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Barry Eichengreen

There is little agreement about deflation as a problem for economic growth and financial stability. Economists may question it as a transitory phenomenon or whether monetary policy can solve it without more serious risks. Historical experience generally confirms that it should be a central-bank priority and does not solve itself. Once deflation is under way, monetary policy can return inflation to positive target levels. If that is not achieved, banks need to do more. If doing more threatens financial stability, macroprudential tools are appropriate. If a central bank runs out of government securities to buy or worries about liquidity in the government bond market, there are other assets to buy. If it worries about purchasing other assets, a helicopter drop of money is an option. If that drop targets productive public infrastructure investments, they not only can proceed without increasing public debt but also can actually reduce it.

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Economic Stagnation in Japan

Exploring the Causes and Remedies of Japanization

Edited by Dongchul Cho, Takatoshi Ito and Andrew Mason

Japan’s dramatic transformation from economic success to economic stagnation offers important policy lessons to advanced countries everywhere that are struggling with stagnation. The term ‘Japanization’ is often used by economists to describe long-term stagnation and deflation. Symptoms include high unemployment, weak economic activity, interest rates near zero, quantitative easing, and population aging. In the global context, what can governments do to mitigate the downward trends experienced by Japan? This judiciously timed book investigates in depth the causes of Japan’s ‘lost decades’ versus the real recovery achieved by the United States, and the lessons that can be learned.
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Frank H. Stephen

Chapter 6 develops and estimates an econometric model of the determinants of growth to illustrate the insights gained from using the NIE-based framework developed in Chapter 4. It demonstrates the influence of the legal environment on the size of the financial sector and the influence of culture on the legal environment including the effectiveness of the legal system. The benefits of information enhancing institutions in promoting financial sector development (FSD) are also demonstrated. The model is used to test the competing claims of legal origin and culture in explaining the content and effectiveness of a jurisdiction’s laws. The tests suggest a limited impact of legal origin beyond that of culture in these respects. They also provide support for the transplant effect. These results suggest that legal reform to support a market-based approach to development must take account of the cultural context in which it is taking place.

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Kyu-Chul Jung

Kyu-Chul Jung examines how Korea’s export market today resembles Japan’s since the 1990s and faces increasing competition from China. In the 1990s Japan lost export market shares as Korea began to catch up, but China began to catch up with Korea in the late 2000s. The old strategy of exporting the same goods as advanced countries is not sustainable. With its limited resources, Korea needs to concentrate on exports where it has a comparative advantage, to undertake structural reforms (dealing with insolvent enterprises and improving labor-market flexibility) and to develop new export markets. Korea needs to focus on core capabilities, so that China and other latecomers cannot easily emulate Korea’s technology and market strategy.

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Mitsuhiro Fukao

Mitsuhiro Fukao examines Japan’s zombie banks since the early 1990s. The causality of these severely undercapitalized banks runs as follows: increasing loan losses from bankrupting borrowers weaken banks’ capital base; undercapitalized banks start to hide losses and provide evergreening loans to loss-making firms; and undercapitalized banks as well as firms continue to operate with deposit taking by zombie banks under forbearance of regulators. The most important factor during Japan’s worst financial crisis (1997–2003) was the loss of confidence in the accounting and auditing system. Unreliable financial statements resulted in a vicious cycle of credit contraction and impeded the functioning of the market economy. Close relationships among bankers, regulators and accountants impeded quick resolution by allowing nonviable banks to hide loan losses. Complex debtor-creditor relationships among related companies make it difficult to ascertain the scale of the bad-loan problem. The most adverse effect is the increased risk of financial crisis.

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Financial markets

An Institutional Critique

Frank H. Stephen

Chapter 5 outlines the role which the financial sector plays in market-based economic development and the role played by the legal system in financial sector development (FSD). After discussing the fundamental functions of any financial system and the different types of markets and institutions which constitute a financial system, the chapter turns to a discussion of how FSD might be measured. The evidence on the relationship between FSD and economic growth is assessed. Building on this empirical evidence, the factors which promote FSD are examined. The chapter draws not only on the finance literature but the institutional literature discussed in Chapters 2, 3 and 4. These tools are then utilized to examine the problems faced and potential opportunities open to FSD in developing countries. In this regard, particular attention is paid to the relative merits of credit markets and capital markets in promoting FSD in developing countries.

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Kyooho Kwon

Kyooho Kwon examines how Korea’s demographic structure resembles Japan’s, with a 20-year lag, and how productivity growth and solving structural problems are key to maintaining dynamism in the Korean economy. Japan’s “lost decades” and lethargy in Korea’s economy lead some Korean economists to worry that Korea may follow in the footsteps of Japan, with its declining growth rate. Japan’s stagnant total factor productivity growth depressed the demand for labor and capital; and the slower growth rate of the working-age population imposed a constraint on labor supply. These factors together caused the marginal product of capital to fall, dampening the demand for additional capital stock and impeding GDP growth potential. Korea’s demographic structure is evolving in a pattern similar to demographic change and unprecedented aging in Japan and is already playing a role in economic slowdown.

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Daehee Jeong

Daehee Jeong examines the increase in Korea’s zombie firms, in the context of Japan’s experience of negative effects on employment, investment, productivity and overall dynamics of the economy. Korea’s delay in corporate-sector restructuring led to an increase in zombie firms, making zombie lending to distressed firms more severe in Korea than in most developed countries. The increase is attributed largely to maturity extensions by banks, rather than to interest exemption by general creditors. Korea’s zombie lending is driven not by insolvent commercial banks but by public banks. One remedy is thus to address their politically directed lending, which has increased exposure to large firms, and instead to restore their role in supporting sectors where the financial market fails, such as small and medium-size enterprises and newly established firms. In addition, the Financial Supervisory Service should ensure that standards for classifying bad loans are consistent across commercial and public banks.

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How we got here

An Institutional Critique

Frank H. Stephen

Chapter 1 sets the scene for the book. It discusses the reasons for the interest in the relationship between the law and economic development beginning with an outline of theories of development. The theory of development currently favoured by multilateral development agencies such as the World Bank is one of market-led development which emphasizes the role of the financial sector. Drawing on an analysis of the reasons why the Law and Development Movement of the 1960s and 1970s failed, criteria by which theories of law and the legal system’s role in development should be evaluated are identified. It is argued that a theory based on New Institutional Economics can satisfy these criteria.

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Dongchul Cho, Takatoshi Ito and Andrew Mason