RIETI Policy Debate
Round 7: The Government and the Bank of Japan should Formulate a Policy Accord to Pull Japan out of Deflation
- To pull Japan out of deflation, it must be first recognized that: 1) the government and the BOJ cannot individually pull Japan out of deflation, 2) there is a lack of clarity over who should implement most counter-deflation measures, 3) the government and the BOJ are each trying to offload responsibility for implementing policy on to the other, and finally, 4) a mechanism must be created to solve these problems.
- Concrete and comprehensive discussions have yet to take place concerning who should do what to overcome deflation. The government and the BOJ should improve their communication by better utilizing the existing framework of meetings.
- Considering how the government and the BOJ have hitherto tried to pass on policy responsibility to each other, it is recommended that the two sides agree on a policy accord with each promising to take specific measures while giving due consideration to the independence of the BOJ. The workability and effectiveness of such an accord depends on its concrete nature as well as on the feasibility of promises made by both parties. The accord could include such policy measures as 1) fiscal expenditure of a specified amount for a specified purpose over a specified period of time, 2) financing by the BOJ and 3) cooperation between the government and the BOJ to prevent a sharp increase in long-term interest rates.
Overcoming deflation is a significant challenge for the Japanese economy. Much attention has been focused on the question of who will head the BOJ when the term of the incumbent governor ends in March as well as on proposals for additional monetary easing measures. Some commentators are pointing out the need to shed more light on the government, another entity responsible for policy implementation, arguing that the government and the BOJ should formulate a policy accord and cooperate, rather than pursuing their own independent policies. Such arguments should be welcomed as they broaden the scope of discussion on how best to counter deflation without reference to a particular government or central bank position.
But the government and the BOJ - each of which has autonomous authority to plan and implement policy - require good reasons to seek a policy accord, a move which would restrict their own freedom. If the emerging argument simply calls for policy coordination without providing convincing reasons, then discussion on this issue may be a passing phenomenon that leaves no positive impact on the relationship between the government and the BOJ.
In this paper, I will first outline, as compared to a number of other government policy measures, some particular issues that need to be considered in planning and implementing counter-deflation measures, to clarify what it takes to achieve the goal of overcoming deflation. Next, I shall summarize what should be done in consideration of another peculiarity that derives from the independence of the BOJ, what it means to have a policy accord between the government and the BOJ and finally what kinds of measures should be included in the accord.
Factors that need to be considered in devising counter-deflation measures
The following three factors need to be considered in devising counter-deflation measures.
(1)Neither the government nor the BOJ can overcome deflation by acting alone
There have been mounting calls for the BOJ to take further steps to ease monetary policy as a way to put an end to deflation. A series of quantitative easing measures hitherto taken by the central bank, however, have failed to bring any definite impact, though interest rates have somewhat declined. Even the Cabinet Office - to which Minister Heizo Takenaka, an advocator for further quantitative easing measures, belongs - does not sound very confident about the effect of such measures. The 'Annual Report on Japanese Economy and Public Finance' (Fiscal 2002), prepared by the Cabinet Office, simply says, "... [apart from a decline in interest rates] there is a possibility that exchange rate depreciation has been functioning as a transmission mechanism [to exert the effects of the ongoing quantitative easing measures] ..."
The government, meanwhile, has not explicitly confirmed that its fiscal measures have played a decisive role in pulling Japan out of deflation. Rather, the government appears to be reluctant to undertake additional fiscal expenditure, a step that may trigger precipitous falls in the price of Japanese government bonds (JGBs) at a time when a massive amount are outstanding.
The government's 'Fiscal 2003 Economic Outlook and Basic Stance for Economic and Fiscal Management', endorsed by the Cabinet on January 24, says, "... the government and the Bank of Japan will act as one to overcome deflation and turn price growth positive as soon as possible ..." indicating that the government recognizes that it cannot overcome deflation by acting alone.
Also, given that there is correlation between higher economic growth and tighter supply-and-demand balance - and thus a higher inflation rate, overcoming deflation (achieving a higher economic growth rate and a higher inflation rate) can be a shared goal for the government and the BOJ for a certain period of time.
(2)Government and BOJ policies are closely linked and thus need to be coordinated
Many people insist that hitherto implemented quantitative easing measures have failed to generate sufficient results because the BOJ has not done enough. They say that the central bank should be able to employ a greater variety of easing measures such as inflation targeting and more outright purchasing of long-term JGBs, foreign bonds, exchange-traded funds (ETFs) linked to the TOPIX index and real estate investment trust (REIT) funds.
