HIKONE, SHIGA PREF. – For four years, the Bank of Japan has pursued monetary easing of unprecedented dimensions — both qualitatively and quantitatively. It is common knowledge that the policy has had no effect for its intended task of ending deflation in this country. There may be a long list of excuses for the failure, such as the fall in crude oil prices, slowdowns in emerging economic powers, and the impact of the 2014 consumption tax hike.
But it is now time for economists to accept that the simple macroeconomic view — which theorizes, by comparing a highly matured economy like Japan to a machine, that you can freely control the output of the economy such as prices, household spending and capital investments by private-sector businesses by adjusting the input like monetary and fiscal policies — no longer works. In other words, it must not be overlooked that the Japanese economy today has undergone qualitative changes from the early 1980s, when fiscal and monetary policies worked effectively.
Had household spending, housing purchases or capital investments been sluggish because interest rates were too high — and prices falling because of a shrinking monetary base — the BOJ’s “unprecedented” monetary easing since 2013 would have swiftly achieved its target of a 2 percent annual inflation and triggered a dramatic increase in domestic demand. In short, the grand social experiment over the past four years has refuted the hypothesis that deflation is a monetary phenomenon. It has become increasingly safe to assume, therefore, that deflation is caused by a gap between supply and demand in the real economy.
In a mature market economy system, the economy should be likened not to a machine, but to an autonomous living organism. During its rapid growth period from 1958 to 1973, Japan’s economy had such robust growth potential that without any intervention it would have sustained a double-digit annual expansion in real terms. There were inevitable negative side effects, though, such as a risk of hyper-inflation and trade deficits. In fact, the government’s role in this period was to achieve stable high growth through a balance of fiscal and monetary policies — the government stimulating domestic demand through public works spending, and the BOJ tightening its monetary grip to cool an overheated economy and put inflation under control. The Keynesian fiscal/monetary policies were quite effective because of the strong growth potential of the nation’s economy then.
The period of rapid growth came to an end in the October 1973 oil crisis, which quadrupled the prices of crude oil. The economy, which had expanded an average of 9.2 percent in real terms annually during the rapid growth period, slowed to a 4 percent growth range. This meant that the growth potential of the Japanese economy, which relied on imports for 99 percent of its oil supply, was roughly halved by the spike in crude oil prices. In short, the very predisposition of the Japanese economy underwent significant changes. What offset the steep increase in the value of fossil fuel imports was the sharp expansion of exports such as automobiles, electronics parts, and equipment and machine tools. Japan’s economy survived the impact of the oil crisis because the international competitiveness of domestic manufacturers of transport equipment, electric machinery and machine tools was improving dramatically.
Japan was able to maintain a relatively strong economic growth after the oil crisis through 1990 not because the government implemented correct fiscal and monetary policies, but because large numbers of Japanese companies endeavored to innovate their technologies, upgraded labor productivity and took steps to save energy, thereby pushing up the nation’s growth potential.
Since the new products brought by the technology innovation were of the demand-pull type that makes life more convenient and comfortable, rather than the technology-push type, the demand-supply gap continued to be tight, leading firms to make fresh capital investments with confidence. This in turn allowed the central bank to concentrate on a traditional monetary policy of fighting inflation.
In the 1980s, new breed of conservative administrations that advocated small government and market fundamentalism came to power in Britain and the United States. In Japan, Prime Minister Yasuhiro Nakasone took the lead in privatizing the state-run Japanese National Railways, Nippon Telegraph and Telephone and Japan Tobacco and Salt, and relaxing and abolishing numerous regulations.
Behind these developments was the thinking that the economy would be best managed if the government’s discretionary intervention in the market was kept to a minimum and all economic activities were left to free and competitive markets. The role of the government would thus be limited to establishing free and competitive market conditions. This was a major paradigm shift in economic policies. Liberalization makes an economy more autonomous and reduces the effects of fiscal and monetary policies.
During the bubble boom in the late 1980s, meanwhile, the financial economy ballooned to an excessive size. Then the stock market crash beginning in 1990 and the collapse of land prices starting in 1991 left Japan’s financial institutions saddled with colossal nonperforming loans, plunging the nation into a post-bubble recession in March 1991. What followed was a quarter century of stagnant growth, when the average annual GDP growth stood a meager 0.9 percent in real terms. In fact, the nation’s annual growth potential is now said to have fallen to around 1 percent.
The latest transformation of Japan’s economy has rendered Keynesian fiscal and monetary policies almost ineffective. There seem to be a wide variety of theories as to the cause of the deflation. But the BOJ’s monetary easing of unprecedented dimensions that began in April 2013 assumed that deflation is a monetary phenomenon. The BOJ theorized that by setting a target of achieving an annual 2 percent inflation within two years and declaring that it will keep increasing the monetary base until the target is reached, people’s deflationary expectations could be converted into inflationary expectations. As I said at the outset, this hypothesis has been refuted by the grand social experiment.
To summarize, the maturing of the market economy has eliminated the ability to control the economy by way of fiscal and monetary policies. Unless private-sector innovations churn out goods and services demanded by the public, stimulating consumption and closing the supply-demand gap, it may be impossible to hope for an end to deflation or the 1.5 percent real economic growth in the next fiscal year that the government foresees.
Takamitsu Sawa is a distinguished professor at Shiga University.