Debate on Japan's Monetary Policy and Foreign Exchange Rate Policy
Richard Katz (The Oriental Economist Report) and Takahiro Miyao (GLOCOM)
The following is quoted from NBR's Japan-U.S. Discussion Forum with the authors' permission.
The monetary/inflation targeting/yen depreciation solution to Japan's problems is, in my view, yet another futile search for a magic bullet that avoids the main problem. Japan has had near-zero interest rates for more than five years. If monetary ease alone were sufficient to cure Japan's problems, it would have done so long ago.
The "inflation targeting" or "yen depreciation" solutions rest on the following chain of logic: 1) the BOJ can create inflation simply by declaring a target and printing lots of money; 2) inflation will cause businesses and consumers to spend more; and 3) yen deprecation will raise the trade surplus sufficiently to end the demand-supply gap. All three links in the chain fail.
All the evidence (from regressions I calculated) shows that the BOJ's ability to create inflation depends on the state of the real economy. In normal periods like 1977-90, when the economy was operating around full capacity, hiking money supply growth clearly led to higher inflation down the road. It did so because monetary ease raised real demand above the economy's ability to produce more; hence prices rose. By contrast, in the 1990s, when the economy was operating far below capacity, the link between money and inflation broke down. Even big increases in money supply growth failed to affect the inflation rate. Instead, the ups and downs of inflation were far more dependent on the ups and downs of real GDP growth.
The inflation faction has cause and effect backwards. It argues that inflation will promote growth, but it can't get the inflation unless it gets growth first. Deflation is not the cause of Japan's problems, but a symptom. It results from the fact that total demand in the economy is about 5-6% below full capacity.
Suppose, nonetheless, that that the BOJ could create inflation at will. Who exactly would increase their spending in response? Companies are plagued by excess capacity, some by 30% or more. Why would any firm with so much useless equipment go even deeper in debt to buy still more useless equipment just because the BOJ promises inflation? As for consumers, to promise them negative real interest rates is to promise them an erosion of the value of their savings. It's a negative wealth effect that would depress consumer spending even more.
Japan needs a three-point program: 1) macroeconomic stimulus focusing on consumer-oriented tax cuts, housing incentives and continued monetary ease to finance these tax cuts; 2) resolution of the bad bank debt problem, including foreclosure on bad debtors and a capital injection with strict conditions; and 3) longterm structural reform to revive the potential growth rate. Japan needs structural reform and macroeconomic stimulus working hand in hand. Neither alone will do the job.
On inflation targeting, readers may be interested in this oped from the Nov. 21 FT.
You sound skeptical about the effectiveness of monetary policy, especially inflation targeting, to revive the Japanese economy. However, it should be pointed out that in Japan there are quite a few economists who insist that the Bank of Japan could stimulate the economy by adopting a more aggressive quantitative easing or inflation targeting policy. For recent articles on this topic, see the following:
Seiji Shinpo, "Quantitative Easing to Accelerate Nominal Economic Growth"
Kikuo Iwata and Yasushi Okada "Towards a New Regime for Monetary Policy --To Adopt Inflation Targeting"
Let me take up the issue of yen depreciation. For ten long years, Japan has scurried from pillar to post, hoping that a "quick fix" would revive growth and avoid the need for painful structural reforms. The previous ones having failed, now comes the latest chimera du jour: yen depreciation.
Over the past few days, officials from the Bank of Japan (BOJ) and the Ministry of Finance (MOF) have suggested that, if the BOJ bought enough foreign government bonds, this would depress the value of the yen. That, in turn, would supposedly trigger a rise in Japan's trade surplus big enough to revive demand. This view is false on several counts:
1) As noted in the FT oped I submitted last week*, the days are long gone when Japan could export its way out of its problems. No matter how low the yen rate, Japan cannot run a trade surplus of $200 billion or $300 billion unless the rest of the world combined runs a trade deficit of exactly the same size. What would it take for Japan to replace a huge budget deficit around 8% of GDP with a price-adjusted trade surplus of the same size? That's about $250 billion. In 1999, Japan's $70 billion trade surplus amounted to 15% of the combined trade surpluses of all the world's surplus countries. To get to $250 billion, Japan would have gobble up more than half the global surplus. That's far higher than its peak share, 34% in 1986 and, since then, Japan's share has steadily shrunk, as new competitors arose. For Japan's surplus to soar, the surpluses of China, South Korea, France, Germany and all the rest would have to dwindle. It's not going to happen.
2) Pushing down the real effective yen rate is easier said than done. The effort would likely trigger destabilizing competitive devaluations in much of the rest of Asia. Like everyone standing up in the bleachers, no one gets a better view. Worse yet, as in the 1996-97 yen depreciation, the "collateral damage" to the rest of the Asia could be severe.
3) A few economists argue that yen depreciation would raise import prices, thereby triggering inflation within Japan, and the latter would supposedly revive demand. This is a particularly strange view. Paying more for imports just takes money out of the pockets of Japanese consumers and sends it to foreign lands. How does that revive demand inside Japan? To believe the imported inflation argument is to believe that Japan would grow faster if oil prices doubled.