However, these additional measures, in nature, resemble the government's economic policy measures. Furthermore, policies implemented by the government and the BOJ are closely linked and affect each other. Therefore, whatever goals are set, they may not be achieved unless the government and the central bank clarify, at least to a some extent, what measures should be implemented by each side.
Let us consider what would happen if the BOJ acting alone were to set target rates for inflation and nominal economic growth.
From the BOJ's point of view, one major uncertainty is whether or not the government intends to allow the ongoing deflation to persist. This uncertainty looms especially large today, when it is said that the Japanese economy faces the danger of falling into an abyss if the government pushes banks too hard to dispose of bad loans. Given these circumstances, how can the BOJ act alone to introduce inflation targeting without coordinating with the government?
The same holds true for the implementation of concrete measures to realize a targeted inflation rate or other macro economic targets. Let us consider the idea of increasing the BOJ's outright purchase of long-term JGBs.
Although the BOJ is already making outright purchases of JGBs, the objective of such operations has been hitherto confined to maintaining money supply growth necessary for sustaining economic growth. Meanwhile, one of the primary aims of the emerging argument calling for a substantial increase in the BOJ's outright purchases of long-term JGBs is to bring about a further lowering or stabilization of long-term interest rates, which are already at a record low level. Even if the BOJ increases its outright purchases of long-term JGBs, however, it will be difficult to stabilize long-term interest rates if the government substantially boosts the issuance of government bonds or increases the proportion of long-term bonds within the overall issuance of JGBs. Here again, policy coordination between the government and the BOJ is necessary to stabilize long-term interest rates as their respective policies affect one another.
(3)Without explicit agreement, the government and the BOJ will maintain the status quo and offload policy responsibility on one another
The expansion of a gray zone, in which there is a lack of distinction between the borders of government and BOJ policy, will not be a problem as long as both sides are ready to take necessary steps towards overcoming deflation. At the moment, however, both the government and the BOJ keep to the "status quo" and seem to be trying to force the other side to take action.
Indeed, the government has expressed its preference for a 'deflation-fighter' as the next governor of the BOJ, thereby pointing to the way to overcoming deflation through monetary, rather than fiscal policy. The BOJ, for its part, has repeatedly said that a series of non-traditional policies - which the central bank is being urged to take by going beyond the existing framework of monetary policy - belong to the realm of fiscal policy.
The reason why both the government and the BOJ keep to the status quo in their own policies while trying to force the other to take new steps may be that both of them are reluctant to take the risk of implementing untested measures that produce unpredictable effects.
The absence of explicit discussions and agreements may be amplifying the risk, thereby keeping both the government and the BOJ from taking decisive action to address the problem.
The government and the BOJ must first share a recognition that both of them need to make efforts. Then, they must sort out what specific measures each side needs to implement in order to ensure that there is no omission of measures or duplication of effort, mutually promise to implement their respective policy pledges and monitor whether the commitments are fulfilled and producing their intended results. Though they may sound basic, I believe these are the steps that must be taken to overcome deflation.
The policy planning and implementation process for pulling Japan out of deflation
(1)How policy planning and implementation should be conducted if it is to be successful
What I say here is not confined to overcoming deflation and may be overly simplistic. Generally speaking, however, policies aimed at achieving certain goals are planned and implemented through the following steps:
Identify challenges and set policy goals (step 1).
Work out policy measures to achieve the goals (step 2).
Implement the policy measures (step 3).
Assess the effects of implemented policy measures (step 4).
Complete the process if the goals have been achieved. If not, return to the stage of establishing policy measures (step 5).
There are numerous examples of such a policy planning and implementation process. For instance, in the case of coal mining industry structural adjustment policies, of which I used to be in charge, the policy goal was to facilitate the exit of the remaining elements of Japan's coal industry from the market because the high cost of domestic coal in comparison to imports was one identified challenging factor in Japan's overall high cost structure (step 1). It was decided that persistent cost-saving efforts should be made and consultations were held with the Ministry of Finance with a view to gradually reducing the budgetary allocation for coal-related policies. That step represented the goal-orientated policy establishment stage (step 2). Subsequent to the implementation of those measures (step 3), a judgment was made as to whether or not to close the remaining domestic coal mines, a step which represented the policy implementation assessment stage (step 4). And, at that time, if it had been judged premature to close domestic coal mines, then the policy would have been reconsidered - taking into account the position of banks which had lent money to the mining companies and the fact that power companies were being forced to buy expensive domestic coal. This final step would be the stage of planning and implementing measures in response to a new situation (step 5).
