Crtique of Central Banking

Henry C K Liu

Part I:         Monetary theology
Part II:       The European Experience
Part III-a:   The US Experience
Part III-b:   More on the US experience
Part III-c:   Still More on the US Experience
Part III-d:  The Lesson of the US Experience
Part IV-a: 
The Asian Experience
Part IV-b:  The Japanese Experience

Part IVc: More on the Japanese Experience

This article appeared in AToL on June 28, 2003

Monetary policy and banking policy in Japan were key factors for that country's post-World War II economic growth. The Japanese economy grew at an annual average of 4 percent from 1974 to 1990, with steady but low inflation. Recessions were infrequent and brief.

The enabling dynamics behind this was the Cold War geopolitical guarantee to Japan of protected access to a large US market. Still, that smooth economic performance was not independent of Japanese monetary policy, in particular the steady growth of money, bank deposits and credit, keeping economic growth strong through steady export expansion, keeping inflation in check, and moderating the boom-bust business cycle. This monetary policy was made possible by the existence of a national banking regime to support national goals.

The Japanese economy began to stagnate in the early 1990s because its national goal of export became dysfunctional after the Cold War. The introduction of central banking in 1998 reduced Japanese banks to financial basketcases in a liberalized financial market, instead of the healthy service institutions in support of a national policy of export under a national banking regime. Under central banking and a liberalized global financial market with floating exchange rates and full convertibility, the price to be paid for having trade surpluses manifests itself in a rising yen. This in turn causes domestic general deflation in Japan.

Japanese policy of keeping the yen's exchange value lower than that dictated by market pressure has now become an attempt to eliminate domestic deflation. But a below-market yen leads to a larger trade surplus in dollars, causing a net shrinkage in the yen money supply, thus shrinking the yen asset economy, leaving it with overcapacity and making yen assets less valuable. What Japan is doing is investing in the dollar economy while disinvesting in the yen economy through its trade surplus. This is the real cause of deflation in Japan.

To restore strong economic growth in Japan, deflation needs to be stopped. Under a central banking regime, the most straightforward way to stop domestic deflation is to force the yen to depreciate in foreign-exchange value. But this would go against market forces generated by Japan's trade surplus. Yet if Japan keeps the exchange value of the yen low merely to sustain its export prowess, it will continue to feed domestic deflation. This is because the rate of shrinkage of the yen economy from a huge trade surplus denominated in foreign currencies, mostly dollars, is greater than the rise in yen money supply released by a reluctant central bank.

Domestic deflation can be stopped if there are more yen chasing after the same amount of yen assets. But more yen in circulation will lower the exchange value of the yen. A low yen in turn will increase Japan's trade surplus, which, because it is denominated in foreign currencies, mostly dollars, is a mechanism that transforms yen input into dollar output, reducing the yen money supply. This reduction of yen money supply increases the amount of under- or non-performing yen assets, reducing their market value.

Thus Japan's trade surplus contributes to increase in the US dollar money supply. Normally this would push down the value of the dollar. But dollar hegemony forces the Japanese and other trade-surplus nations, such as China, to finance their trade surplus with a capital account deficit in favor of the dollar economy. This expands investment in the dollar economy and pushes up the price of dollar assets and pushes down the price of yen and other non-dollar assets. Thus dollar hegemony keeps both the exchange value of the dollar and the price of dollar assets high, while other non-dollar economies must choose between a weak currency and domestic deflation. China is insulated because the yuan is not fully convertible. When the US Treasury allows the dollar to fall against the yen, it is in fact condemning Japan to more domestic deflation through yen appreciation, if all else remains unchanged. By allowing the dollar to fall, the United States is in fact exporting deflation.

To stop domestic deflation, Japan not only needs to inject more yen into the yen economy but it must also keep the yen in the yen economy by reducing its trade surplus without shrinking its economy. This is because the trade surplus coupled with a capital account deficit is leaking yen into dollars faster than the Bank of Japan (BOJ), the central bank, can inject more yen into the yen money supply because of the so-called liquidity trap. Thus Japan needs to shift its historical national role by changing its investment policy from one of promoting ever-increasing export for trade surplus in dollars that are of little use to the Japanese yen economy. Japan needs to adopt a new national goal of developing and expanding the global economy, particularly the Asian economy, from which the relatively overdeveloped Japanese yen economy will derive sustainable expansion in tandem.

This is true with all the Group of Seven (G7) economies: they can only grow by making sure that the rest of the world grows at a faster pace. There was a period during the Cold War when the more advanced US economy grew at a slower pace than those of its Western allies, much to the benefit of the whole Western bloc. The future of the world economy depends on more economic equality, not by shrinking the size of the G7 economies, but by expanding the economies outside of the G7 at a faster pace. It is doubtful whether this shift toward equality can be achieved through neo-liberal globalized trade. This is because trade without global full employment does not yield comparative advantage to the poorer trading partner. Say's Law, which asserts that supply creates its own demand, is only true under conditions of full employment. Comparative advantage in free trade is Say's Law internationalized, true only under conditions of global full employment and shrinking disparity of wages.

Dollar hegemony makes trade surplus denominated in dollars a mechanism to drain wealth from the trade surplus economy to the dollar economy. Development needs to replace trade as the dominant driving force of the world economy. In the long run, Japan will benefit from an Asian common currency not dominated by yen hegemony. And the world will benefit from a global currency not dictated by dollar hegemony or by any other single national currency.

Deflation wreaks havoc with business balance sheets: it discourages investment; it leads consumers and corporations to postpone spending. With the consumer price index falling at about 1 percent per year, and the broader gross domestic product (GDP) deflator falling at about 2 percent per year, deflation has become persistent in Japan in recent years as the country continues to enjoy a substantial trade surplus.

Aside from a temporary increase in 1997 when the consumption tax was raised, prices have been falling in Japan for the past decade. Deflation is damaging to the operation of the banking system, and this is one of the key links between monetary policy and banking policy in a central banking regime. With deflation, interest rates are forced to become very low - close to zero. Yet near-zero interest rates only postpone, not eliminate, the need for banks to deal with problem loans, because, notwithstanding Milton Friedman's famous pronouncement that inflation is everywhere and anywhere a monetary phenomenon, deflation, the reverse of inflation, is not everywhere and anywhere just a monetary phenomenon. Deflation is a problem that cannot be cured by monetary measures alone, as Japan has found out and as the United States is about to. Global deflation can only be cured by reforming the international finance architecture to allow trade to be replaced by development as the engine for growth.

