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No.3 ,Economy  Oct 02, 2010

MONETARY MEDICINE FOR CURING DEFLATION

At a monetary policy meeting on October 5, the Bank of Japan approved a policy of “comprehensive monetary easing.” To hear the media tell it, this is a policy of essentially zero interest rates, and it amounts to inflation targeting and marks a return to the quantitative-easing line. When reading bureaucratese, however, it is generally a good idea to examine the footnotes even more closely than the text, as the notes and the appended material often tell the real story of what is going on. In this case, one discovers that the new policy is not one of essentially zero interest rates, or of rates “from 0% to 0.1%” as advertised, but of essentially 0.1% interest rates. As one of the footnotes indicates, it simply is not possible to move rates below 0.1% as a result of other lending systems.

The claim that the BOJ has embraced a policy akin to inflation targeting is an interpretation of the section of the announcement clarifying the “policy time horizon” based on the “understanding of medium- to long-term price stability.” Actually, however, this is just a restatement of an existing policy stance. The footnote to this section tells us once again that the Policy Board members understand price stability to mean year-on-year change in the consumer price index of 2% or lower and that the midpoint of most members’ “understanding” is around 1%. The talk about a return to quantitative easing, meanwhile, is based on the announcement that the BOJ will consider establishing an asset purchase program. This indicates the bank may become more active in its purchases of government bonds, commercial paper, corporate bonds, exchange-traded funds, and J-REITs (Japan real estate investment trusts). According to attachment 2, however, the scale of the proposed purchases would be only some ¥5 trillion after one year from the start of the program. When one considers that official statistics show the macroeconomic output gap to be on the order of ¥25 trillion, this hardly seems an impressive figure.

The truth of the matter is that the central bank is sticking to a rather passive stance toward monetary easing. Why is that? What should be done to orient the bank in a better direction? And in broad perspective, what would be the best set of economic policies for Japan? Questions like these need answers.

Behind the BOJ’s Passive Stance

If Japan is to pull out of its deflationary slump, aggressive monetary relaxation is indispensable. This requires more than manipulating the benchmark short-term interest rate (the uncollateralized overnight call rate). The BOJ must conduct more open-market operations in order to increase the money supply, such as by buying government bonds and other financial assets in quantities sufficient to lower long-term interest rates. The objective is to close the output gap by invigorating capital investment and consumer spending. Central banks around the world embarked on this course in response to the global financial crisis that hit following the bankruptcy of Lehman Brothers in September 2008.

Japan’s central bank, however, has no intention of moving decisively in the easy-money direction, contrary to what is being said about it. As I see it, the BOJ has fallen prey to three spells. The first is fear of inflation, which even today dominates the thinking of the bank’s officers so completely as to be pathological. The result is that the bank’s policies always produce the opposite of the intended effect. Perhaps what turned the fear into a full-blown phobia was the failure of the monetary policy the bank adopted to deal with the first oil crisis in 1973-74, when prices began to rise rapidly. It is to be admitted that over the course of the bank’s history, inflation has usually been the most serious threat, with the exception of such occasions as the Great Depression, when prices plummeted. In general, accordingly, the warnings by BOJ old-timers to avoid full-scale relaxation were on target. Now, however, deflation has settled in, and the primary need is to bring it to a stop.

The second spell is a consequence of the BOJ’s management as a bureaucratic organization even though it is in fact a modern central bank with recourse to enormous clout. A small group of staff members recruited from within the bank forms the mainstream faction and makes the important decisions. The monetary policy meetings of the Policy Board conduct deliberations that supposedly take the long-term economic outlook into account, but because everyone adheres to the principle of not rocking the boat, the results of the meetings are heavily biased toward preserving the status quo. It looks as if none of the board members are really inclined to take responsibility for implementing radical relaxation measures.

The bias toward maintaining the status quo probably explains why arguments lacking in economic sense often carry the day in policy debates. There is, for instance, a rule that purchases of government bonds must be held within the limits of the cash issued in the form of Bank of Japan notes. The bank’s officials have also made a conscious effort to downplay the ill effects of falling prices, such as by advancing arguments about how some deflation is good. All of these function as a bulwark providing protection for what the BOJ is not doing, not for what it is doing.