(2) Problems in planning and implementing counter-deflation policies
As for counter-deflation measures, a general consensus has formed concerning the first stage of identifying challenges and setting policy goals. A study group on deflation - formed by representatives from the Cabinet Office, the Ministry of Finance, the Ministry of Economy, Trade and Industry and the BOJ - said in its report that the ongoing deflation problem has multiple causes including demand deficiency and monetary factors, and that deflation itself is negatively affecting the economy and therefore must be tackled.
The problem is that little progress has been made from the second stage onwards. However, a number of other issues have been - or are supposed to have been - solved by following the aforementioned steps. So, what are the differences between deflation and other policy issues?
One typical explanation is that the proposed counter-deflation policy measures have never been tested before and therefore involve a great deal of uncertainty. But does this sufficiently account for the differences between the deflation problem and other problems that have been successfully overcome?
It seems to me that the uncertainty concerning the effect of counter-deflation policy measures compared to other policy areas is a matter of degree. Untested measures, which may produce unpredictable results, are often planned and implemented for purposes other than overcoming deflation. The reason why these policy measures, despite the uncertainty of their effect, are implemented and successful is that established decision-making and information-sharing mechanisms are in place, which is not the case for counter-deflation policy. In other words, there is a clear understanding as to who does what. Therefore, when multiple parties are involved in implementing certain measures, they closely communicate with each other. And even if one measure fails to produce its intended results, the parties can collectively work to map out and implement alternative measures, thereby eventually achieving their policy objectives.
Looking at the issue this way, we can see - at least to some extent - why hitherto-implemented counter-deflation policy measures have been unsuccessful. There are many capable experts knowledgeable in their respective fields. However, it seems to me that: 1) there is no close coordination between the government, the BOJ and other concerned parties despite acknowledgement that involvement by all is vital to overcoming deflation, 2) boundaries between monetary and fiscal policies are indistinct and it is unclear who should take what steps and 3) questions as to what subsequent plans should follow and what if such plans do not work have been left unanswered in mapping out a set of measures to counter deflation. Under these circumstances, it will be difficult to achieve the goal of overcoming deflation.
BOJ independence and communication with the government
It would be unreasonable to discuss deflation, a major challenge in the field of macro economy policy, and other policy issues on the same level and naively urge for enhancing the efficiency of the decision-making and information-sharing mechanism. This is because the BOJ, whose role is to decide monetary policies independently from the government, needs to play a major role in fighting deflation. The independence of the central bank is stipulated in the revised BOJ Law that took effect in 1998 and appropriate procedures for mapping out and implementing policy measures must be thought out in line with this law.
(1)Communication between the government and the BOJ: How it is and how it should be
The fact that the BOJ's independence from the government is guaranteed by law does not prohibit the exchange of opinions between the government and the BOJ. According to the revised BOJ Law, monetary policy implemented by the central bank must be consistent with the government's economic policy. The law also allows for provisions concerning adjustment procedures that should be taken when the BOJ and the government experience a difference of opinion. The government, for instance, has the right to express its opinions and/or propose ideas at the BOJ's Policy Board meetings. In addition, the Council on Economic and Fiscal Policy (CEFP), which examines and deliberates on important issues relating to economic and fiscal policies, has the BOJ governor as one of its members, thereby providing another channel for exchanging opinions between the government and the central bank.
If all these existing opportunities are effectively utilized and in-depth discussions occur on what measures are needed and who should be responsible for implementing each measure, economic policies pursued by the government and monetary policies decided independently by the BOJ could be consistent, and one could reasonably expect that these policies could achieve their goal of overcoming deflation.
