C. Peter McColough Series on International Economics: Japan's Great Earthquake: Societal Resilience and Determination to Reconstruct

WILLIAM J. MCDONOUGH: This meeting is part of our Peter C. McColough Series on International Economics.

Now, here's something very important for you technically oriented Americans. Please completely turn off, not just put on vibrate, your cell phones, your BlackBerrys -- there's a free advertisement -- and all wireless devices, to avoid interference with our sound system.

I'd like to remind the members that this meeting is on the record. You will see that there are a great many people from the press in the back of the room. And we look forward to the coverage that the governor's speech I'm sure will richly deserve.

Governor Shirakawa is a career man at the Bank of Japan. He spent six months as the representative of the Bank of Japan here in New York and was such an enormous success and so admired by the people at the Federal Reserve Bank of New York -- I was president at the time -- that he got promoted back to Japan and has been rising like a rocket ever since.

Governor, we look forward to your remarks. The floor is yours.

MASAAKI SHIRAKAWA: Good morning. Thank you, Bill, for kind introduction. Before I came -- before I stand at this podium, I was invited but not being able to come to New York because of my many, many commitments. But finally I could come, and I feel very relieved by coming to this podium.

I'm very much privileged to have the opportunity to speak before the Council on Foreign Relations today. Before beginning my speech, I would like to extend my heartfelt gratitude to the government and people of the United States for the support and encouragement concerning the tragic Great East Japan Earthquake.

The situation in the area close to the earthquake epicenter, particularly coastal areas that were hit hard by the tsunami, is disastrous. The disaster claimed about 13,000 lives, and more than 15,000 people are still missing. Residents of the area near the Fukushima Daiichi nuclear power plant have been directed to evacuate and are forced to spend restless days and nights in shelters.

In this way, Japan has faced a trying time since earthquake struck. At the same time, however, Japanese society has shown resilience. The work of rebuilding has started to get under way gradually but steadily. In my remarks today, I will talk about the situation in Japan in the months after the earthquake and the work being done to rebuild Japan's economy.

A good place to start is what happened in financial market, the area I am familiar with. The earthquake struck at 2:46 p.m. on Friday, March 11th. At the time, I was being briefed by the staff in preparation for the monetary policy meeting scheduled to be held at the beginning of the following week.

Even in Tokyo, about 250 miles away from the earthquake epicenter, the shaking from the earthquake was the strongest that I have -- I had ever experienced, and continued for more than two minutes. The earthquake's magnitude at the epicenter was 9.6, which makes it the largest on record in Japan. And energy released was enormous, which is depicted in chart one.

Based on previously formulated emergency procedures, the Bank of Japan immediately set up a disaster management team with me as head. This task was completed 14 minutes after the earthquake struck. The most important thing for a central bank during a crisis is to ensure stability of settlement system and financial markets. The Bank of Japan financial network system, or BOJ-NET, Japan's core settlement system for (bonds ?) and government securities, has been operating without any problems the entire time since earthquake struck.

The Bank of Japan Fukushima branch, which is about 14 miles away from the Fukushima Daiichi nuclear power plant, has been conducting its business as usual and has been providing cash, including on the weekend immediately after the earthquake. Financial market stability has been maintained. I would also note that trading on the Tokyo stock exchange has been perfectly normal.

Looking beyond the (world ?) of settlement system and financial market, the people in disaster areas have been calm and composed and (full of a state ?) of mutual cooperation despite such a difficult living environment. In Tokyo, although electricity shortages are causing some inconvenience, people have accepted these new realities and adopted immediately. One of the visible change is that people are increasingly deciding themselves to cancel parties or other event as a mark of respect to the victim(s) of the disaster and out of consideration for the feelings of people affected. Another change is a substantial decline in visitors from overseas.

Now let me turn to the effects on Japanese economy of the disastrous events: namely, the earthquake, tsunami and nuclear accident. Something that has not been recognized so much is that Japan's economy in 2010 performed best among G-7 economies in terms of both growth rate and unemployment, which is depicted in chart two.

The disaster occurred at a time when Japan's economy was gradually returning to a recovery path, albeit a moderate one. In the short run, it is inevitable that earthquake will significantly affect production and other economic activity through its damage to supply capacity. The four prefectures most affected by the earthquake and tsunami in total account for about 6 percent of Japan's GDP.

In the case of Kobe earthquake, which occurred in January 1995, real GDP did not decline even in the quarters when the earthquake occurred. In contrast, the March 11th earthquake will have a greater impact on production for the following reasons.

First, this was not just an earthquake that was huge in magnitude and geographically widespread. It also triggered tsunami, which together with the earthquake caused a nuclear accident. Second, how to replace parts and materials produced in factories in the disaster areas are integral to supply chains. A typical example is electronic parts, the shortage of which has been having a severe impact on automotive production even in nonaffected areas.

The effect might go beyond the domestic sphere. The economies of Japan, China and the United States have become interdependent, in that Japan produces the parts, China assembles them and the United States develops the finished consumer products. Therefore, the impact on supply chain could spread internationally.

Third, Japan's power shortage facilities -- third, Japan's power generating facilities have been significantly impaired. The problem associated with nuclear power generation have been a subject of intense scrutiny due to the accident at Fukushima Daiichi nuclear power plant, but it is worth noting that the earthquake also caused serious damage to Samaw (ph) power plant, which is depicted in chart five and six.

Measures are currently being taken to curtail demand through various efforts, such as asking business and household to conserve electricity, and at the same time, steps are being taken to restore generating capacity. The power shortage will be temporarily eased due to seasonal factors, but electricity could run short again in Tokyo Electric Power Company -- TEPCO's service area when demand peaks in the summer.

For historical reasons, Japan has two frequency domains, and there is little room for surface electricity to be delivered across domains. The impact of such supply constraint will be serious in the short term, but at the same time we should remember that the impact of the disaster can be mitigated by human wisdom and determination.

Let me give you two examples of how the impact is being and will be mitigated.

First, top priority is now being pressed on fixing the production and supply bottleneck of parts and materials, with the cooperation of firms using them. At the same time, we are now seeing signs that alternate production has started in domestic factories located in places other than the affected areas. And on the electricity front, efforts are being made to devise effective measures for curtailing energy use during the high-demand period in summer when electricity could run short.

Second, as time passes, demand will also emerge for restoring damaged capital stock, such as roads, factories and houses. While it is difficult to accurately forecast the amount and time (passed ?) of rebuilding demand, the amount of damage to capital stock due to the earthquake and tsunami will be about 3 (percent) to 5 percent of nominal GDP, and 1 (percent) to 2 percent of total capital stock, according to government estimate, which is depicted in chart seven.

Taking these factors into account, most private economists believe that Japan's GDP growth rate will turn positive again from the third quarter of 2011, onward. Moreover, from a long-term perspective, new demand is expected to emerge. For example, the recent experience of disruption to supply chains has made us aware of a concentration of risks in particular region or with respect to particular firm. This new awareness, through a rethinking of business strategies, could generate new investment in, for example, computer centers and distribution depots.

The action at Fukushima Daiichi nuclear power plant has triggered active global discussion on nuclear power policy, which will highlight the importance of energy conservation and environmental technologies. And Japanese firms have an edge in those areas, such as high-end batteries. There will be great room for them to make contributions.

Various challenge lies ahead on the road to overcoming the adverse effect of the earthquake and rebuilding Japan's economy. The first challenge is ensuring the necessary financing for rebuilding. In this regard, Japan has had an excess of saving over investment for a protracted period, which means that from the macroeconomic perspective this financing will not be difficult.

Japan's capacity for foreign (connective ?) funding is extremely strong, given the -- given that the country is the biggest creditor nation in the world, with net external asset of 2.9 trillion U.S. dollar, or 57 percent of nominal GDP. Private financial institutions are fully able to meet an increase in financing demand for rebuilding. Meanwhile, Japanese government bond have been issued quite smoothly, and long-term interest rates have remained stable at low levels, compared with other countries. As long as Japan continues to work tirelessly towards rebuilding, it is unlikely financing problem will arise.

