New Paradigm in Macroeconomics

In the 1980s and 1990s a school of thought reached the zenith of its power. Its influence had become pervasive. Having been the view of only a minority little more than 20 years earlier, this approach had succeeded in dominating its discipline at all leading universities in the world. Academics that did not adhere to it found it hard to make a career: obtaining jobs or moving up the ladder depended on publications in leading journals — which had been usurped by this particular school of thought.

As is readily seen from Figure 1.1 and Table 1.1, Japan’s economic performance has been disappointing for much of the 1990s. Economic growth decelerated in 1992, with nominal GDP growth falling from 6.2% in 1991 to only 2.6%. Over the following year, growth fell further to only 1%. With the exception of 1996 and 1997 (when growth recorded 2.6% and 2.2%, respectively), nominal GDP growth stayed below 1.5% throughout the decade 1992–2002. In 1998, 1999, 2001 and 2002, it even recorded a significant contraction of over 1% (culminating in the 1.5% contraction of 2002).

1992–2002. In 1998, 1999, 2001 and 2002, it even recorded a significant contraction of over 1% (culminating in the 1.50% contraction of 2002).

As in other countries, Japanese fiscal policy has been the exclusive domain of the government, which proposes fiscal spending measures to parliament whose funding is detailed in budgets and supplementary budgets. In principle, the government has been following a balanced budget policy in the postwar era. The Finance Law of 1947 prohibited the issuance of government bonds. As a result of the 1965 recession, it was amended and government bonds were issued for the first time.¹ Oil shock recessions and increased spending programmes produced sizeable deficits in the 1970s.² The elimination of fiscal deficits (‘fiscal reconstruction’) has been a priority since the late 1970s, with the Finance Ministry pursuing a ‘zero [growth] ceiling’ on budget requests since 1982. Thanks to some tax rises (including the introduction of the consumption tax in 1989), high nominal GDP growth and asset price rises in the second half of the 1980s, the target of fiscal reconstruction was achieved in 1991.

Most leading macroeconomic theories postulate that nominal interest rate reductions, as implemented by central banks in many countries over the past several years, operate towards stimulating the economy. Since about the 1980s, central banks have come to emphasize interest rates in their official publications as the dominant tool of monetary policy implementation. It has come to be described as the ‘new consensus’ in macroeconomics (Arestis and Sawyer, 2002). In their discussion of the Bank of England model, Arestis and Sawyer note that monetary aggregates have been relegated to a minor role, while ‘interest rate policy has become demand policy’ (2002, p. 12):

Policymakers attempt to achieve a certain inflation goal by using their control over interest rates to restrain the total demand for goods and services in the economy. (Arestis and Sawyer, 2003a, p. 9)

Monetary policy can be seen as aggregate demand policy in that the interest rate set by the central bank is seen to influence aggregate demand, which, in turn, is thought to influence the rate of inflation. (Arestis and Sawyer, 2003a, p. 17) Taylor (2000) reflects the consensus view, when he reports his finding that even if there are alternative views of the monetary transmission mechanism, ‘the same simple monetary policy rule — one in which the central bank’s target short-term interest rate reacts to inflation and to real output — would perform well’ (p. 60).

The lack of apparent success of fiscal and monetary policies was taken by many economists as evidence that demand-side policies did not work. So they advanced supply-side policies that focus on structural change. Japan, we were told had to implement ‘badly needed’ structural reforms.

In May 2002, Bank of Japan Governor Masaru Hayami proclaimed that Japan was entering its third recovery since the bursting of the bubble economy.¹ Although the 1990s were marked by economic stagnation, there were two periods of brief but remarkable economic growth, namely 1996, when close to 4% real GDP growth was recorded, and 2000, when over 2% growth was achieved. In both cases, very few, if any, economists had forecast such sudden recoveries. Similarly, many economists were surprised by the sharp upturn recorded in most economic indicators in early 2002.²

We now turn to what may be the single most disturbing enigma. Once again it not only concerns Japan, but has arisen in many countries and many time periods around the world. It is disturbing for economics as a theory and for economists as applied social scientists.

Japanese asset prices have recorded significant declines since the late 1980s. The Nikkei index of 225 average stock prices dropped from a peak of ¥38,916 on 29 December 1989 to ¥7862 on 11 March 2003, a drop of 79.8%. Land prices also dropped sharply: since the first half of 1992, land prices have dropped relentlessly, usually falling at a double-digit pace. The semi-annual index of commercial land prices in the six major cities stood at 104.5 in the second half of 1990. By the first half of 2002 it had dropped to 15.9, the same level it had in the second half of 1979 (the figures had become so low that the statisticians decided to switch the base year). Peak to trough, this amounts to a fall of 84.8%. There have been many attempts at explaining such extraordinary and prolonged falls in asset prices. The only sensible explanation, however, remains that asset prices had simply been too high in the first place. Indeed, most observers recognize now that the recession of the 1990s has its roots in the events of the 1980s, especially its asset markets.¹