What of the reality? To what extent do the government and the BOJ communicate and share ideas with each other, going beyond pledging "... firm determination to overcome deflation ..." and does their dialogue lead to the planning and implementation of consistent policies? From examination of full-length and summarized minutes of CEFP and BOJ Policy Board meetings, the following observations can be made about the government and the BOJ respective tendencies:
- has no intention to shift to an aggressive fiscal policy because it believes that ongoing structural reform will eventually generate new demand, while at the same time expecting the BOJ to implement additional easing measures
- has proposed piecemeal policy measures (e.g. introducing inflation targeting, increasing the outright purchase of long-term JGBs, facilitating capital flows to small and midsize enterprises and conducting unsterilized interventions) while presenting no comprehensive proposals concerning to what extent the BOJ should be responsible for implementing these measures.
- has gone no further than pointing out that responses on the fiscal side are absent and inappropriate while acknowledging that measures taken on the monetary side are not good enough to overcome deflation, a monetary policy argument that takes the government's fiscal response as a given condition - has come up with separate counter-arguments for each of the government's policy proposals, rebutting the idea of implementing unorthodox monetary policy measures by pointing out, in a roundabout manner, the lack of government effort.
What is considered to be most problematic issue is that the government and the BOJ - despite their seeming difference in perceptions as to what constitutes consistent economic and monetary policies for overcoming deflation - are neither clarifying the difference nor trying to adjust and coordinate their policies. What the government regards as consistent economic and monetary policy seems to be a combination of non-expansionary fiscal policy and further monetary easing measures, whereas the BOJ appears to have in mind either aggressive fiscal policy in combination with further monetary easing or maintenance of the status quo both with respect to fiscal and monetary policy. As long as these gaps are left unfilled, the government and the BOJ will not be able to form a common understanding of a consistent economic and monetary policy. Not only that, they may not be able to exchange opinions concerning who should be responsible for implementing certain necessary measures.
As previously mentioned, the necessity of communication between the government and the BOJ is stipulated in law. The question is what they should communicate to each other. In order to eliminate the existing gaps, the government and the BOJ should adopt the respective attitudes described below at occasions such as CEFP and BOJ Policy Board meetings:
- The government must stop trying to press its idea of policy direction on the BOJ without specifying details. In other words, it should stop telling the central bank, "We would like you to take additional easing steps. So, why don't you think what specific measures you can take within your realm of independence?" Instead, the government should present, in a concrete and comprehensive manner, what measures it expects from the BOJ, including those which would be ordinarily categorized as fiscal measures.
- The BOJ should proactively propose ideas as to what economic policies it expects from the government in fighting deflation, rather than wondering what monetary policy measures need to be taken in compliance with the government's fiscal policy as a given factor.
(2)Necessity of policy accord
Considering how the government and the BOJ have hitherto tried to pass responsibility to each other, and given the increasingly blurred boundaries between economic and monetary policies, simply exchanging opinions may not be enough to change the situations. It is desirable for the government and the BOJ to enter into a policy accord, each promising the other what specific measures it will take.
By providing an appropriate escape clause, such a policy accord can be made more workable and effective without impairing the independence of the BOJ. Specifically, a provision could be included to allow the BOJ to withdraw from the accord if the government fails to fulfill its obligations leaving the central bank to implement its own promised monetary policy measures.
Contents of policy accord
In order to make the policy accord truly workable and effective, both the government and the BOJ must be as specific as possible in their promises, clarifying how and when to terminate policies once they achieve their intended goals, and a mechanism should be established to ensure that both parties abide by their respective promises.
One way to make them keep their respective promises would be to include an escape clause that, in the case one party breaks its promise, allows the other party to pull out by specifying the reasons. This could be a meaningful penalty because the reputation of promise-breaker would be damaged. Furthermore, such an escape clause would allow the BOJ to maintain its independence in the sense that it would not be forced to implement certain monetary policy measures against its will.
However, it may be necessary to apply different penalties depending on the nature of the promises broken. 'Final goals' such as a nominal growth rate and an inflation rate cannot be attained solely by government and/or BOJ effort, whereas 'operational targets' - such as those for urban reconstruction budget allocation and maximizing the efficiency of radio wave spectrum redistribution - are attainable if the government wishes to do so. It might be reasonable to oblige the government and the BOJ to explain their reasoning before the Diet should they fail to achieve the final goals. Also, should either party fail to achieve its operational goals, a penalty could be imposed in the form of the other party's withdrawal from the accord.
