Embassy official discusses U.S., Japan Economic Outlook

Michael Michalak, Minister Counselor for Economic Affairs, U.S. Embassy in Tokyo
Speech at Keio University
June 12, 2003

It is a pleasure to be here today. I thought that I would take a few moments to discuss the present state of the U.S. economy, recent trends in key areas such as tax policy and corporate governance, and then finish by comparing the U.S. economy and economic policies with what is currently going on here in Japan. I will be more than happy to answer any questions you may have at the end of my remarks.

I have both good news and bad news regarding the U.S. economy. On the plus side, the U.S. economy has proven itself to be remarkably resilient. When you consider the number of negative events that have occurred since March 2000, the economy has not performed badly. Since the bursting of the stock market bubble in March 2000, almost $7 trillion worth of wealth has been destroyed in the U.S. alone. In addition, we have seen a recession in 2001-2002, the September 11 terrorist attacks, and the corporate governance scandals involving Enron, Worldcom and others. In addition, other major advanced economies showed very weak growth in 2001 and 2002. Despite all of this, the U.S. economy still managed to grow 0.3% in 2001 and around 2.2% in 2002. Indeed, the long-run economic outlook remains solid. The United States has low inflation, low interest rates, and strong productivity gains, which should continue to raise real incomes and living standards.

The bad news is that this is not good enough. In order to create enough jobs, the economy needs a higher growth path. Business investment must increase if we are to have a satisfactory expansion pace. Although purchases of equipment and software picked up modestly in the last three quarters of 2002, new orders for non-defense capital goods, which is a forward-looking indicator of investment, actually declined in the last quarter of 2002. High vacancy rates for office and industrial properties continue to depress investment in commercial structures. Household spending, particularly on autos and housing, has played a key role in the latest recovery. That spending has been supported by the continued growth of real personal income, which has been more stable than in the typical postwar recession. Unfortunately, net worth, due to declining equity prices, has fallen dramatically relative to income over the past three years. Declining equity prices have also raised the cost for businesses of financing new investment.

A strong rebound in business investment is necessary if we are to reach a higher growth path. Business investment is the key factor in creating more jobs. As you know, the labor market has been quite weak during the current recovery. The preliminary unemployment rate for April was 6%, up from 5.8% in March.

President Bush recently signed into law a 10-year $350 billion dollar tax-cut package that is designed to address these problems. I will not go into the minutiae of the package but it is designed to provide both demand and supply side support to the economy. The first part of the package, the acceleration of the 2001 Tax Cuts, will put more money in the pockets of consumers. The second part, a major increase in the amount of investment that small businesses may deduct immediately as well as an increase in the first-year bonus depreciation, should substantially increase the incentives for business to invest. Finally, tax rules should not create economic distortions. Unfortunately, the U.S. tax system has created distortions in the past by affecting a number of basic economic decisions such as whether to hold assets that produce dividends or capital gains, when to realize capital gains, and how businesses should finance their investments. A reduction in tax rates on dividends and capital gains should reduce our tax system's current favoring of debt over equity, retained earnings over dividends, and distributions of earnings via complicated transactions like share repurchases over simple dividend checks. By reducing the tax code's preference for debt, retained earnings, and share repurchases, the current package strengthens corporate governance since having the cash to make a dividend payment is a strong indicator of the health of a company.

Corporate governance is another area where the Bush administration has focused its attention. Corporate governance, the series of checks and balances that guides corporate managers' decisions, is vital for the proper functioning of financial markets and healthy business investment. Our current problem is best summed up by a recent statement by New York Federal Reserve Bank President William McDonough: "recovery in the business sector continues to be restrained, not just by geopolitical uncertainty and the need for restructuring in some key sectors, but by caution on the part of investors and lenders. They continue to doubt the quality of internal governance and external oversight, as well as the reliability of the information corporations provide- in short critical issues of investor and lender confidence."

