by Adam S. Posen, Peterson Institute for International Economics
Article excerpted in the Nihon Keizai Shimbun Economic Commentary
February 10, 1999
© Peterson Institute for International Economics
The recent rise in long-term Japanese government bond rates has become the overwhelming focus of economic attention. The increase on the 10-year bond rate from 0.75% to over 2% in the space of a few months, and the announcement that the Trust Fund Bureau will be decreasing JGB purchases just as bond issuance is rising, have contributed to something of a panic. It is essential that the movement in JGB interest rates instead be seen as what it really is—a sign that the financial clean-up initiated with the passage of legislation in October is finally taking hold—and not mistakenly as a source of danger to the Japanese economy. As a result, the Bank of Japan can only do damage in this situation by refusing to accommodate fiscal expansion. The dangers from a limited and transparent purchase of JGBs in 1999 by the Bank are minimal, and the accompanying small rise in inflation would be beneficial.
There is no macroeconomic justification for concern about the current rise in Japanese long-term interest rates. The level of Japanese public debt will be sustainable, even after the borrowing required for the necessary stimulus package in the FY1999 budget is added. This is true because essentially no Japanese government debt is held by foreigners, and absolutely no debt is issued in foreign currency. Thus, there is no outside creditor which can come knocking at the Japanese government's door. The contrast is clear with Belgium or Italy, where there were exchange rate obligations to meet and political instability in budgeting, or with the U.S. in the mid-1980s, where a significant share of public debt was held by foreigners (especially Japanese). In terms of total national wealth and net government debt, the Japanese government remains strong in comparison to all other sovereign borrowers, even if one assumes government assets to be worth only half as much as claimed.
Accordingly, real interest rates in Japan remain well within historical norms. Assuming deflation of 1%, a rate higher than seen in either the CPI or the Corporate Services Price Index, the current real rate is a little over 3%. This remains below the current level of real interest rates in either the euro-zone or the United States. It is true that a rise in long-term interest rates to whatever level usually increases the cost of investment for business, and thereby slows the economy. In the particular situation of Japan today, however, this crowding out of private investment is likely to be extremely small.
Remember that for the last few years the problem has been that, no matter how low the Bank of Japan reduced interest rates, investment did not respond. This was because there was a lack of demand for investment due to companies' weak balance sheets and pessimistic forecasts for capacity utilization. To the extent there has been a credit supply problem in the last 18 months, the source has been the fragility of the Japanese banking sector and its eroding capital. Taken together, these mean that the positive effects on investment of financial clean-up and fiscal stimulus should be far greater than any constraint put on due to the rise in interest rates.
If anything, the rise in Japanese interest rates should be seen as a positive sign because it means that the return on capital is rising. Most would agree that an inefficiently low cost of capital in Japan in the 1980s was a major source of the overinvestment which contributed to the current stagnation—a higher but still reasonable rate of long-term interest will force banks and businesses to make sure investments meet some minimum standard of profitability. And Japan needs profitable investments, not a re-run of simply easy credit to all businesses. This will also increase the rate of return to Japanese savers and investors, and therefore crowd-in investment.
For the banking sector in particular, the interest rate rise should be seen as reflecting positive developments in Japanese financial reform. It is true that in the immediate short-run, the banks will have to take paper capital losses on their JGB holdings. As Vice-Minister of Finance Sakakibara has correctly pointed out, however, the move into JGBs in the last 18 months was the result of perceived financial system weakness, and the abnormally low bond yields were in themselves a bubble. Banks are selling their JGBs because they are finally being subjected to the margin call and fair accounting which they have been hiding from for years. The Financial Supervision Agency is now implementing the long overdue clean-up, and it is all the better if the banks' long-accumulating losses that had been transferred to their bond portfolios come due now, forcing the banks to take the appropriate amount of public capital injections. In this light, it can be seen that it is the desirable financial clean-up which is temporarily driving up interest rates, as it should, and the government bond rates are rising as a side effect of this clean-up.
For both the government and the banking sector, the beneficial effects of an upward sloping yield curve at still reasonable levels of real interest rates are greater than any transitional costs. The government can engage in active fund management by twisting long bonds for short, as recently proposed by Finance Minister Miyazawa. As I argued in Restoring Japan's Economic Growth in September, such active management will have many benefits: it will increase the substitution of private assets for public bonds in portfolios, further crowding in investment; it will decrease the real cost of government borrowing; it will force the Japanese government to confront its debt expansion in the next few years as the shorter bonds come due; and it will be a structural reform by adding depth and liquidity to the JGB market. Meanwhile, the banking sector can expect a steady flow of easy profits from the positive yield curve, an flow of more lasting value than the one-time hit to their capital from JGB losses. That loss was inevitable and, again, is well-timed to force through the public capital injection.
In this context, calls for the Bank of Japan to keep interest rates from rising further by purchasing a portion of the additional public debt to be issued in FY1999 should not cause great concern. The historical record in Japan and elsewhere shows there are three paths to dangerous inflation when a central bank monetizes debt, and none of these are remotely likely to be taken in today's Japan. The same arguments hold, by the way, whether the BoJ buys the bonds in the market or directly from the government - so long as the Bank prints yen to pay for the bonds, the economic effects are essentially the same.
