On the Japanese Economy and Monetary Policy under Deflation

Interview with Nobuyuki NAKAHARA
(Former Policy Board Member of the Bank of Japan)

Q: In your recent book, "The Japanese Economy and Monetary Policy under Deflation" (Toyo Keizai Shunpo-sha, 2002), a collection of the lectures that you have delivered as a BoJ Policy Board member for the past four years, you mentioned that "the third recession in the Heisei depression era will occur " (December 2001). Could you explain?

NAKAHARA: I think that quite a severe economic condition will continue in the next year or two. I believe, however, that the Japanese economy will rebound by the end of 2004 at the latest. By that time, stock prices will finish their downward adjustment and land prices will stop declining after about a 10% decrease from the current level. The overbanking condition has been easing noticeably. If the total loan balance in the five financial sectors decreases by 10% to be around 400 trillion yen, banks will be able to regain profitability and start increasing loans. It will take about two years to see that happen. The business cycle is entering the bottom-up phase and will soon turn the corner to see what lies ahead.

Q: That sound unlikely because of the prolonged recession. Can you imagine the worst scenario of "Japan selling" as a result of further downgrading of government bonds due to expanding fiscal deficit?

NAKAHARA: The recession has been prolonged partly because of policy mistakes. The economy would have been in a better shape if policy makers had not adopted monetary tightening or consumption tax hikes after the bursting of the bubble. I would say, however, that there is little risk of capital flight and government default, because only 6% of Japan's government bonds are held by foreign investors.

Q: What are memorable Monetary Policy Meeting decisions for you during the last four years?

NAKAHARA: First, I remember the decision on the zero interest rate in February 1999. Executive members were hesitant, but my opinion was adopted and the interest rate was lowered further down to zero at the second meeting in February that year. That was memorable indeed. Second, the decision to move away from the zero interest rate policy was made in August 2000, when I believed that the economy had peaked out while executive members thought that the peak would last for at least six more months. While most of the Board members argued for raising the interest rate, I was opposed to such a move. In hindsight, the decision was a mistake. Third, the decision on quantitative easing in March 2001 was quite memorable. It was a 180 degree change from the traditional monetary policy that had targeted interest rates for the past 120 years. If we regard the peak of the bubble in 1989 as the peak of Japan's modern capitalism for the past 120 years, then it was rather natural to see the change in the regime of monetary policy in the 1990s. Due to quantitative easing, the BoJ's checking account balance has become 27 trillion yen, and we need to keep this amount at least for a year or two.

Q: How do you respond to the opinion that quantitative easing does not have any impact on the economy, because money is exchanged only between financial institutions and the government through government bonds?

NAKAHARA: It has been supporting stock prices. Substantial quantitative easing since September last year has prevented the stock market from collapsing. Furthermore, quantitative easing has lead to yen depreciation, having a favorable impact on the Japanese economy. Also the purchase of government bonds by financial institutions has kept the long-term interest rate from rising.

Q: Why are BoJ executive members negative on inflation-targeting policy?

NAKAHARA: Probably they think that "inflation is an evil" under any circumstances. In my opinion, they introduce too much ethical judgment into economics. They are opposed to inflation-targeting policy on the grounds that there is no means to achieve it. I believe, however, that it is possible by adopting alternative means to increase base money by purchasing long-term government bonds and foreign government bonds, for example. We can and should set a 1-3% inflation rate as a target to be achieved in the next two years.

(Translated from "Economist," April 30/May 7, published by Mainichi Shinbun, and posted here with the permission of the publisher)