1998/10/13

1. (Introductory statement)

2. I begin with Japan, not just because it is your country but because it is where some of the most serious problems of the OECD economy today are to be found. A well-functioning Japanese economy is in the interests of all -- both here and abroad.

3. There is no need for me to describe in great depth how weak the current economic situation is in Japan -- our assessment is similar to the consensus view that the economy is contracting sharply this year and will expand only marginally at best in 1999. But it would be useful to discuss why the Japanese economy has ended up in the doldrums. Let me first observe a simple fact. From 1991 to 1996, the economy grew by about 7 1/2 per cent cumulatively. Over the same period, the deficit of the broadly defined government sector also increased in an underlying sense by about the same magnitude as a percentage of GDP. That is to say, fiscal expansion can explain almost all of the cumulative growth in this period, or alternatively, in the absence of fiscal expansion, the Japanese economy would have been as flat as a pancake as it struggled to shake off the negative effects of the bursting of the asset price bubble. This bubble was one of the largest any OECD economy has experienced in modern history: cumulative paper losses since it burst have now reached around one quadrillion yen (one thousand trillion yen) or $7 trillion, equivalent to two whole years of the economy's output of goods and services, and have left the financial system in a precarious state which has only recently been officially recognised and dealt with.

4. So, in a way it shouldn't be surprising that the economy stalled and ultimately fell into recession when fiscal policy was tightened substantially in 1997. Back in 1996 and early 1997, though, many, including the OECD, thought that the strong investment recovery which started in 1995 marked the end of the protracted adjustment process and that the Japanese economy was back on the path of expansion. But, we all know that it didn't turn out that way. And the recession deepened first with the crisis in the rest of Asia and shortly after with the failure of some large financial institutions, which exposed the seriousness of the financial sector problems more generally as well as weaknesses in the regulatory and corporate systems in Japan, which I will take up a little later.

5. What if anything can macroeconomic policies do to end the recession? There isn't much more that monetary policy can do to stimulate demand. The Bank of Japan has been doing its utmost to prevent a financial collapse from occurring by assuming its lender-of-last-resort responsibilities and by aggressively countering the nascent credit crunch with substantial liquidity injections. But the increase in liquidity has not been translated into an expansion of bank credit, as banks have struggled to redress their balance-sheet positions in order to meet capital adequacy requirements and avoid invoking so-called "prompt corrective action" procedures. Some have suggested that the BOJ should set a reasonable inflation target, but I cannot see how this would convince the public that the Bank can raise the rate of inflation to a target level and keep it there, nor is it obvious how the policy could be implemented. Another extreme suggestion -- that the BOJ behave irresponsibly and push inflation up to very high levels -- would destroy its credibility just when it has gained its independence and is therefore out of question.

6. On the fiscal policy side, I hope that last April's stimulus package and the intended additional package will be enough to at least stabilise economic activity. The emphasis on permanent income tax cuts and new types of public investment (such as linking schools through a nation-wide optical fibre system) is welcome. The overtly temporary nature of earlier tax cuts almost certainly contributed to their ineffectiveness, and traditional public works projects appear to have generated at best modest social returns and have left in their wake a construction sector which can only be termed "bloated", accounting for 4 1/2 percentage points more of GDP than in the average OECD country. I am very conscious that Japan will soon have to face substantial spending pressures from the ageing of its population so that the scope for engaging in yet more fiscal expansion is limited, and that's why it is so important to put a strong emphasis on the efficiency of any fiscal measures that the government might undertake. In this regard I strongly hope that the on-going fundamental review of the personal income taxation system will result in lower tax rates and a broader tax base. At the same time, should the situation turn out to be worse than we currently think, then there would be no alternative but to provide further fiscal support. In any case it will be crucial to minimise the time during which all this deficit spending is necessary, for the rapid increases in public debt cannot go on indefinitely.

