A Yen for Cash: How the Bank of Japan Could Threaten the Global Economy

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KIMIMASA MAYAMA / EPA

Japan has been an experiment in economics ever since its crushing defeat at the end of World War II. First, Tokyo employed inventive techniques to rebuild its economy and wealth — the export-led, state-directed system in which bureaucrats “targeted” industries for special support — that broke with economic tradition and became a development model for the rest of the region to follow. Then after the country’s massive stock-and-property-price bubble exploded in the early 1990s, Japan became a much examined case study in how to handle (or not handle) a financial crisis. After that, economists have puzzled over why Japan has been unable to escape the long stagnation it has suffered ever since. Now Japan is embarking on yet another set of unconventional policies in an attempt to revive itself, which, if successful, could rewrite the rules of fiscal and monetary policy. Whatever the result, economists will likely be studying Japan for decades to come.

On Thursday, the new governor of the Bank of Japan (BOJ), Haruhiko Kuroda, announced that the central bank would double the monetary base of the country — adding an additional $1.4 trillion — by the end of 2014 in an attempt to end the deflation plaguing the economy. To achieve that, Kuroda will buy government bonds and other assets to inject cash into the economy — what has now become familiar as quantitative easing, or QE — to bump inflation up to a targeted 2%. The plan is part of a greater strategy ushered in by new Japanese Prime Minister Shinzo Abe to restart the economy through massive fiscal and monetary stimulus. It also expands on the efforts by the Federal Reserve, Bank of England and European Central Bank to stimulate growth and smooth over financial turmoil by infusing huge sums of new money into the global economy.

Even by the standards of central-bank largesse since the 2008 financial crisis, however, the BOJ’s plan is massive, unprecedented and untested. You’d think that traditional economists would be screaming that revving up the cash printing presses on such a scale would spark hyperinflation and turn Japan into another Weimar Republic. Not so. Many voices have been highly supportive of Kuroda’s seismic shift. “Monetary policies — including unconventional measures — have helped prop up the advanced economies, and in turn, global growth,” IMF managing director Christine Lagarde, the policewoman of global economic policy, said in a speech Sunday at China’s Boao Forum. “The reforms just announced by the Bank of Japan are another welcome step in this direction.” Nobel laureate Paul Krugman, who has been cheering on Abe’s new policies, emphatically declared the BOJ’s strategy would work. “Seriously, this is very good news,” he commented in a blog post. “Japan is finally, finally making a real effort to escape from its deflation trap. We should all hope it succeeds.”

(MORE: The Great Central-Banking Experiment: Will Unlimited Cash Solve Problems or Cause Them?)

Of course we should hope. But will it work? The idea is that breaking the deflationary cycle will restart Japanese growth. Deflation does inhibit economic activity. Say you’re a Japanese consumer and you expect prices to go down. You have every incentive to save your money, since it is worth more tomorrow than today, and put off purchases, since whatever you buy will be cheaper tomorrow than today. By bringing down long-term interest rates even further and filling banks with cash, the intention is to get companies investing and banks lending.

The evidence so far, though, is that such a strategy won’t succeed. Though the QE programs already undertaken, by the Fed, for instance, haven’t led to the inflation and financial chaos some had feared, the fact is they haven’t worked very well either. Despite the now regular cash injections by the Fed aimed at boosting employment, last week’s jobs report in the U.S. gravely disappointed. Japan’s own attempts at using QE to stimulate its economy have come to naught. According to HSBC, the BOJ’s QE program from 2001 to 2006 expanded the monetary base by about 60% but failed to create inflation.

