Suddenly it’s game on in Tokyo – and the world is watching. For the last fifteen years Japan has been trying to shrink its way out of its problems. That failed. Now it is about to try the opposite.
Japan’s “lost decades” have become an awful warning of the damage that a spectacular boom and bust can inflict on an economy’s long-term potential. Now Japan could be another kind of example. If Prime Minister Abe’s pedal-to-the-metal reflationary policies succeed, there will be a profound impact on post-crisis policy-making everywhere.
History teaches that Japan rarely does things by half-measures. The financial bubble of the nineteen eighties was probably the biggest in history. At its peak the Tokyo stock market was worth more than half of global market capitalization.
The reaction has been equally intense. Twenty three years after the Japanese bubble burst, the Nikkei Index has been flirting with new bear market lows. Weak growth and deflation have meant that Japan’s nominal GDP is no higher now than in 1992.
Even so macro policy settings have remained contractionary. Just last year Ex-Prime Minister Noda pushed through a bill to double consumption taxes. Spending on public works declined from a peak of ten percent of GDP in the late 1990s to three percent recently.
Unfortunately the reward for such “Austerian” rectitude has been an explosion in Japan’s debt to GDP ratio. Tax revenues have collapsed and social spending has soared – a phenomenon that has become familiar in Europe too.
Monetary policy has done little to support growth. The Bank of Japan’s balance sheet is barely larger now than in 2005. Operations have mainly consisted of buying short-term bonds from the banks. The mood music from BoJ spokesmen was that they didn’t believe that monetary policy could or should be deployed more aggressively.
When a group of investors visited the Bank of Japan last spring to hear about the BoJ’s self-created inflation “goal” (the Japanese text was left deliberately vague), they were surprised to be treated to a forty five minute discourse on demographics. The message was clear – deflation was the fault of Japan’s inadequately fertile womenfolk, not the elite officials of the central bank.
As long ago as 1998, Milton Friedman blamed Japan’s economic problems on “a decade of inept monetary policy.” He also warned against the error of identifying easy money with low interest rates. The high interest rates of the 1970s, he pointed out, were a signal that monetary policy was too loose, not too tight. Likewise the low interest rates of Japan today – like the US of the 1930s – show that monetary policy is too tight, not too loose.
Sooner or later a Japanese politician was going to get the message. That politician turns out to be the new prime minister, Mr. Shinzo Abe. He owes his landslide victory to the reflationary program that was at the heart of his election campaign. Already he has started to revive public works spending – which is sensible, given the inadequacies of Japan’s aging infrastructure and the need to protect against natural disasters.
However the greatest emphasis will be on monetary policy. Mr. Abe has unsheathed his samurai sword and demanded much greater aggression from the BoJ, on pain of the removal of its independence. He wants an explicit inflation target and a weaker yen, to be delivered by an “accord” between the government and the central bank.
Here he is breaking at least two taboos of modern-day central banking. The first is that a more competitive exchange rate should not be a policy target, since that would constitute “manipulation” – an activity frowned on by the US Congress, which produces a list of malefactors each year.
In reality this is humbug. Everyone knows that currency depreciation is a crucial mechanism for reflating demand-starved economies. Indeed outgoing Bank of England governor Mervyn King hinted as much in interviews. Since the Lehman shock, the US itself has benefited greatly from dollar weakness.
The Swiss central bank has already drawn a line in the sand which it will not allow the franc to cross, and the Koreans have effectively been managing the won rate for years. But these are not major currencies. Japan is the first G8 country to challenge this monetary version of political correctness.
The second taboo is to re-establish political influence over monetary policy. It has become axiomatic that central banks should be independent entities, insulated from the grubby machinations of politicians. Again, the reality is more complex. Sophisticated operators like Messrs. King, Bernanke and Draghi know how to trim their sails to the prevailing social and political winds. Furthermore the benefits of independence – greater transparency and predictability leading to cheaper borrowing costs – were more obvious in the inflation-racked seventies and eighties than in today’s world of excess capacity and rock-bottom interest rates.
More fundamentally, is it safe to assume that monetary policy is an apolitical activity and that central bankers are objective arbiters of what is best for the national interest? The Japanese experience suggests not. Monetary policy is inherently political since it affects the balance of interest between savers and borrowers, importers and exporters and, in Japan’s case the old and the young.
Neither are central banks above the fray. Like all bureaucratic entities, they aim to expand their prestige and influence. For the Bank of Japan to admit that its previous strategy was misconceived would leave it open to Friedman-like accusations of responsibility for Japan’s long malaise. It is no more likely to reverse itself of its own accord than the Japanese military seventy years ago.
The interesting question is what happens if Mr. Abe implements his growth program as promised and it actually works. Imagine Japanese exporters recovering market share, tax revenues surging, stock prices in a multi-year bull market and the doomsters predicting fiscal apocalypse getting it as wrong as the Mayans.
In such a case, “turning Japanese” would have a whole new meaning. It would be something to be envied and copied, not feared.