7. The first hurdle to clear in this respect is the banking situation. Unfortunately, there is no easy way out of the current difficulties. Procrastination in taking appropriate measures to deal with weak institutions would simply feed further uncertainty, leading to lower share prices and consequently a further aggravation of banks' balance sheets. I understand that there is wide recognition in Japan that finding a solution to this problem is a necessary condition for ending the recession. The recent adaptation of failed and faling bills to set up a more transparent mechanism to deal with failing institutions and the imminent passage of legislation to set out clear rules and procedures for recapitalisation of weak banks are therefore welcome. But given the clear overcapacity in this sector, any solution cannot avoid painful adjustments for borrowers and employees, which may in the short run push down economic activity through continued contraction in credit, more bankruptcies, a further rise in unemployment and heightened job insecurity. The strategy should be to set a timetable for completing and publishing the results of the ongoing audits of the major banks and for their recapitalisation through public purchase of their securities combined with full write-off of problem loans. This would allow consumers and investors to perceive the new more stable financial landscape and surviving institutions to get on with their credit creation functions relieved of the millstone of trillions of yen in non-performing loans.

8. But at the same time as fighting fires, there is a strong need to enhance the economy's capacity for sustained expansion. The key in this regard is structural reform. The Japanese government has stepped up efforts since 1996 by launching initiatives grouped under six pillars. Among these, regulatory reform should yield large payoffs. I have the impression that in this country much business dynamism can be unleashed by doing away with many outdated regulations. I say this based on several observations: first, deregulation of retail trade has resulted in a significant expansion in supermarkets and convenience stores in Japan. A second example is the partial deregulation of telecommunications industry which led to significantly lower prices of long distance calls and a rapid expansion of mobile phones, an important factor behind the mini investment boom seen in 1995. And most recently new entry in the scheduled airline business is set to stimulate substantial expansion in domestic air travel. Overall, let me say that I am encouraged by the many deregulatory initiatives that are under way, but the pace of decision-making and implementation should be speeded up radically, even at the expense of incomplete consensus, so that the macroeconomic benefits can be gained, thereby also relieving fiscal policy of its unsustainable burden. As an aside, let me remind you that a detailed review of regulatory reform in a selected number of sectors is under way at the OECD, and we hope that this exercise will help advance the pace of reform in Japan.

9. Another area where reform carries a high priority is social security, particularly pensions. I understand that one of the major motives for discretionary saving in Japan is to prepare for old age. The pension system should in principle reduce uncertainty about post-retirement incomes. In my view a fundamental rethinking of the whole system of pensions is in order. Moreover, with the likely increase in unemployment and labour turnover more generally, a review of the unemployment insurance system is urgently needed. In both of these domains the OECD has accumulated expertise which may be useful.

10. There seems to be wide recognition that the Japanese corporate system is in need of an overhaul. I know that certain aspects of it are changing. For example, seniority-based pay is losing ground, the role of bank financing is diminishing, and the vertical keiretsu relations are becoming less prevalent. But, probably the most important required change in the system is to strengthen the monitoring role of outsiders to the company in order to guarantee that invested capital is used as efficiently as in the rest of the world. Japanese companies are typically run by managers promoted from inside, and the main banks and other stable shareholders have not necessarily ensured that the managers maximised returns to shareholders. Such corporate governance arrangements make it very difficult to change the strategies which worked well in the past but are not suitable in different environments. Some world class companies have substantially cut down the total number of directors while increasing the number of outside directors. I think more Japanese companies should follow suit, as I believe that such a move would promote greater risk taking on a well-considered basis and lead to improved corporate performance.

11. More fundamentally, Japan's future will be well served by the society's placing high value on creativity and risk taking. In this regard, I am concerned with a trend decline in the rate of new company formation, which is rather low. I hope that the series of measures taken to improve the supply of venture capital as well as the eventual reduction in the top marginal income tax rate will help reverse this trend. More generally, I welcome recent initiatives to reform the R&D and education systems, though these are just a beginning and tend to be projects requiring a long lead time.

