The Bank of Japan folded as easily as a hot slice of New York pizza. After a few weeks of pounding by newly installed Prime Minister Shinzo Abe, the BOJ’s (officially independent) managers capitulated on Jan. 22 to his demands that the central bank hike its inflation target to 2% (from 1%) and undertake the necessary monetary easing to meet that target. That means the BOJ will keep printing cash until Japanese deflation is reversed. “One can say that it marks a ‘regime change’ in managing macroeconomic policy,” a victorious Abe declared.
A regime change it is, and it isn’t just taking place in Japan. With the BOJ’s surrender, all three of the world’s major central banks have committed themselves to open-ended, cash-pumping programs to stimulate economies and protect financial stability. The Federal Reserve has pledged to keep easing until the U.S. job market improves. And in September, the European Central Bank promised to purchase unlimited amounts of certain government bonds for any troubled country that signs up to a reform program — a move ECB President Mario Draghi took to help quell the euro zone’s debt crisis. These moves, of course, are on top of the already generous policies the three banks have implemented since the 2008 Lehman Brothers collapse.
We’re in uncharted territory for monetary policy here, folks. Never before have the world’s most important central banks engaged in this sort of limitless largesse. If you don’t believe me, believe William White, chairman of the Economic Development and Review Committee at the OECD in Paris. Central banks “have embarked upon one of the greatest economic experiments of all time,” White wrote last year. “The size and global scope of these discretionary policies makes them historically unprecedented.”
Whether these experiments in supereasy money are wise or not, well, that’s another matter. The classical economist in me immediately hears sirens go off. Money is like any other commodity — the more of it there is, the less it is worth. At some point, the deluge of cash could create a tsunami of inflation. Prices of assets could get distorted, blowing up more bubbles that can pop and crash economies.
But then again, perhaps my thinking is stuck in an outdated ideology. Paul Krugman seems to think so. According to a recent column in the New York Times, I’m one of the Very Serious People, as he calls us, trapped in a misguided certitude that has held back smart policymaking in a new economic world. Krugman specifically was writing about Japan, an economy he knows well, and he was cheering on Abe’s heavy-spending approach to the country’s problems. The reason why Japan has been an economic mess for 20 years, Krugman asserts, is that the government and the BOJ have never gone far enough in pumping the economy back to health. Abe’s aggressive policies, Krugman asserts, will finally turn Japan around — and, in the process, rewrite the rules of economic policymaking:
Mr. Abe is breaking with a bad orthodoxy. And if he succeeds, something remarkable may be about to happen: Japan, which pioneered the economics of stagnation, may also end up showing the rest of us the way out.
I hate to disagree with Krugman — he has a Nobel Prize, and I most certainly do not – but my sense is that he’s pressing Abe to take a leap of faith, based on an assumption that more spending and more cash from the BOJ will fix Japan’s economy without creating any serious negative consequences. Krugman’s argument is also based on the notion that ultra-easy money can fix what ails Japan. In a recent column in TIME magazine, I took the exact opposite view. The BOJ already had its benchmark interest rate at zero and pledged itself to a program of quantitative easing, in which the bank buys assets like bonds to bring down interest rates and encourage spending, of more than $1.1 trillion. But Japan sunk back into recession last year and is still suffering with deflation despite all of that BOJ intervention. That implies to me that the sources of Japan’s malaise cannot be found at the BOJ.
For me, the problems of Japan show the clear limits of monetary policy. The BOJ can print all the cash it wants, but unless banks actually lend it out, and companies and consumers use it to invest and spend, then it doesn’t have the full desired, stimulating effect on the real economy. That seems to be happening in Japan. White in his report points out that easy-money policies haven’t necessarily worked in Japan, and that isn’t encouraging for the other countries attempting to employ similar strategies:
Many of the nonstandard measures taken to date are broadly similar to those undertaken earlier by the Bank of Japan. It is instructive therefore that the Japanese authorities remain highly skeptical of their effectiveness in stimulating demand. Perhaps the most important reason for this is that the demand for bank reserves tends to rise to match the increase in supply; in short, loan growth does not seem to be much affected.
