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.

Start your day with The Independent, sign up for daily news emails
ebooksA celebration of British elections
  • Get to the point
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

SThree: Trainee Recruitment Consultant - Swiss Banking and Finance

£20000 - £25000 per annum + Uncapped commission: SThree: Can you speak German,...

Ashdown Group: Marketing Executive - 6 month FTC - Central London

£25000 - £30000 per annum + benefits: Ashdown Group: An exciting opportunity f...

Ashdown Group: Junior Project Manager (website, web application) - Agile

£215 per day: Ashdown Group: Junior Project Manager (website, web application ...

Guru Careers: Software Engineer / Software Developer

£40-50K: Guru Careers: We are seeking an experienced Software Engineer / Softw...

Day In a Page

Fishing for votes with Nigel Farage: The Ukip leader shows how he can work an audience as he casts his line to the disaffected of Grimsby

Fishing is on Nigel Farage's mind

Ukip leader casts a line to the disaffected
Who is bombing whom in the Middle East? It's amazing they don't all hit each other

Who is bombing whom in the Middle East?

Robert Fisk untangles the countries and factions
China's influence on fashion: At the top of the game both creatively and commercially

China's influence on fashion

At the top of the game both creatively and commercially
Lord O’Donnell: Former cabinet secretary on the election and life away from the levers of power

The man known as GOD has a reputation for getting the job done

Lord O'Donnell's three principles of rule
Rainbow shades: It's all bright on the night

Rainbow shades

It's all bright on the night
'It was first time I had ever tasted chocolate. I kept a piece, and when Amsterdam was liberated, I gave it to the first Allied soldier I saw'

Bread from heaven

Dutch survivors thank RAF for World War II drop that saved millions
Britain will be 'run for the wealthy and powerful' if Tories retain power - Labour

How 'the Axe' helped Labour

UK will be 'run for the wealthy and powerful' if Tories retain power
Rare and exclusive video shows the horrific price paid by activists for challenging the rule of jihadist extremists in Syria

The price to be paid for challenging the rule of extremists

A revolution now 'consuming its own children'
Welcome to the world of Megagames

Welcome to the world of Megagames

300 players take part in Watch the Skies! board game in London
'Nymphomaniac' actress reveals what it was really like to star in one of the most explicit films ever

Charlotte Gainsbourg on 'Nymphomaniac'

Starring in one of the most explicit films ever
Robert Fisk in Abu Dhabi: The Emirates' out-of-sight migrant workers helping to build the dream projects of its rulers

Robert Fisk in Abu Dhabi

The Emirates' out-of-sight migrant workers helping to build the dream projects of its rulers
Vince Cable interview: Charging fees for employment tribunals was 'a very bad move'

Vince Cable exclusive interview

Charging fees for employment tribunals was 'a very bad move'
Iwan Rheon interview: Game of Thrones star returns to his Welsh roots to record debut album

Iwan Rheon is returning to his Welsh roots

Rheon is best known for his role as the Bastard of Bolton. It's gruelling playing a sadistic torturer, he tells Craig McLean, but it hasn't stopped him recording an album of Welsh psychedelia
Morne Hardenberg interview: Cameraman for BBC's upcoming show Shark on filming the ocean's most dangerous predator

It's time for my close-up

Meet the man who films great whites for a living
Increasing numbers of homeless people in America keep their mobile phones on the streets

Homeless people keep mobile phones

A homeless person with a smartphone is a common sight in the US. And that's creating a network where the 'hobo' community can share information - and fight stigma - like never before