Most of Japan’s modern economic history consists of a long series of achievements pronounced impossible by the outside world. Japan was building the foundations of world-beating steel and electronics industries while Occupation officials urged that scarce resources be devoted to “suitable” exports such as cocktail favors.
The International Monetary Fund preaches open financial markets as the key to rapid growth; Japan shut its doors firmly to foreign capital and piled up annual growth rates of 10 percent-plus for 18 years financed entirely out of domestic savings.
The world thought Japan finished in 1974 in the wake of the Arab oil embargo; by 1976, Japan had recovered from the resultant stagflation, something that took the United States eight years.
The exchange rate of the yen doubled in the 1980s; according to impeccable Western economic logic, Japan’s trade surpluses were supposed to halve. Instead, they doubled, too.
Now it is surely unremarkable to note that this sort of thing has been going on for a very long time now. But the latest example of the inability of conventional thinking to cope with Japan contains an interesting twist.
Today, Japan is not confounding the world by doing what experts label “impossible.” Rather, it is avoiding what the global punditocracy of economists, commentators and investment gurus has proclaimed the “inevitable” policy response to the country’s predicament.
What is this magic bullet that the Japanese policy elite refuses to fire? It goes under a variety of names — printing money, creating inflation, gunning the money supply — but the essential idea is that the authorities should scare Japan’s households into spending their savings by threatening to melt their value down.
If people frantically start buying things before their money loses value, so the thinking goes, Japanese companies will see sales rise and will start investing to meet all the new demand. They will be able to afford the new investment because of the rivers of low-interest money the authorities will be pouring into the economy to create this cure-all inflation. Meanwhile, the yen will drop in value as the flood of money increases the supply of yen. Pressure on Japan’s exporters will ease, boosting corporate profits. As the economy recovers on newly pumped up corporate profits, consumer demand and investment, tax receipts will rise and the government can begin to pay down the horrendous fiscal deficit.
The analysis leading to this conclusion can be found laid out in admirable detail by Martin Wolf in the Financial Times and reprinted in the Feb. 21 edition of this newspaper, or, more pithily, by Paul Krugman in the Feb. 9 New York Times. But you can read it almost anywhere. The gist of it goes like this:
In the 1990s, Japan fell into what is known as a liquidity trap. Ordinarily, when an economy slows, the central bank can reduce interest rates, thereby sparking investment with lower borrowing costs and reviving the economy. The Japanese government tried this tactic — reducing interest rates to levels not seen anywhere in centuries. But when businesses anticipate no pickup in demand, they will not invest no matter how low interest rates go — something true of Japan today. Keynes labeled this situation a liquidity trap, and famously compared interest-rate cutting for an economy caught therein to “pushing on a string.”
Keynes’ solution to a liquidity trap is, of course, equally famous: public works financed by deficit spending. This, after some initial reluctance, the Japanese government has done with a vengeance. But all this spending has done little more than prevent the economy from falling into a full-fledged depression while saddling the country with heavy debt.
The construction executives, rural workers, various politicians, fixers and ex-bureaucrats who feed off these projects have not turned around and spent the money pouring into their bank accounts. Rather, they have simply let it sit there, adding to the country’s vast pool of inert savings — the origin of the liquidity trap in the first place.
Now perhaps if the allocation of all this spending had been determined by proper policy analysis rather than connections and pull, it might have done the trick, not to mention sparing rural areas devastation that has to be seen to be believed.
But, so goes the Wolf/Krugman analysis, it is too late for such regrets. The Japanese government is reaching the limits of its ability to finance many more spending sprees. Wolf concludes his piece by saying the Japanese “should try printing money.” Krugman advises the Bank of Japan to “roll the printing presses.” These two eminent economists are not alone in their conclusions.
Several well-known investment advisers are so convinced the authorities have no other way out of the policy trap they have confidently predicted a rapid weakening of the yen in the medium term.
In the meantime, various explanations abound as to why the authorities fiddle while Rome burns, or at least while the Japanese economy stagnates. The most widespread blames the perverse pride of the “newly independent” BOJ. After decades as a kind of glorified errand boy for the Ministry of Finance, the last few years has supposedly seen the BOJ win full control over monetary policy, and the BOJ is said to be guarding its new stature as an independent central bank.
Asking a self-respecting central banker to stoke up inflation is like asking a journalist to serve on a state censorship board or a doctor to help wage biological warfare — it violates professional norms, in this case, the central banker’s prime mission of securing price stability. And thus unable to see past its own institutional pride to the wider national interest — so the thinking goes — the BOJ vetoes use of the one remaining weapon in the Japanese government’s economic arsenal.
But before joining the worldwide chorus of condemnation of these beleaguered officials, maybe we should stop a moment and ask what it would mean in a Japanese context to “create inflation” or “print money.” The Wolfs and Krugmans assume that it would be a matter of pulling the same policy levers that the U.S. Federal Reserve would seize in a similar predicament.
