When politicians in Tokyo start talking about Depression-era monetary policies, it's clearly not business as usual in the Japanese Diet. Rebuilding quake-destroyed homes, roads, and ports, not to mention cleaning up radiation leaks from the still-crippled Fukushima Dai-Ichi nuclear plant, will require a 20 trillion yen ($235 billion) reconstruction package, say lawmakers from Prime Minister Naoto Kan's Democratic Party of Japan and the opposition Liberal Democratic Party. The trick is how best to fund it without crippling a Japanese economy that even before the earthquake had been coping with deflation, weak domestic demand, and the world's biggest government debt load.
That's why Bank of Japan Governor Masaaki Shirakawa, the country's guardian of sound money since 2008, has one of the toughest jobs in central banking right now. He's resisting a proposal submitted by a group of ruling party legislators to Finance Minister Yoshihiko Noda on Mar. 18 calling for the BOJ to buy government debt directly, according to a blog posting by DPJ member Yoichi Kaneko. The group claims this radical policy worked in the 1930s. "Bank of Japan bond underwriting is a policy that is evaluated highly worldwide because it helped Japan recover from the Great Depression before others," the Kaneko group's proposal says. These lawmakers also support a 20 trillion yen special reconstruction budget, which the Diet will consider in coming weeks.
In the early 1930s, then-Finance Minister Korekiyo Takahashi instructed the Bank of Japan to buy bonds issued by the government. The BOJ effectively became a cash machine for a government eager to spend. Takahashi boosted spending by 34 percent in the 1932 fiscal year, financing it by doubling bond issuance, according to a report by the Japan Center for Economic Research. While the effort helped end deflation, much of the outlays were used for the military, and Takahashi made enemies when he later attempted to rein in inflation by tightening credit. He was slain in 1936 during an attempted military coup.
Using a central bank's power to print money as a means to finance deficit spending, a technique known as monetizing debt, is controversial. Shirakawa, 61, has repeatedly shot down the idea. "If a central bank starts to underwrite government bonds, there may be no problems at first, but it would lead to a limitless expansion of currency issuance, spur sharp inflation, and yield a big blow to people's lives" and the economy, as has happened in the past, he said in a Mar. 22 appearance in the Diet. He also told lawmakers the Japanese bond market is deep enough to absorb more bond issuance without seriously driving up yields.
Even critics of Shirakawa, who has spent most of his career at the central bank, admire his intellect. Koichi Hamada, a Yale University economics professor who taught Shirakawa at the University of Tokyo in the early 1970s, describes him as a "brilliant student, very cool and objective with a critical spirit." Shirakawa also earned a master's in economics at the University of Chicago. Hamada thinks the BOJ should finance at least a portion of the reconstruction program with direct bond purchases, given the multiple economic hits to Japan this year. "This is a matter of a rather big emergency," says Hamada. He also thinks the BOJ and Finance Ministry should continue intervening in the currency market to push the value of the yen down to 100 to the dollar, from about 85 now, to help exporters.
Deflation, not inflation, is the country's biggest immediate worry. Consumer prices excluding fresh food fell for the 24th straight month in February, by 0.3 percent from a year earlier. Japan's gross domestic product contracted at a 1.3 percent annualized pace in the fourth quarter, and Morgan Stanley MUFG Securities predicts it may shrink as much as 12 percent in the April-to-June quarter. Japan's outstanding government debt is about 200 percent of economic output.
Given these numbers, some lawmakers are reluctant to raise taxes to pay for reconstruction efforts. "There's no way that taxes can be increased when there's deflation," said Kozo Yamamoto, a Diet member with the opposition LDP, in a recent interview. Yet some sort of tax hike is a possibility if the BOJ doesn't underwrite some of the reconstruction bond financing.
Shirakawa can point to the record 15 trillion yen the BOJ pumped into the Japanese banking system three days after the Mar. 11 quake, and the doubling to 10 trillion yen of an existing plan that includes the purchase of corporate and even some government bonds on the secondary market. The BOJ is also considering offering temporary loans to banks to aid companies with cash-flow problems.
The debate in Japan parallels discussions last year in the U.S. and Europe, when the Federal Reserve and European Central Bank adopted government bond-buying programs to boost economic recoveries from the 2008-09 global financial crisis. The Fed and ECB bought bonds on the secondary market, not straight from government issuers.
So why is Shirakawa so opposed to direct purchases of bonds from the government when the BOJ buys them from banks and insurers in the secondary market? It's one thing to conduct bond purchases to manage money supply or ease tight credit conditions; it's quite another to use such purchases to bankroll government deficit spending, in the eyes of bond traders. "If central bank purchases are viewed as financing of government expenditure ... bond yields will also increase, reflecting rising inflation expectations," said Shirakawa in a speech he gave to Japanese monetary economists last September, according to the transcript.
Some sort of tax increase could be part of the combination of options to fund Japan's earthquake cleanup, according to Michael Auslin, director of Japan studies with the American Enterprise Institute in Washington. "You see a lot of social solidarity in Japan right now to recover," says Auslin. "A tax increase might actually be politically palatable." Shinichiro Furumoto, the director general of the DPJ's tax committee, has floated the idea of a 1 percentage point increase in Japan's 5 percent consumption tax.
Even if the current policy debate over how to fund the earthquake recovery is resolved in coming weeks, Shirakawa and the BOJ will continue to face criticism in the Diet over the country's poor economic performance, deflation woes, and economic stagnation over the past two decades. Last fall some 150 Democratic Party lawmakers who call themselves the anti-deflation league proposed that the Bank of Japan adopt an inflation target to eradicate price declines and bolster employment, even if that means adjusting the central bank's current charter, which gives the BOJ a great deal of independence from government meddling.
Yale University's Hamada says the BOJ's priorities need to be redirected. "The Japanese economy has done very poorly," he says, "not only compared with developed economies, but developing ones like South Korea."
The bottom line: The BOJ's credibility is at stake as it resists efforts to underwrite Japanese bonds to fund $235 billion in quake cleanup costs.