The third spell derives from the BOJ’s independence. The trend around the world is to give central banks independence from the government for the implementation of monetary policy. There are sound reasons for that. After all, governments in democratic nations can be easily persuaded to stimulate employment at the cost of price stability. Even when inflation is threatening to become serious, government leaders are apt to call on the central bank to make money easier. This is the lesson Japan and other countries learned from the galloping inflation of the 1970s. The solution is to make the central bank independent of the government and assign it the role of safeguarding the currency’s value.

During Japan’s two lost decades subsequent to the collapse of its bubble economy in the early 1990s, however, the actions of the BOJ ironically revealed that independence has its own evils. When a central bank goes overboard in guarding against inflation regardless of the impact on employment, it is apt to keep the monetary reins unnecessarily tight. Such a contractionary policy may offset the effects of fiscal stimulus, drive unemployment up, perpetuate deflation, and cause the economy to wither. This is precisely what Japan’s central bank has been doing. Its independence has had the ill effect of causing deflation to worsen. Not unexpectedly, the international community has worked out a scheme for preventing monetary authorities from behaving in this way and put it into practice. This is inflation targeting. Japan has not adopted it, however, because of continuing opposition from, of course, the BOJ.

From this perspective, we may say that it is not sufficient for the Policy Board members to simply explain what they mean by medium- to long-term price stability. Their “understanding” makes no promises and has no binding power, and it cannot be easily used to judge the results of the bank’s policies. To enhance the transparency of monetary policy, the BOJ should establish a concrete inflation target and state in writing that this is its target for attaining price stability. It would probably also be wise for the bank to publicly pledge that it will conduct monetary policy in the proper fashion. In short, the bank should adopt the global standard of inflation targeting rather than just following a policy that some say is about the same thing as inflation targeting.

Remembering the Bold Policies of Takahashi Korekiyo

To be sure, the administration and the Bank of Japan need to act in unison in a time of deflation. Here I would call to mind the economic management by Finance Minister Takahashi Korekiyo in the 1930s. Among the fiscal and monetary measures the world adopted to deal with the Great Depression, what is known as “Takahashi finance” provided a model of how to combat deflation. During his career as a public official, Takahashi held the post of minister of finance seven times and also served briefly as prime minister. What he is remembered for is the set of policies he worked out over four years from his designation as finance minister in the cabinet of Prime Minister Inukai Tsuyoshi on December 13, 1931, to his assassination in the February 26 Incident of 1936, an attempted coup d’état.

Under Takahashi’s direction, Japan abandoned the gold standard immediately after he took over as finance minister in December 1931. That alone, however, was insufficient to stop the fall in prices and initiate a business recovery. This is shown by the fact that stock prices headed downward in 1932 while unemployment climbed higher. Further monetary relaxation was required to arrest deflation and revive the economy.

The full-fledged easy-money policy Takahashi implemented turned out to be the decisive component of the economic recovery program. Symbolic of the policy was the sale of newly issued government bonds to the Bank of Japan in November 1932. The general view was that having the central bank directly underwrite government bonds was inappropriate. Japan’s military faction misused this technique in order to raise money, causing inflation to spiral upward in the process. Today’s BOJ holds firmly to this position, and it considers the purchase of government bonds under the Takahashi policy to be one of its most grievous mistakes in the history since its establishment. The bank is, however, in error on this point. Takahashi was steering public finance in the direction of spending restraint and gradually reduced reliance on public bonds, and 90% of the government bonds the BOJ purchased were later sold on the market, thereby recovering the currency created. Over the four years of Takahashi finance, the bank held no more than 9% of outstanding government bonds.

Criticism should be directed instead at the policies of Finance Minister Baba Eiichi, who took over after Takahashi was killed in the February 26 Incident. In order to finance a military buildup and stimulate regional economies, Baba scrapped the plan to scale back public bonds, instead stepping up bond issues and raising taxes. This was the direct cause of rising prices. In short, we need to distinguish between Takahashi’s policies and those carried out by Baba. This was clear to the members of the so-called reflationary camp, who argued that the way to end the depression was to encourage prices hikes relying mainly on an easy-money policy. They were people like the economist Takahashi Kamekichi and the journalist Ishibashi Tanzan, who after World War II went on to serve as prime minister. On witnessing the switch to Baba’s policy line, they warned that inflation was liable to shift into high gear.

