Central banks are missing the point

In Japan, there is a more compelling case than in Europe for measures to stimulate demand

FRUSTRATION IS mounting inside the United States Treasury Department. For several years, the US has been the only locomotive for global GDP growth. Recently, however, the US balance of payments position has started to look dangerous. As a result, the US authorities have quite justifiably increased the pressure on Europe and Japan to accept more of the burden of sustaining world growth.

So far, this seems to have fallen on entirely deaf ears at the European Central Bank, which unaccountably seems to believe that 2 per cent GDP growth is perfectly adequate, at least until they can persuade European politicians to introduce new supply-side reforms. Actually, they should be setting themselves an ambitious GDP growth target of 3 to 4 per cent per annum in the next two years, in exchange for more labour market reform.

The current stand-off between politicians and central bankers in Europe about who should be responsible for reducing unemployment is a truly depressing event, and the UK needs to be certain that this stand-off has been overcome before seriously contemplating EMU membership. Such an impasse between the government and the central bank has not, and would not, happen here.

With the continental Europeans determined to continue examining their own navels, American attention has turned back to the Far East. In Japan, there is an even more compelling case than in Europe for urgent measures to stimulate demand, but yet again the Japanese authorities somehow seem to have missed this central point, and have instead become embroiled in an arcane dispute about the nature of the central bank balance sheet. The intellectual errors being made inside the Bank of Japan (the BoJ) on this subject need to be overcome before there is much hope of redemption for the wider economy.

The basic problem for Japan during the 1990s has been a shortage of demand. Under normal circumstances, this is an easy problem to fix, simply by cutting interest rates, reducing taxation and stimulating government spending.

The Japanese authorities have done all these things repeatedly during the 1990s, but they have never done them with sufficient vigour to overcome the powerful deflationary forces in the system. Numerous fiscal packages have stabilised the economy for short periods, but they have never succeeded in turning around the downward momentum in private expenditure (especially investment spending).

Because of these unsuccessful efforts to prop up private demand through fiscal stimulus, the quality of the government's balance sheet has been rapidly degraded. The ratio of gross public debt to GDP is now exactly 100 per cent, and is rising at an explosive rate of 10 percentage points per annum. Such an explosion in public debt is unmatched in any of the crisis emerging economies, including even Brazil and Russia.

This type of explosion in public debt would normally be expected to lead to much higher real interest rates as the risk of government default starts to rise. Until the end of last year, the Japanese authorities prevented this from occurring by using public entities like the postal savings system to purchase about 75 per cent of the new bonds issued by the government. But this year, they have announced that the public sector will purchase only about 25 per cent of new government bonds, so the supply/demand balance in the bond market has sharply deteriorated. The result has been that the yield on government bonds has risen from about 0.7 per cent to 2.0 per cent.

This may not sound too bad but, because price inflation is negative, it means that the real rate of interest facing the government is likely to exceed 4 per cent later this year. More seriously, the real rate of interest on corporate bonds already exceeds 6 per cent, implying that the burden of corporate debt, which is now over 190 per cent of GDP, could also start to explode. Clearly, this could turn into a very nasty spiral, in which high real interest rates lead to negative GDP, debt ratios rise further, "default" premiums rise in the bond market, and real rates rise yet further. If this were allowed to happen, the economy could implode.

The most obvious way out of this dilemma is to use the only remaining balance sheet in the economy which is still available to solve the problem with the balance sheet of the central bank. The BoJ has already been a large-scale purchaser of government bonds in the past several years, though it has always "sterilised" these operations by selling bills back into the market.

Recently, it has scaled back these operations for two reasons. First, it is worried about the rate of increase in its overall balance sheet, which had been growing at annual rates of about 40 per cent, but is now growing at only 15 to 20 per cent. This is why narrow money growth has slowed sharply. Second, it is worried about both the "liquidity" and the creditworthiness of its assets (i.e. long-dated government bonds and short- dated corporate debt). These concerns are now blocking the BoJ from taking the necessary steps to ease monetary policy. In fact, they are forcing the central bank to allow an entirely perverse tightening in monetary conditions as bond yields rise.

Martin Brookes of Goldman Sachs has recently written a fascinating study of "The Anatomy of the BoJ's Balance Sheet", arguing that both of these concerns are completely misplaced. The key point to recognise is that the central bank is the ultimate source of liquidity in the economy, so it is by definition impossible for it become "illiquid". It is a fallacy to worry about the composition of its asset base as if it were a private sector commercial bank - if its assets become illiquid, or subject to credit downgrades, the BoJ can in the last resort always choose to increase the issuance of banknotes.

The ultimate constraint on the ability of a central bank to create liquidity is, of course, the fear that this might create inflation. For most central banks in most places at most times, this is a very genuine fear, so there is every reason for an "orthodox" approach to the creation of money to finance government deficits. But Japan today is the exception. It is facing deflation, not inflation. As even the most stringent monetarist (including Milton Friedman himself) will instantly confirm, the central bank in such circumstances has the right, in fact the duty, to take direct action to expand the money supply - either by purchasing government bonds in the secondary market, or even directly financing a government deficit by printing money.

