuals of shocks originating from the other expenditure components is by regressing the residuals of the private consumption equation on the residuals of the auxiliary GDP equation. This cannot be accomplished directly, however, given the simultaneity bias arising from the first identifying restriction. Hence, we use the residuals of the public consumption and export equations in the VAR to create an instrument for GDP residuals. The residuals of the private consumption equation (or the residuals of the other expenditure components as the case may be) in turn are regressed on the instrument to attain a measure of the orthogonalized shocks. In order to be able to make relative comparisons, such as, for instance, the observation that shocks to private fixed investment in Japan have been larger than shocks to private consumption in the 1990s, we normalize the orthogonalized residuals by their respective standard deviations. The impact that the different shocks have on overall activity will of course be a function of the relative weights of the respective components of the national accounts system.

Results of the First-Stage VAR

The results of the first-stage VAR, based on the national accounts expenditure variables, are reported in Table 3.2. These shocks are computed on the basis of the procedure outlined above. Each observation in the table represents the cumulative sum of shocks from the given starting date (and expressed as a ratio of the respective standard deviations). We chose 1990:Q2 as the benchmark for cumulating the shocks since it marks the period when equity prices began to fall in Japan. Choosing 1991:Q2, the period when property prices began to collapse, as an alternative starting point for cumulating the shocks does not qualitatively change the results. Since the tables report the cumulative shocks, a decline, for example, in the level of the positive shocks from one quarter to the next should be interpreted as a negative shock in that latter quarter. And a negative shock simply indicates that the value taken by any variable in a given period is less than what would be predicted on the basis of the past performance of that variable, and the past performance of every other variable in the VAR system.

Table 3.2.

First-Stage VAR Shocks

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Note: Each observation in the table represents the cumulative sum of the orthogonalized shocks from 1990: Q2, expressed as a ratio to the standard deviation of the respective shocks.

A notable feature of the first-stage VAR results is that the cumulative buildup of negative shocks to private consumption in Japan has been relatively small during the 1990s. The negative shocks to private consumption that do appear in the immediate aftermath of the collapse of equity prices tend to dissipate toward the end of 1994. The negative shocks reappear in 1996 but are never very large thereafter.

There is, however, a large buildup of negative shocks to both private residential fixed investment and private nonresidential fixed investment by the end of 1993; in the case of the latter, they are almost six times larger than the negative shocks to private consumption at around this time. The negative shocks to residential investment tend to persist and become very large by the end of 1997. While negative shocks to nonresidential investment tend to dissipate from 1995 onward, this process is never very smooth, and sizable negative shocks reappear periodically during the interim.

The buildup of positive shocks to the trade balance up until the second quarter of 1993 reported in Table 3.2 suggests that the external sector in Japan did not act as a dampener on activity during this period, despite the significant appreciation of the exchange value of the yen. The dissipation of the positive shocks to the trade balance by end-1995, and the reappearance of mild positive shocks toward the end of 1997, appears, however, to be consistent with the continued appreciation of the yen until mid-1995, and its sharp depreciation thereafter.

There are large positive shocks to public investment in the 1990s. These correspond in their timing, as can be expected, with the implementation of the various fiscal stimulus packages that were weighted heavily in favor of public investment. Table 3.2 shows a buildup of very large negative shocks to public consumption by the second half of 1994. These negative shocks persist and become even larger by the second quarter of 1998. The potential dampening effects of trends in public consumption on activity in the 1990s have rarely been discussed in the literature. Are these particular results therefore just a quirk of the estimation process adopted, or is there an underlying significance to the large negative shocks to public consumption? This issue, as well as intuitive explanations for the observed pattern of shocks to the other expenditure components, is discussed below.

The absence of large negative shocks to private consumption does indeed pose something of a puzzle at first pass. The asset price collapse in Japan during the 1990s has been very sizable. Equity prices had fallen by about 60 percent from their peak by the middle of 1992, and have not recovered significantly since then. And land prices in the six largest Japanese cities fell by a similar magnitude during the course of the decade. These declines in asset prices in Japan were significantly greater than those observed, for example, in Sweden and the United Kingdom, which had themselves experienced sizable declines in asset prices in the early 1990s. Figure 3.3 illustrates the contrasting experiences among these countries rather clearly. The private savings ratio in Japan stayed relatively stable following the collapse in asset prices, whereas this ratio rose by almost 12 percentage points over the course of two years in Sweden, as private consumption was pruned drastically.

