There are growing
calls for Japan to inflate its way out of its economic troubles. Should
it heed them?
AS JAPAN’S economy
gets sicker, so the calls for a radical approach to resuscitation get louder.
A chorus of senior politicians, bureaucrats and economists has suggested
that a dose of inflation might be just what the country needs.
That Japan needs
to do something to rev up its economy is not in doubt. On July 21st Masaru
Hayami, the Bank of Japan’s governor, suggested that its recent, gloomy
economic reports had been too optimistic. Two days later, Moody’s suggested
it may lower Japan’s top-notch credit rating. So might a spot of inflation
help matters?
The idea that it
might has been gaining ground thanks to two economists. One is Kazuo Ueda,
who sits on the Bank of Japan’s policy board. The other is Paul Krugman,
professor of economics at the Massachusetts Institute of Technology.
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To be fair, all Mr
Ueda really wants is to avoid a deflationary spiral. Wholesale prices are
already falling in Japan, as in most other rich industrial economies; but
the same is not yet true for consumer prices. He and others at the Bank
are worried that they might now fall too.
His answer to this
is to suggest that the central bank should have an explicit inflation target—say,
between zero and 2%. At the moment its guidelines eschew such targets.
Introducing one should actually increase inflationary expectations and,
hence, demand. If they think prices are likely to rise a bit, people may
buy today rather than tomorrow. In short, a Japanese inflation target might
lead to behaviour opposite to that employed by most other central banks
that follow such targets: fostering it, rather than restraining it.
Mr Krugman’s approach
is more radical than Mr Ueda’s. He wants outright inflation. In recent
papers*, he has argued that most analyses of the cause of Japan’s plight—too
much corporate debt, unwillingness of banks to lend, over-regulation—are,
at best, unproven. Japan, he argues, is in a classic liquidity trap. Overall
demand consistently falls short of the economy’s productive capacity, and
saving consistently exceeds investment—despite near-zero interest rates.
That means that monetary policy has become ineffective at boosting demand.
Yet interest rates cannot fall any further, as it is impossible to have
nominal rates below zero.
How to solve this
dilemma? A Keynesian government spending spree? Tax cuts? Neither, thinks
Mr Krugman, is sufficient, though he believes they might help. He considers
monetary policy a better tool. And since nominal interest rates are so
low, that means bringing real interest rates down by generating inflation
of, say, 4% a year. Moreover, it has to be done on a long-term basis—for
15 years, say—in order to raise inflationary expectations. Otherwise potential
borrowers will expect the central bank once again to stamp on prices, driving
up real borrowing costs. The central bank, says Mr Krugman, with his gift
for the bon mot, must “credibly promise to be irresponsible”.
The devil in the
detail
Although they have
different aims in mind, the two economists agree that the central bank
should target inflation. But how would it get prices up—and would the economy
really benefit?
In most modern economies
governments no longer literally print money. Instead, they buy financial
assets, such as government bonds. Most of the proceeds end up with commercial
banks. But if this were done in Japan, it is unclear, given their dreadful
balance sheets and poor capital ratios, that the banks would lend the money
to others—even if firms and households wanted to borrow. So the real economy
might see little boost.
Moreover, savers,
faced with negative real interest rates, are likely to plonk their cash
overseas, an option made easier by changes in the law last April. If they
did this, monetary growth and credit creation would slow once more. The
more so because, without cheap deposits, banks would have to borrow more
expensively in the capital markets.
That makes it highly
uncertain how much money the Bank of Japan should try to inject. Japan’s
output gap is reckoned to be about 5% of GDP
and growing, meaning that production is falling increasingly short of capacity.
To create inflation, the central bank needs to print enough money to fill
that gap. Yet monetary aggregates are already expanding in Japan. The broad
measure of money (M2 + CDs)
is growing at an annual 3.5%.
Inflation might thus
prove surprisingly hard to create even with a large monetary expansion.
And even if it were managed, would it cure Japan’s woes? Although neither
Mr Krugman nor Mr Ueda presents it in this way, some other economists argue
that inflation is a splendid way to transfer wealth from savers to borrowers,
of which Japanese companies are among the biggest. Yet while it is true
that inflation would improve corporate earnings, it is not clear that it
would improve their net indebtedness.
One reason is that
increased inflationary expectations would mean higher long-term interest
rates. To reduce the real burden of debts, inflation must increase by more
than the extra interest costs that borrowers have to pay.
Then there is the
issue of what happens to the yen. A huge increase in the money supply would
almost certainly mean a further collapse in the currency. That could trigger
a sharp fall in the currencies of other Asian countries, driving up the
value of their foreign debts and pushing their economies into deeper depression.
Mr Krugman largely ignores this in his first article, and all but dismisses
it in his second. “Such fears cannot be completely discounted . . . and
if the 29-year-olds in London who rule the world think that something is
true, for a few hours or days it is,” he writes.
It is certainly true
that if Japan were to create modest inflation, and the yen were to fall
gently, that might benefit all of Asia by helping to get Japan’s economy
growing again. But the risk is that, in order to be effective, the Bank
of Japan would have to create so much money that the yen goes into free
fall, throttling its neighbours. The question, as so often, is how much
is too much?
* “Japan’s Trap”.
MIT, May 1998; “Further Notes on Japan’s Liquidity Trap”. MIT, June 1998
(web.mit.edu/krugman/www).