Central banks essentially have two means at their disposal to create money. First, they can buy government bonds. They pay for those bonds with newly created money (literally, you sell a bond to the central bank and the central bank credits your bank account with money that didn’t exist before). Second, they can lend newly created money to banks — the money simply appears as a deposit on the books of the banks. (Central banks can remove money from an economy by doing the reverse — selling bonds or requiring banks to make deposits with the central bank).
In a typical capitalist economy, the demand for money is the result of the interplay of market forces that determine investment and spending decisions in the real economy of factories, groceries and jobs. The central bank accommodates, thwarts or stimulates that demand depending on the business cycle, the central bank’s view of the direction of the economy and the tradeoff it seeks between price stability and growth.
But the final demand for money in the Japanese economy has never been determined by the free interplay of market forces. Until 1991, the major banks were allocated lending quotas by the BOJ and it was up to the banks to see that the money was lent. The banks did not first determine the amount of money they needed to lend in accordance with their customers’ demands; they lent what they were told to lend by the authorities.
Back in the 1950s, ’60s and ’70s, their borrowers were mostly big industrial companies. The banks didn’t ask whether these companies might not be using the money to build capacity in saturated markets, and they didn’t worry about whether their borrowers could pay them back. All they cared about was whether their borrowers were well connected in the Japanese system; it was the responsibility of bureaucracies like the Ministry of International Trade and Industry to guarantee the viability of the loans.
In the 1980s, when Japan’s economic bureaucrats began to worry that they needed something other than exports to an increasingly restive outside world to drive the Japanese economy, they tried to spark a domestic investment boom by pushing more money at the banks. Since the champions of Japanese industry really didn’t need bank loans much anymore, the banks turned to other borrowers — real-estate developers, construction firms, players in the Tokyo stock market. That’s how we got the bubble economy.
But for the last 10 years, the unthinkable has been happening. The Ministry of Finance has defaulted on its promise to keep every bank afloat. Established firms have been going bankrupt. Even the biggest and most solid firms have made it very clear they are no longer prepared to support the liabilities of their affiliates. Now it’s one thing as a banker to loan out all the money the authorities provide you when they guarantee that your borrowers won’t go bankrupt and they promise to bail you out if anything should, after all, go wrong. It’s quite another to do it when those promises turn out to be demonstrably hollow. So if the BOJ follows the Wolf/Krugman advise and floods the banks with money, will they in turn lend it? Maybe not.
Well, what about that other means of creating inflation and gunning the money supply — buying bonds? Krugman and others suggest that the government issue more bonds and the BOJ buy them. Technically, this is possible. Certainly, it would be a sure-fire way of creating inflation in a country like the U.S.
There are, however, two big problems with this approach. First, the Japanese government’s indebtedness is already very high. Increase it by issuing new bonds — even if you simultaneously create new money to buy those bonds — and investors may very well conclude that the existing bonds they hold aren’t going to be worth very much, and that the Japanese government will redeem them only in a depreciated currency. Many may seek to sell those bonds, leading to a drop in the price. When a bond drops in price, its yield — in other words, its implicit interest rate — increases. The BOJ may be holding down interest rates on the money it provides banks, but that is very short-term money. It doesn’t do much good to lower interest rates at the short end if you kick up long-term rates.
In response, one could accurately point out that the Japanese government bond market isn’t really much of a market, that most of the bonds are force-fed to banks and the like that have no choice but to accept them. But that brings us back to the problem we saw in creating inflation by pushing money directly at banks. If you are creating money by buying lots of new bonds, you still have to get that money out into the wider economy if you are going to create inflation. That can only be done in today’s Japan through the banking system, and the banks have to have places to lend in order to get that money moving. To bypass the banks you would have to have a genuine bond market of the type that exists in the U.S., but you cannot create a genuine bond market at the same time you announce your intention to destroy the value of existing bonds.
Krugman has made the bizarre suggestion that the authorities take things one step farther by explicitly announcing their intention to bring on inflation. Well, perhaps Japanese consumers would indeed respond to such an announcement by rushing out to buy more durables to cram into their little houses. But, instead, maybe the growing doubts here about the competence of the authorities would harden into certainties. It is difficult to envisage how, under such circumstances, consumer confidence would be bolstered. Japanese households — like households in most places — have generally reacted to crises and bad times not by going on spending sprees but by hoarding what they have — even if the authorities are doing their level best to melt those hordes away. Aside from the political implications of a government announcing its intention to destroy savings, it’s hard to see how that would translate into any kind of revival of confidence.
It is comforting to think that by rigorous application of “scientific” economic principles that a way can be found out of Japan’s policy trap. Alas, just as members of the orthodox economics fraternity had little to say on the sources of Japan’s success during the “miracle” years, their recommendations today take insufficient account of Japanese institutional reality. Understanding Japan’s predicament has to start with a real-world understanding of Japan’s institutions — in this case, the institutions responsible for the flow of money in the Japanese economy.
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