Before I discuss the administration's corporate governance reforms, I would like to debunk a popular myth. Under U.S. securities law, companies that file financial statements that contain errors must refile the statements regardless of whether the errors were intentional or not. For example, if a company such as Enron files statements that contain incorrect information on earnings, it must file restatements with the correct earnings information. Although there was a substantial increase in the number of earnings and other financial restatements by U.S. companies dating back to the mid-1990s, the truth is that most large U.S. corporations have not restated their earnings. In addition, earnings restatements were concentrated in certain industries, such as the technology sector. In other words, Enron and Worldcom were exceptions to the rule, not the norm.

President Bush signed the Sarbanes-Oxley Act, which was designed to strengthen corporate governance and allay investors' fears, in July 2002. The Act gives courts and Federal agencies new tools to aid investors in verifying the quality of managerial decisions. The Act improves information accuracy and accessibility by introducing new disclosure requirements, dramatically increasing the sanctions for certain disclosure violations, and creating new rules and institutions to strengthen manager accountability and auditor independence.

By clarifying the roles and responsibilities of corporate officers and the corporation's audit committee, the Act strengthened manager accountability. The Act also created a special national board to oversee the auditing of public companies' financial reports.

I would now like to take a few minutes to compare the U.S. and Japanese economies in three key areas: deflation, structural reform, and non-performing loans and assets. As you may have seen in the press, financial markets are concerned about the possible emergence of deflation in the United States. The Federal Reserve itself in its May 6 policy statement also expressed concern over deflation although it stated the probability of an unwelcome substantial fall in inflation was "minor". The reason why deflation is a threat to economic growth is that it raises the real burden of debts, discourages investment, and leads households to postpone expenditures. As I noted earlier, household expenditures have played a key role in the U.S. economy. Although deflation is not a problem in the United States at this time, our policymakers are closely monitoring the situation.

As you know, Japanese deflation has been persistent but modest - at about 1% at the consumer price level. However, as measured by the broader GDP deflator, deflation has been greater, reaching 3.5% year-on-year in the first quarter of 2003. Wages in Japan are currently falling by more than 1% per year and deflation is firmly embedded in expectations. Since deflation increases the real burden of debts, it further exacerbates the banking sector's bad debt problem. Deflation is a monetary phenomenon, which means that the Bank of Japan's monetary policy will play a key role in beating it.

Although the Bank of Japan has increased the monetary base significantly since 2001, economic history suggests that a farther larger increase in money supply over a sustained period of time will be necessary before deflation's grip is broken.

Unfortunately, a sick banking sector makes the task of monetary policy in overcoming deflation much more difficult. Weakened banks do not increase their lending when the central bank provides them with more reserves, thus blocking a principal channel through which monetary policy works. I will discuss the banking sector in more detail in a few minutes.

Structural reform is another important area for both the United States and Japan. The only way the United States and Japan can raise living standards, care for the aging, and shoulder the burden of government debt is through economic growth. One of the keys to sustained economic growth is the elimination of structural impediments to growth.

Although I briefly touched on President Bush's tax package earlier and discussed its emphasis on promoting economic growth, I did not mention that the administration is currently working on the complete overhaul of our international tax rules. When you consider that the U.S. trade in goods and services today represents more than 25% of GDP and cross border investment flows in 2000 was equal to nearly 16% of GDP, a major reform of rules dealing with transfer pricing, interest allocation, withholding rates, foreign tax credits, and the taxation of dividends will have a significant impact on the economy's overall performance. Current reform discussions are focusing on how our tax system differs from major trading partners to the detriment of U.S. companies and how reforms can reduce barriers to efficient capital flows. A reduction in the tax system's disincentives to save, invest, and innovate will help create new opportunities for investment and growth.