With near-zero interest rates, borrowers find it easier to meet their interest payments to banks, allowing loans to remain performing even if the borrowing firms are structurally unprofitable. And deflation makes it harder for borrowers to repay loan principal. High interest rate in an inflationary environment can be a negative real interest rate after inflation adjustment, in which case banks are actually paying their borrowers. Conversely, a zero interest rate can be a high real rate in a deflationary environment. Under a national banking regime, banks are performing their duty as long as they support the national purpose. In Japan's case, the banks' role was to support export. Even if the banks did not make a profit or their corporate borrowers could not meet debt service temporarily with current cash flow, the banks were serving the national purpose as long as the borrowing corporations were gaining market share in the global market.

Postwar Japan was prepared to export the national wealth created by its people in exchange for gold or gold-backed dollars. This mercantilist national purpose for a war-torn economy worked until 1971 when the United States took its dollar off the gold standard. Yet it took another three decades before the full impact of exporting for a foreign fiat currency took its toll on the Japanese economy. This adverse impact was finally brought home by the globalization of financial markets after the end of the Cold War, and exacerbated by the Tokyo Big Bang on April 1, 1998, and the adoption of the Central Bank Law on the same day. The end of the Cold War robbed Japan of its geopolitical guarantee for exclusive access to a huge market in the United States. The Tokyo Big Bang subjected the Japanese financial system to international market pressures and the Japan Central Bank Law forced the Japanese banks to be profit centers rather than service institutions.

With a central banking regime in a neo-liberal globalized market economy, firms and banks are separated from any national purpose, except as affected by domestic tax policies or by national security restrictions. Banks and firms exist mainly to make profit for their shareholders of any nationality. It has become possible for the global banking system to prosper at the expense of national economies, including the home economies of transnational banks.

Monetarists argue that loan default decisions will surface at a more timely stage if interest rates, both nominal and real, stay steady and appropriately low for sustainable expansion of the economy and its money supply, which generally requires an inflation rate between 1 and 3 percent. As a result of delays in confronting de facto default due to near zero interest rates, business failure, liquidation, and loss of jobs when they finally occur can be much more severe than if the finance restructuring were made earlier. Near-zero interest rates dull the sensitivity of interest payments as a barometer of business robustness.

In March 2001, the BOJ, then a three-year-old central bank, made an important change in monetary policy. It announced that it would provide ample liquidity until the inflation rate was equal to or greater than zero; that is, until deflation is ended. That policy is in essence one of inflation targeting.

The BOJ conducts monetary policy and its business operations under the Central Bank Law of April 1, 1998, which was established on the principles of "independence" and "transparency". The BOJ implements monetary policy by adjusting the supply of funds in line with demand for them in the money market through market operations. Since February 1999, the then barely one-year-old central bank has kept the uncollateralized overnight call rate, the operating target, at virtually zero percent. This is known as the zero-interest-rate policy. This means that the BOJ will inject funds into the money market without limit whenever necessary. In fact, the BOJ has been supplying funds in such large volume that excess funds continue to remain in the banks, but the funds have not found their way into the market.

The BOJ, at its Monetary Policy Meetings (MPMs), decides the guidelines for market operations that cover the inter-meeting period of about half a month or a month ahead. Market participants, on the other hand, often engage in funds transactions that become due in three or six months. This requires them to forecast movements in the overnight call rate during the period between the next MPM and the maturity date of their transactions. Consequently, when the outlook for interest rates is uncertain, market forces will set interest rates on term instruments, such as three- or six-month instruments, substantially higher than the prevailing overnight rate.

To avoid such an outcome, the BOJ has announced its intention of maintaining the zero-interest policy "until deflationary concern has been dispelled", suggesting possible continuation of the policy beyond subsequent MPMs. This announcement aims at ensuring that the effects of the zero-interest-rate policy permeate the economy. As a result, money-market rates, including those on three-to-six-month instruments, have stayed around zero percent.

This is an application of Nobel economist (1995) Robert E Lucas's theory of "rational expectations". The theory postulates that expectations about the future can influence the economic decisions independently made by individuals, households and companies. Using mathematical models, Lucas showed statistically that the average individual would anticipate - and thus could easily neutralize - the impact of a government's economic policy. Rational expectation theory was embraced by president Ronald Reagan's White House during his first term, but the theory worked against Reagan's "voodoo economics" instead of with it.

When the BOJ first adopted the zero-interest-rate policy in February 1999, the economy and the financial markets interacted in a downward spiral. Sluggish economic activity had made market participants increasingly worried about the stability of the financial system. Had extreme pessimism spread in the financial markets, Japan's economy could have plunged into a catastrophic crisis. This situation could create an abrupt freeze on economic activities, such as business investment and household spending.

The zero-interest-rate policy in effect stopped the toxic interaction between economic activity and the financial markets by removing concerns among market participants that they might face difficulties in funding due to a liquidity shortage in the market. In the meantime, the Financial Function Early Strengthening Law and other legislation enacted in the autumn of 1998 attempted to provide a framework for the stabilization of the financial system. In March 1999, about a month after the adoption of the zero-interest-rate policy, major banks were recapitalized by injection of public funds. But the "convoy system" of bank mergers shelters the weakest banks at the expense of the strong. Moreover, fiscal spending was increased significantly to stimulate economic activity. But the yen money supply did not expand because of a recurring trade surplus denominated in dollars. The zero-interest-rate policy masked the symptoms, but it did not address the disease.

Japan's economy has shown no signs of a self-sustained recovery in private demand despite the zero-interest-rate policy. Under these circumstances, the timing of a policy change and the meaning of "until deflationary concern has been dispelled", which is generally regarded as the criterion for terminating the current policy, have again become the focus of attention.

The BOJ describes the condition "until deflationary concern has been dispelled" as meaning "until a self-sustained recovery of the economy driven by private demand can be forecast with a certain degree of probability". A fall in prices of goods is not necessarily deflation, for it may be the effect of a rise in productivity from the same cost base. When computer prices fall from productivity gains, it is not deflation. Generally, deflation is defined as a spiral of declining prices, particularly in asset prices in addition to prices of goods, accompanied by contraction in economic activity. An overall decline in the level of prices brings about a fall in corporate profits and wages, and this fall leads in turn to a contraction in economic activity, resulting in another price decline. This indicates that the economic momentum behind price developments is an important criterion in identifying the risk of prices declining further.

