In Japan, the political situation was thrown into turmoil when Prime Minister Suga announced on 3 September that he would not contest the LDP leadership election, effectively standing down as the nation’s leader. The proximate cause of his decision is said to be the failure of his efforts to bolster the administration’s low public support ratings by replacing key personnel in the LDP and the government.
While that may well have been one factor behind the PM’s decision, a more fundamental reason was the emergence of the highly transmissible Delta variant, which meant it took longer than expected for the country to feel the benefits of the vaccine rollout that Mr. Suga had fully committed himself to.

Vaccine campaign was best example of Suga’s strong leadership

The PM believed that pushing ahead with the vaccine rollout was the best way to confront the pandemic head-on, and starting this spring he showed tremendous leadership in support of it—to the extent that many things thought to be impossible were achieved.
As one example, Mr. Suga set for his government a target of vaccinating 1mn people a day. Initially that number appeared so wildly unrealistic that not only media commentators but even vaccination minister Taro Kono declared the goal was unachievable.
Yet the prime minister utilized the execution skills for which he is well known and overcame all opposition to achieve this objective. There were actually days on which as many as 1.7mn people were vaccinated. Mr. Suga’s frontal attack on the virus was so successful that there were parts of the country where vaccine supplies could not keep up with demand.
As a result of the PM’s efforts, Japan quickly made up for its early delays and is now among the global leaders in the vaccination race. It was Mr. Suga’s leadership that enabled Japan to achieve what so many commentators thought was unachievable.

Delta variant obscured impact of vaccine rollout
As a result of the PM’s efforts, Japan quickly made up for its early delays and is now among the global leaders in the vaccination race. It was Mr. Suga’s leadership that enabled Japan to achieve what so many commentators thought was unachievable.
Unfortunately, these efforts coincided with the emergence of the Delta variant, which caused the number of new cases to increase even as the vaccination rate rose (Figure 1). It thus became difficult for people to realize the impact of the vaccination campaign, and the Suga Cabinet’s public approval ratings remained low as the media focused mostly on the number of new infections.

The single biggest contributor to Mr. Suga’s downfall, therefore, was that the appearance of the Delta variant made it seem as though the extensive vaccine rollout—which was to be the administration’s way of restoring its popularity—had failed to keep new infections under control.
But the vaccine campaign has had an obvious impact since 3 September, when the prime minister declared he would not run in the LDP race, and at present the number of daily new cases is only a fifth of what it was at the peak. Mr. Suga’s announcement came two weeks too early in that sense, and I suspect the PM himself wishes he had waited. Yet there was no one, even among the experts, who could have predicted the subsequent downturn in the number of new infections.
Suga was man of action, not words
Mr. Suga is clearly a doer, not a talker, and he has overcome many problems that were thought to be intractable without saying much of anything.
For instance, it was then-Chief Cabinet Secretary Suga’s leadership that enabled the various reforms to Japan’s immigration rules—something originally thought to be impossible—and drove the massive surge in inbound tourism from Asia that was said to be one of the few bright spots in Japan’s pre-pandemic economy.
I suspect that if the timing of the LDP leadership contest had been different, the Suga administration might well have achieved even more “impossible” goals and led the nation—which tends to be held back by a variety of fetters from the past—in a favorable direction.
Pandemic has led to structural “reset” of labor market
Turning to the economy, the inflation recently observed in many countries is due to supply-side bottlenecks that have left supply unable to keep pace with demand, putting upward pressure on prices. I think one aspect of this mismatch of supply and demand is a structural “reset” of the labor market.
Repeated lockdowns and other restrictions have created highly unusual circumstances in global labor markets over the last 18 months. People who have been able to maintain their jobs and income while working at home probably have not greatly changed their views of work, but I suspect this is not the case for many others.
People in this second group have been forced to choose between working in extremely dangerous environments or risk of losing their jobs. And many indeed had no choice if they wished to feed their families and therefore continued to apply for such jobs.

In addition, generous government benefits have provided many with the time to stop and think for the first time since they left school.
Once the government benefits stop coming, as happened in the US this month, most will lose this luxury and will probably need to find a job. Still, I think there will be a substantial number of people who will take time to look for work that truly suits them.