The first danger is that with this source of discipline for government spending removed, ever increasing deficits will follow, and the central bank will have to keep printing money. This is completely unrealistic for Japan, where the Budget Bureau and the LDP leadership have spent the 1990s being too reluctant to spend public money, not too loose with it. No one can truly believe that Miyazawa-san or his successor will show up at the Diet for FY2000 and request another stimulus package, not least because it would be political suicide. The only countries which suffer from hyperinflation are those which have a government so divided and lacking in legitimacy that printing money is the only option—Weimar Germany, Italy in the 1970s, Brazil in the 1980s, or Russia in the 1990s. Stable democracies with coherent party systems, like Japan, may on occasion see a sequence of rising deficits, but never resort to ongoing monetization.
The second danger from Bank purchases of government bonds is an erosion of the credibility of the central bank. A central bank without credibility has a more difficult time resisting inflationary price-and wage-increases. Yet central bank credibility is not as fragile as some would make it out to be—my studies of the German and Swiss central banks, the two most credible anti-inflationary central banks in the world, have shown that even those banks have exercised restraint in their pursuit of price-stability, setting inflation goals of 2% rather than zero, and flexibly accomodating times of weakness in the real economy. The Bundesbank, for example, responded to the second oil shock in 1979 by publicly announcing a rise in its inflation target from 2% to 4% for 1980, and then only brought inflation down slowly over the next six years, yet long-run inflation expectations in Germany remained anchored at a low level. While the Bank of Japan is only recently independent, it is not a maiden whose reputation will vanish overnight if it is touched once. In fact, accomodating the short-run needs of the real economy while publicly explaining its long-run goals would likely add to the BoJ's credibility.
The third danger is one seemingly expressed by Governor Hayami among others, that even a little inflation will automatically feed an upwards spiral of inflation expectations. The evidence is clear, however, that low levels of inflation simply do not behave in that explosive manner. Studies show that inflation rates in the single digits tends to be extremely inertial, that is slow to move up or down, and there is no justification for thinking that the BoJ's buying even a few percent of GDP worth of government bonds will produce more than three points of inflation. Moreover, the effect of money creation on inflation is matter of context. Economies where prices are falling and unemployment is rising are much less fertile grounds for inflation than economies which are pushed into operating above capacity, and the current Japanese economy is far from overheating. One can only be burnt by touching an oven if the oven is on.
So since the dangers from monetization of government deficits do not apply to the one-time purchase of a finite (and preferably publicly agreed upon) number of JGBs in the current Japanese situation, one can turn to the direct costs and benefits of the Bank of Japan so doing. Here matters are even more clearly in favor of the Bank being accomodative. We are all now familiar with the arguments why deflation is a bad thing—it encourages people to withold consumption because they expect prices to fall; it raises the real burden of outstanding debt on already borrowed loans; it puts pressure on the financial system. On the other hand, just from looking around at the other nations of the OECD (as well as at any number of econometric studies) it can be seen that a temporary inflation rate of 2-3% has minimal or no costs to growth.
In addition, it should be remembered that inflation is a form of tax, one which takes money out of savers' pockets and gives it to the government. While usually such expropriations are to be avoided, economics has a well-established theory of the "optimal inflation tax" which argues that inflation should vary over time in accord with revenue needs. In Japan, where citizens will have to pay a lot of taxes in the next few years to pay off the debt and the financial clean-up, as well as to fund pensions, it is important that the burden of tax falls on more than one source in order to minimize distortion of the economy. For this efficiency reason alone, an increase in the inflation tax should be part of the government's general program in the near-term. In addition, since most would agree that part of the current Japanese problem is an excess of saving, using a tax that takes money directly from savers without any implementation problems would seem ideal.
Ultimately, the reason it is important that the current rise in interest rates not give rise to panic—and be offset by Bank of Japan JGB purchases as necessary—is because a failure of the FY1999 fiscal stimulus effort cannot be allowed. Even strong advocates of fiscal stimulus in Japan such as myself recognize that this must be the last attempt at such policies. I argue further that it is better to have one big package pushed with full confidence than a succession of efforts that are too small or too hard to be seen by the general public. Whatever one's opinion on large-scale fiscal stimulus, however, once the decision has been made to undertake it, as it has been made by the Obuchi government, there is no reason to waste the money spent by allowing an interest rate spike or tight monetary policy to counteract it. In fact, that would be a foolishly self-destructive policy and devastating to private-sector confidence.
The government of Japan should see itself as a ski-jumper at the top of the jump. Only by hurling itself down the jump at full-speed and maintaining its good curled form will it get maximum distance upon reaching the end of the jump. The implementation of the financial clean-up and of the FY1999 fiscal stimulus effort constitute sufficient push to get a good and lasting lift-off for the Japanese economy - an ill-founded panic about the essentially healthy rise in interest rates to date, and the Bank of Japan's response to that rise, must not cause the government to hesitate or break form during its run down the jump.
The mistaken linking by some observers of the rise in long-term JGB rates with sharply negative effects exactly repeats the unfounded rhetoric in blind support of fiscal austerity which has already prolonged the Japanese recession. Similarly, fearmongering about the potential for explosive inflation should the Bank of Japan reasonably accommodate the temporary fiscal expansion of FY1999 just perpetuates an unnecessary and harmful deflation. Any interpretation of the recent rise in interest rates as a justified verdict on government policies is profoundly wrong on the economics, and the government should confidently move forward with this in mind.