The second challenge is raising Japan's potential growth rate. Since 2000, Japan has had -- Japan has had -- is one of the highest GDP growth rate per worker among G-7 countries, although slightly lower than the United States. This is depicted in chart nine. However, the decline in the working-age population in Japan is proceeding at a pace that has no precedent in modern economic history, which is depicted in chart 10.

As a result, Japan's economic growth has been on a downward trend. Raising the potential growth rate was the biggest challenge for Japan's economy, even before the earthquake. But the effort to do so by raising both the labor participation rate and productivity have now become all the more important. As Japan seeks to build its economy, efforts to raise the potential growth rate have become even more important. These are certainly not easy challenges, but we have to take them on with greater determination.

Finally, let me briefly touch upon the Bank of Japan's response after the earthquake struck. As was the case in the financial market immediately after the failure of Lehman Brothers, when people's lives and safety are at risk, they sometimes tend to become excessively risk averse, which makes things worse. Incidentally, while foreign nationals residing in Tokyo increasingly left Japan for fear of radiation risk, it has tended to be overlooked that the radiation level in Tokyo are roughly the same as in other major cities around the world, such as Paris (and Bahrain ?), or they were exposed to more radiation on the airplane than they would have been exposed to in Tokyo.

In the money market, financial institutions -- (word inaudible) -- demand for liquidity surged. Rumors have spread among the foreign financial community that the Tokyo financial market would close due to fears of radiation risk. The Bank of Japan has been asked whether there was any truth to the rumor that the Bank of Japan was planning to retreat to a backup site in the western part of Japan. Of course, these rumors were and are groundless. As I said, the financial infrastructure are fully functional and there is no reason for us to relocate from Tokyo.

In such times, the first priority is ensuring calms among market participants. And in this regard, the Bank of Japan has provided ample liquidity on an unprecedented scale day after day. The very next business day after the earthquake, we decided to significantly increase the amount of its asset purchase mainly of the risk asset, with a view to preventing any determination in business sentiment or excessive increase in risk aversion from adversely affecting economic activity.

As a result of these measures, financial market, which became (somewhat jittery ?) in the period immediately after the earthquake occurred, have regained stability. Needless to say, the Bank of Japan's mission is to ensure price and financial system stability, thereby contributing to the sustainable growth of Japan's economy.

We will continue to take appropriate measures as a central bank in order to achieve this mission. As I mentioned earlier, nothing is more heartening in a crisis than the encouragement and support of friends overseas.

I would like to conclude by thanking you once again for your friendship with -- friendship. With the resilience of Japanese society and the determination to rebuild, I am absolutely convinced that Japan's economy will overcome this trying time, successfully rebuild, and become even better place with grater growth potential.

With that, I would like to conclude my remarks. Thank you for your attention. (Applause.)

MCDONOUGH: Governor, thank you very much for that excellent presentation and very informative one.

You have been talking with your counterparties in other countries, and Japan is always very keyed in to the world economy. How do you see the effect of the earthquake on the global supply chain, and especially on the average -- the likely growth rate for the rest of this year in the rest of the world?

SHIRAKAWA: Thank you. Tsunami -- the earthquake and tsunami hit many production facilities in the northern part of Japan. The most crucial is on the damage of -- on the production of electric devices such as microcomputer, which is a critical component for automobiles and the portable terminal such as smartphones. Since such products are so integral, as I said, it could affect supply chains both domestically and globally.

Japan's car industry is well-known for its just-in-time inventory-adjustment model. By adopting such models, the level of inventory is kept at bare minimum. Just-in-time inventory model is so efficient, but by nature, it can't cope with the sudden loss of critical suppliers. The -- following the disaster, the Japanese automakers have shut down their production. And thus, exports declined. The -- just recently, only a handful of automakers resumed its operation; although the -- (inaudible) -- is very limited.

The -- in contrast, Japanese automakers in overseas countries have -- did not stop its operations up until recently, partly because of -- partly because they could count on local input and partly because -- I would say, because they could use stockpiling from imported material from Japan. But result, inventory is dwindling. They are now faced with difficulties; and therefore, they have started to cut production slightly. And so the (narrative ?) externally also felt by the European carmakers and American carmakers as well.

Concerns about -- supply concerns are also apparent for such electronic devices as smartphones. And some of the manufacturers of these products are turning to Korean and Taiwanese carmakers. And my reading of the situation is damage on supply chain is a case of -- the (effects on ?) devices are less severe compared to the damage on automobile production.

The -- these episodes point to the -- (inaudible) -- and the (weakness ?) of supply chain nexus involving Japanese firms. The Japanese firms produce highly original and differentiated product. For that reason, for the time being, the Japanese manufacturers have no choice but to lose out to foreign competitors. But they are working hard; they are working 24/7. And they are trying to rebuild their factories.

So the -- also they are committed to providing a top-quality product. So I believe that Japanese firms are able to revitalize themselves. And the exact timing of recovery of supply chain is uncertain. Some people say it will be June or July. And some others say it takes (different ?) time. I don't know. But the people are working hard.

And finally, let me say a few works on the effect on global economy. I don't think the damage on Japanese firms has a lasting impact on global economies, because rival firms are also providing these parts. Therefore, I don't think this will have a serious -- significant impact on global economy.

MCDONOUGH: Well, thank you very much.

If you try to isolate the various parts of it -- the earthquake, the tsunami and the damage to the nuclear plant --

SHIRAKAWA: Yeah.

MCDONOUGH: -- concentrating on the nuclear plant situation, how do you see that affecting the Japanese economy and for how long?

SHIRAKAWA: OK. First of all, the crisis at nuclear power station is still continuing, and we (freely ?) recognize this is a serious problem for Japan and globally. But let me assure you that government and TEPCO are also doing everything within their capacity to bring the station under control.

Since I'm a central banker, I don't claim on the expert on nuclear power plant or radiation risk or things of that sort. I try to focus on economic impact of this event. It affects the -- both supply side and demand side of the economy.

I start -- I'd like to start with supply side. The impact could be classified into two. One is the impact on the power -- the power. The -- we have to live with the substantial cuts in power for extended period of time, although the economic severity depends on the season. In summer season, the shortage is very serious, and every institution in Japan is now asked to cut peak demand by 25 percent, and -- (audio break) -- Japan is of course subject to such deep cutting, sort of -- so my colleagues at the bank are -- is working hard how to curtail demand by 25 percent. And when you visit Japan, you will be surprised how dark our office is already.

MCDONOUGH: So you're serving as a model for everybody else?

SHIRAKAWA: Yeah.

MCDONOUGH: (Chuckles.)

SHIRAKAWA: And -- but as I said, this is not all Japan's problem. The TEPCO is covering about 40 percent of electricity consumption. And for (political ?) reason, we have two frequency in domain. In the late 19th century, we imported power-generating technology from two countries: one, from Germany, where -- one from Germany. And this system is put in eastern part of Japan.

In the -- in western part of Japan, the American company exported. And the problem with this dual system is the intraregional transfer of electricity can be -- (inaudible) -- and therefore the -- we -- people living in Tokyo are (severely damaged ?), but the -- in western part in terms of electricity, everything is normal. So some people are now shifting the production from east to west.

And second effect on supply is the evacuation zone. The Japanese government has set up the evacuation zone, which spans 20 kilometers around the dysfunctional atomic power plants. Needless to say, economic activity in that evacuation area is impossible.

On demand side, the concern of radiation exposure have affected -- (inaudible) -- of agricultural product and seafood product from that affected area. Understandably, consumers are sensitive to the safety of the food. But at the same time, lack of accurate information tend to cause overreaction.

Also, fear of Japan's radiation diffuse is felt beyond our national borders. As I said, the foreign tourists decrease a lot, and for people outside Japan, the distance between Tokyo and Fukushima is not that clear. But actually the distance between Tokyo and -- the difference between Washington and (Three Miles ?) is further than the distance between Tokyo and Fukushima nuclear power plant.