Figure 3.3.
Figure 3.3.

Selected Countries: Personal Savings

Source: IMF, World Economic Outlook database.

How then does one explain the relatively small negative shocks to private consumption that are derived from the VAR estimations? Firstly, households in Japan hold just about 5 percent of their total financial assets as equities, and furthermore, the proportion of listed equities held by the household sector has been declining ever since the mid-1980s.6 Consequently, the impact of the boom-bust cycle in equity prices on private consumption in Japan can be expected to be smaller than in countries where households are significant owners of equity.7 Moreover, Japan did not experience any significant increase in unemployment up until the beginning of 1998. Consequently, households in Japan most likely did not experience the pressing need to increase precautionary savings that is normally associated with periods of rising unemployment, as had been observed in Sweden, for example.8 A possible scenario is that, looking ahead, if unemployment does increase significantly, there is the likelihood of negative shocks to private consumption as precautionary factors start coming into play. The impact of changes in property prices on private consumption will, likewise, also be a function of the institutional features of the housing market. While home owners gain from rising property prices, non-home owners simultaneously face potential opportunity costs as possible future owners of property. Home ownership in the six largest Japanese cities is roughly about 50 percent, a much lower percentage than in countries such as the United Kingdom and the United States. Consequently, the effects of the boom-bust cycle in property prices on private consumption are likely to be more muted in Japan than in countries where home ownership is proportionately larger. Other special features of the housing market in Japan, such as the asymmetry in the treatment of capital gains and inheritance taxes on property (landholdings provide a favorable tax shelter in the inheritance tax system, but are taxed heavily in the capital gains tax system), as well as the very high absolute levels of property prices, tend to render the housing market particularly illiquid, and dampen potential wealth effects.9 Putting it all together, the relatively small negative shocks to private consumption derived from the VAR are indeed consistent with what could be expected given the specific institutional features of asset and labor markets in Japan.

The large negative shocks to both private nonresidential fixed investment, and private residential fixed investment fit in rather well with conjectures about the unwinding in the 1990s of the “overinvestment” of the latter half of the 1980s. The ratio of private gross fixed investment to GDP, for instance, increased by almost 5 percentage points to reach about 25 percent in 1990. Some of the investments undertaken during this period, spurred by a combination of rising asset prices (businesses in Japan own a significant chunk of the listed equities) and the lax lending policies of banks, were in projects that had low-returns and high risks. Figure 3.4 provides some stylized facts regarding trends in investment. The ratio of net business capital to potential output, for instance, increased sharply in relation to trend between 1987–91; despite the prolonged decline in the rate of private investment during the 1990s, this ratio is yet to revert fully back to trend. An alternative way of evaluating the investment story is in terms of the dynamic efficiency criterion of Abel and others (1989), which compares the relationship between additions to capital and the returns to it. The narrowing of the gap between capital income and the rate of investment in the latter half of the 1980s, and its subsequent widening following the decline in the rate of investment in the 1980s, is again consistent with the hypothesis that the cost of the overinvestment (and declining returns to capital) in the latter half of the 1980s had to be its unwinding in the 1990s (Figure 3.4).

Figure 3.4.
Figure 3.4.

Business Capital-to-Output Ratio and Efficiency of Investment

Source: IMF, World Economic Outlook database.1Potential GDP is generated using a production function approach.

As noted earlier, the large negative shocks to public consumption pose something of a puzzle. However, a closer look at fiscal developments in Japan from a historical perspective provides a convincing story that is consistent with the results of the VAR estimations. The central government in Japan operated an implicit “golden rule”—fiscal deficits to be no higher than the value of public investment undertaken by the central government—up until 1975.10 With the size of the fiscal deficits growing larger by the end of the 1970s, the central government abandoned the golden rule and funded deficits with both construction bonds (that is, bonds issued to finance investment projects undertaken by the central government) as well as deficit financing bonds (bonds issued to finance current expenditures). The golden rule was reinstated once again during the early 1990s, with only construction bonds being issued in this period. Consequently, there was an institutional bias in favor of public investment, and against public consumption, in the early 1990s. While deficit financing bonds began to be issued from 1993 onward, the fiscal stimulus packages during 1993–98 persisted with the emphasis on public investment.

