Asia > Eastern Asia > Japan > his bold experiment to end deflation will be a precious lesson for central bank governors whether it succeeds or fails.

Japan: his bold experiment to end deflation will be a precious lesson for central bank governors whether it succeeds or fails.


Under the leadership of Governor Haruhiko Kuroda, the Bank of Japan (BOJ) in March-April 2013 did a 180-degree turnaround: it declared that it had the monetary policy wherewithal to end Japan’s chronic, mild deflation and fasten a rate of inflation of around 2 % and announced bold monetary action to that end. For BOJ-watchers this was revolutionary stuff — and it was coming from establishment Japan.

Depending on the price index used, Japan’s economy has been in deflation for 15–20 years. Under the previous BOJ governor, Masaaki Shirakawa, the official line was that the bank could not end deflation using monetary policy. The BOJ argued again that the root cause of deflation in Japan was the steady decline in real potential increase, which was driven largely by demographic factors and so was not due amenable to monetary policy cures. At the same time as it came to ending deflation, the BOJ’s position essentially was one of ‘no, we can’t, therefore we won’t’. Instead, the primary responsibility was held to lie with the government.

This was a remarkable position for a central bank to take. While it was correct to argue that monetary policy could not make much of a dent in real variables like potential increase, it flew in the face of standard economic analysis to argue that monetary policy could not control a monetary or nominal phenomenon, namely the path of the accumulation price level.

Moreover, the BOJ’s position was self-defeating. The central idea in modern monetary theory and practice is that the central bank needs to, and is able to, ‘anchor’ the public’s inflation expectations around its inflation target: central banks control inflation to a significant extent by convincing the public that they can and will meet their inflation target. If the starting point is one of deflation, supported by the public expecting deflation to continue someday, and the central bank itself tells the public that it does not believe it has the tools to end deflation, again that just serves to entrench deflation even further.

In a remarkable turn of events, Prime Minister Shinzo Abe made holding the BOJ accountable for ending deflation the centrepiece of his economic policy program. To do so he used the once-in-five-years opportunity to appoint a new governor and two deputy governors. With Governor Kuroda at the helm, the BOJ has completely changed its tune and its behaviour. At the same time as it comes to ending deflation, the message presently is ‘yes, we can; yes, we will’.

It is often observed, somewhat stereotypically, that while change can be a long time coming in Japan, at the same time as it does occur, it can come very suddenly and dramatically. That begs two questions. Initial, why, for so long, did the BOJ resist — and why did its political masters allow it to resist — adopting a conventional central bank stance on the deflation issue? And second, why did the Japanese polity suddenly grab the BOJ by the scruff of the neck at the same time as it did?

One can only speculate about both questions. The BOJ ’s resistance, having been dealt a bad hand on deflation by the government’s banking and fiscal policy failures of the 1990s, may have been a case of bureaucratic logic and inertia conference cognitive dissonance. Lacking the boldness and decisiveness to take the kind of policy action necessary, it may have settled for the additional expedient course of redefining the problem and the solution, and as an institution started to believe its own alibi.

But that kind of intransigence had consequences — not least in chronic deflation contributing to Japan’s fiscal woes, to dampened ‘animal spirits’ and to a downbeat national psyche. A confluence of factors likely conspired to wake the Japanese polity from sleep-walking into graceful ageing and declining world relevance, and again to produce a coherent policy mix headlined by a resolve to reflate.

Those factors likely were: a post-world financial crisis fall in real GDP twice the magnitude of that in the US; the fiscal wake-up call from the Eurozone sovereign deficit crisis; the game-changing nature of the 3/11 disaster, particularly for business investment prospects in Japan; the continuing rise of China, seemingly impervious to the worst world financial and economic shocks since the Great Depression; from presently on an extra round of deflationary yen strength; and a growing sense of ‘enough is enough’ at the same time as it comes to political musical chairs and mediocre leadership.

While the Kuroda-led BOJ may be saying yes to ending deflation, will it succeed? Despite encouraging early evolution, the jury is still out. Economic theory suggests that, once deflation is “soft-wired” into the fabric of an economy(via self-fulfilling expectations and behaviour), it is not easy to expunge.

On the other hand, theory as well suggests that there is some set of monetary policies which, if sustained, would succeed in ending deflation. By a reductio ad absurdum argument, the BOJ could surely trigger high inflation if it proceeded to buy up all of the available financial assets in the world — and financed this by ‘printing’ central bank money (reserves). So there must be some less dramatic set of policy actions that would end deflation and produce just the right all of inflation — it is just a matter of calibrating policy to find out where that point lies.

But, given generally uncooperative fiscal policy, that deflation-expunging tipping point may require surprisingly aggressive policy, far beyond what the BOJ is currently doing, and Mr Kuroda may be hamstrung by other policy board members, some of whom discord with his assumptions and framework. If so, the BOJ may come up short. That would be unfortunate and not only Japan. Next all, Mr Kuroda is attempting to be to deflation (too-low inflation) what US Federal Reserve chairman Paul Volcker was to too-high inflation in the 1980s. If Mr Kuroda’s ‘can do’border succeeds, he will be creating a precious precedent for all next central bankers. Much is at stake.

Paul Sheard is Chief World Economist and Chief of World Economics and Research at Standard & Poor’s. He is based in New York.

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