Eradicating Deflation by Reviving the Banking Sector - Increasing Money Supply Through Recapitalization

Amid the clamor for steps to cure deflation, there is insufficient analysis of the reasons behind it. Just saying "there is a gap between supply and demand" is not enough so long as deflation is considered to be a monetary phenomenon. The causes of deflation must be explained from the monetary point of view, and policies must be formed based on those causes.

'Deflation' is more or less equivalent to saying that the amount of money circulating in the Jpanese economy is not growing. Because the total money supply is not increasing, the price of goods is falling and Japan is experiencing deflation. Money supply is the sum of cash, ordinary deposits and time deposits (M2) plus convertible deposits (CD). Normaly, if the Bank of Japan boosts the supply of high-powered money (cash + BOJ current accounts), credit is created in the banking sector and as a result M2 expands by about 10 times the amount of high-powered money supplied. However, since the 1990s, the extent to which the amount of high-powered money supplied by the BOJ is transformed into M2+CD (the money multiplier) has been decreasing. Especially since the end of 2000, when the BOJ began to aggressively increase the amount of high-powered money through quantitative easing measures, the money multiplier has been shrinking at a rapid pace, as if to nullify the increase in such base money.

What economists must ponder now is "why an increase in high-powered money no longer boosts money supply."

Although a complete answer cannot easily be found, I suspect that "the undercapitalization of banks has led to the decline in the money multiplier and the lack of growth in money supply."

If the banking sector falls short of capital, the risk of bank failures increases. Although deposits are protected through deposit insurance in the event of a bank's collapse, some degree of inconvenience, such as in deposit withdrawals and account transfers, cannot be avoided. When such conditions prevail, trust in bank deposits as a means of settlement is shaken, and as a result depositors tend to withdraw their deposits and increase their cash holdings. In other words, M2 decreases because the amount of money in bank deposits available for settlements falls in comparison with the amount of available cash.

The sort of mechanism I have just described is not merely a theoretical possibility. A study group led by Professor John Boyd of the University of Minnesota and Professor Bruce Smith of the University of Texas-Austin conducted a positive analysis of 23 countries that have experienced banking crises in recent years. A 'banking crisis' was defined as a situation where banks had non-performing loans of at least 5 to 10 percent of their total lending, as once the ratio of non-performing loans exceeds this level, they are effectively in negative net worth.

The study statistically confirmed that when such a crisis occurs, M2 declines sharply and inflation rates fall. In an economy where the inflation rate is not that high, there is a positive correlation between inflation and economic growth, and Smith says that "the reason why economies slow down during banking crises is probably because the situation leads to a decrease in M2."

Looking at data for Japan, we can confirm that the amount of cash held by the non-financial sector has been increasing. Up to the 1980s, virtually all of the cash supplied by the BOJ was absorbed by the banking sector. However, since 1990 cash increases have mostly flowed out of banks and into non-financial firms. This is a clear indication of the loss of trust in bank deposits as a means of settlement. Incidentally, where the decrease in M2 (i.e. banks' deposit liabilities) is shown on the banks' balance sheets, decline in cash is offset by a decline in securities holdings, and lending does not show any marked decrease. These observations match those of Boyd's group that "in recent banking crises, bank loans do not fall."

What these results show is that although banks are not entirely responsible for deflation, the "macroeconomic situation" in which the undercapitalization of banks is leading to a loss of trust in the settlement system is a cause of deflation.

From this viewpoint, it can be said that recapitalizing the banking system may prove effective in combating deflation. Shoring up banks' capital will help them regain depositor confidence, and the public will deposit more of their assets at banks. This in turn will lead to an increase in M2, and allow Japan to eradicate deflation. This is in fact the same mechanism by which the United States was able to rid itself of deflation in 1933, during the Great Depression.

Boyd's group also reports that for every 1 percent of gross domestic product spent on revitalizing the banking system through such means as liquidating failed banks and recapitalizing banks, the rate of M2 growth increases by 5 percentage points. In other words, "in countries with excessive non-performing loans, reinforcing the capital of the banking system to improve its soundness helps increase money supply and induce inflation."

It is important for banks to receive capital injections at an early stage if deflation is to be tackled. Therefore, recent efforts by some Japanese megabanks to procure huge amounts of capital should be highly praised. However, generally speaking, in times of banking crises, such problems as the asymmetry of information make it difficult for banks to procure sufficient additional capital by themselves. This is because private investors shun the idea of putting up capital as the uncertainties surrounding banks, such as fears over hidden non-performing loans, are too great.

Therefore, if we disregard the political difficulties of realizing this policy, deflation could be effectively eradicated by the government injecting public funds into banks at an early a stage as possible, and then swiftly selling its bank equity holdings to private investors once trust in the banking system is restored.

However, just declaring that "public funds will be injected into banks when deemed necessary" as is now the case is not enough to restore depositor trust in the banking system. In fact, it will more likely aggravate the economic downturn and deflation, as banks that do not want capital infusions will rush to condense their assets, thus leading to a credit crunch and aggressive loan collection.

An effective policy to make the banking system sound and at the same time cure deflation would be to inject public funds into banks and have the BOJ finance this by purchasing government bonds. That way, public trust in bank deposits could be restored, while high-powered money should increase significantly, resulting in an increase in money supply and a marked rise in the inflation rate.

However, the side effect of such a policy would be that, in the short term, government debts would expand sharply, heightening concerns over the future of the nation's finances.

Uncertainties over the nation's fiscal condition will lead to anxiety over the future and bring about an excessive shrinkage in personal consumption and capital investment. This would not merely come from economizing due to concerns over future tax hikes, but also from a reduction in economic activity. Therefore, consumption and capital investment will recover if such uncertainties are dispelled through the prompt presentation of a schedule for future tax hikes and spending cuts. The government should swiftly decide on a social security system and a schedule for fiscal reconsolidation that includes drastic reforms in the expenditure structure, such as reductions in civil servant personnel costs as well as reforms to the overall tax system, including the consumption tax. However, as a precondition to this, the government should at the same time approve fiscal outlays to boost banks' capital.

Finally, I would like to add my opinion regarding the policy of inducing inflation through unconventional monetary easing measures by the BOJ, such as its purchase of stocks and property. Based on the realistic judgment that the recapitalization of banks is not making much headway due to political and regulatory constraints, having the central bank use unconventional steps to increase high-powered money may be the next best plan. However, it is an illusion to believe that inflation can be brought about without any fiscal burden. If the BOJ were to purchase stocks and property with low profitability, it would effectively be putting non-performing assets on its balance sheet, and mild inflation of 2 or 3 percent will not be enough to absorb such latent losses. In future, those latent losses will have to be repaid through the use of taxes (fiscal outlays). It should be recognized that unconventional monetary policies are in fact "fiscal policies that have been put on the backburner."

A further conclusion of the Boyd and Smith study was that "countries which solved their banking problems through inflation saw repeated recurrences of non-performing loans and banking crises." This should also be kept in mind.

>> Original text in Japanese

* Reprinted from the Keizaikyoshitsu column of the Nihon Keizai Shimbun, Jan. 28, 2003