To be sure, one cannot truthfully say that Takahashi’s policy of having the BOJ underwrite government bonds was free of problems. The main problem was the absence of criteria for handling underwritten bonds and of a system for holding inflationary concerns in check. If such arrangements had been in place, the chances are good that rapid inflation would not have occurred. Under the prevailing economic circumstances, however, it may well have been impossible to climb out of a deep deflationary hole using fiscal and monetary policies premised on a ceiling for government bond issues. Perhaps what the Finance Ministry and Bank of Japan needed to do was to establish concrete economic targets of some sort.

Even back in Takahashi’s day, precedents for inflation targeting were in existence. When Britain abandoned the gold standard in September 1931, Sweden responded by also leaving it and setting a 0% change in the consumer price index as a target for its monetary policy. Similarly, Irving Fisher and other Western economists had proposed that prices be returned to the level they were at around 1926, before the depression began. In this light, it can be argued that in Japan as well, a system using a price level or inflation rate as a target ought to have been introduced in order to make the underwriting of government bonds more effective.

After Takahashi took Japan off the gold standard, which had become part of the depression regime, he went to work on making money much easier, mainly through BOJ purchases of government bonds. At the same time, he also got busy on fiscal stimulus. The scale of the stimulus, though, was not that large. It is a fact that government allocations for military spending, public investment, and other purposes were expanded during the 1932-33 period, but the ratio of government spending to gross national product rose only slightly, because the economy was also expanding. Over the following two years Takahashi applied the brakes to expenditures, making large cuts in military spending in particular starting in fiscal 1934 (April 1934 to March 1935). To complement these moves, he enunciated the policy of gradually scaling back public bond issues. And he also took steps to tighten money, as by having the BOJ sell the government bonds it was holding to the public, and to improve the health of public finances.

With his assassination, his hope of weaning the government of reliance on public bonds came to naught. Some say we should learn from this failure that successfully implementing an exit strategy is no easy matter. Today, however, the government is not under the sway of a powerful force like the prewar military clique. To be sure, historical experience makes it clear that when an economic crisis strikes, the political situation can change suddenly. At this point in time, accordingly, we need both to get the economy out of the doldrums as rapidly as possible and to head off any upheaval in the political system before it can gain momentum.

Policy Measures on Other Fronts

Having reviewed the needs in the monetary realm, I will move on to other necessary measures. The coalition government led by the Democratic Party of Japan has set its sights on the generation of employment. Clearly Prime Minister Kan Naoto approves of this stance, as he turned the phrase “jobs, jobs, jobs” into a slogan in the campaign for the July House of Councillors election.

A number of points need to be kept in mind if the government seriously plans on using demand generation as the primary means for creating jobs. First, the growth in job openings for nonregular employees is a trend that can be observed globally, not just in Japan. There has been some loosening of the rules preventing Japanese companies from freely hiring nonregular personnel, and Prime Minister Kan is not happy about that. Perhaps this is because he sees it as symbolic of the deregulatory line pursued by former Prime Minister Koizumi Jun’ichirō of the Liberal Democratic Party and his economic czar, Takenaka Heizō, but if so, this is a mistaken understanding. It was in the 1990s, well before Koizumi moved into office at the start of the new century, that demand for part-timers, personnel dispatched from employment agencies, and other nonregular workers began to increase. And it was the Ministry of Health, Labor, and Welfare, which Takenaka was never in charge of, that drew up the legislation encouraging nonregular employment.

That being the case, why has the image of the nonregular worker become so tarnished in the public consciousness? The answer, simply stated, is that the economy fell into a slump. Back in the 1980s people thought much more kindly about workers who did not become ordinary corporate employees, but business in those days was booming. It was then that we began hearing about the new generation of “freeters” (furītā)–young people who hop from job to job–and many approved of their attitude of working only when they wanted to work and fully enjoying their leisure. But the reputation of nonregular workers headed downhill when the economy entered an era of stagnation, and people began considering them to constitute an underprivileged minority. When we look overseas, we can see that the 1990s and most of the 2000s were not decades of severe economic adversity, and the spread of alternative job formats was not regarded as a serious concern. In was only in Japan that nonregular employment came to be regarded as a critical social problem, and that is because of the long-lasting deflationary slump.