12. To conclude my discussion on Japan, let me say that once the current difficult adjustment period is over the Japanese economy can be expected to be able to enjoy a reasonably strong rate of growth for several years thereafter. Making the adjustment period as short and at the same time as beneficial as possible in terms of accomplishing structural reform should be the top priority. Achieving this goal will be feasible only if Japan's leaders make their vision of the future clear to the people. Inevitably, that future will have to be one where government and bureaucracy play a smaller role, with greater emphasis on individual creativity, responsibility and risk-taking.

13. The crises and near-crises now being experienced in Asian and other emerging market economies have revealed serious structural problems even more extensive than those with which Japan is now struggling. The Asian crises particularly underscore the severe damage to overall economic performance that can be produced by financial system distortions and inefficiencies-- even when macroeconomic policies are reasonably sound. In all of the countries now in crisis, strong incentives for excessive risk taking and other forms of imprudent financial behaviour were created by insufficient competition in the financial system; by overconcentration of risks, caused in part by the uneven development of financial markets; by distortions in the real economy that induced excessive investment in property or other sectors; and by incestuous relations among financial institutions, their corporate customers, and government agencies that have come to be referred to as 'crony capitalism'. The resulting damage was magnified and allowed to accumulate because of severe weaknesses in the mechanisms for corporate governance, market discipline, and official supervision that market economies normally rely on to check imprudent financial behaviour. These deficiencies include: lack of transparency in accounting and reporting systems; inadequate bankruptcy laws; inadequately defined property rights and fiduciary responsibilities; and supervisory regimes deprived of adequate resources or a legal mandate to effectively carry out their tasks. These problems extend beyond those countries that are now in crisis to include even some-- notably China-- which have so far fared much better but which need to make major reforms to their financial and enterprise sectors if they are to sustain a healthy economic growth in line with their potential. The recent reports on the handling of the Guangdong International Trust & Investment Corporation by the Chinese Central Bank is promising.

14. The tasks now facing the countries in crisis or which have come close to crisis are daunting. They need to stabilise their external payments positions; restore financial viability to their domestic institutions; maintain and reform public finances in the face of what are likely to be very large outlays for financial system recapitalisation in the worst cases; and contain the substantial inflation pressures arising from their currency depreciations. Longer-term structural reforms will also have to be made, to correct the problems underlying the crises and to provide the boost to confidence that is likely to be needed to sustain a healthy recovery. Needless to say, the prospects for recovery in these countries largely rest on the success of their own efforts in carrying out the needed policy reforms. However OECD countries -- including of course Japan -- can make a useful contribution by helping to ensure that the external environment supports rather than interferes with the adjustments the countries are going to have to make.

15. Perhaps the most important contribution OECD members can make in this regard is to maintain healthy growth and low inflation within the OECD itself. Continued good macroeconomic performance in the OECD would go a long way toward bolstering confidence, reducing uncertainties, and thereby stabilising financial market conditions. Healthy growth will be necessary to absorb export increases from crisis countries -- which are essential to those countries' recovery-- without undue strains on OECD member economies. The current account balances of OECD countries taken together are necessarily having to decline somewhat in the near term to allow the necessary adjustments in the crisis countries to proceed. It is essential that OECD governments vigorously combat any efforts to restrict access to their own markets. Protectionism in present circumstances would be even more detrimental than usual to economic performance-- not least because of the serious risks it could pose to financial stability.

16. OECD investment flows to the crisis countries and other emerging market economies can also play an important role in facilitating their internal reforms. Foreign direct investment flows have become increasingly important to emerging market economies, particularly to the most rapidly growing ones. They have provided a moderate but important boost to overall capital spending in these economies: for example direct investment in the year 1996, before the present crises began, amounted to nearly 4.5 percent of total gross capital formation in Thailand and to nearly 15 percent in China. As important as the financing provided by such inflows are, the transfers of expertise and technology they bring, as well as their role in facilitating privatisations and enterprise restructuring, and as such they play a key role in facilitating broader structural reforms. For this reason, direct investment is likely to take on increased importance over the next several years in the emerging market economies. This is the case in the crisis countries where funds needed to recapitalise the financial sector are so large that substantial injections from foreign investors are likely to be essential.. Portfolio inflows also have a potentially important role to play in helping to increase competition and promote balanced development of financial markets that emerging market economies will need to resume healthy growth and avoid future crises.

