NBER Reporter: Fall 2001

Japan Group Meets in Tokyo

Members of the NBER's Working Group on Japan and their guests met in Tokyo on September 14-15. Their two-day session was organized by Magnus Blomstrom, NBER and Stockholm School of Economics; Jennifer Corbett, Oxford University; Fumio Hayashi, NBER and University of Tokyo; and Anil K Kashyap, NBER and University of Chicago. The following papers and topics were discussed:

Taehun Jung, Yuki Teranishi, and Tsutomu Watanabe, Hitotsubashi University, "Zero Bound on Nominal Interest Rates and Optimal Monetary Policy"

Discussant: Sergio Altimari, European Central Bank

Hiroshi Fujiki and Shigenori Shiratsuka, Bank of Japan, "Policy Duration Effect under the Zero Interest Rate Policy in 1999-2000: Evidence from Japan's Money Market Data"

Discussant: Matthew D. Shapiro, University of Michigan and NBER

Luncheon Speaker: Heizo Takenaka, Economics Minister of the Japanese Government

Donald R. Davis and David E. Weinstein, NBER and Columbia University, "Bones, Bombs, and Break Points: The Geography of Economic Activity"

Discussant: Michael M. Knetter, NBER and Dartmouth College

Panel Discussion: The Looming Social Security Crisis in Japan

Chair: Charles Y. Horioka, NBER and Osaka University

Panelists: Tatsuo Hatta, University of Tokyo, Marten Palme, Stockholm School of Economics, and Toshiaki Tachibanaki, Kyoto University

Ralph Bryant, Brookings Institution, and Warwick McKibbin, Australian National University, "Incorporating Demographic Change in Multi-Country Macroeconomic Models: Some Preliminary Results"

Discussant: Fumio Hayashi

Gavin Cameron, Oxford University, "The Sun Also Rises: Productivity Convergence between Japan and the U.S."

Discussant: Ari Kokko, Stockholm School of Economics

Masaharu Hanazaki, Hitotsubashi University, and Akiyoshi Horiuchi, University of Tokyo, "Can the Financial Restraint Hypothesis Explain Japan's Postwar Experience?"

Discussant: Jennifer Corbett

Heather Montgomery, The Asian Development Bank Institute, "The Effect of the Basel Accord on Bank Portfolios in Japan"

Discussant: Joe Peek, University of Kentucky

Takatoshi Ito, NBER and Hitotsubashi University, and Kimie Harada, Daito Bunka University, "Japan Premium and Stock Prices: Two Mirrors of Japanese Banking Crises"

Discussant: Kenji Wada, Keio University

What can a central bank do when faced with weak aggregate demand even after it has reduced the short-term nominal interest rate to zero? To address this question, Jung, Teranishi, and Watanabe solve a central bank's intertemporal loss minimization problem. They explicitly consider the non-negativity constraint on nominal interest rates and compute the optimal path of short-term nominal interest rates assuming that the central bank has the ability to make a credible commitment about the future path of those rates. They find that the optimal path depends on history, in the sense that a zero interest rate policy should be continued for a while even after the economy returns to normal. By making such a commitment, the central bank is able to achieve higher expected inflation, lower long-term nominal interest rates, and weaker domestic currency in the adverse periods when the natural rate of interest deviates significantly from a normal level. The authors show that this channel of monetary policy transmission is quantitatively important.

Fujiki and Shiratsuka quantify the policy duration effect of the zero-interest-rate policy that was implemented in Japan from February 1999 to August 2000. They show that the policy duration effect observed in Japanese financial markets emerged via the expectations (of the future course of monetary policy) channel, supplemented significantly by the liquidity effects of the severe financial conditions at the time. The resulting policy implication is that the effectiveness of a zero interest rate policy depends crucially on financial and economic conditions.

Davis and Weinstein consider the distribution of economic activity within a country in light of three leading theories: increasing returns; random growth; and locational fundamentals. To do so, the authors examine the distribution of regional population in Japan from the stone age to the modern era. They also consider the Allied bombing of Japanese cities in WWII as a shock to relative city sizes. Their results support a hybrid theory in which locational fundamentals establish the spatial pattern of relative regional densities, but increasing returns may help to determine the degree of spatial differentiation. One implication of these results is that even large temporary shocks to urban areas have no long-run impact on city size.