But anyway, the people are scared, so the sharp drop in foreign -- and which is also affecting economic activity.

And also some people are -- the general sentiment among business and households are eroding.

MCDONOUGH: Right.

SHIRAKAWA: Yeah. So this had impact on --

MCDONOUGH: My last question: Your view on the relationship between the Japanese economy and the Chinese economy. I would think, as close as you are to China, you could see it either as a significant opportunity or quite a threat.

SHIRAKAWA: Yes. Yeah. My short answer to your question is, it's opportunity.

MCDONOUGH: Right.

SHIRAKAWA: Yeah. The existence of China as a global economic powerhouse is a big advantage for Japan. I hope that China will stay on -- continue to stay on sustainable growth path going (afoot ?) -- going ahead.

Last year China's GDP surpassed Japan's growth in GDP. Also, the -- albeit by a very narrow margin. After all, China's population is 10 times larger than that of Japan, and the per capita income in China is one-tenth of Japan's. And the -- to guard against media hype, we should keep this simple arithmetic in mind. The primary objective of economic policy is not outperform the peer. The challenge for us -- the challenge for -- (inaudible) -- people is to reverse the downward trend in growth rate, as I said in my speech.

The -- seen in this light, the growing presence of Chinese economy is in Japan's interest as well. In fact, Japan has a large trade surplus with China.

Let me highlight two dimensions of Japan's China economic ties. First, they are mutually beneficial in that Japan produce parts and China assemble those parts. Second, China's growing domestic market presents a great opportunity for Japanese manufacturers. Due to geographical proximity, this is a great advantage for Japanese firms.

Let me also (think of ?) this issue in historical context. Japan -- Japan's GDP surpassed that of West Germany in 1968, and the next year we hosted the Olympic Games in Tokyo. In those years of high growth for Japan, based upon the usual metrics, such as per capita income, the ratio of agricultural population or the -- and the degree of urbanization, and the current China is the same as -- resembles what Japan was in middle 1960s.

That means that we can tell various lessons to Chinese people. And it is very hard for a country to smoothly move to less -- a bit lower growth rate. In that regard, we were not as successful, say, in the bubble or financial crisis, et cetera, and also we are now coping with a declining population. So all in all, we can tell our experience to Chinese people.

Thank you.

MCDONOUGH: Wonderful.

SHIRAKAWA: Yeah.

MCDONOUGH: It's a very positive view.

SHIRAKAWA: Yeah.

MCDONOUGH: At this time I'd like to invite members to join our conversation with your questions. When called upon, would you please stand, wait for the microphone, and state your name and affiliation. And please limit yourself to one question. A question is something that doesn't make a statement. It ends with a rising inflection -- (laughter) -- (inaudible) -- brief.

Who would like to ask the first question? Sir. Wait till the mic gets to you.

QUESTIONER: I'm Allen Sinai of Decision Economics. You touched on the demand side. My question is demand side and reaction on macropolicy of the Bank of Japan. If it's worse than what you said -- Japanese consumer is cautious; has been -- why won't the Japanese consumer in this -- aftermath of this episode be even more cautious, cut back on spending?

And if that were to happen -- tell me if there's evidence of this hypothesis -- how does the Bank of Japan react and the government of Japan react when deficits are so high relative to GDP, growing debt -- sorry about the --

MCDONOUGH: (Off mic) -- et cetera.

QUESTIONER: (Off mic) -- got to get bigger. And so what does the Bank of Japan do and the government of Japan if it's a worse macroeconomic result, as you seem to imply by your remarks?

MCDONOUGH: Well, thank you for that very long question. And let it be a model for how long your questions shouldn't be. (Laughter.)

QUESTIONER: Too much -- (off mic).

SHIRAKAWA: Thank you, Allen. The best way to answer your question is to compare the current event with the shock -- Lehman shock. In the case of Lehman shock, all of a sudden, demand evaporated because of the erosion of financial system. And this time around, demand is still there. The global economy is expanding. So potentially demand is there. And we are now faced with a sudden supply shortage. So once the principal -- once the supply constraint disappears, then potential demand is coming.

So the issue is how to bridge between now and then -- now and future. And on our part, we were -- we wanted to avoid the case in which the weak sentiment itself could affect the economic activity. Therefore, on the next business day after earthquake, we decided on increasing the purchase of risky assets such as corporate bonds, commercial paper, exchange rate funds and -- et cetera.

And in a crash, people rush for safe assets, namely government bonds. But people try to avoid purchasing risky assets. Therefore, we decided on that. In addition, we provided massive liquidity into the market. And so this is our response so far. And the situation is evolving. And we are carefully watching how situation evolves, but what we are doing is to ease uncertainty. And in the meantime, the private agents are endeavoring to restore damaged capability. And also, government is now -- government has already expressed its will to embark on -- (inaudible) -- for rebuilding of the economy.

MCDONOUGH: Sir. You're -- stand up. That's it, you. Thank you.

QUESTIONER: Thank you. (Name inaudible) -- from (Goldman ?) National Partners. Sir, could you comment on yen exchange-rate policy before and after the crisis?

SHIRAKAWA: Yeah.

MCDONOUGH: Nice brief question. (Laughter.) Bravo.

SHIRAKAWA: Okay. The -- immediately after the earthquake, yen -- the -- abruptly appreciated. And it recorded historic high of 76.5 yen to dollar. And several reasons was -- were cited.

One is the -- one is the alleged -- the repatriation by insurers. The argument goes -- (inaudible) -- the -- because of payment due to casualties, life insurers have to sell foreign currency denominated assets. Therefore, yen appreciates. But this story is not unfounded, because the -- first of all, since earthquake is a part of life, the insurance -- usually insurance doesn't cover earthquake. So if the people want to protect themselves from the casualty from earthquake, they have to buy extra insurance. And also, Japanese -- (inaudible) -- upon conservative estimates, the amount of payment due to casualty is not -- (inaudible).

And also, life insurance do have a sizeable amount of the liquid short-term assets. So there is no reason for us -- for them to sell -- (inaudible) -- estimate. So this is one explanation.

The second is reversal of yen (tariff ?) trade position. The -- (inaudible) -- investors uncertainty. Then the people tried to unwind risky position, that is -- (inaudible) -- position.

And third reason is a technical reason: the -- (word inaudible) -- setting of -- (word inaudible) -- setting of margin trading in foreign exchange market.

But anyway, the -- after yen appreciated, the -- we held the G-7 conference call, and we decided on (coordinating ?) the intervention. And after that, yen rebirth: Yen became stabilized.

And what -- so as for your question, we'll ask questions about the (short ?) -- we are concerned about excessive volatility of exchange rate. And that's why we decided on intervention. But other than that, I don't have any comment on exchanges, because I'm a central bank (guy ?). (Laughter.)

MCDONOUGH: Sir.

QUESTIONER: Thank you. Hugh Patrick, Columbia Business School. One projection is that the electricity shortages and erratic supplies will force many small companies in the Tokyo area to go bankrupt, and that this will then lead to -- by the fall to many small banks having extraordinarily high nonperforming loans and going bankrupt themselves.

How likely do you think this is? And if it should happen, what will the Bank of Japan do?

SHIRAKAWA: First of all, the area which was hit hard by (first wave ?) is basically northern part of Japan. And in terms of ratio, the -- in terms of the GDP ratio, it is about 6 percent. And government has already expressed its intention to deploy in the various -- (inaudible) -- for reconstruction and these -- (inaudible) -- programs, the small, medium or small farms protected from the casualties.

And also, Japanese financial institutions strengthened their capital base in the recent years. So I don't think Japanese farms cannot cope with this testing time. But as a central bank -- as a central bank governor -- as a central bank, we are carefully watching how situation evolves. But my short answer to this -- to your question is, I don't think the Japanese financial institution will be faced with serious problem.

QUESTIONER: Andrew Gundlach from Arnhold and S. Bleichroeder. Could you address the energy security of Japan? Will you return as a country, do you believe, to nuclear power in the same way as you were before the crisis, or do you see coal plants, LNG facilities becoming a greater part of the mix?