Labor market reset will delay recovery in production
This kind of labor market reset will delay a return in production to pre-pandemic levels. Many workers will decide not to come back, and it will take companies time and effort to train their replacements.
Moreover, the highly specialized nature of today’s production floor means the entire line may sometimes have to be shut down when a minimum level of staffing cannot be secured.
Past recessions have led to increased unemployment and layoffs, but the pandemic is a worldwide phenomenon that has persisted for more than 18 months, and I expect that a great deal of time will be needed to restore production to pre-pandemic levels.
Companies are having difficulty finding workers not only in developed economies like the US but also in places like China, which has implemented lockdowns whenever community transmission has been discovered, so that the burden of these lockdowns has been felt most on migrant workers, many of whom chose not to return to their workplaces after the lockdowns were lifted.

While transitory, labor market mismatches likely to fuel inflation for almost a year
I expect it will be a long-term positive for the economy if people begin to think more carefully about what kind of work they want to do instead of jumping at whatever opportunities arise. In the short run, however, it will delay the resumption of economic activity and may prompt some companies to decide not to resume some parts of their operation.
Amid this labor market reset, many companies in the US, China and elsewhere have raised wages substantially in an attempt to secure workers. As it becomes obvious to all that wages are rising, workers are even more likely to take their time and look for work that suits them. Some may jump ship if they see higher-paying jobs elsewhere. That will naturally lead to increases in the price of finished goods.

The Fed’s latest “Beige Book” report on regional economic conditions notes that while employers are willing to pay high wages to replenish their payrolls, they are also concerned this will create a wage disparity with existing workers. Resolving such intra-company labor mismatch issues will also take a great deal of time.
From a long-term perspective, the increases in wages and prices resulting from this labor market reset are transitory phenomena. It is also something that cannot be addressed with central bank monetary policy. In the meantime, these mismatches will contribute to higher inflation for anywhere between several months and a year.
Focus of economic policy under pandemic turns from boosting demand to securing supply
In addition to this reset of the labor market in many countries, the surge in infections in Southeast Asia, which is rapidly becoming the factory for the rest of the world, has complicated the restart of manufacturing activity at many corporations, including Japanese automakers.
Southeast Asia is also a key supplier of the sailors who crew the world’s merchant fleet, and continued lockdowns could affect shipping companies’ ability to hire and replace crew members.
In summary, national governments were forced to used traditional fiscal and monetary stimulus to shore up demand when the pandemic struck, but their biggest problem as they emerge from the pandemic is how to shore up supply in view of various supply-side constraints, including the labor market reset. Further complicating the issue is the fact that these supply issues will take time to resolve because they cannot be addressed with traditional monetary and fiscal policy.
Financial sector indicators run counter to rising prices
The financial sector, meanwhile, is moving in the opposite direction to those suggested by rising wages and prices due to the labor market reset and supply chain turmoil. In particular, financial institution lending has been sluggish even though inflation has pushed real interest rates to very low levels.
For instance, the Fed’s latest Beige Book report contains numerous comments about increased competition between banks and the resulting shrinkage in lending margins.
From a broader economic perspective, these phenomena indicate that savings (lenders) exceeds investment (borrowers). That this is happening at a time of zero nominal interest rates and even lower real interest rates implies that the US does not yet need to worry about an acceleration of inflation, at least from a monetary standpoint.
For the economy to overheat and spark the kind of inflation talked about by people like Milton Friedman in the 1970s, we would first need to see sharp growth in lending coupled with an expansion of the money supply.
Bank lending growth seen early in pandemic has stopped
As Figure 2 shows, many companies initially responded to the pandemic by increasing their borrowings to secure working capital, which helped power a surge in corporate bond yields. But these yields have since fallen back to pre-pandemic levels, in part because of aggressive monetary accommodation by the central banks.
Ever since this initial pick-up, however, US bank lending has been sluggish. The Fed’s quantitative easing and households’ increased savings have driven growth in both base money—which funds loans—and the money supply—which is mostly bank deposits. Yet while bank lending rebased to 100 in August 2008 surged from 145 in the pre-pandemic month of February 2020 to 157 in May of the same year, it subsequently fell back and remains at 150 in July 2021 (Figure 3). This has led to the phenomenon of intensifying lending competition between banks.

