Further Quantitative Easing Needed to Stop Deflation
Seiji SHINPO (Professor, Aoyama Gakuin University)
There seem to exist wide differences in opinion among economists as well as policymakers on Japan's economic woes. Such differences have contributed to serious mistakes in diagnosis and policy prescriptions for the failing condition of the Japanese economy, leading to the wasteful repetition of ineffective policies and the postponement of effective treatments for the real problems.
Mistakes in Diagnosis
1) Fiscal policy vs. monetary policy
In terms of diagnosis, the first mistake is about fiscal policy vs. monetary policy. There are still many economists and policymakers who are advocating expansionary fiscal policy in Japan. But I believe, as many American and European economists do, that the multiplier effect of fiscal policy is not as large as it is often assumed. As a matter of fact, Japan is the only major country that is still trying to boost the economy by expansionary fiscal policy, while other advanced countries went through fiscal restructuring in the 1990s.
The ratio of structural fiscal balance to GDP in Japan was 1.4% in 1991, but declined to minus 5.8% as a result of massive public investments and tax cuts. In contrast, the ratio has increased in the case of the US and European countries, as they adopted the policy of fiscal restructuring consistently throughout the 1990s. They no longer believe that economic growth is accelerated by demand expansion policies such as Keynesian-type fiscal expenditure and tax policies. Instead, they are now subscribing to the idea that reductions in fiscal deficit will help lower interest rates and increase public confidence in the future, leading to higher economic growth. The ineffectiveness of expansionary fiscal policy has been proved by the poor performance of the Japanese economy with massive public investments undertaken in the 1990s, as compared to the much better performance of other advanced countries with fiscal restructuring in the same period.
Furthermore, Japan's fiscal policy has failed to reverse the trend of nominal growth deceleration. As I will show later, it turns out that nominal growth is affected more by monetary policy than by fiscal policy, and tight monetary policy in the first half of the 1990s seems to have contributed to declines in the nominal growth rate, whereas expansionary fiscal policy did not have a significant effect in this regard.
2) Causes of deflation
Another mistake is regarding the causes of deflation. Many American and European economists identify the supply-demand gap or the shortage of money as the cause of deflation. But Japanese economists tend to have an impression that too much money is already supplied and flooding the economy, because they look at the declining trend of the "velocity" (the ratio of nominal GDP to money) over time. However,in Japan there is a long-run trend of declining velocity due to development of financial institutions heavily dependent on indirect financing rather than direct financing. When we calculate the deviation of the velocity from its declining trend line, we find that it consistently deviated upward throughout the 1990s. That means that money was scarce.
Japanese economists tend to believe that deflation is caused by cheep imports from low-cost countries like China. In order to show that this is not the case, I have estimated an inflation rate function using four explanatory variables: the GDP gap rate, the expected rate of inflation, the rate of change in import prices and the deviation of the velocity from the trend line. It has turned out that the GDP gap variable seems to have a more stable effect than the import price variable on deflation, and in addition the deviation of the velocity from the trend line has a significant effect in the case of Japan. This means that money supply tends to affect the rate of inflation (deflation) directly through changes in the velocity as well as indirectly though its effect on the GDP gap.
Mistakes in Policy Prescriptions
1) Interest rate cuts
The first major mistake in policy prescriptions was the delay in interest rate cuts in the early 1990s. Facing a credit crunch around that time the U.S. monetary authority reduced the nominal interest rate substantially, and,as a result the real interest rate became zero by 1992. In Japan, however, nominal interest rates were not reduced enough and the real interest rate remained at relatively a high rate of 2%. The Bank of Japan did reduce the nominal interest rate to the near -zero level after 1995, but it was too late to prevent deflation from happening.
I have estimated a nominal growth rate function using five independent variables: the rate of change in money supply, the rate of change in government spending, the rate of change in exports, banks' lending attitude and the inflation rate. Our result shows that the effect of money supply is much greater than that of government spending. We therefore can conclude that fiscal policy is ineffective, and it was mainly monetary policy that reduced the nominal growth rate in the 1990s.
2) Disposition of NPLs
Another mistake was the delay in disposition of NPLs (non-performing loans), as is often pointed out. Not only Japan but also some other advanced countries suffered a banking crisis from the late 1980s to the early 1990s, but the other countries adopted serious measures to deal with such a crisis between 1991 and 1993. Japan did not learn from the experiences of the other countries, and waited until 1998 when the Long-Term Credit Bank went bankrupt before becoming serious about the banking problem. As a result, the cost of solving the problem has grown very large in the case of Japan.