SHIRAKAWA: As I said previously, I'm not -- I'm not expert on nuclear power plant. And as a citizen, I'm fully aware of the need for discussion. And already some discussion has started. But it's not time for us to think about long-(line ?) policy of power. And it is a stage for rebuilding. It's a stage for the -- rescuing the people. So I think that we have to -- we have to address that issue. But sorry, I can't present the -- I can't present my personal view on the --

MCDONOUGH: Thank you.

The lady in about the eighth or ninth row. I'm pointing my finger right at you, which is rude, but --

QUESTIONER: Chia Leong (sp) from Barclays Capital.

I have a question for you regarding the Central Bank of Japan's position on gold. So -- gold like the precious metal -- do you actually have any plans on buying it any time soon? And why exactly would you be holding a view of either buying or selling?

SHIRAKAWA: (I would care to know ?) how you present this -- present -- I'm going to answer your question, but (I would care to know ?) how you raised this question.

MCDONOUGH: How, or why?

QUESTIONER: Just in regarding to central banks around the world hasn't really -- haven't really bought gold for a very long time, since like the 1980s; and just wondering what your position is in terms of the gold markets and whether you're going to hold more in your reserve.

SHIRAKAWA: OK -- (audio break) -- we don't have any plan to increase the purchase of gold, yeah.

MCDONOUGH: That's pretty concise. (Laughter.)

The gentleman next to the lady who just asked a question.

QUESTIONER: Hi. Jeff Laurenti, with the Century Foundation.

Governor Shirakawa, you a moment ago talked about the life insurance companies being able to insulate themselves from some of the payments because of earthquakes not being counted. To what extent does Japan look to the property insurance companies making some major share of the cost of reconstruction that will be needed? Or are they also off the hook through "act of God" provisions? And to the extent that they are not the major contributors, what receptiveness is there in the Japanese political class to tax increases?

SHIRAKAWA: The casualty insurance covers the losses due to earthquake. And (many build funds ?) by those insurance from casualty insurance. And already the reinsurers -- say, the Swiss Re or Munich Re -- (inaudible) -- have announced their estimate of losses. And according to those estimate, those numbers are rather manageable. And one of the issue is how to cope with the losses due to the nuclear power plant. And this is very contentious issue, and already the fierce debate has started in Japan.

But the law says -- the law said in the -- in the disaster case the government can step in. And the issue is how to interpret these laws. But anyway, the -- one of the issue is how the government is intervening in this area. Yes.

MCDONOUGH: David.

QUESTIONER: David Mullins, QVT Financial.

There's been considerable discussion in the press about the idea of the Bank of Japan directly purchasing reconstruction bonds to help finance the reconstruction.

SHIRAKAWA: Yes.

QUESTIONER: I wonder if you'd like to comment on that.

SHIRAKAWA: OK. In recent week, I am often asked why Bank of Japan is again (sic/against ?) such idea. And but before that, before responding to your question, the -- both government and Bank of Japan are again (sic/against ?) that kind of idea. And it is without any question.

The reason why we are against is, first of all, there is no reason for us to rely on such method, because the -- since the earthquake, the -- we had more than 10 times auction of government bond. And the auction is quite successful; there is no problem at all. After all, Japan is faced with excess saving, and the financial institution or investors are buying JGB at reasonable rate.

And this earthquake and tsunami action shows how important infrastructure is. And one of the basic infrastructures is a stable financial market or stable -- the government bond market, and there is no reason for us to erode this very stable government bond market. And once central bank started underwriting on government bond, it could undermine basic confidence into the currency held by general public.

So we are very much against direct underwriting of government bond. And I think this -- our thought is shared by many ordinary citizens.

MCDONOUGH: Sir.

QUESTIONER: Jeff Shafer, JRShafer Insight. Governor Shirikawa, you focused on, as I would, the impact of the power reduction on the economy, not only now but especially becoming more intense into the summer. And that leads to two questions.

I'm wondering what kind of picture the Bank of Japan is getting, one, of how quickly one will be able to begin to replace this with emergency new power supply. And second, the cutbacks that are required, to what extent will higher prices be the rationing mechanism for that and to what extent will the (new ?) power company and the government rely on rationing and moral suasion for the reductions?

SHIRAKAWA: The government is now working hard to substantiate the exact plan for curtailment of (electric ?) power. And at this time it is not yet decided in concrete terms. But first of all, the government is planning to embark on a law which asks the big users of power to curtail within special amount. If (they're higher ?), then they are penalized. And also, as for middle users, they are asked to present a plan for curtailment of electric power. And for households, they are encouraged to curtail the power. And eventually the (user plan ?) will be announced.

And some people are proposing to use the pricing mechanisms. I don't know whether this pricing mechanism will be introduced or not, but this is one of the ideas.

Along with curtailment of demand, the firms -- every power companies are trying to increase the capacity. So the severest time is this summer. After the summer, the shortage is eliminated. And then the next problem is summer next year. So the issue is to what extent we could effectively curtail demand, and also to what extent we could increase power within next one year and a half.

MCDONOUGH: Yes, sir.

QUESTIONER: (Name inaudible) -- Pace University. How do you explain Japanese deflation? And what are the lessons to be learned for the United States of Japanese monetary policy over the last two decades?

SHIRAKAWA: First of all, I have many things to talk about under the name of deflation. Very often the word of "deflation" is used in describing Japanese economy. Of course we experience deflation, but do you know the exact rate of deflation in Japan?

The consumer price index started to decline in 1998. Since then, cumulative decline of consumer price index is less than 4 percent, less than 4 percent. And when people think about deflation, the deflation which people have in their mind is, say, that in 1930s in this country. The price level declined more than 30 percent in a two-year time window. So -- and the economy contracted very sharply.

But in our case, the level of (economic ?) activity is same, didn't decline. So the image coming from deflation is a bit different from deflation in 1930s in -- as I said.

But having said that, of course it is true that we (expect ?) decline in deflation. And the reason why deflation -- mild deflation occurred in Japan is two. One is decline in trend growth rate of Japan. The -- in the past two decades, the growth rate of Japan is surely, is -- steadily declined. Therefore, people couldn't have the expectation that future income will increase. Therefore, people -- (inaudible) -- spending, which is translated into deflation.

Then the question is how, why, and the growth rate in Japan has decreased. And could you take a look at chart 10 -- or chart nine?

As I briefly touched upon in my remarks, Japan's productivity growth rate is still almost comparable to that of United States, and Japan is the second-best performer in terms of productivity.

But because of rapid aging, the working-age population is decreasing at rapid pace, which is shown in chart 10. Red bar shows decline in number of workers. Since the middle of 1990s, the working-age population started to decline, and this trend is accelerating in year to -- in decade to come.

And that rapid aging means that the more financial burden -- tax burden is shouldered by younger generation or working-age population, which discourage spending.

So the fundamental issues for deflation is how to overcome decline in trend growth rate. And the -- my point is, deflation is a manifestation of more underlying problem facing Japanese economy. So it is not accurate for us to formulate the problem facing Japan in terms of deflation. Rather, we'd like to -- we have to -- we have to formulate the problem in terms of decline in population, decline in the productivity. This is real issue.

And as for the question about monetary policy responses, we've provided massive liquidity into the market, and the -- compared -- contrary to the popular image with Bank of Japan, the Bank of Japan is very aggressive in terms of providing liquidity. Compared with the 1990 -- the latter part of 1990s, our balance sheet has expanded more aggressively than -- compared with U.S. Federal Reserve.

But still this alone could not solve that problem.

So what I'm always telling is we have to redouble the effort to cope with (decline ?) in population and to raise productivity. This is a real issue.

MCDONOUGH: Thank you very much.

Would you join me in congratulating the governor for a wonderful speech, (Applause.)

Thank you very much. Thank you.

Ladies and gentlemen, please join us for a lunch reception immediately following the meeting. And you may pick up a copy of Governor Shirakawa's comments on your way out of the building. Thank you.