Another major ‘anomaly’ that economic theories had not been able to explain concerns Japanese capital flows in the 1980s and early 1990s. While capital flows are determined independently of the current account, balance of payments equilibrium implies that capital outflows counter-balance current account surpluses. These may either take the form of ‘autonomous’ capital flows (traditionally classified as long-term capital flows) or ‘accommodating’ capital flows (the short-term inter-bank capital flows). During the 1970s, the autonomous long-term capital outflows roughly matched the current account surplus (Figure 9.1).¹

Standard economic models assume that banks are financial intermediaries and as such rationally maximize their profits by minimizing risks and maximizing returns from asset allocation of their portfolio. Many economists have been arguing that the lending behaviour of banks during the 1990s has been in line with these models. Banks, it was argued, were not able to locate enough low-risk borrowers, so that overall credit growth failed to materialize. While there has been a dearth of empirical studies, it is conceivable that some empirical support could be found for this argument. Nevertheless, this explanation can only ever be a partial answer, since the true cause remains unexplained: why were there not enough low-risk borrowers?

During the 1990s, many economists have argued that Japan possesses too many banks. The financial press has referred to both Japan and Germany as seriously ‘over-banked’ economies, with the helpful advice that banks should be merged, sold to foreign investors or closed down. However, in order to come to this conclusion, it is necessary to understand the actual role of banks in economies. While the layperson may assume that economists have long solved this issue, in fact the very existence of banks has remained an enigma according to the mainstream theories.

To solve the enigma of why banks exist, and to understand their role in the economy properly, it is necessary to find out what makes them special and why others, for instance brokers or non-bank intermediaries, cannot easily perform the same functions. Fama (1980) argues that one of the two main functions of banks is the provision of transactions and accounting services. Together with the central bank, they serve as the settlement system of non-cash transactions in the economy. This has long been recognized, such as by Schumpeter (1912, 1917/18), who describes the banking system as the ‘central settlement bureau, a kind of clearing house or bookkeeping center for the economic system’ (1934, p. 124). Thus to him banks and the central bank perform the function of a ‘social accounting and clearing system’ of the economy.¹ This feature must indeed be important, since non-cash transactions constitute the majority of all transactions in the economy. It is also what banking systems have usually had in common over the past 5000 years. In Japan, transactions amounting to about 70% of annual GDP are settled through the banking system (and thus through the central bank) every single day.² Thus the volume of annual transactions in Japan amounts to over ¥100,000 trillion. Notes and coins amount to an average outstanding balance of ¥62.1 trillion.³ This means that less than 5%, most likely between 1% and 2%, of all transactions takes place in cash.⁴

Having identified the key feature that makes banks unique, it is now time to re-examine the link between the tangible economy and the monetary or financial part of the economy. In order to identify where possible errors could have been made in the construction of the edifice that is mainstream macroeconomics, it is necessary to return to first principles. As we saw, the various theories all rely on the quantity equation MV = PY. The textbooks consider it an identity that is true by definition and requires little further discussion. Handa (2000) writes that MV = PY However, is this actually true? Following the inductive method, it is of interest how this equation came about. We find that a quantitative link has been proposed between money and the economy for hundreds of years, if not much longer. A quantity relationship was mentioned by ancient Chinese classical scholars (von Glahn, 1996), Spanish scholastic writers of the Salamanca School (Humphrey, 1997), and many others (including Locke, Hume, Cantillon and Ricardo).

is an identity since it is derived solely from identities. It is valid under any set of circumstances whatever since it can be reduced to the statement: in a given period by a given group of people, expenditures equal expenditures, with only a difference in the computational method between them. (p. 25)

However, is this actually true? Following the inductive method, it is of interest how this equation came about. We find that a quantitative link has been proposed between money and the economy for hundreds of years, if not much longer. A quantity relationship was mentioned by ancient Chinese classical scholars (von Glahn, 1996), Spanish scholastic writers of the Salamanca School (Humphrey, 1997), and many others (including Locke, Hume, Cantillon and Ricardo).

Our framework solves the enigma of the velocity decline that was observed in many countries during the 1980s, including Japan. The apparent decline in velocity is simply due to the fact that the equation of exchange has been erroneously defined. Researchers assumed that can be proxied reasonably accurately by However, this is true if and only if that is, all transactions for which money is used are part of and accurately measured by nominal GDP. This ignores the possibility that transactions that are not part of GDP, such as financial and real estate transactions, exist and may develop differently from GDP-based transactions. There is little empirical evidence that equation (3) can be considered to hold true. Instead, it is a special case that only applies when there are no real estate or financial transactions, or, in the case of changes, when these non-GDP transactions remain a constant proportion of all transactions. In general, we must expect that GDP-based transactions are a subset of all transactions. Thus instead of equation (3):

John Law, born in Edinburgh, the son of a goldsmith and banker, recognized the implications of the activities of banks and their link to the economy. He argued that wealth depends on goods and their trade ‘and Trade depends on Money’. ‘But only banker-created money ensures a sufficiently active supply’ (Davies, 1994, p. 553, paraphrasing Law). ‘By this Money the People may be employed, the Country improved, Manufacture advanced, Trade Domestic and Foreign be carried on, and Wealth and Power attained’ (quoted in Davies, 1994, p. 553).

