Is TEPCO “Too-Big-To-Fail”?

Today’s Nikkei reports:

The government is considering creating a state-backed nuclear insurer that would facilitate compensation for the Fukushima Daiichi accident and recoup the payouts from dividends on capital pumped into plant operator Tokyo Electric Power Co. (9501).

The new entity would also provie insurance against future nuclear disasters, charging annual premiums from Tepco and the other electric companies with nuclear reactors. There is also talk of using this money to cover the cost of decommissioning reactors.

This idea clearly comes from deposit insurance and capital injection to insolvent banks.  We can identify some parallels between Tokyo Electric Power Co. (TEPCO) and a large failing financial institution.  For example,

1. They are probably insolvent.
2. Both of them are large.
3. They are essential for functioning of the economy, so shutting them down only for a short period would be prohibitively costly.

But the similarity stops here.  There are some difference between a financial institution and an industrial firm such as TEPCO that makes resolultion of a financial institution much more difficult.  These differences include:

1. Liabilities are mostly in highly liquid form such as deposits.
2. Assets are mostly in illiquid form such as loans.
3. The financial institutions has outstanding financial contracts with many other financial institutions.

Thus, as soon as depositors expect the bank will fail, it is rational for the depositors to run the bank, making the expectation of failure self-fulfilling.  The bank run may spread to other banks which are solvent.  Because the assets are illiquid, if a large amount deposits are withdrawn, the bank cannot generate sufficient liquidity and fails.  To the extent that the failing banks try to sell their assets in the market, the asset prices decline, reducing the value of similar assets held by other financial institutions.  Such “fire sales” of assets can make insolvency of an individual financial institution into a systemic problem.  Although a bank cannot collect the loans immediately, making them illiquid, many borrowers can pay off the loans early.  Some borrowers decide to do so when they see the bank is likely to fail.  Finally, the trouble of a bank can be easily spread to other banks through many financial contacts the banks hold against each other.

Thus, it is not practical to apply the standard bankruptcy procedure for financial institutions.  This is why many countries have a separate resolution mechanism for financial institutions.  Many countries also have deposit insurance to prevent bank runs.

These special considerations do not apply to a regular industrial firm such as TEPCO.  The liabilities are mostly long-term bonds.  The analogy in the government plan seems to be between depositors and people in Fukushima who will have claims against TEPCO, but they cannot “run” to TEPCO for “withdrawal”.  So TEPCO would not be pressured to sell the assets.  TEPCO customers would not leave swiftly (or at all).  Failure of TEPCO is unlikely to have a systemic influence.

For banks, deposit insurance has a benefit of preventing bank runs, but deposit insurance system also has a cost as well.  It eleminates the incentive for depositors to monitor their banks, so it makes the moral hazard problem more serious.  For TEPCO or owners of nuclear power plants, the insurance scheme has no benefits.  It only makes the moral hazard problem (which obviously already exists) even worse.

Japan has the Corporate Rehanibilitation Act that guides bankrupty process.  The resolution of TEPCO, if it is found insolvent as many suspect, should be handled in the bankruptcy process.  The scheme that has been proposed by the government just protects the creditors (and maybe shareholders) at the cost of taxpayers, and worsen the moral hazard.  The Corporate Rehabilitation Act can restructure the financial claims against TEPCO while allowing TEPCO continue to operate.  Indeed this is what the bankruptcy regime is designed for.

TEPCO is not the Lehman Brothers.  TEPCO is more like Enron, which went through bankruptcy process without bringing down the rest of the economy.

Earthquake and the Possibility of Institutional Change in Japan

What do I mean by “institutions”?  Institutions include all economic, political, and social arrangements that may influence the long-run economic growth, espeically through productivity growth.  Economists have identified some institutions that are useful for the growth and those that are detrimental for the growth.  For example, a political and legal system that limits the government’s ability to confiscate private property is found to encourage high economic growth.

A natural disaster destroys institutions, including both pro-growth and anti-growth ones.  If it destroys pro-growth institutions, the economy will fail to recover to the original growth path that the economy was on before the disaster.  If the disaster destroys some institutions that stifled the growth, the economy may recover to a growth path even higher than the original one.