While interest-rate policy can be a stimulant or a depressant in an inflationary environment, a zero-interest-rate policy can have unintended adverse effects in a deflationary environment. Since the cost of money is near zero, there is no compelling reason for banks to lend money, except for earning fees to refinance loans made earlier at higher interest rates. This creates problems for banks down the road by reducing future interest income for the same loan amount. The narrow spread in interest will also force banks to raise credit thresholds, shrinking the pool of qualified borrowers. It can also cause a distortion in income distribution in the household sector by denying interest income it would have otherwise earned by savers. It can create problems for pension funds and insurance companies.

Structural reform can be delayed by too much easing of the necessary cash-flow pain. Market participants' risk perception can be dulled. Institutional investors, such as life-insurance companies and pension funds, can then face difficulty in finding good investment opportunities to pay for long-term commitments made at high interest rates. In the United States, where loan securitization is widespread, banks are tempted to push risky loans by passing on the long-term risk to non-bank investors through debt securitization.

The BOJ's zero-interest policy combined with general asset deflation has caught the Japanese insurance companies in a vise. Both new loan rates and asset values are insufficient to carry previous long-term yields promised to customers. Japan does not have a debtor-friendly bankruptcy law, as the United States has. At any rate, insurance companies, like banks, cannot file for bankruptcy in the US. They are governed by an insurance commission, which normally has a reinsurance fund to take care of insolvency. The fund is nowhere near sufficient to handle systemic collapse. The same happened to the US Federal Deposit Insurance Corp (FDIC) in the 1980s. The insurance sector in the United States will face serious problems as the Federal Reserve further lowers the Fed Funds Rate (FFR). Several segments of the insurance sector, such as health insurance and casualty insurance, have already collapsed for other reasons.

In the era of industrial capitalism, a low interest rate was a stimulant. But in this era of finance capitalism, lowering rates creates complex problems, especially when most big borrowers routinely hedge their interest-rate exposures. For them, even when short-term rates drop or rise abruptly, the cost remains the same for the duration of the loan term, the only difference being that they pay a different party.

Central banks are still applying industrial-capitalism monetary economics to the new finance capitalism. That is the main cause of the multi-wave financial crash that began in 1982 in Mexico and developed with full force of contagion in 1997 in Asia. In fact, in more than two years since the zero-interest policy announcement, the BOJ has significantly expanded money as measured by the monetary base, which is bank reserves plus currency in circulation. The monetary base is up 34 percent since the Bank of Japan began its new policy. However, broader measures of liquidity that are more closely associated with general price increases have not grown nearly as rapidly for reasons stated above. The growth rate of broad money, which includes individual and business deposits at banks, has hardly increased at all. Moreover, bank lending has not increased because of a liquidity trap. As the Japanese trade surplus adds to Japan's dollar reserves, yen deposits and loans remain stagnant. Even after adjusting for loan writeoffs, bank lending was down 2.6 percent in 2002 and consumer prices continue to fall.

The reason the increase in the growth rate of the monetary base has not resulted in higher growth of loans and deposits at banks, or a rise in prices, is not, as some economists suggest, that the increase in the monetary base has not been sustained for long enough. Nor are more increases needed in reserve balances banks hold at the BOJ, a key component of the monetary base. The traditional anti-inflation bias of the central banking regime has deprived policymakers of any historical guide in overcoming persistent deflation.

The current round of global deflation is caused by weak demand resulting from the effects of dollar hegemony as sustained by a global central banking regime regulated by the Bank of International Settlements (BIS). The neo-liberal globalization of trade and finance prevents all non-dollar economies from effectively increasing their local currency money supply for domestic development. To avoid speculative attacks on their currencies, all increases in local-currency money supply must be channeled to fuel export for trade surplus in dollars. This shrinks the exporting economies' own money supply while adding to the dollar money supply to fuel the dollar economy at the expense of non-dollar economies. Consumers in non-dollar economies are robbed of purchasing power because low wages are necessary to compete in the global export market to accumulate trade surpluses in foreign currencies, mostly US dollars. At the same time, state credit cannot be used to finance domestic development to raise income, for fear of inducing speculative attacks on the local currencies. Neo-liberal economists argue that the main reason the increase in the monetary base has not yet worked in Japan is non-performing loans (NPLs) in the banking sector. They point out that funds lent by commercial banks and spent by borrowers create deposits at other banks that can then be lent to other borrowers. According to neo-classical monetary economics, this is the way an increase in the monetary base (high-power money) leads to an increase in the amount of broad money and higher prices, through the money-creation power of banks. But banks that are burdened by NPLs do not seek out new, profitable loan opportunities, even when they have excess reserves. Neo-liberal economists argue that a change in banking policy that effectively deals with the NPL problem will lead to more banks and more businesses seeking out new opportunities and creating new loans. They make this argument all over Asia - in fact, all over the world.

For Japan, they argue that solving the NPL problem would significantly increase the ability of the BOJ to increase broad money, increase bank lending, and raise the price level. This is like arguing that after you leave the gas running in the kitchen stove without first lighting it, an explosion will result when you finally light it. Therefore you must now turn off the gas and open all the windows and there is no alternative to suffering uncooked food for a while until the air is clear. But neo-liberals are careful not to tell you that it was they who first suggested that you blow out the pilot light of national banking. If the pilot light of national banking had remained lit, the economic kitchen of Japan would still be producing delicious hot food. Turning the gas on without a lit pilot light will cause an explosion again, no matter how many times you open the window to clear the air temporarily.

A recent BOJ report highlights the nature of the NPL problem, in effect arguing that NPLs are not simply the legacy of the old bubble days, but reflect continuing problems in the banking sector. There is truth to that observation, but the BOJ report fails to note that the NPL problem is a bastard child of central banking. The BOJ argues that the NPL problem must be addressed quickly. And there is also truth to that view. Problem loans do exert a heavy toll on banks. Heavily burdened banks lose the ability to focus on new lending to new business opportunities. A banking system that is weighed down by bad loans cannot fulfill its role of gauging risk and return and channeling savings to the most profitable investments. Banking problems also exert a heavy toll on the economy. Borrowers who are not servicing NPLs are frequently owners of assets - property, buildings, capital equipment - that are not being used productively or profitably in a free market.

