Inflation Targeting may Produce a Scenario in which the Japanese Economy Collapses

Visiting Fellow, RIETI

Some bureaucrats and scholars search for quick decisive battles to fight and miracle cures to end economic problems

Left un-tackled for so long, Japan's economic problems have grown not only in gravity and magnitude but also in complexity. And even those hoping to change the situation often opt for the status quo when they actually confront difficult issues (which is how things developed when I called for reforms in Japan's Official Development Assistance program during a meeting of the Reform Advisory Board of the Ministry of Foreign Affairs). Not only that, they often begin to search for ways to fight a quick, decisive economic war or for different kinds of miracle cures to solve problems as they lose confidence and are overwhelmed by a sense of resignation that no matter how much effort is expended, Japan's economic problems are intractable. Lately, we have been hearing active debate, calling for the introduction of inflation targeting, but I am afraid that such arguments may end up turning Japan into a lawless jungle. Bureaucrats and scholars have been putting pressure on Prime Minister Junichiro Koizumi, who is not well versed in financial and economic matters, to appoint a deflation fighter as the next governor of the Bank of Japan, which would be a move in the right direction. But it is hard to understand why this should lead to calls for inflation targeting. Monetary policy cannot solve structural deflation. The BOJ has already expanded the monetary base substantially, keeping the year-on-year growth in base money at 30 percent. The money supply, however, has increased by only 2 to 3 percentage points. This provides evidence that monetary policy can have little impact.

Zero interest-rate policy turns out to be a mistake

While claiming to uphold capitalist principles, the Japanese government sometimes dismays the world with its sudden and unexpected actions. The BOJ's zero interest rate policy can be cited as one example. The Japanese monetary authorities say such a policy is a natural choice for a country which suffers from deflation and negative economic growth. Leaders of other developed countries, however, try to avoid adopting such a policy even at a time of deflation because they know all too well how dreadful things could become if their country falls into the liquidity trap. My fellow bankers in the City, the financial center of London, nowadays do not come to Japan on business because they conclude Japan is incapable of recovering on its own. Previously, however, they used to come and visit government officials, inquiring about implementation of the zero interest rate policy. These bankers believe that the zero interest policy is a mistake. Explanations they received from Japanese government officials can be summarized as follows:

1) "After a series of failed attempts to pull Japan out of deflation and lift the economy by means of cutting the target rate for overnight call money, we turned to quantitative easing measures to guide the market interest rates closer to zero. We expect Japan's economy to improve under these measures. In the mean time, these measures will also help avert major corporate bankruptcies and suppress a rise in the unemployment rate despite the presence of serious deflation scenario."

2) "Lower interest rates will reduce borrowing costs for the government as the issuer of Japanese government bonds (JGBs). The same benefit applies to companies saddled with excessive debts, which is the case for many Japanese companies. Thus, the zero interest rate policy is expected to help companies restore their business performance."

As a person who has worked in the financial markets for years, I fear that the zero interest rate policy may turn out to be the fatal dose for investors and banks. Investors can no longer see an appropriate correlation between investment risk and return. For many years, life insurers and pension funds have been facing structural investment difficulties. Ongoing deflation and the zero interest rate policy are reasons behind the poor business performance of insurance companies. At the same time, Japan's call money market has ceased to function. When interest rates fall to zero, short-term capital ceases to flow. Even if a massive amount of free-to-borrow money is out there, capital demand will continue to diminish. It is widely acknowledged that Japan is now in the liquidity trap. As a result of the quantitative easing policy, companies with a high risk of bankruptcy - those with share prices falling below face value - hardly fail today. The BOJ's quantitative easing policy, which has been maintained since March 2001, has now come to be more significant as a measure to curb unemployment, aggravating the moral hazard. This suggests a huge risk in the future. When the monetary authorities eventually return to normality in monetary policy, there will be a sudden rise in the number of companies going under.

Why inflation targeting?

Bringing interest rates down to a near zero level and boosting liquidity in the money market have failed to end deflation. And now, the idea of inflation targeting is receiving much media attention as a miracle cure to drag Japan out of deflation. As proposed, the basic ideas behind the scheme are to have the BOJ set a target inflation rate (e.g. 2 to 3 percent) and force it to achieve the target by embarking on aggressive JGB buying operations without limitation and to purchase stocks and real estate. The aim would be to raise inflation expectation among companies and the public by having the BOJ make an unequivocal commitment to generating inflation, thereby inducing more private-sector investment so as to end deflation. That is to say that the BOJ's aggressive purchase of land and stocks (e.g. exchange-traded funds or ETFs) will boost stock and land prices, consequently improving the balance sheets of the government, companies and households, and accelerating the disposal of nonperforming loans (NPLs).