Thank you for that. Wonderful. You were terrific.


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WILLIAM J. MCDONOUGH: This meeting is part of our Peter C. McColough Series on International Economics.

Now, here's something very important for you technically oriented Americans. Please completely turn off, not just put on vibrate, your cell phones, your BlackBerrys -- there's a free advertisement -- and all wireless devices, to avoid interference with our sound system.

I'd like to remind the members that this meeting is on the record. You will see that there are a great many people from the press in the back of the room. And we look forward to the coverage that the governor's speech I'm sure will richly deserve.

Governor Shirakawa is a career man at the Bank of Japan. He spent six months as the representative of the Bank of Japan here in New York and was such an enormous success and so admired by the people at the Federal Reserve Bank of New York -- I was president at the time -- that he got promoted back to Japan and has been rising like a rocket ever since.

Governor, we look forward to your remarks. The floor is yours.

MASAAKI SHIRAKAWA: Good morning. Thank you, Bill, for kind introduction. Before I came -- before I stand at this podium, I was invited but not being able to come to New York because of my many, many commitments. But finally I could come, and I feel very relieved by coming to this podium.

I'm very much privileged to have the opportunity to speak before the Council on Foreign Relations today. Before beginning my speech, I would like to extend my heartfelt gratitude to the government and people of the United States for the support and encouragement concerning the tragic Great East Japan Earthquake.

The situation in the area close to the earthquake epicenter, particularly coastal areas that were hit hard by the tsunami, is disastrous. The disaster claimed about 13,000 lives, and more than 15,000 people are still missing. Residents of the area near the Fukushima Daiichi nuclear power plant have been directed to evacuate and are forced to spend restless days and nights in shelters.

In this way, Japan has faced a trying time since earthquake struck. At the same time, however, Japanese society has shown resilience. The work of rebuilding has started to get under way gradually but steadily. In my remarks today, I will talk about the situation in Japan in the months after the earthquake and the work being done to rebuild Japan's economy.

A good place to start is what happened in financial market, the area I am familiar with. The earthquake struck at 2:46 p.m. on Friday, March 11th. At the time, I was being briefed by the staff in preparation for the monetary policy meeting scheduled to be held at the beginning of the following week.

Even in Tokyo, about 250 miles away from the earthquake epicenter, the shaking from the earthquake was the strongest that I have -- I had ever experienced, and continued for more than two minutes. The earthquake's magnitude at the epicenter was 9.6, which makes it the largest on record in Japan. And energy released was enormous, which is depicted in chart one.

Based on previously formulated emergency procedures, the Bank of Japan immediately set up a disaster management team with me as head. This task was completed 14 minutes after the earthquake struck. The most important thing for a central bank during a crisis is to ensure stability of settlement system and financial markets. The Bank of Japan financial network system, or BOJ-NET, Japan's core settlement system for (bonds ?) and government securities, has been operating without any problems the entire time since earthquake struck.

The Bank of Japan Fukushima branch, which is about 14 miles away from the Fukushima Daiichi nuclear power plant, has been conducting its business as usual and has been providing cash, including on the weekend immediately after the earthquake. Financial market stability has been maintained. I would also note that trading on the Tokyo stock exchange has been perfectly normal.

Looking beyond the (world ?) of settlement system and financial market, the people in disaster areas have been calm and composed and (full of a state ?) of mutual cooperation despite such a difficult living environment. In Tokyo, although electricity shortages are causing some inconvenience, people have accepted these new realities and adopted immediately. One of the visible change is that people are increasingly deciding themselves to cancel parties or other event as a mark of respect to the victim(s) of the disaster and out of consideration for the feelings of people affected. Another change is a substantial decline in visitors from overseas.

Now let me turn to the effects on Japanese economy of the disastrous events: namely, the earthquake, tsunami and nuclear accident. Something that has not been recognized so much is that Japan's economy in 2010 performed best among G-7 economies in terms of both growth rate and unemployment, which is depicted in chart two.

The disaster occurred at a time when Japan's economy was gradually returning to a recovery path, albeit a moderate one. In the short run, it is inevitable that earthquake will significantly affect production and other economic activity through its damage to supply capacity. The four prefectures most affected by the earthquake and tsunami in total account for about 6 percent of Japan's GDP.

In the case of Kobe earthquake, which occurred in January 1995, real GDP did not decline even in the quarters when the earthquake occurred. In contrast, the March 11th earthquake will have a greater impact on production for the following reasons.

First, this was not just an earthquake that was huge in magnitude and geographically widespread. It also triggered tsunami, which together with the earthquake caused a nuclear accident. Second, how to replace parts and materials produced in factories in the disaster areas are integral to supply chains. A typical example is electronic parts, the shortage of which has been having a severe impact on automotive production even in nonaffected areas.

The effect might go beyond the domestic sphere. The economies of Japan, China and the United States have become interdependent, in that Japan produces the parts, China assembles them and the United States develops the finished consumer products. Therefore, the impact on supply chain could spread internationally.

Third, Japan's power shortage facilities -- third, Japan's power generating facilities have been significantly impaired. The problem associated with nuclear power generation have been a subject of intense scrutiny due to the accident at Fukushima Daiichi nuclear power plant, but it is worth noting that the earthquake also caused serious damage to Samaw (ph) power plant, which is depicted in chart five and six.

Measures are currently being taken to curtail demand through various efforts, such as asking business and household to conserve electricity, and at the same time, steps are being taken to restore generating capacity. The power shortage will be temporarily eased due to seasonal factors, but electricity could run short again in Tokyo Electric Power Company -- TEPCO's service area when demand peaks in the summer.

For historical reasons, Japan has two frequency domains, and there is little room for surface electricity to be delivered across domains. The impact of such supply constraint will be serious in the short term, but at the same time we should remember that the impact of the disaster can be mitigated by human wisdom and determination.

Let me give you two examples of how the impact is being and will be mitigated.

First, top priority is now being pressed on fixing the production and supply bottleneck of parts and materials, with the cooperation of firms using them. At the same time, we are now seeing signs that alternate production has started in domestic factories located in places other than the affected areas. And on the electricity front, efforts are being made to devise effective measures for curtailing energy use during the high-demand period in summer when electricity could run short.

Second, as time passes, demand will also emerge for restoring damaged capital stock, such as roads, factories and houses. While it is difficult to accurately forecast the amount and time (passed ?) of rebuilding demand, the amount of damage to capital stock due to the earthquake and tsunami will be about 3 (percent) to 5 percent of nominal GDP, and 1 (percent) to 2 percent of total capital stock, according to government estimate, which is depicted in chart seven.

Taking these factors into account, most private economists believe that Japan's GDP growth rate will turn positive again from the third quarter of 2011, onward. Moreover, from a long-term perspective, new demand is expected to emerge. For example, the recent experience of disruption to supply chains has made us aware of a concentration of risks in particular region or with respect to particular firm. This new awareness, through a rethinking of business strategies, could generate new investment in, for example, computer centers and distribution depots.

The action at Fukushima Daiichi nuclear power plant has triggered active global discussion on nuclear power policy, which will highlight the importance of energy conservation and environmental technologies. And Japanese firms have an edge in those areas, such as high-end batteries. There will be great room for them to make contributions.

Various challenge lies ahead on the road to overcoming the adverse effect of the earthquake and rebuilding Japan's economy. The first challenge is ensuring the necessary financing for rebuilding. In this regard, Japan has had an excess of saving over investment for a protracted period, which means that from the macroeconomic perspective this financing will not be difficult.

Japan's capacity for foreign (connective ?) funding is extremely strong, given the -- given that the country is the biggest creditor nation in the world, with net external asset of 2.9 trillion U.S. dollar, or 57 percent of nominal GDP. Private financial institutions are fully able to meet an increase in financing demand for rebuilding. Meanwhile, Japanese government bond have been issued quite smoothly, and long-term interest rates have remained stable at low levels, compared with other countries. As long as Japan continues to work tirelessly towards rebuilding, it is unlikely financing problem will arise.

