Deflation and the Bank of Japan
by Adam S. Posen, Peterson Institute for International Economics
Op-ed from "Business Insights"
The Japan Times
September 23, 2002
© Japan Times
I am treating this as a separate topic because several Japanese business leaders indicated to me during my July 2002 visit that they are lobbied hard by the Bank of Japan (BOJ) to accept the BOJ's current position, and that they are very concerned about these issues. The recent proposals of the Koizumi Government for economic stimulus also acknowledge the conflict over the potential role for expansionary monetary policy as part of a policy package. Japanese business and government are right to be very concerned about deflation: deflation makes all economic problems worse, particularly the bad debt problem, and interferes with structural reform. The longer deflation is allowed to go on, the more difficult it is to reverse it, and the harder it is to control.
Yet, it is a simple fact that no one responsible outside of the BOJ believes that the Bank is pursuing the right policies now, or that they have been in recent years. The Federal Reserve does not-see the recent working paper they published in June 2002. The IMF does not—see the recent Article IV consultation report they just published. The US Government does not—see the recent speeches of CEA Chairman Glenn Hubbard. Reputable academic economists do not-see the recent writings of Takatoshi Ito from Japan or of Lars Svensson of Sweden or of Ben Bernanke from the United States, to cite three of the most important monetary economists in the world today (articles and citations are available in Japan's Financial Crisis and Its Parallels with US Experience). Any claims that the BOJ makes that responsible people have support for its position are false, just propaganda.
The Bank of Japan’s September 19 announcement that it planned to purchase ¥8 trillion of nonfinancial shares from a limited number of banks does nothing to change the deflationary dynamic. When the Bank’s monthly quantitative target for the outstanding balance of the current accounts at the Bank is ¥10 trillion to ¥15 trillion, and that is insufficient to expand credit and raise prices, there is no reason to think that injecting ¥8 trillion spread over a period of six months would constitute meaningful monetary expansion. In fact, the BOJ gave no indication that it will print yen in order to make these purchases, and if it simply swaps Japanese government bonds (JGBs) for equities on its balance sheet, it has no monetary effect at all. Governor Masaru Hayami admitted as much by stating that the share purchase proposal is solely for financial stability reasons and not to change monetary policy. If this proposal is to have an impact, it will be as the initial round in a negotiation with the Japanese government over a new policy package, and we can hope for a good outcome. But without additional monetary policy action from the BOJ, deflation will continue.
There is good reason why no one outside of the BOJ supports its policies. They are misguided, harmful to Japan and to the world economy, and without economic foundation. The leadership in Japanese politics and business must confront the BOJ as strongly as it can to make the Bank take the steps needed to end deflation. They can do so politically by publicly stating:
"According to law, the mandate of the Bank of Japan is to provide price stability. Since the price level has been declining for the last five years, we need an equal number of point-years of positive inflation to restore price stability. All responsible observers believe that the Bank of Japan can create this much inflation if it committed to do so. Therefore, the Bank of Japan must deliver a low positive rate of inflation over the medium-term to fulfill its mandate. If the current Monetary Policy Committee does not deliver these results, whether through incompetence or unwillingness, it should take responsibility for its failure to live up to its legal obligation to the people of Japan and resign."
Of course, in hopes of preventing such pressure, the Bank of Japan offers several incorrect arguments as to why they should not stop deflation, why they cannot stop deflation, or why they would cause harm by creating inflation. All of these are easily disproved, and their arguments should be challenged.
False argument # 1: Deflation, for the most part, is beneficial because it is driven by deregulation, technology, and imports.
True response # 1: If prices were declining due to these good reasons, prices only in those sectors directly affected would decline. The decrease in relative prices of those goods would lead people to feel richer and spend more, as it did in the United States in the 1990s when these forces were at work in our economy. It would not lead to a general decline in the overall level of prices, and a decrease in consumer spending, as we have seen in Japan.
False argument # 2: Zero interest rates or looser policy would keep inefficient businesses open.
True response # 2: In a recession, it is new businesses, growing or potential start-ups, which are disproportionately excluded from credit. Old, established, inefficient businesses continue to get credit, especially if the banks are already undercapitalized. By refusing to loosen policy, the BOJ is making structural problems in Japan worse, not better.