All this is valid, but only in a central banking regime. Under a national banking regime, these problems remain, but they take on a very different character. Under national banking, rather than private bank profits deciding what should be financed, the national purpose decides what is financially profitable. Furthermore, the claim that cleaning out NPLs in the Japanese banking system under a central banking regime will revive the Japanese economy has not been empirically verified. It is only part of the snake-oil cure promoted by the Washington Consensus to perpetuate US dollar hegemony.

It is true that unresolved NPLs freeze non-performing assets in place and prevent them from moving to more profitable activities. But it is also true that under central banking, some profitable activities may well be detrimental to the economy as a whole. The US economy is full of examples of this truism. The result is a robust financial sector and a sick real economy.

Under conditions of excess capacity, failure to deal with NPLs locks in excess capacity, worsening deflationary pressures. But solving the NPL problem in the wrong way, through massive layoffs, for example, will only add to deflationary pressure. The solution requires more than simply reducing or writing off debt. Over-indebted borrowers are almost always overextended businesses, having expanded into activities with little economic benefit. In the case of Japan, the overextended business is export of manufactured products for money that is useless in Japan.

Addressing the problems of the distressed borrowers requires substantial restructuring in order to identify a profitable business core, and in some cases liquidation of the borrower is the only alternative. The Japanese economy has been historically structured toward export. It would be unthinkable to liquidate the entire export sector. However, it is quite possible to make the export sector earn yen instead of dollars. A yen trade surplus would contribute to curing deflation in Japan. But it will still not solve Japan's economic malaise.

The Japanese export engine has become unprofitable not only because world trade is shrinking. The solution to the NPL problem lies not in liquidating the export sector, but in redirecting it toward yen-earning developmental institutions. The catch is that this redirection from trade to development cannot be accomplished by relying on neo-liberal market fundamentalism operating in a central banking regime.

The market favors trade over development because the market treats development cost as an externality. When someone other than the recipient of a benefit bears the costs for its production, for example education and environmental protection, the costs of the benefit are external to its enjoyment. Economists call these external costs negative "externalities". These externalities amount to a market failure to distribute costs and benefits fairly and efficiently within the economy. Globalization is basically a game of negative externalities. Inhuman wages and working conditions, together with neglected environmental protection and cleanup, are other negative externalities that protect corporate profit. It is by ignoring the need for development and by externalizing its cost that the market can deliver profitability to corporate shareholders. Development can only be done with a revival of national banking in support of a new national purpose.

For the 44 trillion yen in loans to corporations classified by Japanese banks as bankrupt or in danger of bankruptcy, the harsh choices are clear. But a more corrosive problem arises with loans that are technically performing but are owed by companies that are barely able to keep afloat, have little prospect for long-term survival, and have no possibility of ever paying back the loan. These firms may be able to scrape together their required interest payments in Japan's low-interest-rate environment. How many of the roughly 100 trillion yen in loans that "need attention" fall into this category and are likely to become non-performing loans is at the heart of the dispute about the size of Japan's bad-loan problem. This highlights the futility of a central-bank interest-rate policy as a tool to deal with deflation.

Dealing with these walking-dead firms before they spiral into bankruptcy, and while there is still value and employment that can be salvaged, is a critical issue. But the answer is not retrenchment through layoffs. The answer lies in turning these distressed firms from export dinosaurs to development dynamos domestically, regionally and globally. Instead of exporting cars and video games, Japan can export education, health care, environmental technology, management know-how, engineering and design, etc, systems to generate wealth rather than products to absorb wealth from overseas.

Yet the delay in addressing the NPL problem has not spared Japan the pain of unemployment. Thus the NPL problem is merely a symptom, not a cause, of the economic malaise Japan has placed on itself by continuing to pursue export for dollars as a national purpose.

For economic growth to increase in any country it is necessary not only for productivity growth to increase; it must also accompany productivity growth with consumption growth. Productivity is the amount of goods and services that workers can produce in a fixed period of time, such as a day or year. Productivity growth is driven by the ability to move productive resources - labor and capital equipment - from low-productivity activities to high-productivity activities. Consumption growth in a modern economy cannot rely merely on quantitative increase. It must take the form of qualitative improvement. A higher level of living standard includes a rising level of culture, morals, aspirations and sensitivities.

The Japanese economy combines industries where productivity is the highest in the world with industries that lag behind their counterparts in other countries. This is unavoidable for most economies because culture demands more than efficiency. The trouble is that in Japan the high productivity is heavily concentrated in the export sector, while the lagging productivity is concentrated in the domestic sector. And as mentioned repeatedly before, export earns US dollars. And dollars cannot be spent in the Japanese yen economy. So Japan is dollar-rich but yen-poor. The more Japan prints yen to finance export, the more dollars it will supply to the dollar economy to make it stronger and richer, and the yen economy poorer.

Economists have pointed out that in no other major country are the differences between leading and lagging sectors as large, or the potential productivity gains so great from closing the gaps. Food processing is an industry that employs 11 percent of Japan's manufacturing workforce. Analysts have estimated that if productivity in Japanese food processing were raised to the level of France, a country with equal attention to quality, freshness, and presentation, then productivity in the Japanese economy as a whole would rise by 1.64 percent. Yet this would only exacerbate deflation in Japan by making processed food cheaper.

The Japanese government is developing measures to deal with the NPL problem. Financial Services Agency (FSA) Minister Heizo Takenaka has outlined principles that will guide its approach to banking policy. The first is assuring that banks accurately classify their loans and that they hold sufficient provisions against losses. The second is assuring that banks are adequately capitalized. And the third is improving the corporate governance of banks, to assure that they operate both effectively and profitably.

Yet these goals are music only to the ears of neo-liberal monetarists. They do not address the real problems facing the Japanese economy. The real problems are caused by a crisis in national purpose. Without addressing the issue of national purpose, cleaning up the banks would merely be dealing with the symptoms. In fact, Japanese banks can again be healthy institutions if a national banking regime is revived to serve a new, viable national purpose. Otherwise, forcing the distressed banks to clean up their NPLs under a central banking regime governed by BIS regulations would risk destroying the entire Japanese economy.

Japan has already used public funds to try to strengthen its banking system, and more will be required. Yet public funds are not a viable solution for a wrong-headed national purpose. Effective banking reform can be aided by the use of public funds. But using public funds without condition is a recipe for moral hazard and damaging delay.

A healthy, vibrant Japan is a Japan that can take its proper place on the world stage - a critical factor in the security of the region and the world. Yet a prosperous region and a world without poverty will enhance the security of Japan more than any military alliance or rearmament program. Japan can contribute toward a more secure world by focusing on economic development by exporting wealth-creating technology rather than wealth-absorbing products.

