What’s at stake: Japan, with its huge government debt, its aging population and its history of self-induced policy paralysis – or as Milton Friedman put it its “decade of inept monetary policy” – was not expected to be the country breaking with the economic orthodoxy of the day. But the recently elected Prime Minister Shinzo Abe appears decided to reflate the Japanese economy through expansionary monetary and fiscal policies, even if it means breaking taboos of central banking such as re-establishing political influence over monetary policy.
An unexpected maverick
Paul Krugman writes that for the past three years macro policy all across the advanced world has been dominated by orthodoxy: Nothing should be done because nothing can be done, except ever harsher austerity, which will someday, somehow, be rewarded. Even where there haven’t been explicit austerity policies, as in the United States, fear of deficits has led to de facto fiscal tightening, while monetary policy has fallen far short of the kind of dramatic expectation-changing moves theoretical analysis suggests are crucial to getting traction in a liquidity trap. Now, one country seems to be breaking with the orthodoxy — and it is, surprisingly, Japan.
Christina Romer and David Romer argue in a recent paper presented at the AEA meeting that this unduly pessimistic view of what monetary policy can accomplish has been a more important source of policy errors and poor outcomes over the history of the Federal Reserve than overinflated beliefs in the power of monetary policy. The authors note that there are intriguing parallels between policymakers’ beliefs in the period from roughly the end of the recession to the latter half of 2012 and beliefs in the 1930s and 1970s. Monetary policymakers in each period have to some extent believed that their tools were not very effective and were potentially costly. And they have been explicit that these considerations have muted their policy response.
Peter Tasker writes in the FT that for the past 15 years Japan has been trying to shrink its way out of its problems. That did not work. Now it is about to try the opposite approach. If the pedal-to-the-metal reflationary policies of Shinzo Abe, the recently elected prime minister, succeed, there will be a profound impact on post-crisis policy making everywhere.
Floyd Norris writes in the New-York Times that the Bank of Japan has in the past been hesitant to really try to establish a higher inflation rate, for at least two reasons. One is that there is fear that the Japanese government bond market would be disrupted. Another is that it could do severe damage to the central bank’s own balance sheet. It owns a lot of Japanese government bonds whose market value would fall. Conceivably, that could cause the bank to seek a recapitalization from the government, something that would be embarrassing, to say the least.
Paul Krugman writes that Japanese policy makers have, at least for now, managed to persuade markets that deflation will give rise to mild inflation. And this has not been reflected at all in a rise in nominal interest rates; instead, it’s all a fall in real rates.
Source: Japan Bond Trading (HT Paul Krugman)
Scott Sumner writes that the surge in the Japanese stock market and the big plunge in the yen began right when Abe announced he’d push for a 2% inflation target, well before the election. (It was mid-November.)
Lars Christensen writes that the BoJ actually changed its inflation target last spring (February) and also at the same time announced at it would do open-ended QE. The announcement certainly was made in a rather unclear way and it took analysts and market participants some time to realize that the BoJ actually had changed its policy and its policy targets. Christensen thinks this have been more important for longer-term inflation expectations than the Abe effect. The Abe effect, however, seem to have had a strong impact on the shorter-term inflation expectations.
The motives of Mr. Abe
Noah Smith points out that Abe is probably doing it for disreputable reasons. All Abe cares about are his cultural conservative quest of erasing the legacy of World War 2 and boosting Japanese nationalism – he is a type of Japanese Newt Gingrich. His present actions are not aimed at permanently anchoring inflation expectations at a higher level, he is just using an old mercantilist strategy of his LDP: talk down the Yen by convincing foreigners that inflation is coming in order to boost exports. That is not a sustainable strategy, but it should give him what he wants of the economy: enough political breathing space to enact a constitutional reform aimed at removing the pacifist element and giving Japan a “real” military.
Paul Krugman writes that none of that may matter. Whatever his motives, Mr. Abe is breaking with a bad orthodoxy. Abe may be ignoring the conventional wisdom on spending, and bullying the Bank of Japan, for all the wrong reasons — but the fact is that he is actually providing fiscal and monetary stimulus at a time when every other advanced-country government is too much in the thrall of the Very Serious People to do something different. It will be a bitter irony if a pretty bad guy, with all the wrong motives, ends up doing the right thing economically, while all the good guys fail because they’re too determined to be, well, good guys. But that’s what happened in the 1930s, too.
Matthew Yglesias think there may be a connection between Abe's hawkish foreign policy views and his dovish monetary views. Foreign policy crises rather than economic crises can drive countries towards heterodoxy and growth in the economic policy sphere. With China growing and the USA’s protection to Japan becoming less certain, Japan is in the type of national security crisis to rouse it from its economic policy slumber.
“Political dominance” and central bank independence
Peter Tasker writes that Abe broke the taboo re-establishing political influence over monetary policy and argues that it was certainly necessary for securing a change in policies at the BoJ. For the BoJ to admit that its previous strategy was misconceived would leave it open to Friedman-like accusations of responsibility for Japan’s long malaise.
Gavyn Davies writes that the macroeconomic debate is now buzzing about “political dominance” over the central banks, under which elected politicians force central bankers to take actions they would not choose to take, if left to their own devices. This is clearly what is happening in Japan, where the incoming Shinzo Abe government is not only imposing a new inflation target on the Bank of Japan (which is legitimate), but is changing the leadership of the central bank to ensure that the BoJ adopts policies compliant with the fiscal regime. This is not just political dominance; it is fiscal dominance, where monetary policy is subordinated to the decisions of those who set budgetary policy. In Europe and America, it seems, however, to be the central bankers who are pushing the politicians in unorthodox directions, not the other way around.
Tim Duy wishes the Bank of Japan had moved in this direction on its own, thus maintaining independence. Central bank independence is important in the long run, and even in the short run is important to ensure that “cooperation” does not become the route to hyperinflation.