I. Diagnosing Japan’s Deflation
In 1999, Alan Blinder contended in his book, Central Banking in Theory and Practice, that central bankers must learn more about economic theories AND economists must learn more about central banking practice. Japan’s experience of the past decade suggests that this message should be extended: Pundits must learn more about how financial institutions, particularly banks, and financial markets function.
Throughout Japan’s financial malaise and the ensuing deflation, pundits have offered a “panacea” after “panacea” in macroeconomic policies, often with a scant understanding of how financial institutions and markets work. Indeed, understanding them is critical because, after all, the main reason for the malaise of the Japanese economy has been the overhang of banks—excess lending—some of which have turned into non-performing loans (NPLs)—and, on the flip side, the overhang of excess borrowing by firms.
This should not be interpreted as an underestimation of the importance of macroeconomic policies. As the past decade has proven, while macroeconomic stimuli are imperative for creating an environment that is conducive to banks’ debt liquidation, they alone cannot bring a final resolution to Japan’s financial malaise. Unequivocally, liquidation of NPLs is an absolute precondition for sustainable economic recovery. This simple conclusion, though widely accepted by now, is amazingly still not totally well understood even by some economists.