Amid widespread economic uncertainty, some economists prefer a more expansionary monetary policy or inflation targeting. At a recent meeting of the government’s Economic and Fiscal Advisory Council, many members called on the Bank of Japan to relax credit restraints even further.
Those experts fail to recognize that the effects of monetary policies will spread only through corporate activities. Most companies today are struggling to overhaul their balance sheets, and few executives are willing to increase investments in response to the Bank of Japan’s monetary expansion or inflation targeting.
Economics textbooks say that if the central bank offers additional money to commercial banks — or if it increases its “monetary base” — bank loans will increase and stimulate the economy. This theory would apply if banks had unlimited lending opportunities, but that is not the case in today’s Japan.
Companies borrow money when they have investment opportunities. Banks, if they have a fund shortage, raise funds in the short-term capital market. That is where the central bank comes in. The central bank tightens credit to prevent the economy from overheating and eases credit to help economic recovery when it slows down. Demand for funds is all-important. If demand for funds is very slow, an easing by the central bank will not lead to an increase in commercial-bank loans.
Economist Naoki Tanaka says an expanded monetary base will immediately lead to more orders for machinery through lower interest rates and the increased availability of funds. That is not true under the present circumstances, where companies have only limited investment opportunities and demand for funds, or where banks have limited lending opportunities.
Kikuo Iwata, a professor at Gakushuin University, advocates an increase in money supply through buying operations in securities for companies and institutional investors. He says this will lead to an increase in money supply that will be invested in stocks and will lead to a rise in stock prices. This view is based on the wrong assumption that companies are curbing investment due to their limited cash position and that once such limits are removed, investment will increase.
Most companies, fearful of a fall in stock prices and a downgrade in their credit ratings, are trying hard to regain market confidence by reducing low-priority assets and corresponding liabilities in their balance sheets. Even if they are not short of funds, the companies are unlikely to make investments that do not match their strategic goals, or to invest without weighing potential returns and risks involved on the basis of carefully prepared plans. No executives will acquire assets that have little to do with their management strategies and have low priorities, even if interest-free loans are available.
Advocates of inflation targeting say that to stimulate the economy, the BOJ should set a target of around 3 percent for inflation and should increase money supply sharply as long as the inflation rate stays below the target. However, executives who have a blind faith in the BOJ’s inflation target and increase investment and wages in anticipation of inflation will be doomed to failure.
Proponents of inflation targeting say that anticipation of inflation will help reduce real interest rates and stimulate corporate investment. In my view, short-term interest rates may decline but long-term interest rates, used to calculate returns on capital spending, are likely to rise. If investors were to naively trust the BOJ’s inflation target, they would rush to sell government bonds, fearing a fall in government bond prices. This would trigger a rise in long-term interest rates. An inflation target would be useless unless it was trusted. If trusted, however, the target would touch off a vicious rise in interest rates that would retard economic recovery.
Companies continue to make necessary investments, but their total sum is not sufficient to prompt self-sustaining economic recovery. Since companies are willing to increase investments if they have profitable opportunities, everything should be done to facilitate investment. If corporate demand for funds increases with investment, long-term interest rates will post a “benign” rise.
Advocates of inflation targeting often cite foreign examples. A BOJ survey of inflation targeting covers 12 nations, including Britain, Canada, and Brazil. These are either developing countries with double-digit or nearly double-digit inflation, or developed countries with high inflation rates or recent memories of runaway inflation.
Tatsuzo Miyao, a professor at Kobe University, conducted studies of Japan in the 1990s, when effects of monetary policies on prices were nonexistent. He says his studies showed that inflation-targeting policies would be difficult to implement when the target rate is higher than the existing inflation rate. Advocates of inflation targeting must be ready to explain how the inflation target will work in a deflationary period.
Policy proposals based on wrong assumptions are of little use and could be used as a pretext for delaying structural reform. If it were possible to use monetary policies to promote economic recovery, painful structural reform would be unnecessary. This would be convenient to politicians representing vested interests. Japan has delayed structural reform that is required for easier investment, and has depended excessively on monetary and fiscal policies. As a result, it has failed to get out of the recession, and can no longer resort to expansionary monetary policy and expanded fiscal spending to stimulate the economy.
John Maynard Keynes proposed using fiscal spending to make up for a shortage of effective demand if expected return on investment, or marginal efficiency of capital, did not exceed prevailing interest rates. Following his theory, Japan has cut interest rates to almost zero and maximized fiscal spending, yet it has failed to perk up the economy. Keynes took as given the existing equipment and technique that affects the marginal efficiency of capital, but added that these factors are not necessarily constant.
Efforts to put a floor under the flagging economy in accordance with Keynesian theories should be accompanied by efforts to create an investment-friendly environment. Measures required include deregulation for reinvigorating economic activities and expedited writeoffs of banks’ bad loans, which impede their lending operations.
The theories of increasing money supply and inflation targeting are not valid, with their advocates neglecting the realities of corporate activities. Economists and executives seem to live in different worlds. Economists can restore the validity of their theories by learning from executives. They have a responsibility to give valid theoretical support to economic recovery.