A likely reason for the emphasis placed on public investment in the fiscal packages in Japan is that construction projects can be used as one-off stimulatory measures. In contrast, once a commitment has been made to increase public consumption, it is more difficult to reverse it at a later stage. Thus, when viewed solely as a tool of countercyclical fiscal policy, spending programs that focus on public investment provide governments with greater flexibility than ones that place emphasis on public consumption. A trend that appears to have gone relatively unnoticed in much recent analyses on Japan is that, as a consequence of the policy choices that were adopted in the fiscal arena, the average growth of public consumption in the 1990s declined significantly in relation to its trend growth between 1973–90, whereas public investment grew on average in the 1990s at about twice the pace of the previous period (Figure 3.5). Given that public consumption constitutes roughly the same share of overall output that public investment does, the impact of the negative shocks to public consumption is likely to have broadly offset the positive shocks to public investment in the 1990s.11

Figure 3.5.
Figure 3.5.

Public Consumption and Public Investment

(Percent change)

Source: IMF, World Economic Outlook database.

The Second-Stage VAR

The first-stage VAR provides a useful framework for understanding the precise manner in which deviations in the pattern of expenditure components from past trends contributed to the dampening of activity in the 1990s. However, the changes in the behavior of economic agents during this period did not occur in a vacuum. Both monetary and fiscal policies were used actively in Japan during the 1990s to influence the course of economic developments. In the case of monetary policy, the official discount rate (ODR) was lowered from 6 percent in mid-1991 to about 1¾ percent by end-1993. As activity continued to be weak through 1994, the ODR was lowered sharply to ½ percent by end-1995, a level at which it has remained since then. The Bank of Japan eased monetary conditions further by lowering its operating target for the overnight call rate to 0.25 percent in September 1998, and to “as low as possible” in February 1999. In the case of fiscal policy, there has been at least one major stimulus package every year since 1992, except in 1997, when fiscal policy turned contractionary with the implementation of cuts in public works spending and the increase in the consumption tax.

How does one judge whether the monetary and fiscal policies pursued during this period were successful or not? The fact that economic activity continued to stagnate in the 1990s is not necessarily an indication of the failure of policies. The counterfactual scenario could clearly be one in which economic conditions in Japan would have been even more dismal had the expansionary monetary and fiscal policies not been undertaken. How then can such a counterfactual hypothesis be verified empirically? The VAR approach has both a limitation and an advantage for evaluating the counterfactual hypothesis about the effectiveness of policies. The main limitation is that one is attempting to draw structural inferences from what is, despite the identifying restrictions adopted, essentially a nonstructural exercise. The advantage of the VAR methodology, however, is that because of its focus on residuals (or shocks, as the case may be) it provides a convenient metric for estimating how the shocks would have evolved once monetary and fiscal policies are incorporated as part of an enlarged second-stage VAR.

How can monetary and fiscal policies be proxied in the case of Japan, and how do they enter into the second-stage VAR for evaluating the counterfactual scenario? We use a real interest rate, defined as the 3-month CD rate minus consumer price inflation, to proxy the effects of monetary policy.12 Getting a proxy for fiscal policy turns out to be more complicated in the case of Japan. Both public investment and public consumption, which have been used to varying degrees as tools of fiscal policy, are already in the first-stage VAR. One way of getting an appropriate variable to represent the additional discretionary fiscal effects in a second-stage VAR would be to strip out both public investment and public consumption from the general government balance. To capture the effects of discretionary fiscal policy, we take the ratio of the “trend” of the adjusted general government balance to “trend” GDP.13 (It should be noted that using the nonadjusted general government balance instead in the estimations does not change the results of the second-stage VAR qualitatively). The second-stage VAR also incorporates the net worth of the household sector as a ratio of GDP to capture the impact of potential wealth effects. Granger-causality tests indicate that the monetary, fiscal, and household wealth variables are block exogenous to the system and are accordingly entered as exogenous variables in the enlarged system.14

