Psst, will this really work? The Fed’s Ben Bernanke and Bank of Japan governor Masaaki Shirakawa (Yuriko Nakao/REUTERS)
The Federal Reserve has finally announced what everyone expected – a giant program of quantitative easing aimed at restarting the stalled economic recovery. The idea is to push more money into the economy to encourage banks to lend and companies to borrow, invest and hire. In other words, the Fed thinks that by pumping an extra $600 billion into the economy (through purchases of Treasury bonds), it can rescue the recovery and prevent deflation.
But will it work? One way to answer that question is to look at Japan’s experience. The Bank of Japan tried out a QE program from 2001 to 2006 under generally similar conditions to what the Fed is confronting today. In both cases, central bankers faced a situation in which the real economy was stagnating after a crisis, but they were unable to use the usual monetary-policy mechanism to stimulate growth – lowering interest rates – since those rates were effectively zero and couldn’t be lowered any further.
Generally, I think we’re in trouble when we have to look to Japan for economic guidance, based on its miserable performance over the past 20 years. But it is the case that after the BoJ implemented its QE program, Japan’s economy did enjoy its strongest period of growth (2002-2007) since the bursting of its gargantuan asset bubble in the early 1990s. The question we have to ask then is: Was there a connection between QE and the revival of the Japanese economy?
I spent a big chunk of my Thursday reading through assorted views on the impact of Japan’s QE experiment (lucky me), and, not surprisingly, there is no consensus among economists. An occasional voice of optimism argues Japan’s QE program helped economic growth by spurring on investment and demand. Here are some comments from Tomoya Masanao of PIMCO, made back in 2008:
The recovery in the banking system, the sustained low rates and the reduction in risk premiums have led to rising business activity and investment. In turn, the expansion in the corporate sector is driving real wages higher, supporting the consumer sector. External demand from the U.S. and China also aided Japan’s recovery, but the BoJ’s quantitative easing policy played a large role in helping to stimulate internal demand.
My own view on this issue, however, is that QE had little impact on Japan’s real economy, and thus is likely to have little impact on America’s this time around. What I found most surprising is that some experts at both the Fed and BoJ agree with me. The best they could say about QE in Japan is that it helped stabilize the financial system and stopped matters for getting worse. Here’s the conclusion of a report done by economists at the Federal Reserve Bank of Cleveland about Japan’s QE in 2008:
The connection between the quantitative easing policy and the macroeconomic recovery remains somewhat more flimsy. Most observers believe that because the quantitative easing policy aided the banking sector, economic activity at least did not deteriorate further. The pace of economic activity did pick up, with contributions from consumer spending and investment, but exports, which benefited from growth among Japan’s trading partners, spurred much of the improvement. Although deflation ended in 2006, along with the quantitative easing policy, it returned after a very short hiatus in 2007, and continued until the recent commodity price boom.
A study of its own program by the BoJ in 2006 came to a similar conclusion:
The QEP had the effects of dispelling the funding concerns of financial institutions. This finding implies that the QEP had the effects of maintaining financial market stability and an accommodative financial environment, and thereby avoiding further deterioration of the economy and prices stemming from corporations’ anxieties regarding future funding…When gauging the effects of the QEP broadly, the results show limited effects on raising aggregate demand and prices, despite realizing more monetary easing …The major factors behind these limited effects were the erosion of the financial intermediary functions of banks burdened by nonperforming loans and corporate balance sheet adjustments, which diminished the manifestation of policy effects.
In other words, the QE policy was of limited use because the companies and banks in Japan were too sickened to take advantage of the extra cash. That’s the real catch with a QE program. Just because there’s more money around doesn’t mean anyone will use it in ways that could boost economic growth. Let’s use an example: One day you open your mail to find your generous Uncle Harold has sent you a check for $5,000 for your birthday. If you’re feeling secure in your job and your finances, you might take that $5,000 down to the local Best Buy and pick up a new Samsung flat-panel TV. But if you’re worried about your job, or in too much debt, you might choose to just save the birthday present, or pay off a credit card bill. Banks and corporations behave the same way. If they’re nervous about the prospects of the economy, they might just hoard the extra cash provided by QE programs.
So what this analysis tells us is not encouraging: That banks and companies won’t lend, invest and hire until they’re ready to do so – when they fix their own financial houses and the outlook on the economy improves. How much cash QE throws at them doesn’t matter. Even PIMCO’s Tomoya Masanao, who believes QE worked in Japan, makes this point:
It is true that bank lending did not improve until recently despite the excess liquidity provided by the BoJ. But bank lending did finally improve. It just took a long time for excess liquidity to work because the banking system was weak and the corporate sector was busy cleaning up its balance sheet. The BoJ just needed to wait for the banking sector to become healthier before the liquidity started to work.
John Richards of RBS, went much further. Japan’s QE, he wrote on The Financial Times website in 2008, was “nearly irrelevant” to the economic expansion Japan enjoyed after 2002:
The expansion was largely self-financed by corporations’ free cash flow and therefore not constrained by an absence of banks’ lending…The economy cured on its own most of the structural problems such as excess capacity and too much debt associated with the deflationary environment…About all quantitative easing did on the positive side for Japan was to help the BoJ keep its independence from the politicians by giving the appearance of action…One of the lessons of this episode for policymakers is that while quantitative easing may help to solve the short-run liquidity problems that arise in times of extreme financial duress, it is not a substitute for some of the harder choices governments must make.
So as the Japan case shows, QE is no silver bullet. It can only work if the conditions are in place to convince companies, banks, investors and consumers to take advantage. It’s not a substitute for reform. I have my doubts whether the U.S. is at the stage where QE is going to make a big difference in the real economy. The U.S. financial system is not lacking in liquidity. Consumers don’t need more debt; just the opposite. Banks and companies are still too nervous. In other words, the U.S. is going to have to work through its structural economic problems for a full-fledged recovery to emerge, even with QE in place. Consumers have to deleverage, the housing market has to repair itself, companies have to faith in the future to start hiring again. QE can’t make any of that happen.
In that light, the impact of the Fed’s new QE program could be much larger on the rest of the world than on the U.S. economy. All of those dollars might chase better investment options around the globe rather than be put to work on a recovery at home. That means dollars flooding into countries that don’t need them – emerging markets with good growth prospects, or countries (Australia, India) hiking interest rates to fight inflation. These inflows could just spark more inflation, add to the risk of asset bubbles and increase the likelihood of currency wars.
So as I said earlier: Following Japan on matters of economic policy is probably not a grand idea.