Krugman would say that the BOJ’s past efforts have fallen short of what is really needed. But others (myself included) aren’t so sure. In order for companies to invest, they have to find something to invest in; banks have to find loans worth making. Otherwise, the newly minted money just sits around, or ends up outside the country. Consumers will spend more if they think their future earnings prospects are getting better. That means Japan has to post sustainable growth. If you believe that Japan’s deflation is the result of a lack of demand, then supplying more cash won’t necessarily tackle deflation or restart growth. What Japan needs, then, is real reform alongside its monetary deluge, to break down the regulatory hurdles to growth. That means opening the domestic economy to more competition and fixing a distorted labor market. Here’s what rating agency Fitch had to say:

Experience in other major advanced economies shows that quantitative easing is not in itself an economic panacea. QE cannot be extended indefinitely. However, in the short to medium term, it can buy time to tackle other issues by holding down the government’s debt servicing costs and by giving a broader fillip to activity. Therefore, developing and implementing a credible fiscal strategy over the medium term, and enacting structural reforms to raise the real economic growth rate, remain central issues for Japan.

We also have to be sensitive to the potential downside of the BOJ’s program. Japan is in a highly strained financial situation, with extremely high public debt and extremely high government financing requirements. The Abe program will almost certainly increase that debt. He’s talking of stimulating the economy with large-scale public spending on infrastructure projects — a favorite of Japanese politicians. With the BOJ pledging to spend billions buying up government bonds, the central bank will effectively be financing Abe’s spending spree. The question facing the world economy is: How far can Abe take this strategy before making the nation’s finances unsustainable? And even if the BOJ is successful in ending deflation, that may only heighten the risks to the economy. Here’s how economist Ken Courtis did the math in the Wall Street Journal:

Should inflation rise substantially, as is Tokyo’s declared objective, interest rates would surely follow. The problem here is that debt service already swallows a quarter of Japan’s annual budget — and government debt is set to hit 250% of GDP by the end of next year … As the average cost of government funding begins adjusting upward to account for quintupled interest rates, debt service, like a giant python, would swallow virtually the entire budget. What’s more, with 2.5% interest rates on public-sector debt of 250% of GDP, Japan would have to grow nominal GDP by 6.25% per year simply to keep its debt level from increasing. In real terms (adjusting for 2% inflation), real annual growth would have to be 4.25%. Real growth of 4.25% is conceivable in the abstract, but will not occur on a sustained basis for Japan during our lifetimes.

(MORE: Is Asia Heading for a Debt Crisis?)

There are other risks as well. By flooding Japanese financial markets with cash, that cash will have to find someplace to go, and it won’t all find a home in Japan. That suggests that the BOJ may be stoking inflation elsewhere, as well as potential asset bubbles. Furthermore, the BOJ policy will weaken the value of the yen (as has already started to happen). This is a conscious policy to aid Japanese exporters. But it is also a beggar-thy-neighbor policy that could spark countermeasures from Japan’s trading partners. We forget in all of the mania about China that Japan, despite its two-decade decline, is still the world’s No. 3 economy, and what the BOJ does will have a sweeping impact around the world. As Courtis warns:

Moving from mild deflation to sharply higher inflation will expose Japan to risks of vast financial turmoil. Yet it is to this very risk that Tokyo is now opening the door. Given the size of its economy, the scale of its debt and how tightly its financial system is interwoven with world markets, Tokyo’s strategy holds frightening implications for us all.

Let’s hope that the economics lesson Japan offers this time will be one to praise, not lament.

10 comments
Luis_de_Agustin
Luis_de_Agustin

Since last September when Japanese Prime Minister Shinzo Abe came to power and donned pink colored glasses, the yen has declined about 18 percent against the US dollar and 9 percent relative to gold. Mr. Abe’s explicit goal is to increase Japanese inflation to two percent. At first sight, the stock market welcomed the new policy, with a gain of 34 percent over the last six months, but that’s in yen. In dollars, the Japanese market has returned 12.6, not much more than the 10.7 return earned by the recession ridden euro zone.

Strategic investment research consultancy, Wainwright Economics, continues to suspect that stock market gains in the US, Europe and Japan alike have been carried more by an acceleration of growth in the emerging world than by domestic economic improvement. The research house believes that a weak yen will not help Japan any more than a weak dollar has helped the United States historically, notwithstanding the initial rosy picture.

Luis de Agustin

reepotomac
reepotomac

another idiot who thinks falling prices are bad

AbinicoWarez
AbinicoWarez

Blah, blah, blah - bottom line there are plenty of places like China, Malaysia, even Mexico where labor is a lot cheaper.

