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The Cost of Forbearance in Japan; the Benefits of Korean Unification

Each year, Michael Milken, the American financier, holds a roundtable discussion in Los Angeles with Nobel Laureates to discuss the state of the world economy, which Global Economic Viewpoint excerpts below. This year’s panel includes Kenneth Arrow, professor emeritus at Stanford University, who was awarded the Nobel prize in economic science in 1972; Gary Becker, professor of economics and sociology at the University of Chicago, awarded the Nobel prize in economic sciences in 1992, and Myron Scholes, an emeritus professor at Stanford University, awarded the Nobel prize in economics in 1997.

MICHAEL MILKEN: Today, more than 50 percent of the assets of all the individuals in Japan -- $12 trillion -- are held in cash yielding less than 1.5 percent. Equities have declined by more than 80 percent, as have real estate values, over the last 15 years. Why has it taken so long to get Japan going?

GARY BECKER: There is a misperception about what has happened in Japan in the last decade. It has not had a serious recession or downturn or erosion of income. What Japan has had is stagnation: population stagnation and income stagnation. That means per capita income has been more or less flat during the ’90s.

Japan is a very rich country. I just visited Japan and was impressed by the amount of wealth there, not only in cash but also in the automobiles, in the department stores, in the clothing that people wear. And it has plenty of real assets -- strong human capital, hard-working people and some very good international companies that can give any company in the world a battle for market share.

Mainly, the Japanese problems are twofold. They have been reluctant, for what can only be political reasons, to clean up the huge financial problem they have with a basically negative net value in a lot of the loans that they had extended. Instead, they have been giving additional loans to companies they know will have no chance of ever repaying them. By way of comparison, the United States moved much more quickly with a smaller problem in the savings and loans industry.

The second problem Japan faces, from a longer term perspective, is that it remains an overly closed, overly regulated market. It was never a major importer of foreign capital. It remains hostile to immigration despite its rapidly aging population and shrinking work force.

Despite all this, a lot of countries of the world would like to be in the Japanese position of being so wealthy. So, Japan is not in decline but recline -- that is, stagnation.

MYRON SCHOLES: If a country has a primary deficit of 7 percent of GDP a year, and it is growing by less than 1 percent a year with a 120 percent debt-to-GDP ratio, that is not sustainable. Something has got to give.

Of course, Japan’s trade surplus with the rest of the world, and the willingness of its citizens to hold huge quantities of government bonds, are what has allowed the government’s continuing ability to finance huge deficits.

When the banking system failed in the early 1990s, it did so because the corporations failed. In effect, then, society ended up owning the corporations and the banks. But instead of saying ‘‘okay, we will have to recapitalize these socially owned assets to keep them going,’’ what they have done instead is institute a system of forbearance. If effect, they’ve tried to sweep the bankruptcy under the rug with the hope that something, somehow was going to create value enhancement to bail them out of their predicament.

If you are the managers of these in-effect socialized companies or banks, then there is not really an incentive to do anything to upset the government. Thus, the bankers became very afraid of lending money to anyone other than Toyota -- which did not need to borrow money -- or push loans on already bankrupt companies, such as the so-called ‘‘zombie firms,’’ because they did not want them to lose any more money.

Over the last five or six years the lending infrastructure that was in place has essentially disappeared. When small businesses ask for a loan, they can no longer get it from the local branch. The information is sent to the headquarters, and then the upper echelons decide whether a loan is to be granted. So excessive regulations, excessive rules, an inability to make decisions because of the forbearance problem, have caused a lot of the financial technology to wither. As a result, there has been starvation of lending to middle-market entities and middle-market activities. There is a lot of dead capital in Japan. Assets that could be leveraged for growth are just not being put to work.

MILKEN: The largest amount of capital that exists in the world today is invested short in Japan. When the United States had the savings-and-loan crisis, we did not suffer this forbearance problem because we are not dependent on the banking system for capital, but look to the publicly traded markets to finance growth.
A company like Bank of America, which was the largest in the world at the beginning of the ’80s, has shrunk in real terms 50 percent since. But it did not slow down our economy.

KENNETH ARROW: There seems to be one factor that has not been taken account of, which is the very high savings rate of Japan. We tend to think of this as a good thing because it means provision for the future. But maybe some elements in Keynesianism are not dead.

The high savings rate means that the rates of return have been driven down to a level which some might interpret as the liquidity trap. There is not much competition for capital because there is so much laying around, so to speak.

SCHOLES: You have to be careful, though, because in a deflationary environment such as Japan, the real interest rate is much higher. If prices are falling, even by making nothing on your money you are making something because your ability to consume later at less cost obviously is enhanced.

