Stephen King: Bank of Japan's new policy reignites old debate

Stronger Japanese demand growth can only be good news for the global economy

The debate between monetarists and Keynesians may have died away in many parts of the world but, in Japan, it's suddenly all the rage.

The Bank of Japan (BoJ) announced last week that it was ending its policy of so-called "quantitative easing". Over coming months, it will be draining "excess" liquidity out of the Japanese economy.

For those of a monetarist persuasion, the BoJ's decision will leave Japan, once again, staring into a deflationary abyss. For others, the BoJ's decision is just a technical matter, with no direct implications of any significance for Japan's future economic development.

So which view is right? And what does the BoJ's decision mean for the rest of us? To answer these questions, we have to delve into the reasons behind Japan's recovery over the past two to three years.

For monetarists, the recovery has everything to do with quantitative easing. Japanese interest rates fell to zero many moons ago yet, despite low interest rates, Japan's economy seemed unable to stage any kind of resilient recovery.

There were a few, fleeting, moments of economic strength but, all too often, these proved to be disappointingly fragile: both the Asian crisis in 1997-98 and the collapse in global equity prices in 2000-01 had a bigger depressing effect on Japan than on other major industrialised economies.

Quantitative easing seemingly offered a different approach. For monetarists, this was Milton Friedman's famous "helicopter money": the BoJ "dropped" money into the financial system, leaving banks with too much liquidity: they, in turn, lent the new money out and, as a result, spending in the economy began to recover.

Bolted on to this story was the so-called deposit multiplier. This is a remarkably simple idea: if, on the back of an injection of ¥1,000 of helicopter money, a bank lends out an extra ¥800 to a customer, and the customer spends ¥600, the recipients of that expenditure can then deposit the ¥600 in the bank. The bank can then lend out a further ¥480 - assuming that, each time, the bank chooses to lend out four-fifths of any increase in deposits. And the whole story is repeated all over again.

By the end of the process, the overall increase in lending - and, hence, in spending - is a multiple of the original injection of helicopter money.

It follows, therefore, that any attempt to "drain" liquidity out of the Japanese financial system will, in monetarist eyes, put the mechanism into reverse.

Instead of helicopter money, Japan ends up with "vacuum money": liquidity is sucked out of the economy and activity collapses.

The monetarist concern, therefore, is not so much that quantitative easing is coming to an end but, rather, that the BoJ is about to tighten monetary conditions in a wholly inappropriate manner.

But is the monetarist case really convincing? The Friedman helicopter, and the deposit multiplier, both assume that there are plenty of willing borrowers but not enough lenders.

By adding liquidity, the banking system is better able to meet the demands of would-be borrowers. Through draining liquidity - as the BoJ is proposing to do - the demands of would-be borrowers are no longer met: as a result, the economy weakens once again.

The evidence to support this view is, however, very limited.

Increasing helicopter money - or, expressed more conventionally, boosting the monetary base - should lead eventually to an increase in the broader monetary aggregates; in other words, the money that is created by the banking system, rather than by the central bank.

The left-hand chart, however, shows this has not transpired. Base money did increase rapidly between 2002 and 2004, but even the most ardent monetarist would be hard-pressed to spot any recovery in the broader monetary aggregates, in this case, M2 plus certificates of deposit. There is no evidence of any deposit multiplier at work.

Indeed, the evidence from recent years suggests Japan's underlying problem has not been an absence of lending but, rather, an excess of liabilities.

Quite simply, Japan's post-bubble economy was loaded with debts. Few companies or individuals had the appetite to borrow.

So while the banks found themselves awash with liquidity, they simply didn't have the customers to take the cash away: without customers, there can be no deposit multiplier.

Only the public sector was prepared to borrow. So, if quantitative easing has worked at all, its impact has come through bigger budget deficits.

Rather than selling government bonds to private investors, the Ministry of Finance has, in effect, sold them to the BoJ. The BoJ, in turn, has bought these bonds through resort to the printing press.

Thus, liquidity has found its way into the economy through a mechanism familiar to both monetarists and Keynesians, ensuring that effective demand is propped up by the public sector rather than relying on the depressed animal spirits of the private sector.

Importantly, the BoJ has forcibly stated that, even with the end of quantitative easing, it will continue to buy Japanese government bonds, thereby ensuring that bond yields will remain low.

Put another way, even if financial markets feared a sustained rise in short-term interest rates in the years ahead, long-term interest rates would hardly budge because the value of government bonds would still be underwritten by the BoJ.

Quantitative easing may, therefore, have had an important effect on the economy through the public sector but the private sector has been broadly unaffected.

Excess liquidity within the private sector is exactly that: money balances held within the financial sector that hold little relevance for the economy as a whole.

If the printing press had really worked to lift activity within the private sector, the effect would probably have come through higher inflation which, in turn, would have reduced the real value of excessively high corporate debts.

Inflation, however, has not picked up (see right-hand chart), implying that corporate sector debt reduction has come about the hard way, through cutbacks in capital spending. A persistent period of economic weakness was, until recently, the inevitable outcome.

So, if it's not the quantitative easing that's led to a recovery in private-sector activity, what has? Undoubtedly, the strength of US and Chinese growth in recent years has been a huge help, supporting Japanese exporters.

So, too, has the end of a painful "hollowing out" adjustment, during which Japanese capital headed to China to take advantage of cheaper labour costs.

And companies, finally, may be benefiting from all their years of debt repayment.

For Japan's bigger players, debts have come down to levels seen before the late-1980s bubble. Quantitative easing may have played a useful supporting role, helping to underpin confidence during the difficult times.

But those tricky times appear to have faded: with confidence returning, the need for a quantitative placebo may be fading. As for the rest of us, we should welcome a Japanese renaissance.

Stronger Japanese domestic demand growth can only be good news for the global economy. And with the BoJ desperate to avoid a renewed slide into deflationary recession, Japanese interest rates are going to remain incredibly low for many months to come.

The end of quantitative easing may be a momentous event, but it signifies growing confidence in Japan's recovery, not a momentous mistake by the Bank of Japan.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com