For Japan, the economy has stagnated for a long time before the earthquake.  The report that I completed with Anil Kashyap for NIRA (National Institute of Research Advancement) identifies several structural impediments to growth that are observed for Japan.  The summary of the report is found here.  The text is found here.  The appendix is found here.

If the current shock leads to elimination of these impediments, then it is possible for Japan to increase the long-run economic growth rate.

What are the Economic Consequences of the Japanese Earthquake/Tsunami?

For the last couple of weeks, I have been receiving inquiries about this question.  So I decided to write Q&A’s with Anil Kashyap for most often posed questions.  Our piece has been posted in Steve Levitt’s blog. 

The disaster is certainly a tragedy and it is not completely over, but the implications from the standard economic theory is optimistic.  After such a disaster, the economy eventually recovers and records higher growth rates than before the disaster.  It is even possible that the economy will move to higher growth path.  The key is what will happen to the “institutions.”

Bernanke’s Bet

On November 3, the Federal Reserve announced that they will buy up to $600 billion of long-term Treasury securities by the end of the second quarter of 2011.  This is perfectly in line with the market expectation. 

David Wessel has a nice article in the Wall Street Journal on the rationale of the decision to go for QE II.  I agree with him. 

It is true that the impact of the quantitative easing is not certain.  It is likely to stimulate the demand but we do not know how much.  It is not likely that the quantitative easing causes very high inflation or asset price bubbles any time soon, but it is possible that the economy will stagnate despite the QE. 

The best guidance we have is the experience in Japan.  The Bank of Japan was very reluctant to implement aggressive non-traditional monetary policy until recently.  The result was the stagnation that lasted a long time.  We can point to many differences between Japan in back then and the U.S. now, but the two economies look very similar overall.  Both governments have spent a lot to stimulate the economy to the point that it is hard to step up on the fiscal stimulus without jeopardizing sustainability of the debt.  The financial system recovered from the crisis situation but many financial institutions are still tackling with troubled assets and are having trouble increasing the amount of credit.

So the consequence of not trying with the QE II is certain: Japan-like stagnation.  The consequence of trying the QE II is uncertain, but the worst case scenario is that it does not work and the U.S experiences Japan-like stagnation.  If the QE II works, the U.S. can do much better than Japan did.  This should be an attractive bet.

Moreover, the track record of the QE I (or credit easing) is good.  The U.S. economy recovered from the crisis by the end of the second quarter of 2009.  We could debate how much role the monetary policy played in the recovery, but it is likely to have had significant positive impacts.

BOJ’s Assets Purchase Plan

Following the monetary policy meeting on October 28, the Bank of Japan disclosed the composition of assets that they plan to buy in the new comprehensive monetary easing.  The composition of the maximum of five trillion yen of assets the BOJ plans to purchase by the end of 2011 is the following.

• JGBs: about 1.5 trillion yen
• T-Bills: about 2 trillion yen
• CP: about 0.5 trillion yen
• Corporate bonds: about 0.5 trillion yen
• ETFs: about 0.45 trillion yen
• J-REITs: about 0.05 trillion yen

 The amount (5 trillion yen) is the same as what the BOJ announced after the previous monetary policy meeting (October 5).  The amount seems to be too small to have a big impact, especially when the Federal Reserve is expected to come up with their asset purchase program of 500 to 600 billion dollars (roughly 40 to 50 trillion yen) in the FOMC meeting next week.  But the direction of the BOJ policy is the right one.

The Bank of Japan also decided to move the dates of the next monetary policy meeting from November 15-16 to November 4-5.  The official reason is to allow them to determine the conditions for purchases of ETFs and J-REITs as early as possible, but this also gives the BOJ to respond to the FOMC decision by increasing the amount of the asset purchase.  The date change may be a result of the BOJ’s decision to see the FRB’s move before they decide if they need to increase the amount of assets purchase or not.

Fiscal Consolidation in Europe

The U.K. has become the latest country to join the wave of fiscal consolidation in Europe.  Making the fiscal policy sustainable, especially after the post-crisis fiscal stimulus packages, is important, but the government should avoid tightening the fiscal policy too rapidly.