Another fact that needs to be kept in mind is that not only the proposed accord between the government and the BOJ, but many other policies cannot be enacted unless they are approved by politicians and the Diet. The government budget, which is the most typical example, is based on a one-year budget cycle and implementation cannot be promised by the government without seeking the Diet's approval. Given that this is the case, it is necessary to consider how the government can make promises, drawing upon a series of long-term public works projects and the 'Science and Technology Basic Plan', for which fiscal expenditures over multiple years are committed in the form of Cabinet endorsement.
Given all these circumstances, the following can be suggested as concrete proposals for consideration:
Target rate should be set either for nominal economic growth or consumer price index (CPI) growth.
(2)Policy consistency and cooperation in respective fields
(a)Disposal of nonperforming loans (NPLs) or fiscal expenditures to help counter deflation (e.g. public fund injection into banks, reinforcement of the safety net, measures to help nurture venture businesses and expenditures on strategically important areas such as information technology, biotechnology and urban redevelopment)
- The government provides certain indications concerning the scale of additional fiscal expenditure and government bond issuance.
- By specifying the time period, amount and applications of such additional expenditure, the government persuades the BOJ that the outstanding amount of JGBs will not expand infinitely.
- At the same time, the government must reform its revenue and expenditure structure to ensure that fiscal resources will be used in a way to effectively contribute to boosting demand.
- With respect to the JGBs issued to finance such demand-boosting policies, the BOJ implements necessary measures, including the outright purchase of the JGBs, in accordance with its judgment on the credibility of the government's promises.
(b)Measures to facilitate corporate finance
- The government and the BOJ implement support measures to help develop new indirect financing channels (e.g. the BOJ provides part of the financing when a private financial institution extends loans to a new corporate borrower.)
- The BOJ decides on and provides a schedule as to how and when the existing measures to facilitate smooth corporate financing (e.g. accepting a broader range of asset-backed securities (ABSs) as collateral, making asset-backed commercial papers (ABCPs) eligible for the BOJ's market operations) will be reinforced.
(c) Foreign exchange policy
- The BOJ clarifies its intention as to whether or not to purchase foreign bonds.
- The BOJ seeks prior approval from the U.S. Department of Treasury and the Federal Reserve Board, which are concerned about the impact on U.S. long-term interest rates, if it is to purchase foreign bonds on a major scale. - The BOJ keeps close contact with the Ministry of Finance so as not to countervail the effect of market intervention by the ministry.
- The BOJ keeps close contact with the Ministry of Finance so as not to countervail the effect of market intervention by the ministry.
(d) Stabilization of long-term interest rates
- The government promises to keep the outstanding amount of JGBs below a certain level.
- The government and the BOJ together work out measures to prevent a sharp rise in long-term interest rates until the Japanese economy firmly recovers (e.g. careful arrangement of a government bond issuance plan to keep the outstanding JGBs well-balanced in terms of maturity timing, temporary and emergency introduction of the book value evaluation method for JGBs, a large-scale buying operation by the BOJ in case signs emerge of a sharp rise in long-term interest rates).
(3) Termination of policy accord
- A benchmark that allows little room for interpretation, such as a 'steady increase in CPI' should be set beforehand as a condition for the termination of the policy accord between the government and the BOJ, thereby providing an institutional guarantee to enable the BOJ to take the necessary steps to tighten the money market when prices begin to rise.
- As to measures that not only serve the temporary purpose of tackling deflation but also contribute to enhancing policy transparency (e.g. inflation targeting), the BOJ should make an independent judgment as to whether or not to retain them as policy options.
The current conditions, in which the boundaries between government and BOJ policies, as they make a concerted effort to tackle deflation, must be changed. If things are left unchanged, concern will remain that the government and the BOJ will continue to try to pass responsibility to each other in planning and implementing policies.
There surely remain a number of challenges in forming a policy accord. For instance, there are questions on how concrete such an accord should be, how to improve relations not only between the government and the BOJ but also with politicians and the Diet, and how the government can make a commitment when its policies - even those involving a single-year budget - are subject to Diet approval in principle. However, a policy accord between the government and the BOJ is one way to ensure the implementation of necessary policies regardless of whichever side is to take action. And if appropriate conditions are attached, it can be an accord under which the independence of the BOJ is ensured. At the same time, it is hoped that the ongoing debate on a policy accord, a set of comprehensive counter-deflation measures, will help facilitate not only communication between the government and the BOJ but also improve the decision-making process within the government.
March 18, 2003
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