In yet another move to roll back deflationary pressures, the Bank of Japan on Monday decided to increase the money supply and bring the key overnight money-market rate back to zero. The decision, which follows a round of marginal interest-rate cuts in February, indicates that the central bank is pulling out all stops to prevent the economy from slipping into a vicious cycle of falling prices and declining output.
In recent weeks, Japan’s economy has has been showing clear signs of going from bad to worse, with the Nikkei stock average dropping below 12,000 points to its lowest level in 16 years. U.S. officials have expressed concern that a fresh bout of recession in Japan, coupled with a sharp slowdown in the United States, could even undermine the security alliance between the world’s two largest economies.
The BOJ, which is explicitly committed to price stability, is more cautious about easing credit than tightening it. That is why the central bank raised the money-market rate from zero last August, overriding objections from the government. Then, the bank said that “deflationary expectations are beginning to disappear.” With hindsight, that judgment was premature. Now it has reversed itself and acknowledged that the economy is “deteriorating again, rather than entering on the path of sustainable growth, despite the fiscal and monetary stimulus measures that have been taken over the past decade.”
The latest action will increase private banks’ demand deposits in the central bank so that they can divert more of these interest-free reserves to lending and other profitable uses. The central bank will also buy more long-term government bonds from banks. Clearly, the BOJ is listening to what the market has been saying for some time: that pumping up the money supply is more effective than nominal interest-rate cuts. Given that the bank has been cautious about quantitative easing, the shift in emphasis is significant.
The government is equally straightforward about economic conditions. The minister for economic and fiscal policy, Mr. Taro Aso, told a meeting of economics ministers last week that the economy is “in mild deflation.” It was the first time the government had officially acknowledged the existence of deflation. Mr. Aso rightly stressed that the government will continue to give top priority to achieving a quick economic recovery.
Japan’s economy started to founder during the second half of last year, as exports declined as a result of a U.S. economic slowdown. Now the slump in foreign sales is beginning to affect a broad spectrum of domestic industries. Private-sector capital spending — which has been the biggest engine of growth with consumer spending is in the doldrums — is now showing signs of leveling off. Declining prices, at both the wholesale and retail levels, are not stimulating demand; rather they are depressing business and consumer confidence.
With price declines leading to slower demand, the economy appears to be headed for a vicious deflationary spiral, something the Japanese economy has not experienced since the end of World War II. The BOJ says it will supply more funds if stability in the financial market is threatened. It is also committed to quantitative easing until consumer prices stop falling. But monetary policy — either interest-rate reduction or quantitative expansion, or both — is clearly reaching its limit.
The deflationary crisis, of course, originates with the bursting of the asset-price bubble of the late 1980s. The lesson to remember is that during the boom years the government made fiscal reform a priority while the Bank of Japan kept the money spigot wide open. Surplus money found its way into stocks and real estate, sending their prices to dizzying heights and setting the stage for a crash landing of the bubble economy.
The government is moving in tandem with the central bank to avert a deep deflation. Last week, the tripartite ruling coalition put together an emergency economic package intended to reinvigorate the stock market and facilitate land transactions. More important, the program calls for drastic measures to eliminate private banks’ bad loans, a major obstacle to banking and industrial reform and a heavy drag on economic recovery. Japan’s bad-debt problem, combined with a slumping U.S. stock market, threatens global economic growth.
So far, banks have cleared roughly 70 trillion yen of such loans, drawing on profits they have earned from rock-bottom interest rates and from share sales. However, they have yet to write off a nearly equal amount of dud loans. Massive writeoffs would shake debt-heavy clients in construction, real estate and distribution, possibly driving some into bankruptcy. It is the task of fiscal policy to provide support for workers displaced and small businesses stricken by such necessity.
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