The experience in Japan in the mid 1990s offers an example of tightening too quickly.  In 1996, many observers believed that the Japanese economy was finally coming out of the post-bubble recession.  The real growth rate for 1996 was about 4%.  The Japanese government thought this was a good time to start addressing the issue of mounting government debt.  The debt to GDP ratio was quickly approaching 100%.  So the government stopped the fiscal stimulus, phased out the income tax cut, increased the consumption tax from 3% to 5%, and increased the copay on health insurance in 1997.  Ex post this was a mistake and Japan got back into recession.

The economic recovery in Europe today does not seem to be as robust as the Japanese recovery in 1996.  This should make us worry about the impact of fiscal consolidation in Europe today.  Unless it is combined with massive monetary expansion, the fiscal consolidation is likely to slow down the European economies and put many of them back into recession.  And monetary expansion is difficult when the policy interest rate is near or at zero.

The best response would be to credibly announce the plan for fiscal consolidation in the near future without cutting government expenditure or raising taxes too quickly.  I guess this is easier said than done.

Japanese bubble in the 1980s and lessons for China today

In the FT article “Emerging markets at risk from a gigantic bubble,”  Peter Tasker argues that it was not the yen appreciation starting from the Plaza accord of 1985 that put the Japanese economy into a long period of stagnation.  It was the speculative bubble and its collapse that started the lost decade (or two).  I agree with him.

I would add that, to the extent the bubble was encouraged by the low interest rate policy in the late 1980s that the Bank of Japan took to prevent the recurrence of endaka (high yen) recession in 1986, it was the resistance to yen appreciation that put Japan eventually into stagnation.  Takatoshi Ito at University of Tokyo also made a similar point.

As Tasker and many others point out, the situation with China today is quite similar to the situation with Japan in the 1980s in many aspects (with a blown up magnitude).  In both cases, the excess savings manifested as huge trade surplus especially against the U.S.  The attempt to correct the global imbalance forced the excess savings to look for profitable investment domestically, and contributed to the bubble.

From this perspective, the interest rate hike by China yesterday may turn out to be a wise move to contain the speculative bubble.  It may turn out to be not big enough to stop the bubble, or it may turn out that it was already too late to prick the bubble without costing the economy.

In any event, one additional useful lesson that China should learn from the Japanese experience is that the collapse of the bubble alone does not explain the very long stagnation of the Japanese economy.  Mismanagement of the economy and the financial sector in the aftermath of the collapse of the bubble made the Japanese trouble long lasting.  There are many mistakes that Japan made and that China should try to avoid, when their bubble collapses.

Chairman Bernanke’s Speech at the Boston Fed Conference

In today’s speech, Chairman Bernanke has clearly indicated that the Federal Reserve considers the current inflation rate too low and more expansion of monetary policy is necessary, confirming the expectation of many observers of the U.S. monetary policy.  The speech shows that Chairman Bernanke and the Federal Reserve studied the case of Japan, where the economy faced (and is still facing) the challenge of deflationary pressure.

I find several parts of this speech important.  First, Bernanke stresses the importance of clear communication.  He understands that how the central bank can influence the expectations is the key when the interest rate is already at zero.  Indeed the expectations are the only thing that matters.  Bernanke explains that the long-run economic projections that the Federal Reserve are the ones “to which the economy is expected to converge over time, in the absence of further shocks and under appropriate monetary policy.”  The phrase “appropriate monetary policy” is important.  Bernanke goes on to say:

Because appropriate monetary policy, by definition, is aimed at achieving the Federal Reserve’s objectives in the longer run, FOMC participants’ longer-run projections for economic growth, unemployment, and inflation may be interpreted, respectively, as estimates of the economy’s longer-run potential growth rate, the longer-run sustainable rate of unemployment, and the mandate-consistent rate of inflation.

Thus, although the Federal Reserve does not have an explicit inflation targeting, they operate with de facto inflation target, which currently is “about 2 percent or a bit below.”

Second, Bernanke understands that a part of the high level of unemployment rate may be due to structural problems, but believes the high unemployment rate today is mostly due to the lack of aggregate demand.  The demand problem is something monetary policy can tackle, so the Federal Reserve must act.  This is an interesting contrast to the Bank of Japan, which often downplayed the importance of demand shortage and failed to act.