BECKER: This is true. The Japanese are probably getting 2 or 3 percent return on money, even though the official rate is at zero. I would be very doubtful, however, that the high savings rate for Japan is a problem.

Not long ago most economists in the United States were lamenting the fact that we had such a low savings rate while Japan had such a high savings rate, and that is why they were eating our lunch and were going to overtake us. And it did not happen.

People exaggerated the strengths of Japan and the weaknesses of the United States at that time. And I think now somewhat of the opposite is going on.

There are, to be sure, real difficulties in Japan. Yes, they have an aging population. But they also have a hard-working, highly educated population, a skilled population, and very good companies. And high savings, in an environment where you can turn things around, will be very productive. In a stagnating environment, it is much less clear.

But in the longer pull, the high savings rate for Japan will be a benefit, even if they send some of it abroad, as they are doing, to China and elsewhere in Asia.

MILKEN: To summarize some of our thoughts: If Japan could get some of the regulatory and financial technology in place, it has some excellent opportunities for growth by lending again to small and medium business, creating jobs and getting the economy going. And still it has the capital that could fuel large parts of the world’s need -- particularly in the rest of Asia -- for access to capital.

SCHOLES: I would add a last point. Japan has to stop these public works programs, which are essentially doing nothing but wasting society’s resources and increasing government debt. They are not very productive. It is not very productive uses of capital.

BECKER: Initially, Japan’s debt creation was kind of a Keynesian pump-priming effort. They thought that by the government spending more and running deficits, they would be able to spend their way out of the recession. But what happened?

If you go back to 1992, there was not a high debt/GDP country. It is all a result of misguided policies in the ’90s to try, through deficit policies, to spend their way out of the recession. They diagnosed the wrong problem and they took the wrong solution to the problem. And that only created more trouble as a result. Trillions of dollars have been invested and still have not solved the problem. At this rate of debt growth, five years from now their debt/GDP ration will be 220 percent!

(NEXT: China, the European Union and the American Deficit)



Financier Michael Milken and Nobel Laureates Gary Becker and Kenneth Arrow discuss the costs and opportunities of Korean unification.

GARY BECKER: In discussing the unification of Korea, it is important to separate the economic and the political issues, which is difficult to do. When you think of German unification, the terms were set more by political desire than economic judgment. While the politicians decided it was desirable to have a one-to-one conversion rate between the East and West German mark, economist knew then it was wrong when the two economies were at such different levels.

Clearly, economic unification would be in the interest of both South and North Korea so that people, machinery and goods can move freely between the two regions. They were once a single country; they have a long common history of being an independent nation. Therefore, there would be a natural yearning to have a considerable amount of interaction between the two parts.
However, moving toward a single country -- political unification -- presents problems that in some respects are more severe than those facing East and West Germany.

While the populations in North and South Korea are very similar, the relative incomes are very different. South Korea is much richer. The gap is much larger than even the large gap in incomes between East and West Germany. While the German income gap was probably on the order of 4/1, Korea is more like 10/1. Unifying such disparate standards of living raises a whole set of difficult questions. How do you try to reduce that gap? What kind of transfer of payments must take place? What kind of taxes will be imposed on the South Koreans in order to eliminate that gap in a reasonable amount of time?

West Germany had a $100 billion surtax per year in order to finance East German unification. Relative to the Korean per capita income, that would probably have to be larger for South Korea.
That 10/1 income gap has to be closed for any kind of political unity. You cannot have a country integrated now where one part of the country is earning one-tenth of what the other part of the country is earning. And the only way you are going to close that in the short run is by transfer payments -- taxes on the South Koreans to finance the transfers to the North Koreans.

MICHAEL MILKEN: It sounds to me like we are talking about $1,500 per person in South Korea per year for a while, to allow this to happen. Perhaps there might be a referendum to ask people in South Korea of they would be willing to spend $1,500 per person per year for 10 years to combine their country with the North?

KENNETH ARROW: That is roughly what the West Germans are paying now, still, 10 years after the reunification. The Korean cost will be at least that, but probably higher. Of course, given the threat that North Korea presents to South Korea, it may be more beneficial than not paying it. East Germany didn’t pose much of a threat to West Germany as such. The North Koreans pose a great threat, particularly because of the geographic location of Seoul just south of the DMZ, right near the heavily armed North Korean troops stationed there.

There are boons, too, but they are going to take a long time to realize. For example, there is trainable manpower. But if the German experience is any guide, we are talking about a generation or more before this transformation takes place.

The price is going to be enormous. And, probably, a good part of it will be by North Koreans migrating South to seek work in industries that already exist. In fact, something like that is happening in Germany, too.

(c) 2003, Milken Institute/Global Economic Viewpoint. Distributed by Tribune Media Services.
For immediate release (Distributed 5/15/03)