Inflation targeting, in essence, is a tool to control inflation and stabilize prices. It has never been used as a means to eliminate deflation. The BOJ is opposed to the idea of trying to raise the inflation rate without making efforts to boost expectation of real economic growth in the future and improve productivity, calling such a policy a "reckless gamble."

If it is possible to generate inflation as a prescription to cure deflation, it would be a convenient option for the government, which is saddled with huge fiscal deficits. Normally, fiscal deficits can be reduced in only three ways, namely, by 1) reviving the economy, 2) reducing expenditure and 3) increasing taxes. Of these, the second and third options are unpopular with both politicians and government officials, while the first option has been unrealizable even after lowering the interest rate to zero. That said, if the currency value falls because of inflation, the government will be able to achieve the same debt reduction effect as a tax hike without using the term "tax hike" (and even without bothering to collect taxes).

It is thus acknowledged that inflation can bring positive effects by reducing the burden of government debts and NPLs. Indeed, it is said that Japan was able to ride out the postwar fiscal crisis thanks to hyperinflation (See note). As to the ongoing arguments calling for inflation targeting, however, there remain many unanswered questions, such as:

1) How can inflation be generated and how can it be controlled? (Scholars advocating the introduction of inflation targeting stress that the inflation they call for is different from the "Great German Inflation" following World War I, which was caused by the printing of bills). It is also unclear who is going to take responsibility if inflation becomes uncontrollable.

2) When the expectations for inflation increase, nominal interest rates rise, increasing the cost of issuing new bonds. Meanwhile, the price of outstanding bonds will fall. If this happens, what impact will there be on plans to issue JGBs, local government bonds and Fiscal Investment and Loan Program (FILP) bonds, as well as on the outcome of their issuance? (Because investors holding outstanding bonds suffer losses, they may hesitate to buy newly issued JGBs.) How can it be assured that fiscal collapse will not occur even if Japan's sovereign ratings are lowered and interest rates shoot up?

3) When inflation (of 5 percent, for instance) actually occurs, what will happen to employment? (Because labour costs are bound to go up, the jobless rate is expected to increase. More companies may choose to replace their full-time employees with part-time workers.) Will companies which are now on the verge of collapse survive and recover? Will the value of small and midsize enterprises increase? What will become of the oversupply problem plaguing Japanese industry? Will the nation's tax revenues increase?

4) A decrease in the value of money due to inflation will lower pensioners' living standards. When they become dissatisfied, might the ruling Liberal Democratic Party's support rate fall? Should we not fear an increase in the suicide rate of the elderly?

No magic drug is available to stop deflation

Is inflation targeting the solution we arrive at after having experienced all those years of high economic growth? I find the idea hard to swallow. I am afraid that inflation targeting may produce a scenario in which the Japanese economy collapses rather than a prescription to drag Japan out of deflation. Macroeconomists, who advocate inflation targeting, have not sufficiently explained the risk to Japan's 120 million population that, if the scheme fails, many could be in a miserable situation. If the government has the courage to introduce inflation targeting, it had better use that courage to face the public squarely, explaining in a comprehensible fashion the critical condition of the state's coffers and the seriousness of the NPL problem, then present the available options for recovery along with an estimate of the likely pain associated with each. Japanese people appear not to feel a sense of crisis but this may be because they are not being informed of the true state of affairs. I believe it would be preferable for the government to seek understanding for an increase in the tax burden rather than opting for a policy of inflation targeting (for which the government should disclose its debt redution schedule). Such an approach would be even more effective if the government proceeds with its plan for an uncompromising privatization of national assets and for regulatory reform, while at the same time striving to improve labor productivity of central and local government by introducing a more transparent, accrual-based accounting system. Although inflation targeting is being presented as a policy to end deflation and boost demand, the real motive of those advocating the scheme may be to reduce the burden of NPLs and fiscal deficit. Both the public and financial sectors are in deficit and it is nearly impossible for them to self-propel a recovery, whereas the household sector stands alone with its huge surplus. Considering this, I cannot help but suspect that the government is trying to revive the Japanese economy by using the 1.4 quadrillion yen available in personal financial assets. It is said that pensioners' savings account for a great portion of that 1.4 quadrillion, and it may be exactly their assets that the government has identified as a financial resource for bailing out the nation's economy. But those pensioners belong to the generation who remember the freeze on bank deposits in the postwar period and they are surely deeply distrustful of the government. By introducing inflation targeting, the LDP may antagonize pensioners, many of whom are LDP supporters.

February 25, 2003

1) According to "Zaisei-saiken wa sakiokuri dekinai (Fiscal reconstruction cannot be postponed)" by Toshihiro Ihori (published from Iwanami Shoten), Japan's real debts, which stood at some ¥200 billion, were reduced to less than one third of that amount in one year thanks to the hyperinflation of 1945, then eliminated by the subsequent inflation. But the book also states that such a phenomenon occurred under a controlled and closed economic system.

February 25, 2003