17. Resumption of capital flows to emerging market economies, and their ability to derive fully the benefits offered by these flows, depends in the first instance on their own policies. Foreign investors need to be assured that necessary reforms will be undertaken. Significant progress has been made this year- for example in developing plans for financial restructuring in Thailand and Indonesia and toward improving the budget position and carrying out privatisations in Brazil-- but there also needs to be assurance that reforms will continue at a steady and expeditious pace. The longer-term climate for foreign as well as domestic investment also needs to be improved. This requires a lowering of existing barriers to foreign participation in domestic business in many cases but also institutional reforms to improve transparency and clarify property rights. Recent measures introduced by several Asian countries to allow greater foreign participation in their financial sectors and to reform bankruptcy codes represent important steps in the direction of assuring that openness to international markets promotes internal stability and efficiency. More broadly, I cannot overemphasise that, both during the process of restructuring and beyond, emerging market economies need to maintain and further extend the openness of their markets to the international economy. Indeed, the crises have only underscored the lessons drawn in the OECD's recent multidisciplinary study, "Open Markets Matter", namely that international trade and investment are more important than ever and that protectionism only aggravates adjustments countries have to undergo as a result of their own internal problems. Globalisation is often under attack. It should not be seen as a problem but rather as part of the solution.

18. The efforts taken by countries individually to improve the environment for foreign investment could be substantially enhanced if national policies toward foreign investment were anchored in a broader multilateral framework. Such a framework would be helpful in at least two ways. First, it would improve clarity and transparency in the 'rules of the game' concerning cross-border investment. And second, such a framework would provide strong incentives for further market opening, based on the prospect that those doing so can benefit from greater access to partner markets. These goals were guiding principles of efforts in the OECD to develop a Multilateral Agreement on Investment. This effort has not yet reached fruition, but given the difficult issues and complexities involved this is not entirely surprising and should not be viewed overly pessimistically. If anything, the crisis in emerging markets has increased the potential value to the world economy of such a multilateral framework on investment policy.

19. Finally, the OECD countries have an important, indeed indispensable, role in supporting crisis countries beyond the immediate assistance they can provide to their restructuring they are now undergoing. The collective efforts that OECD countries have been taking, through multilateral institutions such as the IMF, the World Bank, and BIS as well as their own forums in the Group of Seven and Group of Ten, have become even more essential. The themes that emerged before the crisis-- the need to bolster financial stability in individual countries and to strengthen the international safety net-- have only been underscored by the crises -- as have key specific lessons, such as the critical importance of realistic standards on loan classification, loan provisioning, and capital standards in maintaining the financial soundness of banking systems. The crises also have underscored the need for adequate resources to deal with threats to international financial stability and for effective international institutions to handle those resources and to provide the expertise and incentives to individual countries to improve their financial systems. At the same time, the crises have revealed that the issues raised by these efforts are even more complex and difficult than was earlier appreciated. It is clear that we still lack an adequate answer to a key question: how to maintain the necessary international safety net while, at the same time, containing moral hazard and limiting the demands on the international community from individual crises. Clearly we all have much thinking to do. Nevertheless, I remain confident that the skills and determination of OECD members, together with those of the broader international community, will be successful in alleviating the present crises and in strengthening the international financial system over the longer term.

20. Throughout this period of deepening recession in Japan and financial market turmoil in emerging markets, the eleven European countries that will soon form the European economic and monetary union (the EU11) have been largely immune to the impact of the crisis. The currencies of the EU11 countries have maintained their parities among themselves, and appreciated against other currencies, including the dollar and the yen. Finland, for example, has had no visible pressure on its exchange rate, despite important trade links with Russia and in sharp contrast to the way it had been buffeted by earlier shocks.