The problem with Japan, in my view, is that easy money has not been accompanied by reforms in the real economy. In Japan’s case, that means deregulating domestic industries, encouraging entrepreneurship and breaking down trade barriers to spur growth and create better jobs. The BOJ can’t fix those problems on its own. The same can be said of the other major central banks. The Fed can smooth the way toward a repaired housing market but can’t repair it with monetary policy alone. As Catherine Mayer and I wrote in a recent TIME cover story, the ECB’s Draghi may be heralded as the euro’s savior, but he doesn’t have the power or the tools to improve the governance of the monetary union or implement growth-unleashing reforms within individual economies to truly put the euro on a firmer foundation. The question is: Will governments capitalize on the calm brought about by central-bank generosity to impose the reforms needed to restore healthy growth?
The record in Japan on that front is abysmal. Its politicians have used easy money as a substitute for reform; Abe’s now continuing the trend. Some in Europe fear that Draghi, rather than encouraging reform within the euro zone’s weakened economies, is allowing debt-ridden governments to slide on reform efforts by bringing calm to financial markets. “There has been a little progress [on reform] but not enough, so the ECB has stepped in to do the job,” Johannes Müller, chief economist at DWS Investments, recently told me in Frankfurt. “The ECB in this game of poker with political leaders has given in too early.”
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And what happens if central banks persist in printing money even if real reform stalls? White worried about the fallout:
What central banks have done is to buy time to allow governments to follow the policies that are more likely to lead to a resumption of “strong, sustainable and balanced” global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.
And those “unintended consequences” can get pretty ugly. White kindly provides us with a list:
Over time, easy monetary policies threaten the health of financial institutions and the functioning of financial markets, which are increasingly intertwined. This provides another negative feedback loop to threaten growth. Further, such policies threaten the “independence” of central banks and can encourage imprudent behavior on the part of governments. In effect, easy monetary policies can lead to moral hazard on a grand scale. Further, once on such a path, “exit” becomes extremely difficult. Finally, easy monetary policy also has distributional effects, favoring debtors over creditors and the senior management of banks in particular. None of these “unintended consequences” could be remotely described as desirable.
The consequences of central-bank easing could be more immediate. In a recent speech, Jens Weidmann, president of Germany’s conservative Bundesbank, fretted that central banks were unintentionally tipping off currency wars. By easing money, central banks usually weaken their national currencies — in effect attempting to reflate their own growth at the expense of others by supporting exports. Softening the value of the yen to help Japanese exporters is clearly a goal of Abe’s program in Japan (and he’s already had some success). Here’s Weidmann:
It is already possible to observe alarming infringements, for example in Hungary or in Japan, where the new government is massively involving itself in the affairs of the central bank, is emphatically demanding an even more aggressive monetary policy and is threatening an end to central bank autonomy. Whether intended or not, one consequence could be the increased politicization of the exchange rate. Until now the international monetary system got through the crisis without competitive devaluations, and I hope very much it stays that way.
Will aggressive central-bank easing actually cause any of these terrible outcomes? Sadly, we’ll only discover the consequences of this grand experiment in money — both the good and the bad — over the next few years. But one thing is certain: cherished principles of central banking — their independence of decisionmaking, the primary focus on prices — are being tossed out the window. Maybe that will free us from Krugman’s “bad orthodoxy.” Maybe it will undermine the entire purpose for having central banks — ensuring financial stability. As Abe’s “victory” over the BOJ shows, central banks are seeing their independence eroded by politics. Who knows where that will take us. Stephen King, chief economist of HSBC, tried to answer that question:
Following two decades of central-bank independence, we have to face facts. They can no longer be properly “independent” because their policies are creating both winners and losers. They are making decisions that are inherently political. Once politicians recognize this, they will surely be tempted to take over the reins. At that point, monetary stability, for good or bad, can no longer be guaranteed.
Our central banks are undergoing a historic change, and that will probably have historic consequences. Perhaps positive, perhaps negative, but definitely historic.