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The folly of inflation targets

by Mamoru Ishida

Prime Minister Junichiro Koizumi said recently the next governor of the Bank of Japan must take aggressive action to fight deflation, giving rise to expectations of inflation targeting among government and ruling coalition officials. I doubt, however, that inflation targeting will cure deflation. In March 2001, the BOJ raised the balance of commercial banks’ current deposits with the central bank to 5 trillion yen to enable banks to increase loans. Continued pressure for easier money from the political community and mass media prompted the BOJ to raise the amount to 6 trillion yen and then to 7 trillion yen, a former BOJ official recalled. The amount now stands between 15 trillion yen and 20 trillion yen, but bank loans have kept decreasing and business investment remains sluggish.

The government has been trying hard to expedite the disposal of banks’ non-performing loans. Undoubtedly, it is necessary for banks and companies to restructure their balance sheets, but that does not guarantee recovery in capital spending.

In fact, companies without balance-sheet problems are moving their production plants overseas, which means a decrease in domestic investment. Low-cost imports from their overseas plants have deflationary effects on the economy. Increased supply of and decreased demand for land lead to a drop in land prices.

Business investment offers poor returns in Japan, where costs are higher, regulations are tighter and tax systems are less favorable for businesses than in other countries. This is the basic cause of Japan’s deflation. No wonder unprecedented easy-money policy has not cured it.

Koichi Hamada, chief of the Cabinet Office’s Economic and Social Research Institute, argues that, since deflation is a monetary phenomenon, it can be cured by monetary measures. If an inflation target of 2 to 3 percent, to be achieved in two years, is announced by BOJ, it will stir expectations of inflation and make savings less attractive. Easier money will also cause the yen to depreciate, he says, which will help Japan’s economy.

Theoretically, he is right, but Japan has a large current-account surplus while the United States suffers from a huge deficit. Experience tells us that a sudden change in U.S. exchange-rate policy could cause the yen to appreciate overnight. The nation’s destiny should not be left to such uncertainty. Finance Minister Masajuro Shiokawa says the yen’s exchange value should be lower, but is he ready to negotiate an agreement with the U.S. to stabilize the yen-dollar exchange rate at a level lower than at present?

Inflation targeting would work only if it prompted consumers and companies to increase spending in anticipation of inflation, for it would then improve the supply-demand balance and cause a rise in prices. I doubt that those economists advocating inflation targeting will start spending more money.

Companies making investments on the basis of an inflation target would be forced out by the market, which demands that every effort be made to reduce large interest-bearing liabilities. Companies will invest only in projects that are strategically important and promise certain levels of returns, say 8 percent a year or more. A 0.2 to 0.3 percent fall in the long-term interest rate will have practically no effect on business investment.

What if both the business sector and the financial market trusted the BOJ’s inflation target? Business investment is a time-consuming process, involving market research, planning and construction. On the other hand, the financial market reacts much faster. Many market participants forecast that inflation targeting would trigger a fall in government bond prices and a rise in the long-term interest rate. A decline in government bond prices would further worsen banks’ balance sheets.

The BOJ would then buy a large amount of government bonds to stabilize bond prices, but that could unleash more selling. That’s because the market is basically uneasy about the large-scale issuance of government bonds with no end in sight. The time has come to acknowledge once and for all that the credibility of government bonds as well as that of the BOJ’s balance sheets ultimately depends on the government’s tax-collection prospects.

An inflation target will not work unless it is trusted. If it is trusted, though, the resultant rise in long-term interest rates will discourage capital investments. Macroeconomic consumer and business spending is a sum of microeconomic consumer and business spending. We should not be under the illusion that something that does not happen in the microeconomies will happen in the macroeconomy.

Kikuo Iwata, professor at Gakushuin University, told the Lower House Budget Committee last year that those countries that adopted inflation targeting in the 1990s succeeded in their economic policies, but he didn’t name any. In fact, New Zealand, Canada, Britain, Sweden, Australia, Chile, Israel, Czechoslovakia, South Korea, Poland, Brazil and Indonesia used inflation targets — to control inflation or stabilize exchange rates, not to end deflation. Corporate and banking executives know from experience why the central bank is unable to change deflation into inflation.

Companies borrow money from banks for investment. Banks raise the required funds in the short-term money market. When the economy is overheated, the central bank tightens money supply, forcing banks to restrain lending and companies to curb investment. This helps control inflation.

Under the present low-interest environment in Japan, there is little room for interest-rate cuts. Very small cuts, if any, will not make unprofitable investments profitable. Banks will have no need to raise funds in the market. An increase in the BOJ’s money supply will lead only to a rise in banks’ current deposits with the central bank.

This shows that an environment conducive to business activities must be created to end deflation. That was Prime Minister Junichiro Koizumi’s objective when he said “no economic growth without structural reforms.” His reforms have not produced visible results in the macroeconomy, mainly because his tax and regulatory reforms have been too little, too late.

Koizumi should go back to the drawing board and refocus tax and regulatory reforms on economic revitalization. Unfortunately, Heizo Takenaka, his chief economic adviser as minister in charge of economic, fiscal and financial policy, is instead urging the BOJ to implement an inflation-targeting policy.

Monetary policy is the BOJ’s responsibility. It should explain explicitly to the public why inflation targeting will not work and what the bank will contribute toward ending deflation. This is the first step in defending its threatened independence.