In December 2001, the government forecast that Japan's gross domestic product for fiscal 2002 (April 2002-March 2003) would post zero growth in real terms. Because of the slumping economy, investment in plant and equipment was expected to drop 3.5 percent, while housing investment was forecast to decline 1.9 percent. Because of the difficult employment and wage environment, personal consumption was expected to grow only 0.2 percent. This weak domestic private-sector demand would push down real growth by 0.5 percentage point. Public-sector demand, meanwhile, was forecast to boost real growth by 0.3 point through increased spending on the new national nursing-care system and other programs. As for external demand, exports were forecast to increase during the latter half of fiscal 2002, bolstering the real growth rate by 0.2 point. Even these bleak forecasts proved to be over-optimistic. The Cabinet Office had insisted on forecasting negative growth for fiscal 2002, in line with the actual state of the economy in fiscal 2001. But the Ministry of Finance (MOF) and the Ministry of Economy, Trade, and Industry (METI) were opposed to a government forecast of negative growth that might be self-fulfilling. In typical Japanese style, the two sides agreed on a compromise. The government would prevent the economy from bottoming out in the first half of fiscal 2002. It would make use of the second supplementary budget of fiscal 2001, totaling 4.1 trillion yen, to continue to implement public works, which usually experience a lull in the first half of the fiscal year due to administrative procedures.

In the meantime, exports were optimistically forecast to improve, especially those bound for the United States, which was expected to get back on the path of recovery, notwithstanding that the decline in value in the US equity market between March 2000 and March 2003 has exceeded 90 percent of GDP, as compared with 60 percent during 1929-31.

Since this scenario was a compromise, however, there was criticism of it even within the government. One high-ranking official said presciently, "Since it depends on a recovery of the US economy, the figure 0.0 percent [growth] is nothing more than wishful thinking." These forecasts had not even taken into account the adverse impacts of the then unforeseen Iraq war and the surprise SARS (severe acute respiratory syndrome) epidemic.

Private-sector economists predict that a second consecutive year of negative growth as inevitable. Behind these predictions lies the judgment that it is difficult to foresee any pick-up in personal consumption and investment in plant and equipment, the two main engines of growth, when the economic situation will worsen because of structural reforms, mainly progress in the disposal of NPLs.

Private-sector economists remain skeptical that business can act as the locomotive pulling the Japanese economy out of recession because of continued shrinking profits as a result of falling prices and severe competition from China and other low-wage countries. Because of increasing overseas Japanese production, a weak yen can no longer boost exports as much as in the past. In the draft budget for fiscal 2002, public-investment-related expenditures, which include both the construction and operation of public facilities, are down 10.7 percent from the previous year to 9.2525 trillion yen, which will add to deflation. With the unemployment rate rising, consumer attitudes toward personal spending will continue to worsen.

The biggest cause for concern in the near future is the stability of the financial system, the backbone of the economy. The financial system has been facing recurring crises, as evidenced by the continued drop in the value of bank shares that began in the fall of 2001, reflecting the drop of the equity market of which the banks own substantial holdings. The Japanese economy has fallen into a vicious circle. Deflation leads to the emergence of new bank NPLs, worsening the problem, which in turn exacerbates further deflation. The disposal of NPLs must be expedited, but banks are clearly threatened by the combined weight of the economic slump, the collapse of the equity market and their own falling shares. Recurrent instability in the financial system would destabilize the financial capital market beyond a credit crunch. Banks may then be forced to call in an excessive number of loans, a move that would be disastrous for the real economy.

Additionally, the government introduced a so-called "payoff" cap in April 2002 under which individual bank accounts are guaranteed only up to 10 million yen plus interest in the event of a bank failure. So dark clouds hang over the economy after fiscal 2002. The FSA has been pressing local financial institutions that are short of capital to speed up efforts to reorganize and consolidate, and it stands ready to prevent any chaos, such as a run on banks, from occurring as a result of the introduction of the payoff system. But in 2001 alone a total of 46 credit banks and credit cooperatives were forced into bankruptcy. If this wave spreads to regional banks and second-tier regional banks, and there are more cases like that of Ishikawa Bank, which collapsed at the end of 2001, serious effects are expected. Because regional and second-tier regional banks occupy a weightier position in local economies than credit banks, local industries may be unable carry on. As for a recovery in the US economy, on which the government's zero-growth forecast was premised, the correction after the collapse of the information-technology bubble has been more severe than expected. Despite the recent rebound of the tech sector, US recovery when it comes will not be led by high-tech industries, but by military hardware, heavy construction and financial services, which will not have a major effect on Japanese exporting industries.

Ever since the United States abandoned the Bretton Woods international monetary agreement in August 1971 and took its dollar off gold, the global monetary system has been plagued by a fiat currency at the core. Countries that have been hit by currency runs suddenly realized that the promise of market capitalism had been a cruel joke to rob them of their wealth and dignity through an unjust international finance architecture. In the absence of a stable, equitable international monetary order consistent with open global markets, the US continues to push for financial globalization. The unregulated free-to-manipulate approach to currency-exchange relationships engenders only monetary nationalism and ultimately fosters a protectionist backlash in all countries. The currency carnage rages on with disastrous economic and political consequences around the entire globe. Economic war, like all wars, are recognized as undesirable by all, yet it happens because of an inequitable world economic order.

Japanese sovereign debt does not face the issue of the Japanese government not able or willing to pay its obligations. It is because both Japanese debt and currency are freely traded in the open, largely unregulated global market that credit ratings become important. Recurring and persistent Japanese government budget deficits impact the price of JGB (Japanese Government Bonds). For the past three years, ever since the BOJ reduced short-term rates to zero, Japanese banks, as well as a host of international speculators, have been borrowing cost-free funds to invest in 10-year JGBs at about 1.3 percent. The banks have by the end of fiscal 2002 some 67 trillion yen ($540 billion) in fixed-income securities, doubling their holdings in February 1999 when the BOJ first introduced its zero-interest hyper-loose monetary policy. The banks have sold roughly 10 percent of their holdings in the first half of fiscal year 2002.

