Why Japan needs higher interest rates: the first step toward shifting to a consumption-based economy.

• Author: Nakamae, Tadashi

The biggest challenge facing the Japanese economy is to move toward consumption-led growth. When conventional monetary stimuli were ineffective following the bursting of the so-called "bubble" economy, the Bank of Japan rolled out its zero interest rate policy in February 1999 and initiated its quantitative easing strategy in March 2001. These emergency measures, however, accelerated the already excessive transfer of income from the household sector to the corporate sector, and have stifled a recovery in household consumption.

Meanwhile, thanks to the fall in borrowing costs and a decline in labor's share, corporate profits have improved dramatically. But with domestic consumption still weak, corporations have only had reason to pursue export-related capital investment. Sadly, this shows that Japan's economy is still heavily dependent on exports and export-linked investment as major growth engines.

The greatest harm from the ultra-low interest rate policy has been the transformation of the household sector into a net payer of interest. According to the Annual Report on National Accounts, the household sector received a healthy [yen] 12 trillion in net interest income in 1992. Due to the decline in interest rates, however, households became net payers of interest in 1996, and have remained so ever since. The latest available data show that the household sector received [yen] 5.3 trillion in interest income in 2003, but made interest payments of [yen] 14.1 trillion. The [yen] 8.8 trillion deficit runs counter to the fact that households' net interest-bearing financial assets actually increased from [yen] 365 trillion to [yen] 525 trillion between 1992 and 2003.

Interest rates on financial assets held by households plummeted from 5.4 percent in 1992 to 0.6 percent in 2003. The average rate of interest paid by households on financial debts also fell, but only from 7.8 percent in 1992 to 4.3 percent in 2003. If we take the actual interest income received and interest payments made by households from 1993 to 2003 and compare them with hypothetical interest income and payments calculated using 1992 interest rates over the same eleven years, cumulative net losses total a staggering [yen] 218 trillion.

Against this, the cumulative gains in the net interest income of non-financial corporations and the government--sectors riddled with financial liabilities--stood at [yen] 140.6 trillion and [yen] 125.2 trillion, respectively. In the case of...