Both the United States and Japan need sustained economic and productivity growth in order to deal with the challenges posed by their aging populations and pay-as-you-go retirement benefits systems. Under a pay-as-you-go system, the government collects payroll taxes from workers and then immediately transfers the proceeds to retirees. According to the United Nations, the percentage of the U.S. population over the age of 65 will increase from 12.3% in 2002 to 20.2% in 2030. It will increase from 17.2% to 30% in Japan. Since the workers in the United States and Japan fund retirees through social security payroll taxes under our pay as you go systems, a decline in the number of workers relative to the number of retirees will make it increasingly difficult to fund old-age benefits. The United Nations estimates that in 2030 there will only be three people in the working-age population for every retiree in the United States. In Japan there will only be 1.9 people in the working-age population per retiree. When you consider that not everyone in the working age population actually works, the numbers are even more serious.

A 2002 study published by the Federal Reserve Bank of New York concluded that the United States and Japan only have three policy options: increase payroll taxes, reduce benefits, or dedicate other tax revenues to social security. However, the study also noted something interesting about productivity: "If employers succeed in increasing productivity, then wages will rise faster than prices. Higher wage growth, in turn, means that more money will be collected in social security taxes. Thus, stronger than expected productivity growth should ease the burden that the payment of social security benefits impose on workers and the government. This effect is particularly pronounced when social security systems adjust annual increases to inflation, as in the United States and Japan."

Unfortunately, Japan's productivity growth rate has dropped farther and faster than any other G7 country. Although Japan's industrial elite has some of the highest productivity rates in the world, many industries lag far behind their counterparts in other countries. On average, Japanese worker only produces 70% as much as an American worker. Lagging industries such as financial services, distribution, communications, and medical services have extensive regulations governing technologies and products. These regulations and in some cases extensive trade barriers also shield these industries from competition. History has shown us time and again that industries that do not face competition fail to innovate. To make matters worse, many of these sectors such as medical and financial services offer the greatest potential for growth. Structural reform that promotes competition, the entry of new firms into markets, and new product introduction is the best way to increase productivity and stimulate growth. Prime Minister Koizumi was correct when he stated "no growth without structural reform".

Finally, I would like to discuss the banking sectors of our respective countries. As you know, the United States faced a banking crisis in the late 1980s and early 1990s. The United States did not adopt a policy of corporate restructuring such as Sweden or South Korea. Instead, we chose to sell assets quickly. Although the recent recession, excesses in certain industries, and international exposures have weakened bank balance sheets in the United States, the recent increase in non-performing loans (NPLs) has been relatively modest. Most of the increase in NPLs stems almost entirely from the lending activity of large banks, particularly their commercial and industrial lending. In addition, loan quality problems in 2002 were concentrated more heavily in certain sectors such as the broadcast and telecommunications sectors. This indicates industry specific problems rather than broad macroeconomic trends.

A healthy financial system is vital to a developed economy such as Japan's. The flow of funds from savers to investors via the banking system acts as oil in an engine. When a banking system breaks down, it chokes normal economic and business growth. If a banking system is weighed down with bad loans, it cannot fulfill its role of gauging risk and return and channeling savings to the most profitable investments. In addition, as I mentioned before, a sick banking system also seriously limits a central bank's monetary policy.

Recent experience with banking crises have taught us that four steps are necessary to cleaning up a troubled banking system. They are:

  1. Recognize the full extent of bad and troubled loans.
  2. Close insolvent banks.
  3. Make sure the remaining banks accurately gauge the risks of their loan portfolios, have sufficient reserves against losses, and maintain enough capital to operate prudently, and
  4. Ensure that the new management of the remaining banks have the skills and incentives to run their banks well.
The FSA's Financial Revival Program is a step in the right direction. The Japanese government has taken significant measures to strengthen the regulations dealing with the provisioning of loans, the valuation of collateral, and the classification of bank capital. In addition, the Industrial Revitalization Corporation has begun to deal with the difficult issues of corporate restructuring and turnaround. Although all of these steps are positive, I would like to point out that the implementation of these measures and the additional measures that will be required is key.

In conclusion, I would like to point out that bad debt workout, deflation, and structural reform are not individual challenges. As I have tried to point out in this lecture, all of them are intertwined. Progress in all of these areas is self-reinforcing but the failure to achieve progress in any one of them acts as an anchor to continued progress in the other areas. I will be more than happy to answer any questions you might have.