As we saw, asset price bubbles and subsequent busts have been observed in many countries across the world, including Japan in the 1980s and 1990s. Usually, neither the surge in asset prices nor the subsequent fall can be explained by standard economic models. Banking crises have happened in over one hundred countries in the past half century, usually following a period of financial boom. Many of the policies, especially those adopted by the IMF in such post-crisis countries have focused on raising bank stability by tightening up loan procedures, bank supervision and capital adequacy. These policies had a significant negative impact on macroeconomic performance, which was not explained by standard theory.

We saw that the movement of Japanese long-term capital flows in the 1980s and early 1990s has remained a mystery according to standard explanations.¹ Indeed, very few researchers even tackled the problem. One of the few is Ueda (1990), whose regression has a disappointing fit and is not subjected to the standard tests. The only paper that successfully explains Japanese long-term capital flows in the 1980s and early 1990s has done so by moving beyond the traditional portfolio models by incorporating, more or less ad hoc, a variable that represents the Japanese asset price bubble: in a portfolio model of capital flows, of the Kouri and Porter (1974) type, price variables, such as interest rates, had little explanatory power, while land-related credit creation, which was suspected to be fuelling the land price boom in Japan, was strongly significant (Werner, 1994a). However, this attempt to reconcile traditional models with reality did so with great difficulty: the key variable of the portfolio model is not a price, but a quantity. Moreover, this quantity — land-related credit — is not a private sector asset, but a liability. This raises questions about the applicability of the portfolio model approach altogether, which so far has been the theoretical underpinning of capital flow studies.

Japanese fiscal expenditures were substantial during the 1990s, but did not achieve the desired effects. Even the crowding out effect due to higher interest rates, which the literature recognizes, could not be observed. Since these findings discredit the Keynesian analysis and more recent, related theories, including the IS-LM model, it may be necessary to revisit the type of literature that was prevalent before the Keynesian fiscal multiplier analysis was proposed.

It has by now already been demonstrated that with the framework of disaggregated credit creation in a world of credit rationing the enigmas of monetary policy in the 1990s can be solved.

In Chapter 16 it was found that the strong growth in bank lending during the 1980s was the main cause of asset price movements in the 1980s and early 1990s. Further, in Chapter 15 it was shown that the weak credit growth of the 1990s was the cause of the recession. The weak lending of the 1990s was due to banks’ substantial bad debts, which rendered them risk averse, thus increasing the always present rationing in the credit market. These findings motivate interest in the question why banks increased their lending so aggressively during the 1980s. Moreover, in the previous chapter the issue of how to avoid moral hazard was raised. Also for this purpose and the formulation of suitable policies it is necessary to identify the cause of the rapid bank lending of the 1980s and identify those who are responsible for it. It is this question that will be examined in the present chapter.

Under the active ‘guidance’ of the IMF and the World Bank, far-reaching banking reforms have been implemented in several dozens of countries during the postwar era. These were not seldom part and parcel of broader structural adjustment programmes. However, the banking reforms have often not had the declared impact of improving social welfare, but instead produced adverse results. Przeworski and Vreeland (2000) found that the effect of participation in IMF programmes is to lower growth rates for as long as countries remain under a programme. Furthermore, the fact that banking crises have often recurred even in countries that have implemented IMF-guided banking reforms indicates that these reforms failed to address some fundamental problems with the operation of the banking system. It is thus necessary to re-examine the topic of banking reform in the light of our approach.

We have confirmed that the cause of Japan’s recession has been the sharp reduction in credit creation that began in 1992 and was triggered by the bad debts in the banking system. We have also found that this was due to excessive loan growth quotas imposed on the banks by the Bank of Japan during the 1980s. Finally, we found that the problem of lack of credit during the 1990s could easily have been solved through monetary policy. Bad debts could have been taken off the banks’ balance sheets without costs by the central bank. Even without bank lending, the central bank could have created a recovery a decade ago, by significantly increasing its own credit creation. In other words, Japan’s recession of the 1990s has been the result of the Bank of Japan’s policies.²

There are several criteria for deciding among competing theories. We already considered the more narrowly defined statistical criteria drawn up by Hendry and Richard (1983) in Chapter 15. Among their seven criteria, four are of broader significance and find application whenever scientists seek to choose between alternative theories.

Neoclassical economics demonstrated that there is significant room for welfare-enhancing government intervention, because the conditions under which government intervention is inefficient are so unusual and exceptional that they do not apply anywhere in this world. Neoclassical economics showed that in the real world (as opposed to a theoretical dream-world), free markets cannot possibly lead to a social optimum. This means that there is a sound case for developing countries to oppose unmitigated free trade, for implementing suitable industrial policy to enhance growth and welfare, for organizing economies in a more cooperative fashion, for successfully establishing a more inclusive form of capitalism that provides social welfare for all and treats all people as valuable human beings.