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.”
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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.
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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.