The second challenge is raising Japan's potential growth rate. Since 2000, Japan has had -- Japan has had -- is one of the highest GDP growth rate per worker among G-7 countries, although slightly lower than the United States. This is depicted in chart nine. However, the decline in the working-age population in Japan is proceeding at a pace that has no precedent in modern economic history, which is depicted in chart 10.

As a result, Japan's economic growth has been on a downward trend. Raising the potential growth rate was the biggest challenge for Japan's economy, even before the earthquake. But the effort to do so by raising both the labor participation rate and productivity have now become all the more important. As Japan seeks to build its economy, efforts to raise the potential growth rate have become even more important. These are certainly not easy challenges, but we have to take them on with greater determination.

Finally, let me briefly touch upon the Bank of Japan's response after the earthquake struck. As was the case in the financial market immediately after the failure of Lehman Brothers, when people's lives and safety are at risk, they sometimes tend to become excessively risk averse, which makes things worse. Incidentally, while foreign nationals residing in Tokyo increasingly left Japan for fear of radiation risk, it has tended to be overlooked that the radiation level in Tokyo are roughly the same as in other major cities around the world, such as Paris (and Bahrain ?), or they were exposed to more radiation on the airplane than they would have been exposed to in Tokyo.

In the money market, financial institutions -- (word inaudible) -- demand for liquidity surged. Rumors have spread among the foreign financial community that the Tokyo financial market would close due to fears of radiation risk. The Bank of Japan has been asked whether there was any truth to the rumor that the Bank of Japan was planning to retreat to a backup site in the western part of Japan. Of course, these rumors were and are groundless. As I said, the financial infrastructure are fully functional and there is no reason for us to relocate from Tokyo.

In such times, the first priority is ensuring calms among market participants. And in this regard, the Bank of Japan has provided ample liquidity on an unprecedented scale day after day. The very next business day after the earthquake, we decided to significantly increase the amount of its asset purchase mainly of the risk asset, with a view to preventing any determination in business sentiment or excessive increase in risk aversion from adversely affecting economic activity.

As a result of these measures, financial market, which became (somewhat jittery ?) in the period immediately after the earthquake occurred, have regained stability. Needless to say, the Bank of Japan's mission is to ensure price and financial system stability, thereby contributing to the sustainable growth of Japan's economy.

We will continue to take appropriate measures as a central bank in order to achieve this mission. As I mentioned earlier, nothing is more heartening in a crisis than the encouragement and support of friends overseas.

I would like to conclude by thanking you once again for your friendship with -- friendship. With the resilience of Japanese society and the determination to rebuild, I am absolutely convinced that Japan's economy will overcome this trying time, successfully rebuild, and become even better place with grater growth potential.

With that, I would like to conclude my remarks. Thank you for your attention. (Applause.)

MCDONOUGH: Governor, thank you very much for that excellent presentation and very informative one.

You have been talking with your counterparties in other countries, and Japan is always very keyed in to the world economy. How do you see the effect of the earthquake on the global supply chain, and especially on the average -- the likely growth rate for the rest of this year in the rest of the world?

SHIRAKAWA: Thank you. Tsunami -- the earthquake and tsunami hit many production facilities in the northern part of Japan. The most crucial is on the damage of -- on the production of electric devices such as microcomputer, which is a critical component for automobiles and the portable terminal such as smartphones. Since such products are so integral, as I said, it could affect supply chains both domestically and globally.

Japan's car industry is well-known for its just-in-time inventory-adjustment model. By adopting such models, the level of inventory is kept at bare minimum. Just-in-time inventory model is so efficient, but by nature, it can't cope with the sudden loss of critical suppliers. The -- following the disaster, the Japanese automakers have shut down their production. And thus, exports declined. The -- just recently, only a handful of automakers resumed its operation; although the -- (inaudible) -- is very limited.

The -- in contrast, Japanese automakers in overseas countries have -- did not stop its operations up until recently, partly because of -- partly because they could count on local input and partly because -- I would say, because they could use stockpiling from imported material from Japan. But result, inventory is dwindling. They are now faced with difficulties; and therefore, they have started to cut production slightly. And so the (narrative ?) externally also felt by the European carmakers and American carmakers as well.

Concerns about -- supply concerns are also apparent for such electronic devices as smartphones. And some of the manufacturers of these products are turning to Korean and Taiwanese carmakers. And my reading of the situation is damage on supply chain is a case of -- the (effects on ?) devices are less severe compared to the damage on automobile production.

The -- these episodes point to the -- (inaudible) -- and the (weakness ?) of supply chain nexus involving Japanese firms. The Japanese firms produce highly original and differentiated product. For that reason, for the time being, the Japanese manufacturers have no choice but to lose out to foreign competitors. But they are working hard; they are working 24/7. And they are trying to rebuild their factories.

So the -- also they are committed to providing a top-quality product. So I believe that Japanese firms are able to revitalize themselves. And the exact timing of recovery of supply chain is uncertain. Some people say it will be June or July. And some others say it takes (different ?) time. I don't know. But the people are working hard.

And finally, let me say a few works on the effect on global economy. I don't think the damage on Japanese firms has a lasting impact on global economies, because rival firms are also providing these parts. Therefore, I don't think this will have a serious -- significant impact on global economy.

MCDONOUGH: Well, thank you very much.

If you try to isolate the various parts of it -- the earthquake, the tsunami and the damage to the nuclear plant --

SHIRAKAWA: Yeah.

MCDONOUGH: -- concentrating on the nuclear plant situation, how do you see that affecting the Japanese economy and for how long?

SHIRAKAWA: OK. First of all, the crisis at nuclear power station is still continuing, and we (freely ?) recognize this is a serious problem for Japan and globally. But let me assure you that government and TEPCO are also doing everything within their capacity to bring the station under control.

Since I'm a central banker, I don't claim on the expert on nuclear power plant or radiation risk or things of that sort. I try to focus on economic impact of this event. It affects the -- both supply side and demand side of the economy.

I start -- I'd like to start with supply side. The impact could be classified into two. One is the impact on the power -- the power. The -- we have to live with the substantial cuts in power for extended period of time, although the economic severity depends on the season. In summer season, the shortage is very serious, and every institution in Japan is now asked to cut peak demand by 25 percent, and -- (audio break) -- Japan is of course subject to such deep cutting, sort of -- so my colleagues at the bank are -- is working hard how to curtail demand by 25 percent. And when you visit Japan, you will be surprised how dark our office is already.

MCDONOUGH: So you're serving as a model for everybody else?

SHIRAKAWA: Yeah.

MCDONOUGH: (Chuckles.)

SHIRAKAWA: And -- but as I said, this is not all Japan's problem. The TEPCO is covering about 40 percent of electricity consumption. And for (political ?) reason, we have two frequency in domain. In the late 19th century, we imported power-generating technology from two countries: one, from Germany, where -- one from Germany. And this system is put in eastern part of Japan.

In the -- in western part of Japan, the American company exported. And the problem with this dual system is the intraregional transfer of electricity can be -- (inaudible) -- and therefore the -- we -- people living in Tokyo are (severely damaged ?), but the -- in western part in terms of electricity, everything is normal. So some people are now shifting the production from east to west.

And second effect on supply is the evacuation zone. The Japanese government has set up the evacuation zone, which spans 20 kilometers around the dysfunctional atomic power plants. Needless to say, economic activity in that evacuation area is impossible.

On demand side, the concern of radiation exposure have affected -- (inaudible) -- of agricultural product and seafood product from that affected area. Understandably, consumers are sensitive to the safety of the food. But at the same time, lack of accurate information tend to cause overreaction.

Also, fear of Japan's radiation diffuse is felt beyond our national borders. As I said, the foreign tourists decrease a lot, and for people outside Japan, the distance between Tokyo and Fukushima is not that clear. But actually the distance between Tokyo and -- the difference between Washington and (Three Miles ?) is further than the distance between Tokyo and Fukushima nuclear power plant.

But anyway, the people are scared, so the sharp drop in foreign -- and which is also affecting economic activity.

