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Koizumi's last chance to rescue Japan

February 10, 2003

During the next 50 days, prime minister Junichiro Koizumi has a real chance to turn round the Japanese economy. It is his best chance since he came to power nearly two years ago. It could be his last.

The five-year term of the governor of the Bank of Japan expires on March 19. Mr Koizumi is expected to nominate a new governor and two deputies by February 20 (leaving the Diet a month to confirm the appointments). If he is serious about ending deflation, he should nominate three deflation fighters to the top BoJ posts.

Mr Koizumi must do three things quickly to steer Japan out of its deflationary trap. First, he has to convince the BoJ of the virtues of unconventional monetary policy in order to circulate more money to the economy since orthodox monetary policy - the lowering of interest rates - cannot do more. Deflation can be cured only by monetary expansion. Mr Koizumi should also persuade the bank to embrace inflation-targeting in order to hasten the effect of monetary expansion and to limit its side-effects.

Second, he has to resist the call for more deficit-financing. The ratio of debt to gross domestic product is already dangerously high at 140 per cent. Instead, the composition of public spending and the weights of different taxes have to be reformed in order to stimulate aggregate demand without increasing gross budget deficits.

Third, the non-performing loans problem has to be resolved, once and for all. Zombie companies, which by all commercial and financial criteria are essentially bankrupt, should be allowed to go under. The weakest banks have to be nationalised to shed bad assets before being injected with public funds for reprivatisation. In addition, there needs to be progress on structural reform to stimulate new activities.

What is important is to implement these policies in combination. To restore mild inflation and to return growth to potential, Japan needs a package of three policies. For if structural reform, which is dear to Mr Koizumi's heart, were carried out without an expansionary monetary policy, the economy would fall deeper into deflation.

Introducing the package requires co-ordination among the BoJ, the ministry of finance and the financial services agency. Only Mr Koizumi can ensure there is such co-ordination.

The missing piece in the puzzle is a change in monetary policy. Under Masaru Hayami, the current governor, the BoJ has been sceptical about the effectiveness of monetary policy in the fight against deflation and has opposed the introduction of inflation targeting. Having mistaken relative for absolute prices, BoJ economists once even asserted that deflation was a good thing, as it reflected cheap imports and technological progress.

Lately, the bank's policy-makers have argued that increased BoJ purchases of government bonds, listed stock funds or listed property investment funds either have no effect since deflation is structural, or result in hyper-inflation, as inflation will run out of control. Mr Hayami recently described expansionary monetary policy via inflation targeting as a "reckless gamble", contradicting the view of most of the world's leading economists.

In order to change monetary policy, central bankers committed to fighting deflation must be nominated to the BoJ's top three posts. The bank has a nine-member monetary policy board. Once a new governor and two new deputies are installed they will still have to win over two more members of the board to reverse policy. So Mr Koizumi needs to appoint candidates who are willing to say that past BoJ policy was wrong and to send strong signals of ending deflation. That would change the expectations of deflation that have become prevalent. The prime minister should embrace inflation targeting as a useful framework of monetary policy. He should work with the new BoJ to set a reasonable target, such as consumer price inflation of 1-3 per cent within two years.

Resistance to radical change is still strong in the BoJ. Thanks to active lobbying by Mr Hayami and his staff, some politicians now believe that conventional monetary policy is impotent once the nominal interest rate is driven to zero and inflation targeting with unconventional monetary policy is a ticket to hyperinflation. Ironically, those politicians use Mr Hayami's argument to promote public spending programmes of their choice as a way out of deflation. High public debt and a public deficit of 7 per cent are of no concern to them. Now an unholy alliance of inflation fighters (or deflation promoters) at the BoJ and deficit champions in the Diet is emerging.

Mr Koizumi has to take on this alliance. One compromise solution would be to split the term of the next BoJ governor. For the first 20 years, the post could be held by a bold fighter of deflation. If inflation then threatened to run out of control, a conservative anti-inflation hawk could be installed.

This is the last chance for five years for Mr Koizumi to influence monetary policy. He must use it. If deflation and deficit financing were to continue for five more years, the debt-to-GDP ratio would climb to 200 per cent, pushing Japan to the brink of default.

Discussion Questions:

1. The author proposes that Japan use monetary policy to stimulate its economy instead of persisting with government budget deficits. Because nominal interest rates are already close to zero (and can't go below zero), he proposes that additional monetary stimulus take the form of purchases of assets (such as government bonds, stock mutual funds, and property investments) by the central bank.

Critics have responded by saying that the Bank of Japan is helpless. It cannot make prices go up because "the deflation is structural." Try an extreme thought experiment and see if you agree.

Imagine that the Bank of Japan started buying houses from homeowners for 100 billion yen per house (100 yen is equal to about 1 dollar). It can do this because it can simply print up trillions of yen in paper money and give the yen bills to the homeowners. What would, for example, a retired couple with 100 billion yen be likely to do? As the bank bought more and more houses at this price, what do you think would start to happen to the Japanese economy?

2. What risks do opponents see with this strategy of printing lots of yen to buy assets? What does the author fear even more?

Can net expots, be. negative? If so, what would the central bank have to do to maintain a fixed exchange. rate?

Can a central bank supply a negative amount of its own currency to the foreign exchange market? That is, can a central bank buy its currency instead of selling its currency? What would it use to pay for Its Currency if it wanted to buy some?

What kind of circumstance might lead to a currency crisi5 in which a government Finds that it can no longer maintain a fixed exchange rate?
Which large. Asian economy (not Japan) was maintaining a fixed exchange rate in 2003? (Hint: It is a large net exporter to the United' States.) What must its central bank be doing in the foreign exchange market?

What will happen to the inflation rate if policymakers use monetary or fiscal policy to hold unemployment below, its natural rate?

In some countries, the central bank now Follows a policy of announcing a specific target for the Inflation rate.. IF it keeps inflation equal to this target rate and does not worry about hitting a specific value of the unemployment rate, what will happen to the unemployment rate? How might announcing a target inflation rate affect the public's expectation of inflation?

Under what conditions might the natural rate of unemployment increase or decrease? What programs right the government pursue in order to lower the natural rate of unemployment?

Why is it important for a central bank to prevent deflation?

IF an economy were suffering from fall in demand that caused deflation and if the central bank refused to provide the stimulus needled to raise aggregate demand, what other actions could the government take to bring the economy out or its slump?

Suppose that an economy 15 5Uffering from a rapid rate of deflation, perhaps at 20% per year. By cutting interest rates to zero, the central bank can only reduce the real interest rate to 20%, still a very high level. Can you think of some extreme action that the central bank could undertake that would drastically increase the purchases that consumers want to make and would, therefore, start to make prices increase?