Businesses do not want to increase borrowing despite rising inflation
If many companies were worried that an excess of demand was driving inflation higher, they should be borrowing as much as possible at today’s deeply negative real interest rates in preparation for the purchase of more materials and equipment to meet increasing demand.
But that is not what we are seeing. Instead, banks are competing among themselves for a dwindling pool of borrowers. I suspect most businesses are not interested in borrowing any more because they view the recent pick-up in inflation as being transitory.
Viewed from another perspective, this suggests the recently observed inflation is due to supply-side problems in the real economy: if it were being driven by demand-side factors, corporate demand for loans would also be rapidly increasing.
Companies want to avoid damaging balance sheets with too much debt
In that case, why are companies behaving in this way despite the sharp decline in real interest rates? One reason noted previously is that corporate leverage is already at high levels, and managers are afraid that further increasing borrowing could harm their balance sheets.
Some business owners in Japan have said that if they were to borrow any more during the pandemic, they might not be able to pay it back. I suspect similar concerns are starting to emerge in the US.
One reason for this may be that many business owners woke up to the importance of maintaining a healthy financial position in the balance sheet recession that began in 2008. During the pandemic as well, companies with weak balance sheets were the first to go under.

Early start to tapering the right answer as monetary easing reaches limits
But if it is the case that many businesses (and individuals) have stopped borrowing because they want to maintain a solid balance sheet, that in turn means that central bank monetary policy has lost much of its effectiveness.
Monetary policy works basically by raising or lowering the cost of private-sector borrowing. For it to work, there must be private-sector borrowers who will respond to the signals being sent out by the central bank.
The latest Beige Book report indicated that banks in some parts of the US are even relaxing their lending standards in an attempt to win business, which suggests the Fed’s monetary easing policies have reached their limits. Continuing those policies beyond this point will force financial institutions to pursue loans and investments with poor risk-return profiles, with potential harms far outweighing the benefits.
In that sense, it is good to hear Fed Chair Powell making comments supportive of tapering—a gradual reduction in the Fed’s asset purchases under quantitative easing. Continuing the present policy beyond this point risks tipping the US economy into another cycle of asset bubble followed by balance sheet recession.
Japan has suffered from shortfall of private borrowers ever since bubble burst in 1990
Japan faces a more severe shortfall of private-sector borrowers than any other country. Thirty-one years ago, the collapse of a massive asset bubble sent commercial real estate prices in the six largest cities down by an average of 87% from the peak, taking them back to 1973 levels. As of March this year, commercial real estate prices were still down 80% from the peak.
In the pre-1990 era, real estate was deemed so essential as a form of loan collateral that Japan’s economy was said to be operating on a “land standard.” Private-sector balance sheets suffered a devastating blow as commercial real estate prices plunged 87%, causing asset values to sink while liabilities remained at their original values.
This was what triggered private-sector efforts to repair balance sheets by reducing debt (paying down loans), a process that ultimately took nearly 20 years (Figure 4).
Figure 4 illustrates the financial surplus or deficit of Japan’s nonfinancial corporate sector. In this graph, white bars stretching above the horizontal zero line in the graph signify an increase in financial assets, while red bars below the zero line imply an increase in financial liabilities.
The line with small circles in the graph indicates financial assets less financial liabilities—i.e., the financial surplus or deficit. When this is above the center line, the nonfinancial corporate sector is running a financial surplus and is therefore a net saver. When it is below the center line, it is running a financial deficit and is a net borrower.