This interest-rate spread has allowed Japanese banks to earn profits to cover some of their losses from distressed loans and equity deflation. Prime Minister Junichiro Koizumi's cabinet is not expected to be able to keep its promise to cap new bond issues to finance further deficits. Banks, already weaken in their capital base by asset deflation, cannot sustain a sudden collapse of the bond market. Under BIS guidelines to be introduced in 2005, government debt rated with a single A standing carries a 20 percent risk rating, meaning that holders must set aside capital reserves to cover 20 percent of the assets. The latest rating for JGB has dropped from AA+ to AA. Although a local regulator can ignore these BIS guidelines, it would still be a serious blow to Japan and its banks' international standing, which would cost Japan a high risk premium in the international debt market.

There is open political pressure for the BOJ to adopt a reflation target. Ironically, the bank lobby is most among the most vocal in this pressure group. Japanese banks have been selling their JGB holdings as a risk management move. There is also political pressure to depreciate the yen to the 150-160 range from its benchmark of 120 to the dollar. Yet a 148-yen dollar would trigger regionwide competitive currency depreciation, including China's yuan, which is considered undervalued in relation to that country's current account surplus.

With Japan caught in a liquidity trap, zero interest has had the effect of pushing on a credit string domestically. But profits are being made by those who borrow cost-free yen to invest in US treasuries, Japanese deflated real estate and distress debts. The purchase of US treasuries caused a temporary reverse-yield curve in US debts in the late 1990s, making long-term rates lower than the short-term Fed Funds rate target set by the Federal Reserve. This amounts to a black hole of unlimited drain on the future of the Japanese economy. With potential yen depreciation, this problem is further exaggerated, motivating market participants to borrow yen to invest in instrument-denominated in dollars. Overseas investors had built up arbitrage positions between bonds and yen swaps on the assumption that swap rates would not fall below JGB yields. But 10-year swap yields were about 1.3 percent (as of November 27, 2002), 9.5 basis points below the 10-year cash JGB yield. This prompted liquidation of JGBs against swaps, leading briefly to serious contagion to other markets. This type of mini-crisis is now commonplace and hardly attracting notice in the financial press. One of these days, it will add up to a major crash.

The fact is that Japan, and really the whole world, cannot solve its financial problems without facing up to the reality that no free market or regulated markets exist now for foreign exchange, credits or even equity anywhere. Arbitrary, secretive and whimsical intervention on a massive scale hangs as an ever-present threat over the global system of financial exchange. Individual self-preservation moves and short-term profit incentive will bring the system crashing down some Tuesday morning. This is what Alan Greenspan, chairman of the US Federal Reserve, means by the need of central banks to provide "catastrophic insurance".

The BOJ stunned the market on September 19, 2002, by announcing that it would buy shares directly from Japanese banks. On October 11, it announced that it would buy 2 trillion yen ($16.5 billion) of bank shareholdings to make them less vulnerable to stock-market swings. The BOJ also urged the government to use public funds to accelerate the disposal of banks' NPLs. The share-buying plan would last up to the end of September 2003 and would cover more than 10 banks. Masaru Hayami, BOJ's then retiring governor, said: "If liquidity problems emerge from declines in stock prices, the BOJ is ready and has the means to provide additional funds."

The move signaled a more coordinated approach between the BOJ and the government, which had for some time been at loggerheads over tackling Japan's weak economy, deflationary environment and bank NPLs. But the BOJ decided to keep its monetary policy unchanged, despite a call from Masajuro Shiokawa, the finance minister, for further easing. The Nikkei dropped almost 20 percent within months after September 19. The benchmark Nikkei 225 average had difficulty closing above the key 8,500 mark. It hit new 19-year lows almost every day for the week ending on October 11, on uncertainty regarding the government's plans to clean up NPLs. Analysts say that if the Nikkei falls to 7,000-7,500, bank capital-adequacy ratios could fall below the BIS requirement of 8 percent. The 2003 first-half low was 7,607.

Japan's banks are estimated to have 40 trillion yen ($322 billion) in equity holdings, making them vulnerable to market swings. At the same time, an export slowdown is threatening to derail recovery in the world's second-largest economy, largely because of a decline in US consumer demand for Japanese products such as cars and electronic goods.

Japanese government data show that the country's jobless rate in October 2002 rose to 5.5 percent, its highest level of the postwar era and a figure last seen in December 2001.

Reform is seldom an engine of growth. It is also never a timely cure for emergencies. Instead of concentrating on making the economy roll, government bureaucrats devote most of their energy thinking up ever more ingenious ways of pandering to official directives while at the same time ensuring that their own official turf is not reorganized out of existence. This tends to stop the economy in its tracks. Japan's banking crises greatly reduced the impact of any macroeconomics policy to stimulate demand. Regardless of measures to stimulate domestic demand in the economy, Japan is structurally condemned to no growth for the foreseeable future, unless its national purpose shifts.

Even if Tokyo does all that Washington wants it to - spurring demand with monetary and fiscal policy, cleaning up the banking system and vigorously pursuing systemic reform - its estimated contribution to stability in the global economy is overstated. US export to Japan is a mere 1 percent of US GDP, to all Asia 2.4 percent. Rising European economies are filling in the Asian gap in world demand.

The Japanese insurance companies offered below-market yield during the boom in return for safety to customers. The insurance companies then put their assets in real estate, fueling the bubble, not only as lenders but as investors to capture capital gain. The long period of deflation that followed the bursting of the financial bubble in 1990 has caught Japan's life insurance in a double bind. On the one hand asset values are falling, while on the other hand high returns to policyholders are still being offered in an effort to stave off a collapse of new policy subscriptions. A vicious circle of insolvency then arises when liquidity needs oblige these funds to liquidate depreciated assets. Bankruptcies have multiplied. These institutions are at the heart of Japan's economic system but have now become a source of uncertainty, leading to deflationary pressures.

The bankruptcy of Nissan Mutual Life in May 1997 pushed the most protected sector of Japan's financial system into open crisis: of the 18 life-insurance funds that have developed historically in Japan, six have gone into liquidation. In expectation of further bankruptcies, the Financial Services Authority got the Japanese Diet (parliament) to revise substantially the Insurance Code and the Framework Law organizing the restructuring of the financial system. Of the various modifications adopted, the most notable involves state commitment to providing public funds for supporting the restructuring of the sector. This type of decision can only be justified economically if the social cost of bankruptcy is considerably greater than the direct costs borne by shareholders and creditors, and hence shows clearly the importance Japanese authorities have given to these financial institutions in the economic stability of the country.