And also some people are -- the general sentiment among business and households are eroding.

MCDONOUGH: Right.

SHIRAKAWA: Yeah. So this had impact on --

MCDONOUGH: My last question: Your view on the relationship between the Japanese economy and the Chinese economy. I would think, as close as you are to China, you could see it either as a significant opportunity or quite a threat.

SHIRAKAWA: Yes. Yeah. My short answer to your question is, it's opportunity.

MCDONOUGH: Right.

SHIRAKAWA: Yeah. The existence of China as a global economic powerhouse is a big advantage for Japan. I hope that China will stay on -- continue to stay on sustainable growth path going (afoot ?) -- going ahead.

Last year China's GDP surpassed Japan's growth in GDP. Also, the -- albeit by a very narrow margin. After all, China's population is 10 times larger than that of Japan, and the per capita income in China is one-tenth of Japan's. And the -- to guard against media hype, we should keep this simple arithmetic in mind. The primary objective of economic policy is not outperform the peer. The challenge for us -- the challenge for -- (inaudible) -- people is to reverse the downward trend in growth rate, as I said in my speech.

The -- seen in this light, the growing presence of Chinese economy is in Japan's interest as well. In fact, Japan has a large trade surplus with China.

Let me highlight two dimensions of Japan's China economic ties. First, they are mutually beneficial in that Japan produce parts and China assemble those parts. Second, China's growing domestic market presents a great opportunity for Japanese manufacturers. Due to geographical proximity, this is a great advantage for Japanese firms.

Let me also (think of ?) this issue in historical context. Japan -- Japan's GDP surpassed that of West Germany in 1968, and the next year we hosted the Olympic Games in Tokyo. In those years of high growth for Japan, based upon the usual metrics, such as per capita income, the ratio of agricultural population or the -- and the degree of urbanization, and the current China is the same as -- resembles what Japan was in middle 1960s.

That means that we can tell various lessons to Chinese people. And it is very hard for a country to smoothly move to less -- a bit lower growth rate. In that regard, we were not as successful, say, in the bubble or financial crisis, et cetera, and also we are now coping with a declining population. So all in all, we can tell our experience to Chinese people.

Thank you.

MCDONOUGH: Wonderful.

SHIRAKAWA: Yeah.

MCDONOUGH: It's a very positive view.

SHIRAKAWA: Yeah.

MCDONOUGH: At this time I'd like to invite members to join our conversation with your questions. When called upon, would you please stand, wait for the microphone, and state your name and affiliation. And please limit yourself to one question. A question is something that doesn't make a statement. It ends with a rising inflection -- (laughter) -- (inaudible) -- brief.

Who would like to ask the first question? Sir. Wait till the mic gets to you.

QUESTIONER: I'm Allen Sinai of Decision Economics. You touched on the demand side. My question is demand side and reaction on macropolicy of the Bank of Japan. If it's worse than what you said -- Japanese consumer is cautious; has been -- why won't the Japanese consumer in this -- aftermath of this episode be even more cautious, cut back on spending?

And if that were to happen -- tell me if there's evidence of this hypothesis -- how does the Bank of Japan react and the government of Japan react when deficits are so high relative to GDP, growing debt -- sorry about the --

MCDONOUGH: (Off mic) -- et cetera.

QUESTIONER: (Off mic) -- got to get bigger. And so what does the Bank of Japan do and the government of Japan if it's a worse macroeconomic result, as you seem to imply by your remarks?

MCDONOUGH: Well, thank you for that very long question. And let it be a model for how long your questions shouldn't be. (Laughter.)

QUESTIONER: Too much -- (off mic).

SHIRAKAWA: Thank you, Allen. The best way to answer your question is to compare the current event with the shock -- Lehman shock. In the case of Lehman shock, all of a sudden, demand evaporated because of the erosion of financial system. And this time around, demand is still there. The global economy is expanding. So potentially demand is there. And we are now faced with a sudden supply shortage. So once the principal -- once the supply constraint disappears, then potential demand is coming.

So the issue is how to bridge between now and then -- now and future. And on our part, we were -- we wanted to avoid the case in which the weak sentiment itself could affect the economic activity. Therefore, on the next business day after earthquake, we decided on increasing the purchase of risky assets such as corporate bonds, commercial paper, exchange rate funds and -- et cetera.

And in a crash, people rush for safe assets, namely government bonds. But people try to avoid purchasing risky assets. Therefore, we decided on that. In addition, we provided massive liquidity into the market. And so this is our response so far. And the situation is evolving. And we are carefully watching how situation evolves, but what we are doing is to ease uncertainty. And in the meantime, the private agents are endeavoring to restore damaged capability. And also, government is now -- government has already expressed its will to embark on -- (inaudible) -- for rebuilding of the economy.

MCDONOUGH: Sir. You're -- stand up. That's it, you. Thank you.

QUESTIONER: Thank you. (Name inaudible) -- from (Goldman ?) National Partners. Sir, could you comment on yen exchange-rate policy before and after the crisis?

SHIRAKAWA: Yeah.

MCDONOUGH: Nice brief question. (Laughter.) Bravo.

SHIRAKAWA: Okay. The -- immediately after the earthquake, yen -- the -- abruptly appreciated. And it recorded historic high of 76.5 yen to dollar. And several reasons was -- were cited.

One is the -- one is the alleged -- the repatriation by insurers. The argument goes -- (inaudible) -- the -- because of payment due to casualties, life insurers have to sell foreign currency denominated assets. Therefore, yen appreciates. But this story is not unfounded, because the -- first of all, since earthquake is a part of life, the insurance -- usually insurance doesn't cover earthquake. So if the people want to protect themselves from the casualty from earthquake, they have to buy extra insurance. And also, Japanese -- (inaudible) -- upon conservative estimates, the amount of payment due to casualty is not -- (inaudible).

And also, life insurance do have a sizeable amount of the liquid short-term assets. So there is no reason for us -- for them to sell -- (inaudible) -- estimate. So this is one explanation.

The second is reversal of yen (tariff ?) trade position. The -- (inaudible) -- investors uncertainty. Then the people tried to unwind risky position, that is -- (inaudible) -- position.

And third reason is a technical reason: the -- (word inaudible) -- setting of -- (word inaudible) -- setting of margin trading in foreign exchange market.

But anyway, the -- after yen appreciated, the -- we held the G-7 conference call, and we decided on (coordinating ?) the intervention. And after that, yen rebirth: Yen became stabilized.

And what -- so as for your question, we'll ask questions about the (short ?) -- we are concerned about excessive volatility of exchange rate. And that's why we decided on intervention. But other than that, I don't have any comment on exchanges, because I'm a central bank (guy ?). (Laughter.)

MCDONOUGH: Sir.

QUESTIONER: Thank you. Hugh Patrick, Columbia Business School. One projection is that the electricity shortages and erratic supplies will force many small companies in the Tokyo area to go bankrupt, and that this will then lead to -- by the fall to many small banks having extraordinarily high nonperforming loans and going bankrupt themselves.

How likely do you think this is? And if it should happen, what will the Bank of Japan do?

SHIRAKAWA: First of all, the area which was hit hard by (first wave ?) is basically northern part of Japan. And in terms of ratio, the -- in terms of the GDP ratio, it is about 6 percent. And government has already expressed its intention to deploy in the various -- (inaudible) -- for reconstruction and these -- (inaudible) -- programs, the small, medium or small farms protected from the casualties.

And also, Japanese financial institutions strengthened their capital base in the recent years. So I don't think Japanese farms cannot cope with this testing time. But as a central bank -- as a central bank governor -- as a central bank, we are carefully watching how situation evolves. But my short answer to this -- to your question is, I don't think the Japanese financial institution will be faced with serious problem.

QUESTIONER: Andrew Gundlach from Arnhold and S. Bleichroeder. Could you address the energy security of Japan? Will you return as a country, do you believe, to nuclear power in the same way as you were before the crisis, or do you see coal plants, LNG facilities becoming a greater part of the mix?