A second point to be kept in mind is the strong regulatory protection Japan provides for the jobs of regular employees. In other industrially advanced countries it is not that hard to dismiss regular workers, and not such a high wall has been erected between regular and nonregular personnel, with the result that labor mobility is much greater. Because labor markets are not divided into segments, the rule of equal pay for equal work is more easily upheld. Nonregular workers are not necessarily paid low wages, and if their work is good enough, they can earn promotions. Japan’s strict rules restraining companies from firing their regular employees are a major cause of the country’s low level of labor mobility. With the market divided into segments, nonregular personnel are treated much less favorably than regular employees and cannot expect to receive as much pay even if they do the same work. There is, in short, a very high wall separating these two employment categories.

The ruling DPJ coalition has unveiled a growth strategy, but deregulation is not one of its parts at present. On the contrary, the administration is moving in the direction of tightening regulations, notably those that apply to the dispatch of nonregular workers. If it hopes to create more jobs, it must first adopt fiscal and monetary policies of the sort I have been discussing, putting special emphasis on monetary relaxation to vanquish deflation and invigorate business. Perhaps the DPJ leadership is anxious not to displease labor unions, since they constitute one of the party’s main support groups, but even so it should not act to strengthen labor market regulations. In order to speed up growth, the administration should move boldly forward on the deregulatory front, giving firms a freer hand in areas including the dismissal of workers. What people expect of the DPJ is the implementation of policy measures that truly benefit workers. The party’s leadership needs to persuade the public that great benefits can be realized by relaxing regulatory controls.

Industrial Policy’s Poor Track Record

Another aspect of the DPJ coalition’s growth strategy also bothers me. The strategy appears to be based on the assumption that new industries supporting growth can be fostered by channeling government funding away from public works and toward selected sectors, such as the environment, nursing and healthcare, and tourism. As I see it, though, this approach to creating new demand is basically the same thing as what the successive administrations of the Liberal Democratic Party used to call “industrial policy.”

Generally speaking, an industrial policy is a tool used by the government to take the lead in changing the industrial structure by fostering or protecting designated industries. There is, however, no commonly accepted understanding of what an industrial policy should consist of. According to one definition, it should be “a policy influencing a country’s economic welfare (economic benefits of the country overall) through intervention in resource allocation among industries or the industrial organization of designated industries.”

It is fair to ask, however, whether Japan’s industrial policy of the past really led to greater economic welfare. Empirical analyses of the results of industrial policy have been conducted, and they are reported to have found that the more protection the government extended to an industry through, for instance, tariffs, tax breaks, and public financing, the lower that industry’s growth rate was. Productivity increases in such industries were on the low side when measured using total factor productivity, which includes capital and labor productivity. Stated in simple terms, government support for an industry has been a recipe for productivity stagnation. Studies have also been conducted on South Korea’s industrial policy, and they have come up with similar results. The message such research conveys is that Japan’s industrial policy has in reality tended to be an income redistribution policy for the protection of declining industries.

Why does productivity suffer when an industrial policy is applied? Here I would mention the findings from a study of Japan’s cotton-spinning industry from 1956 to 1964. Data for the top 10 cotton-spinning firms show that market shares became fixed, the structure of the market rigidified, and competition was in effect constrained as a result of industrial policy as it was then applied. Inefficient firms were blocked from scaling back production and closing their doors, and this dragged productivity down. Of course, measuring the impact of industrial policy is difficult, as nobody can say what might have happened in such industries if they had not been selected for preferential treatment. But the general conclusion is in agreement with one of the most basic principles of economics, which is that restricting competition will impede productivity gains.