21. The near absence of financial pressures in the EU11 countries is partly linked to strong economic fundamentals, following earlier efforts to prepare EU Member States for the launch of the euro. Indeed, after fairly difficult economic times, economic conditions in the EU11 area have improved considerably since 1997 and prospects for the launch of the euro are favourable. Output in the area has been growing slightly faster than potential in 1997 and 1998, while inflation has continued to decelerate to reach its lowest level in over thirty years. And with growth picking-up, labour market conditions have improved, although unemployment remains very high and large differences persist across Member States.

22. However, the main benefits from the launch of the euro will accrue in the years to come. These benefits include reduced transactions costs associated with trading with other EU11 countries, lower uncertainty with respect to future exchange rate movements and sharpened price transparency. There are also costs entailed with monetary union. The main one is the loss of a sovereign monetary policy as a tool to respond to shocks at the national level. The European Commission has estimated that the benefits could be around 1/2 a per cent of GDP. This may sound like a relatively small benefit, but it largely ignores the dynamic gains that are likely to stem from greater price transparency, unleashing stronger competitive forces and deeper structural reforms. Monetary union could thus be a catalyst to speed-up structural changes.

23. Some sectors of the economy are likely to change further and more quickly than others. For example, service industries in general and financial markets in particular, which have traditionally operated on a national basis, are likely to adopt a more European focus with the advent of the euro. Demand for their services will come from a broader geographic area and stronger competition will prompt firms to specialise and seek business beyond their traditional national boundaries. This process is already manifest in the hectic merger activity, as financial companies forge strategic alliances and seek greater scale economies. For manufactured goods, the impact of the euro is likely to be relatively smaller, since policy regimes governing trade in goods have for some time been more liberal. Nonetheless, greater price transparency will benefit consumers, as the scope to maintain large price differences between countries for virtually identical products, such as cars, shrinks. In the long run, this process will enhance efficiency and be positive for growth, inflation and employment. It will also help forge a more integrated EU11 economy.

24. While the EU11 economy has so far been largely immune to the impact of financial crisis, this does not, of course, mean that this would continue to be the case if the global situation deteriorated markedly further, or that it will be sheltered from future shocks that may hit the area, or part of it; business cycles are a fact of economic life. If economic conditions change in a broadly similar way across the whole euro area, monetary policy could respond and limit the negative economic impacts. If, however, a shock falls on only part of the monetary union area -- a so-called asymmetric shock -- adjusting monetary policy will normally no longer be an option. An example of this kind of shock was the unification of Germany in 1990. As I already mentioned, losing this option is the main cost of the euro project. But the cost can be limited and reduced to the extent that alternative adjustment mechanisms are strengthened and business cycles in the different national economies converge.

25. The main alternative adjustment mechanisms are raising wage flexibility and geographic mobility of labour, enhancing product market competition and ensuring that budget positions are sufficiently strong for fiscal policy to operate effectively without being unduly constrained by the Stability and Growth Pact. Labour market flexibility is fairly low in most European countries. We have analysed labour markets in depth and provided recommendations for each member country. But progress in reforming labour markets has so far been very slow. Geographic labour mobility, alongside wage flexibility, is often seen as crucial for the smooth functioning of monetary unions. In the EU11 area it is low in comparison with the United States and Canada and -- despite the gradual dismantling of legal barriers -- has not risen. Part of the explanation, no doubt, reflects language and cultural barriers. But economic factors also play a part. High costs associated with moving, difficulties for certain professions having their qualifications recognised, limited portability of some social assistance entitlements, and relatively generous social security benefits reduce the incentive to move when regional economic conditions deteriorate. The European Commission has taken a number of steps in recent years to address some of these obstacles. Nevertheless, it is unlikely that geographic mobility will rise sharply and quickly to levels that would absorb major asymmetric shocks.

26. Interest rates -- the "transmission mechanism" of monetary policy -- are likely to have differing effects in different parts of the euro economy. Because of differences in the mix of interest-rate and exchange rate sensitive industries across regions, the financing structure of firms, the composition of household wealth and the mix of flexible and fixed interest rate loans, monetary policy will have uneven economic impacts within the EU11 area. These impacts are forever evolving as financial markets innovate and change at a rapid pace. Thus identifying how important they are likely to be is a difficult exercise. Empirical studies suggest that the differences are relatively small, but any ranking of the most and least sensitive areas to monetary policy changes is highly uncertain. At the outset, the challenge facing the European Central Bank will be gaining credibility for steering monetary policy in largely uncharted waters.