Biggest reason for Japan’s long slump was lack of bold fiscal policy despite private savings surplus
It was not until FY2013 that Japan’s broader corporate sector finally stopped paying down debt in spite of zero interest rates (see red bars above center line in Figure 4). During this period, many companies were forced to use the earnings from their main businesses to pay down debt instead of engaging in forward-looking R&D or capex. This process of “restructuring,” as it was euphemistically called at the time, involved a great deal of pain.
But when one group in a national economy is a net saver (including the paydown of debt), the income cycle will stop unless another group borrows and spends those savings. When the broader private sector is running a large savings surplus to repair its balance sheet, only the government can rescue the economy by borrowing and spending via fiscal policy. Unfortunately, the Japanese authorities did not understand this, and every pick-up in the economy was quickly followed by calls for fiscal consolidation and a balance. During these years the government even made three increases in the consumption tax rate, which is the opposite of fiscal stimulus.
In other words, the biggest reason why Japan’s economy remained in a slump for 30 years was that unlike in a normal economy, where households save and businesses borrow, both sectors became net savers starting around 1995, and the government failed to step in and actively borrow and spend the resulting savings surplus.
Japan stopped growing because businesses stopped borrowing
After finally completing this balance sheet repair process and emerging from a “debt hell,” traumatized businesses never wanted to borrow again. This led to the concept of “cash flow management,” under which companies sought to pay for everything, including capital investment projects, with cash on hand.
However, for an economy to grow, it is necessary for someone to spend more than they earn. If everyone spends exactly what they earn, the economy will be stable, but it will not grow.
Most expenditures in excess of income involve businesses borrowing money to invest in new projects. When companies are averse to debt and pursue cash flow management, their expenditures always equal their income, which means they no longer contribute to economic growth.
This sort of debt trauma is not limited to Japan. A similar phenomenon was observed in the US following the Great Depression, as a result of which long- and short-term interest rates did not return to their average during the pre-bubble 1920s for 30 years (i.e., until 1959).
Notably, although the astronomical fiscal stimulus mobilized to win World War II succeeded in repairing private-sector balance sheets by 1945, interest rates did not normalize for another 14 years.
Japan did not carry out fiscal stimulus on this scale. In fact, the government unnecessarily prolonged the recession by frequently opting for deficit-reduction
policies. It is likely therefore that Japan will take longer than the post-Great Depression US to overcome its debt trauma.
Debt trauma and pursued-economy problems cannot be addressed with monetary policy
In an interview with the Nikkei on 9 September, BOJ Governor Haruhiko Kuroda attributed the sluggishness in prices and wages to a “persistent deflationary mindset.” While superficially this may seem to be the case, the underlying cause is actually the deflationary gap that opened up when Japanese companies stopped borrowing despite zero interest rates.
In addition, Japan has been a pursued economy—wherein most companies can earn higher returns on their capital by investing in emerging economies than they can at home—for about 20 years now. This is another reason why even companies that repaired their balance sheets remain unwilling to borrow domestically. As a result of these factors, Japan’s corporate sector has run a financial surplus averaging 1.86% of GDP over the last 30 years (Figure 4).
In the short term, the only way to address the deflationary pressure coming from balance sheet problems and inferior returns on capital problems is for the government to administer fiscal stimulus and become the borrower of last resort. In the longer run, the authorities need to pursue tax reforms and deregulation to restore the nation’s attractiveness as an investment destination.
That also means these problems cannot be addressed with monetary policy, something that was demonstrated beyond the shadow of a doubt by the failure of Mr. Kuroda’s “bazooka” to raise the inflation rate over the past eight years.
When Japanese companies responded to the pandemic by borrowing for the first time in nearly three decades to ensure access to working capital, I initially hoped this meant they had finally overcome their aversion to debt and abandoned the cash-flow management philosophy and were returning to a textbook world in which businesses use borrowed money to maximize profits. But for now, at least, that does not seem to be the case.

Markets now know QE doesn’t work and have not responded to subsequent easing
In the interview noted above, it was said that one result of QQE was an increase in the USD/JPY rate to its current level around 110 from somewhere in the 90s when the policy was launched in April 2013. At the time, however, most market participants were unaware of the concept of balance sheet recessions and were operating based on the assumption of a textbook economic world.
In that world, if one nation’s central bank engages in massive monetary accommodation while other central banks leave their policies unchanged, money supply growth in the nation that eased policy will accelerate relative to those that did not, causing inflation to pick up as well. The value of the currency in the country that eased monetary policy should therefore decline relative to those of countries that did not.
This was the market logic that sent the yen lower after Kuroda fired his bazooka, and it was the same rationale that caused the GBP and USD to fall sharply against the yen after the UK and the US implemented quantitative easing in response to the failure of Lehman Brothers.
However, private-sectors in the US, Japan, the UK, or Europe were all huge net savers at the time—all were in the midst of balance sheet repairs triggered by the collapse of asset bubbles. Quantitative easing did not succeed in boosting lending or money supply growth in any of the countries that tried it, nor did it cause inflation to accelerate.
Having thus understood the limits of this policy, the markets mostly stopped responding to subsequent rounds of accommodation, which included both quantitative easing and negative interest rates.
In short, the yen declined in response to Kuroda’s bazooka in April 2013 because market participants held an incorrect view of the economic world. Now that most have realized their mistake, we should not expect the same policy to have the same effect it did then.