SHIRAKAWA: As I said previously, I'm not -- I'm not expert on nuclear power plant. And as a citizen, I'm fully aware of the need for discussion. And already some discussion has started. But it's not time for us to think about long-(line ?) policy of power. And it is a stage for rebuilding. It's a stage for the -- rescuing the people. So I think that we have to -- we have to address that issue. But sorry, I can't present the -- I can't present my personal view on the --

MCDONOUGH: Thank you.

The lady in about the eighth or ninth row. I'm pointing my finger right at you, which is rude, but --

QUESTIONER: Chia Leong (sp) from Barclays Capital.

I have a question for you regarding the Central Bank of Japan's position on gold. So -- gold like the precious metal -- do you actually have any plans on buying it any time soon? And why exactly would you be holding a view of either buying or selling?

SHIRAKAWA: (I would care to know ?) how you present this -- present -- I'm going to answer your question, but (I would care to know ?) how you raised this question.

MCDONOUGH: How, or why?

QUESTIONER: Just in regarding to central banks around the world hasn't really -- haven't really bought gold for a very long time, since like the 1980s; and just wondering what your position is in terms of the gold markets and whether you're going to hold more in your reserve.

SHIRAKAWA: OK -- (audio break) -- we don't have any plan to increase the purchase of gold, yeah.

MCDONOUGH: That's pretty concise. (Laughter.)

The gentleman next to the lady who just asked a question.

QUESTIONER: Hi. Jeff Laurenti, with the Century Foundation.

Governor Shirakawa, you a moment ago talked about the life insurance companies being able to insulate themselves from some of the payments because of earthquakes not being counted. To what extent does Japan look to the property insurance companies making some major share of the cost of reconstruction that will be needed? Or are they also off the hook through "act of God" provisions? And to the extent that they are not the major contributors, what receptiveness is there in the Japanese political class to tax increases?

SHIRAKAWA: The casualty insurance covers the losses due to earthquake. And (many build funds ?) by those insurance from casualty insurance. And already the reinsurers -- say, the Swiss Re or Munich Re -- (inaudible) -- have announced their estimate of losses. And according to those estimate, those numbers are rather manageable. And one of the issue is how to cope with the losses due to the nuclear power plant. And this is very contentious issue, and already the fierce debate has started in Japan.

But the law says -- the law said in the -- in the disaster case the government can step in. And the issue is how to interpret these laws. But anyway, the -- one of the issue is how the government is intervening in this area. Yes.

MCDONOUGH: David.

QUESTIONER: David Mullins, QVT Financial.

There's been considerable discussion in the press about the idea of the Bank of Japan directly purchasing reconstruction bonds to help finance the reconstruction.

SHIRAKAWA: Yes.

QUESTIONER: I wonder if you'd like to comment on that.

SHIRAKAWA: OK. In recent week, I am often asked why Bank of Japan is again (sic/against ?) such idea. And but before that, before responding to your question, the -- both government and Bank of Japan are again (sic/against ?) that kind of idea. And it is without any question.

The reason why we are against is, first of all, there is no reason for us to rely on such method, because the -- since the earthquake, the -- we had more than 10 times auction of government bond. And the auction is quite successful; there is no problem at all. After all, Japan is faced with excess saving, and the financial institution or investors are buying JGB at reasonable rate.

And this earthquake and tsunami action shows how important infrastructure is. And one of the basic infrastructures is a stable financial market or stable -- the government bond market, and there is no reason for us to erode this very stable government bond market. And once central bank started underwriting on government bond, it could undermine basic confidence into the currency held by general public.

So we are very much against direct underwriting of government bond. And I think this -- our thought is shared by many ordinary citizens.

MCDONOUGH: Sir.

QUESTIONER: Jeff Shafer, JRShafer Insight. Governor Shirikawa, you focused on, as I would, the impact of the power reduction on the economy, not only now but especially becoming more intense into the summer. And that leads to two questions.

I'm wondering what kind of picture the Bank of Japan is getting, one, of how quickly one will be able to begin to replace this with emergency new power supply. And second, the cutbacks that are required, to what extent will higher prices be the rationing mechanism for that and to what extent will the (new ?) power company and the government rely on rationing and moral suasion for the reductions?

SHIRAKAWA: The government is now working hard to substantiate the exact plan for curtailment of (electric ?) power. And at this time it is not yet decided in concrete terms. But first of all, the government is planning to embark on a law which asks the big users of power to curtail within special amount. If (they're higher ?), then they are penalized. And also, as for middle users, they are asked to present a plan for curtailment of electric power. And for households, they are encouraged to curtail the power. And eventually the (user plan ?) will be announced.

And some people are proposing to use the pricing mechanisms. I don't know whether this pricing mechanism will be introduced or not, but this is one of the ideas.

Along with curtailment of demand, the firms -- every power companies are trying to increase the capacity. So the severest time is this summer. After the summer, the shortage is eliminated. And then the next problem is summer next year. So the issue is to what extent we could effectively curtail demand, and also to what extent we could increase power within next one year and a half.

MCDONOUGH: Yes, sir.

QUESTIONER: (Name inaudible) -- Pace University. How do you explain Japanese deflation? And what are the lessons to be learned for the United States of Japanese monetary policy over the last two decades?

SHIRAKAWA: First of all, I have many things to talk about under the name of deflation. Very often the word of "deflation" is used in describing Japanese economy. Of course we experience deflation, but do you know the exact rate of deflation in Japan?

The consumer price index started to decline in 1998. Since then, cumulative decline of consumer price index is less than 4 percent, less than 4 percent. And when people think about deflation, the deflation which people have in their mind is, say, that in 1930s in this country. The price level declined more than 30 percent in a two-year time window. So -- and the economy contracted very sharply.

But in our case, the level of (economic ?) activity is same, didn't decline. So the image coming from deflation is a bit different from deflation in 1930s in -- as I said.

But having said that, of course it is true that we (expect ?) decline in deflation. And the reason why deflation -- mild deflation occurred in Japan is two. One is decline in trend growth rate of Japan. The -- in the past two decades, the growth rate of Japan is surely, is -- steadily declined. Therefore, people couldn't have the expectation that future income will increase. Therefore, people -- (inaudible) -- spending, which is translated into deflation.

Then the question is how, why, and the growth rate in Japan has decreased. And could you take a look at chart 10 -- or chart nine?

As I briefly touched upon in my remarks, Japan's productivity growth rate is still almost comparable to that of United States, and Japan is the second-best performer in terms of productivity.

But because of rapid aging, the working-age population is decreasing at rapid pace, which is shown in chart 10. Red bar shows decline in number of workers. Since the middle of 1990s, the working-age population started to decline, and this trend is accelerating in year to -- in decade to come.

And that rapid aging means that the more financial burden -- tax burden is shouldered by younger generation or working-age population, which discourage spending.

So the fundamental issues for deflation is how to overcome decline in trend growth rate. And the -- my point is, deflation is a manifestation of more underlying problem facing Japanese economy. So it is not accurate for us to formulate the problem facing Japan in terms of deflation. Rather, we'd like to -- we have to -- we have to formulate the problem in terms of decline in population, decline in the productivity. This is real issue.

And as for the question about monetary policy responses, we've provided massive liquidity into the market, and the -- compared -- contrary to the popular image with Bank of Japan, the Bank of Japan is very aggressive in terms of providing liquidity. Compared with the 1990 -- the latter part of 1990s, our balance sheet has expanded more aggressively than -- compared with U.S. Federal Reserve.

But still this alone could not solve that problem.

So what I'm always telling is we have to redouble the effort to cope with (decline ?) in population and to raise productivity. This is a real issue.

MCDONOUGH: Thank you very much.

Would you join me in congratulating the governor for a wonderful speech, (Applause.)

Thank you very much. Thank you.

Ladies and gentlemen, please join us for a lunch reception immediately following the meeting. And you may pick up a copy of Governor Shirakawa's comments on your way out of the building. Thank you.

Thank you for that. Wonderful. You were terrific.


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