The deterioration of the financial health of Japanese life-insurance institutions is the direct consequence of their aggressive commercial policy implemented during the speculative bubble, and pursued for a further five years during the subsequent deflation. Between 1985 and 1986, the 50 percent appreciation of the yen led to colossal portfolio losses in foreign-currency holdings. In order to maintain the overall returns on assets, institutions were subsequently tempted to compensate for losses by participating in Japan's rising stock-market euphoria. To increase the scope of their investments, and hence raise profits, the funds sought to attract more savings, through aggressive marketing. Returns of 6-7 percent, if not 10 percent, to clients were thus offered constantly. Given the long-term nature of such savings, only continued rises in asset prices could support such payments.

But the bursting of the bubble in 1990, followed by the long period of financial deflation, put the life-insurance institutions in the position of having asset returns that have fallen below interest payment commitments to policyholders. Their own reserves have been insufficient to absorb this shock. On the one hand, reserves were reduced to a minimum during the bubble as regulations on the use of capital gains and constraints on reserves were relaxed. On the other hand, market values have depreciated considerably since the euphoria has ended. Under these circumstances, the life-insurance funds had to reduce their guaranteed returns on new policies as soon as possible, for their financial position to be restored. But this revision did not take place until 1995, when the guaranteed rate went from 4.5 percent to 3.5 percent, the latter still being excessive given Japan's deflationary context. Thus, these institutions continued to sell policies likely to generate losses up until the second half of the decade.

The importance of these financial institutions led the MOF, as well as the institutions themselves, to conceal the weaknesses of the sector while waiting for a recovery. As long as policies were not canceled or did not mature, the opaque accounting system allowed losses to be hidden from public view. But, as the deflation took hold, such losses rose. Despite the level of returns offered, market saturation and economic recession led to a fall in new policies. This in turn led to a persistent cut in the current resources available to the insurers. Reimbursing contracts reaching maturity by liquidating corresponding assets would lead to the forced revelation of losses. To prevent such a liquidation of assets, the insurers must therefore ensure that current resources are higher than those in use: hence they are forced to bid up returns to attract new investors. This has led to the development of Ponzi-style finance. Savings are attracted at a high cost and are meant to be invested, but in reality are used to mop up losses on existing policies. Financial charges rise as high-yield policies reach maturity.

From 1996 onward, the losses associated with the returns gap were declared. The fall in stock market values and the leveling-off of interest rates led to a collapse in investment incomes and latent capital gains. This double bind on the profit-and-loss account led to the failure in May 1997 of Nissan Mutual Life, whose disastrous management triggered a slump in household confidence. The fall of new subscriptions has been aggravated by an explosion of policy cancellations; in short, there has been a run on the funds, though less violent than in a real banking crisis. The weak macroeconomic and financial situation of the late 1990s thus led to a self-fulfilling deterioration of solvency. To satisfy their rising liquidity constraints, the life insurers, which found it increasingly difficult to borrow, were led to liquidate depreciated assets in ever-increasing volumes.

Since 1997, each new bankruptcy announcement has reduced the credibility of the sector as a whole and intensified the crisis. While all the institutions are not in the same situation, low accountancy standards tarnish all actors and reduce the solvency of the sector as a whole, thus becoming a self-fulfilling prophecy. Official pronouncements by the authorities, as well as from the profession itself, have been that latent capital gains in life-insurance portfolios should make it possible to mop up losses, a position that was previously applied to banks until their recapitalization in 1999. This argument is still faulty. On the one hand, latent capital gains (net of latent capital losses) have in essence been exhausted. On the other hand, cleaning up balance sheets by liquidating assets in the middle of a crisis actually nourishes the downward pressure on asset prices, reduces the solvency of asset owners and worsens the need for liquidity. This aggravates a vicious circle of financial deflation, from which life-insurance companies cannot escape by themselves. At the heart of the Japanese economy, these institutions have now become an important factor in worsening uncertainty and sustaining deflationary macroeconomic pressures.

As with the banks, Japanese life-insurance companies are "not just another financial services institution". They have a systemic influence on the economy, which is directed through three major channels: 1) household savings; 2) long-term financing; and 3) financial markets.

Pensions in Japan are mainly financed by capitalization. Within this system, the life-insurance institutions manage the major share of individual, long-term savings, as well as a substantial share of the savings collected by pension funds. Overall, the financial holdings of the 18 mutual funds are drawn from 96 percent of households and account for more than one-quarter of their savings. Confidence by savers in these institutions is vital to the stability of behavior and the long-term equilibrium of the economy. Conversely, doubts concerning the solvency of mutual life-insurance funds are leading to a general feeling of insecurity about the future, encouraging cautious behavior and a fall in consumption, which in turn is feeding deflationary pressures. The last two bankruptcies have affected 3.5 million savers, and may cause them to lose part of their long-term savings.

As an integral part of Japan's large financial and industrial groups (the keiretsu), mutual life-insurance funds play a structural role in the organization of finance and industry. They are dormant shareholders and providers of stable finance. During the 1970s and 1980s, their long-term liabilities along with the continued growth of their markets ensured that they did not suffer from liquidity constraints. They were protected from competition through a cartel structure, and from shareholder pressure by their status as mutuals. Thus, they are bound little by the obligations of short-term profitability, by transparency rules or the need to build up equity resources. Above all, they are protected from hostile takeover, which makes them very stable core players in the financial cross-holdings of Japan's large groups, and in particular in their cross-holdings with banks.

When the life-insurance institutions weakened, the solidity of the whole financial system came under threat. As stable funds became rarer, the expectation horizon of numerous economic agents shortened. Debt reduction and the buildup of equity have become priorities over investment projects, while the downgrading of the latter stifles economic growth and future profits. Since the first bankruptcy in the sector in 1997, the solidarity and links between life insurers and their partners have been called into question, clouding the outlook for painless restructuring of the keiretsu and the whole of Japan's market sector.

Last, the most powerful and visible channel for propagating tensions is that of the financial markets. The concurrence of significant financial weight, high concentration and homogenous behavior in terms of portfolio investments gives the mutual life institutions particular power. Under these circumstances, the worsening of their financial situation is likely to provoke highly sensitive market movements that could weigh down on the liquidity and solvency of all investors, especially the banks.

Since the collapse of Nissan Mutual Life revealed the absence of a framework for managing bankruptcies in the sector, significant progress has been made with respect to guaranteeing saving-insurance contracts, accounting rules and prudential policy. However, problems still persist, necessitating substantial progress. The life sector's Policies Protection Fund was set up in 1995, and reformed in March 2000. Henceforth, it has become an essential tool for restructuring the industry. Its present capital stands at 460 billion yen, but is set to rise by a further 100 billion yen contributed by the industry itself by this year, plus 400 billion yen in the form of government loans. The fund may also borrow in the markets, with the state underwriting such borrowing. The fund will thus guarantee life-insurance policies through to this year, in the case of bankruptcy.