Clearly, increasing costs due to the delay in dealing with the NPL problem have been affecting the growth rate in Japan. The other countries that had dealt with the NPL problem returned to a steady growth path by 1994, whereas Japan experienced a decline in the growth rate in the mid- and late 1990s. This is because Japan's problem has progressed from the simple supply-demand gap problem to a more complicated one due to the delay in disposition of NPLs.
3) Transition to technology-led economy
A mistake from the long-term point of view is the delay in transition from an investment-led economy to a technology-led economy. For that purpose, it is necessary to construct a new incentive system based on individualism and creativity by thoroughly reviewing the existing institutions of education, corporate governance, taxes, capital markets, etc. Furthermore, Japan's economic structure should be reformed by privatization, deregulation and liberalization with emphasis on equality in opportunities, not necessarily in results, so that it can be more flexible and adaptive to changing economic conditions.
Many economists are still arguing that economic recovery is needed before structural reform, but the problem is how to achieve economic recovery. The most serious problem with the Japanese economy is that public confidence in growth capacity has been lost due to the prolonged stagnation of the economy in the 1990s, and as a result expansionary fiscal policy can no longer stimulate corporate investment. What needs to be done, therefore, is to change the existing policy stance and proceed with structural reform, while dealing with the NPL problem.
Necessity of Quantitative Easing
Although I have emphasized the importance of structural reform, it could take 5 to 10 years for such reform to bear fruit, as exemplified by the Reagan-Thatcher revolution. In the meantime there is a high probability that deflation might be worsening. Without curing deflation we will face a number of serious problems.
First it would be very difficult to solve the banking problem under deflation. Banks could not raise interest rates in order to improve profitability because the real interest rate is quite high. In addition, borrowers' balance sheets would worsen under deflation.
Second, fiscal deficits might well be increasing and possibly leading to fiscal bankruptcy. This is due to the fact that the nominal growth rate remained below the long-term interest rate throughout the 1990s, and this situation could not be sustained too long. To avoid fiscal bankruptcy the nominal growth rate should be raised to at least around two percent. That would only be possible by increasing money supply and not by increasing fiscal spending.
In the spring of 2001, the Bank of Japan--which had insisted that quantitative easing would be ineffective-- decided to adopt the policy of quantitative easing and increased the monetary base substantially from mid-2001 to mid-2002. However, the increase in the monetary base appears to have slowed down in recent months. Some economists are claiming that increasing the monetary base would not have a significant effect because banks' lending route is not working properly.
To refute this claim I have estimated a money supply function with four explanatory variables: the monetary base, time trend dummy, lending attitude and money supply with one-period time lag, using yearly data from fiscal year 1974 through fiscal year 2000, and obtained the result that the monetary base does have a significant effect on money supply. Our simulation, applying this money supply function, has indicated that if the Bank of Japan continues to increase the monetary base at the rate of 10% per year, money supply will increase to 7% per year and the nominal GDP growth rate will become about 2% by 2006. If, on the other hand, the growth rate of the monetary base is kept at the low rate of 1.2%, money supply as well as the nominal growth rate will decrease in the future.
More recently I re-estimated the same money supply function by using quarterly data from the first quarter of 1974 through the first quarter of 2003, and it has turned out that a new trend dummy is required for the period from the first quarter of 1999 to the first quarter of 2003. This is the period of the zero interest rate, when the effect of the monetary base on money supply became more limited than before because there is little room left for further interest rate reductions. Based on this result our simulation shows that the 10% increase in the monetary base would no longer be enough to avoid negative nominal growth rate. At least an average of 25% increase in the monetary base per year would be needed to increase the nominal growth rate by about 2% over the next five years.
To solve the banking problem and to avoid a fiscal bankruptcy in the future we need to raise the nominal GDP growth rate, which can only be done by increasing the monetary base. Given the current condition of the Japanese economy we must accelerate the growth rate of the monetary base substantially at least for several years to have an intended effect on money supply and nominal GDP growth. It is also important to diversify means to increase the monetary base by purchasing long-term government bonds, foreign government bonds, and even private securities if necessary.