Third, Bernanke realizes that the effects of non-traditional monetary policy are uncertain and there are some potential costs.  But here, we have been accumulating data on the non-traditional monetary expansions in Japan and the U.S., and elsewhere.  Japan is not the only country that tried some forms of quantitative easing.  Bernanke mentions the experience in the U.S. and the U.K. after the Lehman Shock as examples of successful monetary stimulus.  With these data, we are in a better position to judge the trade-off between the benefits and the costs of non-traditional monetary policy.    Overall, Bernanke judges the benefits seem to outweigh the costs of more expansion now, which seems reasonable.

Finally, Bernanke points out the importance of the central bank’s commitment to continue near zero interest rates.  This point is a consensus among the observers of the Bank of Japan’s zero interest rate policy, including Governor Shirakawa of the Bank of Japan.  In the book he published right before he became the governor (Modern Monetary Policy in Theory and Practice: Central Banking and Financial Markets.  in Japanese), he argued that the quantitative easing worked primarily through this commitment channel.  The current Federal Reserve policy states that the low interest rate regime will continue “for an extended period,” but Bernanke says that they may consider modifying the wording.  The Bank of Japan has tried with several different ways to phrase the commitment in the past.  I am sure the Federal Reserve has been studying these experiences.

Demand Stimulus or Structural Reforms?

That is a question often asked these days in the U.S.  Some people argue that we need to continue expansionary macroeconomic policy to prevent the economy from falling back into recession.  The government should not cut the spending or raise taxes now, and the Federal Reserve should restart buying assets.  Other people argue that what we need is structural reforms.  The economy has too many workers with outdated skills (financial engineers?) and too few workers with skills that are required now (material engineers?).  Fiscal expansion or monetary expansion would not do anything to accelerate such required restructurings.

The debate is basically the same as the one that we observed repeatedly in Japan during its lost decade (or two).  One side argued that the deflationary stagnation was just a result of demand shortage.  Expansionary fiscal and monetary policy, including non-traditional ones, would solve the problem.  The other side argued that the problem was slowdown of productivity growth.  One cannot restore economic growth without painful structural reforms.

A problem of the Japanese debate and the one in the U.S. today is that expansionary monetary policy and structural reforms are not alternatives.  One can have both.  Microeconomic policy to encourage restructurings can be combined with expansionary macroeconomic policy that eases the pain of the restructurings.

Unfortunately, what happened in Japan most of the times was the division between the Bank of Japan that believes in the structural reform view and the government that believes in expansionary macroeconomic policy.  The Bank of Japan has consistently argued that monetary policy alone cannot cure the problem.  This made the BOJ very reluctant to continue the zero interest rate policy or the quantitative easing, which actually slows down the necessary restructuring according to their view.  On the other hand, the government sometimes pressured the BOJ to take more expansionary monetary policy, even when the government looked reluctant to force major banks to get rid of the non-performing loans and to restructure zombie firms.  The result was the combination of the lack of extremely expansionary monetary policy and the lack of restructuring.  Only when the serious structural reform was combined with the quantitative easing during the Koizumi government, the Japanese economy recovered (until the global economic crisis of 2008).

I wish that the U.S. would not make the same mistake.  As David Wessel wrote in the Wall Street Journal last week, this is not the time to debate which diagnosis is more appropriate, we need to both to treat the economy.

Monetary expansion as a substitue for protectionism

Douglas Irwin has a very nice article in today’s Wall Street Journal making a point similar to what I had in mind in my previous post. Citing his own work with Barry Eichengreen, he points out that the countries that were on the gold standard (which prohibited them from devaluing their currencies) were more likely to impose heavy restrictions on imports.  The protection and the currency devaluation were substitutes.  The consequence is much better for currency devaluation.  If all the countries raise tariffs, no countries gain competitiveness against the others in the end, the trades stop, and the world suffers.  If all the countries try to depvalue (depreciate) their currencies, no countries gain competitiveness in the end, but the monetary policy becomes expansionary everywhere, and the world economy is more likely to recover.