Building on the theoretical work of Blanchard, Weil, and others, Bryant and McKibbin incorporate demographic structure into open-economy empirical macroeconomic models. They combine changes in birth and mortality rates with an approximation of age-earning profiles to allow demographic shifts to influence human wealth, consumption, and asset accumulation. Their preliminary work introduces the new approach into two simplified empirical models; they are still refining the empirical adaptation of the theoretical work in both of these models. The stylized shock on which the authors initially focus is an unanticipated and transitory demographic bulge, analogous to the "baby boom" experienced by some industrial nations several decades ago. With the passage of time, the shock results in population aging of the type now confronting industrial nations, especially Japan. One set of simulation results describes the effects when the demographic bulge occurs simultaneously in both of the two model regions. A second set considers the consequences when the shock occurs in one of the regions but not the other. Preliminary findings strongly support the conclusion that this analytical approach is promising. The findings also strongly confirm the hypothesis that differences across countries in the timing and intensity of demographic shifts can have significant effects on exchange rates and cross-border trade and capital flows.

The growth process for a technological leader is different from that of a follower. While followers can grow through imitation and capital deepening, a leader must undertake original research. This suggests that as the gap between the leader and the follower narrows, the follower must undertake more formal R and D and possibly face a slower overall growth rate. Cameron constructs measures of relative total factor productivity for 11 Japanese manufacturing industries and uses dynamic panel data methods to test whether a smaller productivity gap leads to slower growth, and whether R and D takes over as the engine of growth as Japan approaches the technological frontier. His results suggest that Japanese and U.S. productivity have been growing at similar rates since the mid-1970s, and that some of the Japanese growth slowdown is attributable to the exhaustion of imitation possibilities.

According to the "financial restraint hypothesis" advocated by Hellman, Murdock, and Stiglitz (1996), comprehensive competition-restricting regulation in Japan was effective in motivating banks to monitor their client firms prudently by giving the banks excess profit opportunities. The financial deregulation begun in the early 1980s undermined banks' profitability and thus induced the banks to shirk monitoring. According to the financial restraint hypothesis, Japan's bank crisis in the 1990s was a consequence of the financial deregulation in the 1980s. Hanazaki and Horiuchi criticize that hypothesis and propose an alternative: that the banking sector was potentially fragile even before the 1980s because the government was unable to penalize inefficiently managed banks in credible ways. Manufacturing firms, which were subject to competitive pressures from abroad, reduced their reliance on bank credit in the late 1970s; non-traded goods industries, such as real estate, became major borrowers of bank credit in the 1980s. This structural change in the market for bank credit revealed the potential fragility of the Japanese banking sector. The authors' empirical analyses based on more than 1,600 manufacturing firms support this alternative hypothesis.

Montgomery asks whether stricter capital adequacy requirements introduced under the 1988 Basel Accord caused Japanese banks to restrict loan growth. Using a panel of Japanese bank balance sheets for fiscal years 1982-99, she finds that the Basel Accord regulation requiring international banks to hold a BIS (Bank for International Settlements) capital-to-risk-weighted-asset ratio of at least 8 percent increased the sensitivity of total loan growth to capitalization for international banks in Japan. A similar, but quantitatively smaller, finding is reported for a group of "switcher" banks that initially pursued the 8 percent BIS capital adequacy requirement following the signing of the Basel Accord, but then later switched to pursue a domestic 4 percent MOF (Ministry of Finance) capital adequacy requirement. Domestic banks, which were subject to the 4 percent MOF capital adequacy requirement for the entire post-Basel period, show no evidence of increased sensitivity of lending to capitalization in the post-Basel period.

Ito and Harada investigate how financial troubles among Japanese banks in the second half of the 1990s were viewed by the market. Specifically, they examine two indicators: the Japan premium and the stock price index of the banking sector in Tokyo. Testing to see whether different kinds of investors saw the banking crisis differently, and what kind of news had the most impact on market pricing of Japanese banks, they find that the factors that most pushed up the Japan Premium were the Daiwa Bank incident in the fall of 1995, failures of large financial institutions in November 1997, and uncertainties in the resolution of banking problem in fall 1998. The bank stock index declined (relative to the general stock index) most with bank failures, in particular the Yamaichi Securities failure in November 1997. Individual failures of financial institutions may or may not have an impact on other banks' stock prices, the authors conclude. The bank stock index and the general stock index historically moved together, but structural changes occurred in that co-movement relationship around the summer of 1995. News that affects the Japan premium and bank stocks sometimes is different, the authors note. The bank stock price index Granger-causes the Japan premium, but the reverse does not hold. This result is consistent with the view that the Japan premium reflects both domestic structural problems and banks' liquidity problem in the euro dollar market, while bank stock prices reflect only the former.

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