But the terms under which such guarantees are met lead to harmful uncertainties. In effect, the measure stipulates that if bankruptcy procedures go ahead, then the returns on policies already sold may be revised, retroactively. This amounts to the ending of obligatory liabilities for policyholders. Thus, it is already clear that some households holding policies with Chiyoda Life will see their assets depreciate by at least 10 percent. These measures have a strongly negative impact on private consumption behavior. They may also worsen the instability of the insurance sector, by accelerating the pace of contract cancellation. The debate surrounding a satisfactory resolution of the crisis thus remains open.

The governing Liberal Democratic Party (LDP) has put forward a proposition that would allow mutual life-insurance institutions to modify the guaranteed rates of return on existing policies. This proposal is being supported by the largest institutions. They are less vulnerable to savings flight than the smaller institutions because of their renown, and they hope to capitalize on this at the expense of the rest of the sector. But the proposition does not provide a way out of the crisis. On the contrary, it risks provoking a macroeconomic shock and aggravating the crisis of confidence faced by the whole life-insurance industry.

The errors of the banking crisis are being repeated. By liquidating depreciated capital assets to meet obligations, the life institutions have weakened themselves day-by-day. These institutions need to be recapitalized by an injection of public funding, as finally happened with the banks. A major lesson from the Japanese crisis is that institutional investors can raise systemic risk by intervening in the financial markets. All such investors must therefore be subject to supervisory rules and strict prudential standards. This has been common knowledge concerning banks for a long time. It is a lesson learnt with respect to Long Term Capital Management (LTCM) hedge fund crisis in the United States and it is beginning to be learned for pension funds and for the Japanese life-insurance industry.

The BOJ policy board said on March 25 that it would buy more stocks from the nation's lenders and flood the credit markets with yet more yen in hopes of stabilizing financial markets unnerved by the fighting in Iraq. The decisions came after the board met in a one-day extraordinary session, and are the first policy steps taken under the bank's new governor, Toshihiko Fukui.

In the weeks since he was nominated for the post, Fukui has been pressed by lawmakers to cooperate closely with the government on measures to revive the economy and rid the banks of NPLs. By calling the special meeting, the bank's first since it became independent from the Finance Ministry five years ago, Fukui signaled his willingness to go along. For five years, the "independent" central bank worked at cross purposes against government efforts to halt deflation, revive the economy and rebuild business and consumer confidence. Now many economists and analysts in Japan say it has become clear that the situation will not improve unless the two act in concert. They raise questions whether the "independence" of the central bank is in the national interest. Richard A Werner's best-selling Princes of the Yen (En no Shihaisha) documents how the Japanese economy has been manipulated by its central bank. Based on its arguments, several well-known LDP politicians in Japan recently founded a new Central Bank Reform Research Group, which Werner advises.

Fukui's predecessor, Masaru Hayami, guarded the bank's independence jealously and often was dismissive of suggestions from outsiders. The new governor's modest moves signaled that the central bank will now be more accommodating. The Bank of Japan slipped into a shaky position under Hayami. The message now is that this central bank will be proactive.

Significantly, Fukui assembled his policy board just five days into his term, and did not wait for the regular two-day meeting scheduled to begin April 7. The Japanese fiscal year ended on March 31.

BOJ governor Fukui said the country could suffer a financial crisis "at any time" unless its near-crippled financial sector is fixed, with the banks becoming more and more vulnerable to shocks.<>
The central bank's plan to buy an additional 1 trillion yen ($8.3 billion) in equities from the nation's banks comes even though Japanese stock prices have largely stabilized after hitting 20-year lows in early March. It expands the bank's appropriations for stock purchases by 50 percent, to 3 trillion yen. Through March, the bank had actually spent only 1.032 trillion yen of the 3 trillion.

Japanese regulators have for years allowed banks to count as capital a portion of their immense stock portfolios, which often include substantial stakes in their customers. But the regulators have recently started insisting that the banks revalue their portfolios to match market prices at the end of each fiscal year, making the banks' balance sheets highly vulnerable when share prices fall. The central bank has tried to aid the lenders by agreeing to buy portfolio holdings from them, especially holdings that could not be sold in an orderly way in the open market.

The central bank said recently that it would go on flooding the money markets with cash in excess of its formal target of 20 trillion yen, and that it would loosen its restrictions further on making money available to borrowers. Some analysts said these measures would do little to blunt the longstanding criticisms of the central bank and the government, and that they seemed capable only of piecemeal steps, and then only under duress. Exhibiting this distrust of the central bank's efficacy, the Japanese stock market fell both before and after the BOJ policy announcement. On May 16, nearly a decade into Japan's banking crisis, the Resona Group, Japan's fifth-largest banking group, with $360 billion in assets, announced that it needed an estimated $17 billion cash infusion to shore up its capital base. Koizumi offered to put up the cash, giving the government majority ownership. It was the use of deferred tax assets to calculate core capital that sank Resona, and the same accounting device could trigger other bank bailouts. Deferred tax assets are in essence future tax refunds banks anticipate collecting once they clean up bad loans. The government figured that this accounting technique, which is used also in the United States, would encourage a financial cleanup. Auditors have allowed the uncollected refunds to be counted as part of capital even though they aren't a concrete asset. On Resona's books, these yet-to-be-earned credits represented an amazing 77 percent of its core capital. But the bank's auditor, Shin Nihon, refused to count more than three years' worth of deferred tax assets as capital, slashing Resona's capital to 2 percent of its assets. That pushed it below the 4 percent capital-adequacy ratio mandated for domestic lenders, forcing Resona's senior execs to go hat in hand to the government.

Resona Group appealed to the government for a giant funding injection to bring itself back to fiscal health. The call triggered the first ever meeting of the Financial Crisis Management Committee, and the money was immediately granted. The 2 trillion yen government bailout and de facto nationalization of Resona is a major development in Japan's struggle to right its economy.

Kozo Yamamoto, a member of the LDP's Finance Committee who questioned key figures in the debacle over Resona bank, which received 1.9 trillion yen ($16.6 billion) of public money, said that if the criteria used to calculate Resona's capital are applied to other Japanese banks, "there will be a flurry" of banks that will need public funds.