UnclePhil
UnclePhil

While the study of law only narrows minds, the study of economics seems to turn them to mush.   Those not content to remain mush heads may study econometrics, a field that Paul Volker once said makes voodoo look respectable, and help give birth to newer and stronger demonstrations of their diminished mental capacities, like "quantitative easing."  

All economists should study Bitcoin for the lessons it teaches us, some of which are:

1.  In the future, money will be increasingly unnecessary to the exchange of goods and services.  Internet-based barter systems will take hold and flourish and this will foster economic growth and, more importantly, a better quality of life.  Key international financial institutions like the International Monetary Fund and the World Bank would do well to re-engineer themselves for this eventuality, although this seems unlikely.  Nonetheless, our distant future probably includes some international oversight of barter systems, perhaps including something akin to an "SDR Coin" and an occasional "SDR Coin Allocation," with proceeds going directly into citizen accounts.  (The SDR, or Special Drawing Right, is a weighted average of various currencies and is the unit of account for the IMF.  SDR allocations provide a mechanism for occasionally adding to the global money supply.)  Local and regional barter systems are likely to emerge first, however.

2.  The trust-no-one principle embodied in the design of the Bitcoin system is extremely attractive compared to the faith-based principle inherent with holding most government currencies.  Since faith in government currencies continues to decline for obvious reasons, the demand for alternatives like Bitcoin will continue to grow.  Also, confidence in Bitcoin is strengthened because its design embodies a fixed limit on the number of Bitcoins that can be "mined", so users don't need to worry that some "quantitative easing" might take place in the future.  

3.  The essence of Bitcoin is its non-monetary unit of account, while the schedule of prices for goods and services that may be purchased with Bitcoins provides relative values for those goods and services.  Once the unemployed begin to offer their services in exchange for Bitcoins (or other similar units of account), many will be able to start working for one another, and in doing so, help one another.  In fact, this is perhaps the most important aspect of the Bitcoin solution.  Imagine people in need helping one another directly without having to rely on government agencies, non-profits or charities.  Pay it forward, in Bitcoins.

For the above reasons, while international financial problems seem dire and the outlook bleak, my hat is off to the anonymous inventors of Bitcoin for showing us a way forward. Thanks, guys and/or girls, or providing a rosier outlook for my grandchildren.




MarkHolland
MarkHolland

Give newly minted money to the people and THEN you'll see the economy roar. That's right, just GIVE it to them, tax free, no strings attached. Is it inflationary? Of course it is. But it's vastly more stimulative than giving it to banks that don't loan.

melonheadx13
melonheadx13

how about a usa public bank?  i read that 3 trillion into a public bank might help.

DarylBrunt
DarylBrunt

So why has it failed in Europe and the US? Simple. The US and European Central Banks are simply injecting money into the economy. The corporations are taking it, and not actually passing it on. If the US took their injections and bought AT&T and then allowed the company profit margin to be reduced to say +10% and then employed people the ECONOMY would start to work. 

Ken90
Ken90

I'm a Japanese. I think one of main factors why Japanese consumers do not spend much is not deflation expectation (prices will go down tomorrow), but their concern over post-retirement life.


You know, Japan has one of the longest life expectancies in the world. Many people could live until 80 or 90. But many people fear that the pension amount they are going to receive, may not enough to feed themselves. So they keep saving money. Some think about post-retirement life even in their 20s!


They have concern over pension because the number of elderly people is surging and children decreasing in Japan. Simply. in Japanese pension, working people pay, and elderly people receive money. But this structure may collapse in the future. Thus, people can't stop saving money for their retirement life.


I don't think this will change even if there is inflation in Japan. In fact, if they spend more instead of saving, there will be another problem of elderly people who can't feed themselves and resort to welfare.

AbinicoWarez
AbinicoWarez

@UnclePhil - you some sort of rich guy - I'm retired and live on SS - bitcoin is useless to me.

UnclePhil
UnclePhil

@AbinicoWarez @UnclePhil  Nope, retired on fixed-income, and Bitcoin no particular help to me, either.  View it more as an experiment whose success will foster more innovation.