27. Some of the elements that make up the monetary policy transmission mechanism have already changed significantly. For example, the EU11 area's exposure to exchange rate movements, which can affect the economy through its competitiveness, has been lessened over recent years through broadly constant exchange rates within the European Exchange Rate Mechanism which preceded the monetary union. Since much trade is among EU11 countries, exposure of the area to trade will not be much different from that of the United States or Japan, suggesting that this channel will be less important than it has traditionally been for European economies, and especially the smaller ones.

28. To sum up, the outlook for the EU11 economy is positive, although the risks to the global economy are unusually large and no part of it can be entirely immune to them. Part of the reason the EU11 area has been relatively unscathed from financial market turmoil is related to the hard steps participating countries have already taken over the past five years in preparation for the euro. Pressure to qualify at the outset led to substantial fiscal consolidation which has lowered inflation, reduced interest rates and enhanced credibility. While the conditions for the launch are good, to make monetary union a success requires considerable further policy reforms in labour and product markets and government spending programmes. Provided these challenges are met, the benefits from monetary union will build as economies become more closely integrated, and ensure not just a successful launch, but also a successful monetary union.

29. Let me now turn to the role of OECD. Today's financial crisis and the challenges I have outlined above provide very clear evidence of the need for continued, even increased, co-operation and co-ordination at an international level. The changes being brought about by globalisation and the growing importance of non-OECD countries in the world economy mean that mechanisms must be found to extend the tremendous knowledge and experience gained through our own policy successes and failures to countries whose needs are greater in so many areas. Only if nations work together to design policies and institutions to balance economic growth, social stability and effective governance can we hope to tackle the challenges and reap the gains from continued trade and investment liberalisation, technological progress and sustainable development.

30. International organisations have an important role to play in this effort, each with its own particular focus. Through its work, the OECD has long supported the objective of more open flows of goods, services and capital; market-based economic policies, and social programmes that facilitate countries' adjustment to a more open world economy. But in addition to helping governments put in place sound economic and social policies, as I noted earlier the OECD also works in important ways to help governments build the institutional and regulatory infrastructures that are necessary to support these policies. Through our extensive outreach efforts with Russia, Asia, and other non-Member countries, we are attempting to support those governments' efforts to shape strong policies and institutions and to facilitate their increased integration into the global economy.

31. In the face of today's crisis and the challenges ahead, it is more important than ever that the steps we take today be those that will set the stage for the world of the next twenty years and beyond. We should not retreat from the policies that have served the world and its people so well over the past fifty years. A continued emphasis on sound, sustainable macroeconomic policies, open trade and investment systems, flexible labour and product markets, support for education and training programmes, and sustainable development are among the key ingredients for building a successful future.

32. Fifty years ago, the Marshall Plan helped Europe emerge from the devastation wrought by World War II. The world learned from that experience that building stronger linkages among nations, and co-operation in addressing the problems faced by all is the best way to create the conditions for economic growth, political stability, and, in the end, peace. My remarks, as well as those of other speakers today, have made it clear that the problems we face are by no means small ones. However, we must recognise that no government, no society, no business can wall itself off from the forces of integration and globalisation. Our choice is clear: either we take the steps necessary to prepare our economies and societies for this future, correct flaws in the international architecture; and co-operate to address these problems together; or we risk repeating mistakes of the past and consigning our nations and their citizens to a less prosperous, less stable future.

33. The right policies and institutions are important. But making the right choices also will require strong political leadership, in order to avoid a return to destructive policies pursued in the 1930s and at other difficult times in the past. Government leaders and opinion makers need to remind their fellow citizens that while the process of adjustment to a globalising world is not always easy, the route to a more secure and prosperous future lies in strengthening our ties to the world and in co-operating with other nations to ensure rising living standards and an improved quality of life for all of this planet's inhabitants.