Central banks are missing the point
In Japan, there is a more compelling case than in Europe for measures to stimulate demand
Monday 15 February 1999
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.
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