Mixed-up policy mix links U.S. and Japan


Economic policy is all about mixing and matching. The trick is to get the mix just right between monetary policy and fiscal policy so that they match and complement each other nicely.

The mixture can take a variety of forms. You can have a tight monetary policy coupled with a cut-loose fiscal policy, or vice versa. You can also have monetary and fiscal policies both going the same way: a combination of low interest rates and big budget deficits strikes a familiar chord.

The last combination is, in fact, the kind that we have been using in Japan for quite some time. Interest rates are virtually nonexistent. Meanwhile, the government’s budget deficit is running at alarmingly close to 10 percent of Japan’s GDP.

In theory this ought to make a lot of sense, given that Japan has been suffering from deflation for so long. A deflationary economy needs support: low interest rates to support borrowers, low taxes and lots of government spending to support consumers and business.

In practice, however, it hasn’t so much been a case of policy supporting the economy, but more of the economy playing havoc with both monetary and fiscal policy. For interest rates remain low less by policy design than for a lack of borrowers in the private sector. And the budget deficit is large because the tax intake is not enough to cover the debt service obligations that the government has accumulated as a result of past profligacy.

The United States is another country where both monetary and fiscal policies are currently very lax. It was not always thus, though.

There was a time when the U.S. policy mix was one of very loose fiscal policy and extremely tight monetary policy. This was back in the 1980s. It was, in fact, the Reaganomics answer to economic management.

Supply-side tax cuts led to ever larger budget deficits and ever faster growth in the money supply. The Fed tried for all it was worth to prevent that money supply growth from getting out of hand, with the result that short-term interest rates shot up into double-digit heights toward the mid-1980s, upsetting a lot of debt-ridden American consumers.

There was, however, a silver lining in that monetary squeeze, because the double-digit interest rates attracted a lot of foreign capital to the United States. This pushed up the dollar, and the high dollar in turn prevented inflation rates from going up. Thus, lo and behold, the United States looked as though it had achieved inflationless growth.

Is that option open for the United States today? And will Japan be able to escape unscathed from the low-interest-rates-plus- large-budget-deficit fix it finds itself caught in today?

The answers are no to the first, and with extreme difficulty to the latter.

The way that market sentiments are running about the U.S. economy and its twin deficits at present, higher interest rates will more likely be the result of a run on the dollar rather than the product of conscious monetary policy. In Japan, the Bank of Japan is still seeking that elusive exit from its zero-interest-rate policy that won’t result in soaring long-term interest rates and slumping government bond prices.

Meanwhile, the yen-dollar exchange rate, the hinge that connects the two sets of loose money-loose budget policy mixes, looks poised to break the 100 yen barrier at any time.

That eventuality spells more deflation for Japan, and no more getting away with the twin deficits for America. The latter is a good thing. The former is not. One cannot help having mixed feelings about policy mixes.