There is mounting pressure against the Bank of Japan (BOJ) to further loosen its monetary policy. Roughly, there are three school of thoughts that argue for further expansionary monetary policy. On the other hand, the BOJ is resisting the demand to engage in "quantitative" expansion of monetary policy. The BOJ is arguing that that the changes in the data are not yet sufficient to repeal its decision in last August to end the zero interest policy. It is also stressing that the effect of monetary policy is very limited in solving the problems of the economy. At the same time, the BOJ refers to the possibility that inflation can get out of control if monetary expansion is pursued too far. Let me present to you a brief explanation of these arguments, especially the three school of thoughts that argue for further easing of monetary policy, and my views on the issue.
The first group, consisting of faithful believers in traditional macroeconomic theories, argues that if fiscal policy cannot be useful (considering the ever-expanding public sector debt), the remaining piece of macroeconomic policy, i.e. monetary policy, must be tried. But let us look back at the history. The call rate has been lowered dramatically from more than 8% at the beginning of 1991 to 0.5% or lower after 1995. In February 1999, the interest rate was lowered to an unprecedented level of zero. In spite of such a super-low interest rate policy for years, the Japanese economy never really took off. For those who lived in Japan during this period and experienced the long period of very low interest rates, it appears rather implausible that monetary policy can solve the problems of our economy just because it is the remaining piece of traditional macroeconomic policy. This argument seems naive considering recent economic history.
The second group argues that in light of the continuous drop in prices, i.e. deflation, monetary policy must be exercised to prevent further deflation. Deflation hurts the profitability of firms with fixed cost structures that can not be changed in line with deflation. Deflation adds to the burden of firms with substantial debt. In this manner, deflation would have a negative effect on the economy. This is the reason why the second group seem to be gathering support recently.
Before jumping to the conclusions of this group, careful scrutiny is necessary. First, the mechanism to stop deflation and create inflation is not clear. The BOJ can print more money, but if the demand for capital and goods is weak, an increase in base money would not necessarily translate into increase in money supply, and hence into inflation. The most likely destination of increased base money, created by the purchase of JGBs by the BOJ, would be the JGB market. While it is true that at some point in increasing base money, inflation may be created, possibly through higher import prices reflecting a weaker yen, the speed of base money growth that can trigger inflation and the point at which inflation may surface is unclear.
Second, even assuming that deflation can be stopped, it is not clear if the end of deflation can solve the problems of the Japanese economy. To be sure, the end to deflation can ease pain among firms which face a profit squeeze and debt burden. But deflation is the result of weak demand. It has been hard for companies to invest when the lending activities of the banking sector, still with weak balance sheets, have been hampered. With the balance sheets of many firms damaged, they have had difficulty raising capital and making new investments. With low return on investment expected, even sound companies would hesitate to invest. If these problems are not resolved, recovery of private sector investment is not easy. A negative real interest rate, which might be realized as the result of the possible combination of nominal zero interest rate and the expectation for inflation, would not be sufficient to generate substantial investment. To put it in other words, deflation is the symptom and not the illness itself. Monetary policy may ease the pain but not necessarily cure the illness itself.
The third group argues that, even though monetary policy may not have positive effects, if there are few obvious side effects, every remaining measure must be tried. This argument has appeal to many politicians who face Upper House elections in July. It resembles the first group, with the "naive" view that monetary policy would be the solution for the Japanese economy, but differs in that it presses for monetary expansion regardless of the expected effects, as long as the side effects are limited. This argument requires scrutiny too.
Too much monetary expansion can ultimately lead to collapse in the bond market and currency market. The combination of very cheap yen and high long-term interest rates can be harmful to the economy. National wealth would shrink substantially. Hyperinflation may be contained in the end through the tightening of monetary policy when necessary. But the bond market and the currency market can be much more volatile than the price of goods and services.
There is also a more obvious side effect. Monetary expansion generates easy money. Easy money would enable marginal firms, which should exit, to survive longer. Easy money would slow down the process of resolving the bad loan problems by lowering the cost for banks to carry non-performing loans. In this manner, easy and cheap money can delay the necessary restructuring of the balance sheets of Japanese banks and corporations, which has been one of the root problems of our economy.
Let me use an analogy to explain my discussion. Monetary policy, under the circumstances in Japan, can be seen as "morphine." It can ease the pain but cannot cure the illness of the Japanese economy by itself. It can delay the necessary restructuring of the economy. This risk is especially serious when the politicians, policy makers and the media are led to believe that the so-called "quantitative" expansion of monetary policy can be a kind of magic cure to solve the problems of the Japanese economy. Such an illusion can further delay the necessary restructuring. Morphine would then turn into a "drug" which can give short-term pain relief but lead to further deterioration of the soundness of the economy. Injections of morphine would continue to be demanded whenever there is pain. Monetary policy can easily turn into an "addiction to drugs." The bad news is that the remaining amount of morphine, i.e. the room for additional monetary measures, is getting smaller after years of expansionary monetary policy. This pain relieving strategy is reaching its limit.
On the other hand, monetary policy can have a meaningful role. That is, when monetary policy is used as "anesthesia" to ease the pain during "surgery" to resolve the problems of our economy. The surgery would be associated with increased bankruptcies and unemployment. Morphine when used during surgery is no longer a drug but "anesthesia." The remaining morphine must be used wisely to solve the problems of the Japanese economy, such as the bad loans of the banks and the companies with excessive debt. The statement of G7 Finance Ministers and Central Bank Governors issued on February 17 points out that monetary policy should provide ample liquidity and that financial sectors should be strengthened. The statement covers the two important policy areas in a parallel manner, but fails to identify which is the higher priority. As discussed above, monetary policy would have a supporting role but not the leading role. The difference is a fine one, but I believe it is a very important distinction. Monetary policy, without the necessary "surgery," will not be the solution of the problems of our economy.
There is an important choice before us. Will we use monetary policy as a "drug" to relieve the pain for the short term? Or will we use monetary policy as the anesthesia to facilitate surgery, resolving the structural problems of the Japanese economy? The easier choice is the former and the tougher choice is the latter. There is no official decision on this point. But I sincerely hope that the latter choice will prevail.
Author, Tatsuya Terazawa
Special Research Fellow, RIETI, M.E.T.I.
e-mail: terazawa-tatsuya@meti.go.jp
tel: 03-3501-1480 fax: 03-3501-1704
Editor in Chief, Nobuo Tanaka
Executive Director, Research Institute of Economy, Trade and Industry, M.E.T.I.
e-mail: tanaka-nobuo@rieti.go.jp
tel: 03-3501-1362 fax: 03-3501-8391
The opinions expressed or implied in this paper are solely those of the author, and do not necessarily represent the views of the Ministry of Economy, Trade and Industry (METI), or of the Research Institute of Economy, Trade and Industry (RIETI).