So far, despite mounting pressure from LDP politicians, the BoJ has steadfastly set its face against such action, and as a result is now watching the economy sink towards a worsening deflationary spiral. If the BoJ policy board is so stuck in pseudo-orthodox thinking that it fails to realise this, why does it not set itself an inflation target of zero for the next two years? Surely no sane central banker could argue that such a target would lack toughness or credibility. But in order to hit a zero inflation target, the BoJ might well have to print money sooner or later.

Central bankers do not like taking risks. Usually, this means that they prefer doing nothing to taking decisive action. But in Japan today, the risk of doing nothing is the greatest risk of all.

people And here is why...
Arts and Entertainment
Amazon has added a cautionary warning to Tom and Jerry cartoons on its streaming service
voicesBy the man who has
Arsene Wenger tried to sign Eden Hazard
footballAfter 18 years with Arsenal, here are 18 things he has still never done as the Gunners' manager
Life and Style
The new Windows 10 Start Menu
Arts and Entertainment
Kristen Stewart and Robert Pattinson star in The Twilight Saga but will not be starring in the new Facebook mini-movies
tvKristen Stewart and Stephenie Meyer will choose female directrs
Arts and Entertainment
Hilary North's 'How My Life Has Changed', 2001
books(and not a Buzzfeed article in sight)
ebooksAn unforgettable anthology of contemporary reportage
William Hague
people... when he called Hague the county's greatest
More than 90 years of car history are coming to an end with the abolition of the paper car-tax disc
newsThis and other facts you never knew about the paper circle - completely obsolete today
Arts and Entertainment
There has been a boom in ticket sales for female comics, according to an industry survey
comedyFirst national survey reveals Britain’s comedic tastes
Arts and Entertainment
Twerking girls: Miley Cyrus's video for 'Wrecking Ball'
arts + ents
Arts and Entertainment
Ed Sheeran performs at his Amazon Front Row event on Tuesday 30 September
musicHe spotted PM at private gig
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Trust Accountant - Kent

NEGOTIABLE: Austen Lloyd: TRUST ACCOUNTANT - KENTIf you are a Chartered Accou...

Graduate Recruitment Consultant - 2013/14 Grads - No Exp Needed

£18000 - £20000 per annum + OTE £30000: SThree: SThree are a global FTSE 250 b...

Law Costs

Highly Competitive Salary: Austen Lloyd: CITY - Law Costs Draftsperson - NICHE...

Day In a Page

Ebola outbreak: The children orphaned by the virus – then rejected by surviving relatives over fear of infection

The children orphaned by Ebola...

... then rejected by surviving relatives over fear of infection
Pride: Are censors pandering to homophobia?

Are censors pandering to homophobia?

US film censors have ruled 'Pride' unfit for under-16s, though it contains no sex or violence
The magic of roundabouts

Lords of the rings

Just who are the Roundabout Appreciation Society?
Why do we like making lists?

Notes to self: Why do we like making lists?

Well it was good enough for Ancient Egyptians and Picasso...
Hong Kong protests: A good time to open a new restaurant?

A good time to open a new restaurant in Hong Kong?

As pro-democracy demonstrators hold firm, chef Rowley Leigh, who's in the city to open a new restaurant, says you couldn't hope to meet a nicer bunch
Paris Fashion Week: Karl Lagerfeld leads a feminist riot on 'Boulevard Chanel'

Paris Fashion Week

Lagerfeld leads a feminist riot on 'Boulevard Chanel'
Bruce Chatwin's Wales: One of the finest one-day walks in Britain

Simon Calder discovers Bruce Chatwin's Wales

One of the finest one-day walks you could hope for - in Britain
10 best children's nightwear

10 best children's nightwear

Make sure the kids stay cosy on cooler autumn nights in this selection of pjs, onesies and nighties
Manchester City vs Roma: Five things we learnt from City’s draw at the Etihad

Manchester City vs Roma

Five things we learnt from City’s Champions League draw at the Etihad
Martin Hardy: Mike Ashley must act now and end the Alan Pardew reign

Trouble on the Tyne

Ashley must act now and end Pardew's reign at Newcastle, says Martin Hardy
Isis is an hour from Baghdad, the Iraq army has little chance against it, and air strikes won't help

Isis an hour away from Baghdad -

and with no sign of Iraq army being able to make a successful counter-attack
Turner Prize 2014 is frustratingly timid

Turner Prize 2014 is frustratingly timid

The exhibition nods to rich and potentially brilliant ideas, but steps back
Last chance to see: Half the world’s animals have disappeared over the last 40 years

Last chance to see...

The Earth’s animal wildlife population has halved in 40 years
So here's why teenagers are always grumpy - and it's not what you think

Truth behind teens' grumpiness

Early school hours mess with their biological clocks
Why can no one stop hackers putting celebrities' private photos online?

Hacked photos: the third wave

Why can no one stop hackers putting celebrities' private photos online?