Developed economies require different kinds of policies at macro and micro level
Former foreign affairs minister Fumio Kishida, one of the candidates in the race to become the LDP’s next president and the nation’s next prime minister, has argued that Japan needs to say goodbye to neoliberal policies if it wants to revitalize its economy. While it is extremely unusual for a specific economic philosophy to be given center stage in this type of election in Japan, the pandemic has ushered in a similar unease with neoliberal ideas and “small government” by economists and policymakers in the West.
While it is natural for the government to lead public health initiatives, Japan and other developed nations also need very different economic policies at the macro and micro level than they currently have. I think this policy mismatch is responsible for the ongoing rejection of neoliberalism.
From a macroeconomic standpoint, a negative (deflationary) output gap exists because households continue to save for the future while the businesses that used to borrow and invest those savings have stopped borrowing because of balance sheet problems and inferior domestic returns on capital.
As governments are unable to demand that households stop saving, it is essential that they use fiscal stimulus to borrow and spend this private sector savings surplus, but that requires “big government.”
From a microeconomic standpoint, on the other hand, persuading companies that moved overseas to bring investment home requires efforts to raise domestic returns on capital. That cannot happen without bold tax cuts and deregulation of the kind implemented by US President Ronald Reagan in the 1980s.
Tax cuts and deregulation are symbols of “small government” and run counter to the “big government” policies required at the macro level.

Golden age economies should pursue small government in both macro and micro policy
Milton Friedman, viewed by many as the father of neoliberal economic thought and its preference for small government, favored deregulation and tax cuts designed to increase private-sector freedom and was strongly opposed to fiscal stimulus, which implied big government. In that sense, his arguments were consistent.
But when Friedman was making his arguments half a century ago, there were no balance sheet problems and no pursued-economy problems. Moreover, most US companies had no overseas factories and were still actively investing in domestic production facilities.
I have dubbed this period the “golden age” of economic development. In these eras, strong private-sector demand for capital investment means corporate loan demand is robust, and both interest rates and inflation are relatively high. Government fiscal stimulus at such times not only crowds out private investment, thereby undermining any benefits, but also has undesirable side effects, including high interest rates and inflation and an inefficient allocation of resources.
Now that Japan and other developed economies have entered the “pursued” phase of economic development, in which they face direct competition from emerging economies, private-sector loan demand has declined to the extent that the private sector is running a large financial surplus despite zero interest rates and banks are competing with each other to loan money, for the reasons described above.
Consequently, even though the Japanese government dramatically increased fiscal stimulus starting in 1990 (the US and Europe did the same after 2008), the private sector has continued to run a savings surplus that is often larger than the stimulus, prompting interest rates to fall to levels that would have been unthinkable during the golden age.

Correct policy for pursued economies: big government at macro level, small government at micro level
Now that these developed nations have undergone a historical transition from “golden era” to “pursued era,” a combination of big government at the macro level and small government at the micro level is not only not inconsistent but is actually an essential policy mix.
As noted above, Mr. Kishida has declared his opposition to neoliberal economic policies, and a similar rejection of such views is spreading among academics in the West. The key question, however, is whether they are rejecting neoliberalism at the macro level or also at the micro level.
At the macroeconomic level, pursuing the sort of small government sought by Friedman at a time when private-sector loan demand is as depressed as it is today would—like Friedman’s belief in the primacy of monetary policy—have potential harms that far outweigh the benefits. But at the micro level, neoliberal policies designed to raise the return on capital are needed in order to bring capital investment back home from the emerging economies.
Renewed appreciation of fiscal policy a positive development
The US was the first country to confront pursued-economy problems in the 1970s as it was chased by Japan. Under Reagonomics, it undertook major reforms to taxation and regulation that significantly boosted the nation’s growth rate by creating the soil from which new businesses continue to spring forth even today.

Although the US private sector has run massive financial surpluses averaging 7.02% of GDP since 2008, its government succeeded in abandoning neoliberal, “small government” policies to sustain growth by then-Fed Chairman Ben Bernanke warning about the dangers of falling off the “fiscal cliff” and by Presidents Trump and Biden implementing the large-scale fiscal stimulus during pandemic recession. In that sense, the US has skillfully utilized both big- and small-government policies as necessary.
Economic mindset among policy makers in Japan and Europe, on the other hand, remains trapped in the golden age era, with both regions pursuing small-government policies even though their private sectors are running large savings surpluses (7.99% in Japan, 4.97% in the eurozone) at a time of zero or negative interest rates. Both economies remain sluggish as a result.
While I do not expect policy debate to focus on these policy mix issues in the upcoming elections in Japan and Germany, at the very least it is good to see many countries showing a renewed appreciation of the need for fiscal stimulus at a time when relying on monetary policy no longer works.

Richard Koo

Richard Koo is chief economist at
Nomura Research Institute. This is his
personal view.


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