How do we evaluate the counterfactual scenario about the effectiveness of policies in terms of the pattern of shocks derived from the second-stage VAR? An intuitive way of trying to make sense of this question is to consider the baseline of a hypothetical scenario in which the slump in activity during a given period coincides with the implementation of contractionary monetary and fiscal policies. Negative shocks derived from a first-stage expenditure-based VAR should disappear, or at least decline significantly in the second-stage VAR, if the slump in activity was precipitated by the implementation of these contractionary policies. In the case of Japan, the scenario being considered is obviously the obverse. The slump in activity coincides in timing with a significant easing of monetary and fiscal policies. In order for the counterfactual hypothesis—that the slump in activity would have been even more severe in the absence of the expansionary monetary and fiscal policies pursued—to be true, the negative shocks in the first-stage VAR should become even more negative in the second-stage VAR. The intuition for using this metric as a test of the counterfactual is that, once past relationships between activity and policies are incorporated into the estimation process, the deviation of activity from historical relationships in the second-stage VAR should be more severe than it is in the first-stage VAR. Correspondingly, if the shocks in the second-stage VAR do not become more negative, or in fact become less negative, then these results are consistent with the hypothesis that the slump in activity would not have been much worse in the absence of the actual monetary and fiscal policies that were pursued.

Table 3.3 reports the results from estimations of the second-stage VAR. (The estimations stop in 1997:Q1 because of lags in the availability of data on the government’s fiscal balance.) It can be seen that the shocks to private consumption in the second-stage VAR are not very different from those in the first-stage VAR. The fact that these results are consistent with the hypothesis that policies had little impact on private consumption during the 1990s should not come as much of a surprise. As argued previously, wealth effects in Japan are likely to have been small. And banks played only a limited role in extending consumer credit against collateral to households. Consequently, one would expect the response of private consumption to changes in monetary policy to be small, as borne out by the results of the second-stage VAR. The apparent failure of fiscal policy to stimulate private consumption can also be explained. As noted earlier, the fiscal stimulus packages were weighted heavily in favor of public works projects and measures to support land purchases. Moreover, the tax reductions incorporated in the fiscal packages have mostly tended to be temporary in duration, and ad hoc in conception, a combination that is unlikely to prove effective in stimulating private consumption.

Table 3.3.

Enlarged VAR Shocks

(Deterministic variables: real interest rates, household wealth, fiscal balance)

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Note: Each observation in the table represents the cumulative sum of the orthogonalized shocks from 1990: Q2, expressed as a ratio to the standard deviation of the respective shocks.

It can also be seen from Table 3.3 that the shocks to private residential fixed investment do not change much until 1992:Q2 in the second-stage VAR when compared with the first-stage estimations, but then become visibly more negative thereafter. Shocks to private non-residential fixed investment, in contrast, become more negative until 1992:Q2, but then become less negative thereafter. This would imply that while private residential investment did respond positively to the fiscal stimulus packages, nonresidential investment did not. The fact that the shocks to private residential investment get more negative precisely during the period when the fiscal stimulus packages, with their emphasis on construction projects, land purchases, and subsidized loans for investments in residential property, are implemented in earnest argues in favor of a positive relationship between the stimulus packages and residential investment. In contrast, one would not expect, on a priori grounds, a strong relationship to exist between fiscal stimulus and nonresidential investment, particularly if the negative shocks to private nonresidential investment partly reflect the necessary unwinding in the 1990s of the overinvestment in the previous decade. These arguments find support in an experiment in which the fiscal policy variable is dropped from the enlarged VAR. As can be seen from Table 3.4, the shocks to private residential investment revert back to the levels of the first-stage VAR. In contrast, the shocks to private nonresidential investment become larger, suggesting that while such investment does not respond to fiscal stimulus, it does to changes in monetary policy.

Table 3.4.

Enlarged VAR Shocks

(Deterministic variables: real interest rates, household wealth)

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Note: Each observation in the table represents the cumulative sum of orthogonalized shocks from 1990:Q2, expressed as a ratio to the standard deviation of the respective shocks.

The shocks to the trade balance are relatively unaffected in the second-stage VAR, as can reasonably be expected. And the shocks to both public investment and public consumption get smaller, reflecting their strong collinearity with the fiscal variable in the enlarged VAR.

Thus, while the results of the second-stage VAR are consistent with the conjecture that activity would not have been significantly weaker in the absence of the discretionary fiscal policies that were actually pursued in the 1990s, this does not necessarily constitute an argument about the ineffectiveness of policies in general in the Japanese context. Fiscal policy could conceivably have been more successful in stimulating the economy had it been implemented in a less ad hoc manner and concentrated more on measures that could have had a more direct and longer-lasting impact on activity.