4) Even within Japan, the "collateral damage" of a cheap yen policy could be far greater than the benefits. For the past four years, the ups and downs of the yen and the stock market have been correlated. The reason is that one-third of the trades in the market are being made by foreign investors. They're the critical swing factor. To tell foreign investors that the yen will be depreciated by 20% is to tell them that the value of their stocks as measured in, say, dollars will also drop by 20%. They'll head for the exits.
Here are a few comments on your seemingly persuasive argument.
I don't know about BOJ or MOF, but I believe that the depreciation of the yen will have a positive impact on the Japanese economy, mainly through the balance-sheet effect. Let me comment on the four points that you have just made.
1) In reality, the depreciation of the yen tends to raise the stock values of exporting industries, having a positive asset effect on the economy. This is due to investors' expectations, regardless of whether they are rational or not.
2) I don't think China would devalue its currency even if the yen goes down to 130 or 140 yen per dollar. And the rest of Asia might well go along with China, rather than with Japan.
3) This is a very important point to discuss in detail. I believe the most serious thing about Japan now is the negative effect of deflation affecting balance sheets in the corporate and banking sectors of the economy. Cheep imports are hurting these sectors, while partially benefiting the consumer ("partially" because the consumer is also suffering from deflation due to its negative impact on their employment, income and assets). Therefore, yen depreciation would have a positive impact on the corporate and banking sectors, where their stock prices could increase significantly, leading to the revival of Japanese corporations and banks, and the consumer would not mind import price increases too much if employment and income are secured.
4) Ask yourself as a foreign investor if you prefer a Japan with the real economy being destroyed by deflation while keeping the high value of the yen or a Japan with the real economy being revived by moderate inflation while gradually depreciating the yen. At least Japanese domestic investors would choose the latter.
In response to your first point that "in reality, the depreciation of the yen tends to raise the stock values of exporting industries, having a positive asset effect on the economy," I must say that it often does raise the stock prices of exporting firms, but it has tended to lower the prices of most of the rest of the stock market.
Regarding the second point about Asia, China has control over its currency rate (provided, in part, by capital controls). The rest of Asia does not, as shown in 1997-98.
As for the third point, you wrote: "I believe the most serious thing about Japan now is the negative effect of deflation affecting balance sheets in the corporate and banking sectors of the economy."
Even if one accepted this argument, there is a huge difference in the impact of domestically-generated inflation and "imported inflation" caused by higher import prices. The latter is a clear negative for all but a few import-competing industries. If you disagree, I ask you if you think a doubling of oil prices would help Japan. Imports from competing foreign firms are such a small share of the economy that, aside from a few sectors like apparel, they are a small share of the source of deflation. As for the economy, a big drop in apparel prices means consumers can spend a lot less on clothes, leaving money to buy other items. Lower import prices can raise overall demand in the economy. Regarding the consumer, whatever the impact may be on employment and income, deflation ADDS to the real value of consumer assets (e.g. savings accounts). It is borrowers that are hurt by deflation, not savers.
In response to your fourth point that "you ask yourself as a foreign investor if you prefer a Japan with the real economy being destroyed by deflation while keeping the high value of the yen or a Japan with the real economy being revived by moderate inflation while gradually depreciating the yen," I should say that if yen depreciation could really do what you say, then foreign investors would prefer it. But Japan has tried it and it has failed. Investors have seen this. What would really improve growth prospects, draw in foreign investment (and thereby tend to raise the value of the yen) is a real commitment to serious reform.
In order for us to make a more fruitful argument about yen depreciation, let us go back to the original message that you posted on NBR's Japan Forum mailing list.
Richard Katz wrote:
For ten long years, Japan has scurried from pillar to post, hoping that a "quick fix" would revive growth and avoid the need for painful structural reforms. The previous ones having failed, now comes the latest chimera du jour: yen depreciation.
Over the past few days, officials from the Bank of Japan (BOJ) and the Ministry of Finance (MOF) have suggested that, if the BOJ bought enough foreign government bonds, this would depress the value of the yen. That, in turn, would supposedly trigger a rise in Japan's trade surplus big enough to revive demand.
First, it could be quite misleading to characterize the monetary easing/inflation targeting/yen depreciation policy as a "quick fix" to "avoid the need for painful structural reforms," because there are a lot of reformers even within the Koizumi Administration, including Heizo Takenaka and other Cabinet members, who are advocating such a policy (since they would like BOJ, not the government, to stimulate the economy), Richard Katz himself has admitted that "Japan needs structural reform and macroeconomic stimulus working hand in hand. Neither alone will do the job." (Richard Katz, Inflation Targeting, on Nov. 16, NBR's Japan Form)
Second, the recent suggestion that BOJ buy foreign government bonds seems to be aiming at yen depreciation AND more money supply, i.e., killing two birds with one stone, as reported in the December 6 issue of Nihon Keizai Shinbun Newspaper. So it is not fair to focus exclusively on the effect of yen depreciation in our debate. We need to take up the overall impact of BOJ's policy of purchasing foreign government bonds. Here the best reference, in my view, is the Iwata-Okada paper on the GLOCOM Platform, as I pointed out before:
(Quoted from "Japan-U.S. Discussion Forum" <email@example.com>.
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