False argument # 3: Monetary conditions in Japan are already loose with zero interest rates.
True response # 3: What matter are real interest rates, not nominal ones. With deflation, the nominal zero interest rate in Japan is actually a real interest rate of more than 2 percent, which is high for a recession. Very few new businesses are being started, and wide credit spreads between types of borrowers are other indications that credit markets in Japan now are tight (except for those aforementioned old, already bankrupt companies who can force the undercapitalized banks to keep rolling over loans).
False argument # 4: The BOJ is already doing everything it can to create money and credit.
True response # 4: The BOJ could either print more yen and buy more JGBs, or buy more foreign currency without sterilizing that intervention, or even buy other yen-denominated assets. All of these would increase liquidity if done on a large enough scale.
False argument # 5: Further expansion will not be effective because banks will not lend.
True response # 5: The difficulties of the banking system are why the BOJ should engage in market operations to purchase nonbank assets like JGBs, dollars/euros, or commercial paper, or, even better, the BOJ should directly fund tax cuts/bank recapitalization by monetizing public debt. This will require larger purchases to have the same effect than if the banking system were functional, and the timing and size of the effect will be harder to predict than if the banking system were functional, but it will definitely have an expansionary effect in the end.
False argument # 6: If the BOJ announces a target, it will miss it, and this will harm credibility.
True response # 6: Central banks announce targets and miss them all of the time, with no real effects, so long as the intent to hit the target is credible, and the target is reasonable. Look at the Bundesbank (pre-euro) or the Swiss National Bank, both of which are extremely credible, who missed their monetary targets 50 percent of the time. Running a deflationary policy is far more harmful to credibility than missing a clearly justifiable target. Attacks by the BOJ on "inflation targeting" are a straw man anyway--the point is to raise the price level and inflation expectations, and inflation targeting is just one means of doing so. What is important is changing the BOJ's goal.
False argument # 7: To stay independent, the BOJ cannot give in to the
True response # 7: The point of central bank independence is to be able to refuse unreasonable or politically motivated government requests-the point of independence is not to refuse any and all requests. Refusing to work with the government to pursue a constructive policy just so it does not appear as though the central bank is cooperating is self-defeating. Look at how successfully the Fed under Greenspan cooperated with the US Treasury under Rubin.
False argument # 8: If we monetize JGBs and give the government money, they will waste it.
True response # 8: Perhaps, but even wasted government spending is better than deflation. In any event, it is possible to structure what the government does with the money (like my proposal of a one-time bond issue to recapitalize the banks after closures and nationalization, which the BOJ would purchase, but which would limit both the amount and the usage of the money in the government's hands). That is what political oversight and fiscal-monetary cooperation are about.
False argument # 9: If we monetize JGBs, interest rates will rise and the banks will be wiped out.
True response # 9: The banks should be wiped out-they have hidden their losses in their JGB holdings, and have created a bubble of low JGB interest rates by parking their "assets" there. Only a public recapitalization, wiping out past shareholders, will fix the problem. If you want to save the banks, do it with financial reform, not with monetary policy. For the functioning of the Japanese financial system overall, there is much to be gained from inflation inducing an upward-sloping yield curve and above-zero nominal interest rates, including increased bank profits and lending. Meanwhile, real interest rates would decline because real rates never rise one-for-one with inflation at low levels of inflation, so investment would increase.
False argument # 10: If we start to create inflation, it will get out of control, and hyperinflation will result.
True response # 10: Of all of the BOJ's false arguments, this is the most laughable. If the BOJ wants to spend its time telling people that it would be difficult to create inflation, then they cannot simultaneously claim that inflation will easily get out of control. The simple fact is that all the evidence from all countries is that inflation and inflation expectations are very sticky (inertial), especially when starting from low rates of inflation. There has never been a country that has gone directly, let alone quickly, from deflation to hyperinflation. The only times hyperinflation occurs is either when a country loses a war or when the government loses its ability to collect taxes due to social breakdown. Neither is going to happen in Japan. High government debt levels alone are not enough to cause hyperinflation-look at Belgium and Italy which in the recent past had similar debt levels to that of Japan today, with more debt owed to foreigners, and neither country experienced hyperinflation. In fact, both countries have had inflation below 10 percent for over 10 years. This is simply a scare tactic that no one should believe.