Conclusions

This chapter has provided a framework for identifying the driving forces of the slow growth in Japan during the 1990s. Large negative shocks to both private residential investment and private nonresidential investment have been shown to be the principal factors dampening activity during the 1990s. The negative shocks to private investment essentially reflected the unwinding in the 1990s of the overinvestment that took place in the latter half of the 1980s. Negative shocks to public consumption also contributed to the slowdown of activity. Despite the severe collapse of asset prices in the 1990s, negative shocks to private consumption proved to be relatively small, reflecting the low ownership of equities by households, and the absence of an urge to increase precautionary savings due to the low levels of unemployment in Japan. The external sector did not act as a major dampener on activity despite the significant appreciation of the yen in the first half of the 1990s.

The VAR estimations do not lend support to the counterfactual conjecture that activity would have been significantly weaker in the absence of the expansionary shift in the stance of fiscal policy in the 1990s. The relative ineffectiveness of fiscal policy identified by the VAR model is likely to reflect the shortcomings in the design and implementation of the stimulus measures—tax reductions tended to be temporary in duration and ad hoc in conception, and some of the spending measures had neither a direct nor long-lasting impact on activity.

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1

Bayoumi (in Chapter 2 of this volume) uses VAR estimations to provide evidence for the hypothesis that disruptions to bank lending have played an important role in explaining the recent weaknesses in activity.

2

The methodology adopted for the VAR estimations in this paper follows closely the approaches adopted for analyzing the 1990–91 recession in the United States, by Blanchard (1993), and the 1990–92 recession in the United Kingdom, by Catão and Ramaswamy (1996).

3

We further test if the variables are cointegrated. The Johansen rank test reveals the presence of three cointegrating relationships. Based on this finding the natural modeling strategy may appear to be to estimate a vector error correction mechanism (VECM) with three cointegrating vectors. However, the problem with this strategy lies in assigning economic meaning to three long-run relationships in a large system based on purely statistical criteria. We therefore opt for a VAR in first differences as the more meaningful estimation strategy in this context. Note, moreover, that cointegration is of less importance when the focus is mainly on isolating shocks, and not on parameter estimation. Nevertheless, in order to check if the estimations carried out using first differences were robust, we estimated a VECM with three cointegrating vectors. The results indicate that the relative magnitude of the shocks to the different components of real GDP are much the same as those derived from the VAR in first differences, but the absolute magnitude of all the shocks are smaller when the VECM strategy is implemented.

4

The two identifying assumptions adopted imply that there are 44 restrictions in total. Note that to identify the system at least 28 restrictions are needed.

5

Block exogeneity tests do not reject the hypothesis that both public consumption and exports Granger-cause the rest of the macroeconomic system. The estimated chi-square test for the joint exclusion of public consumption and exports is 30.39, which is significant at the 1 percent level. Moreover, single equation tests carried out separately for each of the expenditure components are also consistent with the assumption of the exogeneity of public consumption and exports.

6

See the various issues of the Annual Securities Statistics of the Tokyo Stock Exchange.

7

It is interesting to note in this context that the impact of wealth effects arising from equity price movements on private consumption has been estimated to be relatively small even in the case of the United States. See, for instance, the discussions in Poterba and Samwick (1995), and Starr-McCluer (1998).

8

See Carroll (1992) for a detailed discussion of issues pertaining to precautionary savings.

9

For a more detailed discussion of these issues, see Ito (1992), and Nishimura and others (1998).

10

For a more detailed discussion, see Bayoumi (1998) and Ishi (1996).

11

The contribution of public consumption to growth in the 1990s was, on average, about half that of the contribution between 1973–90. In contrast, the contribution of public investment to growth in the 1990s was, on average, twice that of the contribution in the earlier period.

12

Using the GDP deflator rather than the consumer price inflation to calculate real interest rates does not make a difference to the results.

13

The “trend” components of both the general government balance and GDP are calculated using the Hodrick-Prescott filter.

14

The estimated chi-square test for the joint exclusion of these variables is 131.48, which is significant at the 1 percent level. When these tests are overridden, and the policy variables are included as endogenous variables, the results of the second-stage VAR do not change much.

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Cover Post-Bubble Blues
Post-Bubble Blues
How Japan Responded to Asset Price Collapse
Author: Mr. Tamim Bayoumi and Mr. Charles Collyns
ISBN:
9781557758729
Publication Date:
09 Mar 2000
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557758729.071
Pages:
244

Growth and Volatility Comparisons

Japanese GDP at 1990 Prices, 1990–99

Selected Countries: Personal Savings

Business Capital-to-Output Ratio and Efficiency of Investment

Public Consumption and Public Investment

(Percent change)