If competition results in mergers, acquisitions, and weeding out, no doubt the productivity of Japanese industry would increase, since efficient companies would survive. But that does not mean that a policy of encouraging reorganization will necessarily improve productivity. In former years MITI (Ministry of International Trade and Industry, today known as METI, the Ministry of Economy, Trade, and Industry) assisted the formation of cartels and even prepared legislation to formalize this practice, but the firms that survived because of the cartels tended to be inefficient and unproductive. Japan’s ability to withstand international competition would only weaken if it preserved industries dominated by such cartels, the opposite of the intended result.

The economic policy required for boosting growth is one that encourages innovation. There is no miracle drug for this. Industrial policy has thus far left no evidence that it is a good prescription for promoting innovation, and there is no guarantee that it will produce better results in the years to come. A true growth strategy should be centered instead on a competition policy and deregulatory measures, not on programs of the industrial policy type.

Optimizing the Policy Mix

A good policy mix needs to achieve a balance among three objectives: promoting economic growth, stabilizing business cycles, and redistributing income. Innovation cannot be speeded up during a deflationary slump. What has been abnormal in the Japanese economy over the past 20 years or so is the virtual absence of nominal economic growth. Other developed countries have achieved nominal growth rates in the vicinity of 4%. With respect to promoting growth, accordingly, Japan should set its sights on a 4% nominal rate.

With respect to the second policy objective of stabilizing business cycles, we should observe that even official statistics reveal that there is a very wide gap between the economy’s latent capacity and the output it is actually producing. As I pointed out before, the output gap is on the order of ¥25 trillion, and it is one of the reasons why the unemployment rate is stuck at a high level and deflation is persisting. When comparing policies, one needs to consider not just their qualitative features but also their quantitative dimensions. If business cycle stability is to be achieved, there must be a policy in place for reducing unemployment. If the inflation rate were set at 2%, we could expect the jobless rate to fall from the vicinity of 5% to about 3.5%. The BOJ says that the midpoint of its Policy Board’s understanding of price stability is a 1% inflation rate, but that would leave many workers without jobs. The Policy Board members should reconsider their assumptions and aim for faster price increases. And as a tool for attaining business stability, an inflation target should be adopted for fiscal and monetary policies.

When targeting inflation, the relationship between the government and the central bank is crucial. I have complete confidence in the practical ability of the BOJ’s staff to manage monetary policy. The BOJ is, however, a quintessential bureaucratic organization, and that means it is likely to find changing the status quo a difficult proposition. From this perspective, probably the best solution is to introduce an inflation target, as other developed countries have done, and to clarify how the government and the central bank should divide responsibility for reaching this target. For the construction of an ideal relationship between politicians and bureaucrats, responsibility for setting the target should be assigned to the government, which can appeal to the public, and responsibility for achieving the target should be assigned to the BOJ, making it a matter within the purview of this bureaucratic organization.

Redistributing income is the third policy objective, and in this area the first need is to give assistance to the impoverished. This is the minimum duty of any state. There is, however, also another side to what is morally advisable, and this is that when one segment of the population is provided with benefits over an extended period, some people will grow dependent on welfare. The prime goal to pursue when seeking to reduce welfare dependency and succor the impoverished is to lower the unemployment rate. Unemployment, currently running in excess of 5%, needs to be returned to around 4%, where it was prior to the global economic crisis, or to the vicinity of 3.5%, as I suggested above. The government would also be wise to revive the income redistribution function of taxes, as the present tax system is a harsh one for the poor.

The yen has once again begun to strengthen despite the BOJ’s announcement of its comprehensive monetary easing. This is partly a result of the observation that the US Federal Reserve is likely to take steps making money easier. Insufficient monetary relaxation on Japan’s part, though, is also to blame. Unlike the United States, Japan is already experiencing deflation, and this should allow it to go further down the easy-money path than the United States.

Another aspect of recent business trends is also ominous for Japan. In an interview by Reuters in Ankara, Turkey, on September 14, Secretary General Angel Gurría of the Organization for Economic Cooperation and Development ruled out a double-dip recession for the developed world: “We are saying yes there is a slowdown in the recovery, not a double-dip recession, just a slowdown in the recovery.” But Japan, he added, “is a different situation.” “You have to take Japan away, because Japan has been fighting with deflation for ten years.” Clearly the need in Japan is to root deflation out completely and get back on the growth track.

Translated from an original article in Japanese written for Japan Echo Web. [October 2010]

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