The debate over monetary policy in Tokyo is shaping up to be the mother-of-all-battles over economic policy. The latest skirmish began when Bank of Japan Gov. Masaru Hayami spoke out in favor of ending Japan’s zero-interest policy.
The ongoing struggles to restore life to Japan’s moribund economy have contributed to a loss of credibility of its political class and government officials in its most prestigious institutions while burdening future generations with massive debts. Besides questions of competence, the Bank of Japan and the Ministry of Finance also suffered from corruption scandals. Restoring the BOJ’s lost luster requires an assertion of its newly-granted immunity from outside interference.
While deflecting criticism from local political authorities, monetary policy makers are also having to fend off sniping from foreign economic ideologues like U.S. Treasury Secretary Larry Summers and MIT economist Paul Krugman. Happily, Hayami seems to be well inoculated from their entreaties and is willing to steer his own course.
Japan’s ongoing economic problems have taxed the minds and patience of many. However, one of the worst policy proposals for recovery comes from a group of Keynesian economists in the United States. They would have the BOJ not only keep open the credit floodgates open, but increase the rate of monetary growth to spark inflation that would induce households and businesses to buy today to avoid higher prices tomorrow.
After years in retreat due to decisive failures in Western economies, Keynesian economics is being resuscitated. Originally conceived as a method for jump-starting economies temporarily stalled by depression, the key features of Keynesian theory are boosting public-sector spending and loosening credit policy. For much of the post-World War II period, it provided a theoretical justification for activist intervention by governments in markets.
Unfortunately, proposals that suggest that Japan’s problems can be solved by reflation reflect a misunderstanding of the economy. While the inflationary route may generate short-run benefits, the underlying illusion is temporary and generates long-run losses.
In all events, raising the rate of inflation would destroy the value of cash deposits, including those held by pensioners who rely upon them to tide them over during retirement. This would effectively constitute a most onerous tax. It would also require the BOJ to buy massive amounts of new public-sector debt when Japan is already burdened with the highest debt-GDP ratio (over 140 percent) of the advanced economies.
Another reason to avoid inflation is that it provides relief to debtors who repay loans with devalued currency units. This would reward Japan’s corporate debtors that have been destroying shareholder value for years.
When monetary authorities pump in excessive amounts of new money, businesses and consumers find themselves with rising nominal cash balances that exceed their normal needs. Their adjustments to these higher than necessary balances lead to increasing expenditures. But because production facilities take longer to expand, prices rise. Meanwhile, input costs tend to be fixed by contract so that rising prices for outputs lead to increased profits. In successive rounds, producers may be fooled into believing that the new spending patterns are part of a permanent trend and enlarge productive capacity. Reality sets in when it becomes clear that there have been no changes in economic fundamentals. As such, for all the effort there is little extra output.
In all events, a proposed inflationary remedy for Japan’s economy misses the point. Most of the problems are the outcome of Japan’s corrupt political culture and defective corporate governance. The policies of “directed development” led to economic arrangements that suffered from fatal contradictions.
The zero-interest policy has allowed Japan’s wobbly banks to avoid clearing off their nonperforming loans. They have been able to borrow or take deposits at historically low rates and earn wide interest-rate spreads by buying U.S. Treasury bonds. As long as this situation lasts, there is little incentive for banks to restructure their bad debts. It also contributes to Japan’s massive net capital outflow that underwrites the expanding current account deficit in the U.S.
Continuing to rely upon Keynesian nostrums will be an expensive mistake. If Keynesian remedies work at all, they only do so when aimed at correcting cyclical problems instead of the structural defects that plague Japan’s economy. Near-zero interest rates are consistent with the promiscuous fiscal and monetary policies supported by Keynesian economists and have delayed the unavoidable restructuring that must take place in Japan’s corporate and financial sectors. The BOJ’s Hayami should stay the course. The sooner he and the BOJ end the exceptional zero-interest policy, the better.
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