Commentary: Japan: "Reflation" without Reform Equals Disaster

The U.S. markets are surely a mess. But they're nothing compared with what's left of Japan Inc. The Nikkei stock index has plunged to its lowest level in 16 years. News of a possible ratings downgrade of 19 Japanese banks sent a chill through global markets on Mar. 14. Behind the spate of bad news: an economy caught in a deflationary spiral that is dragging the country into its second recession in three years.

Japan's woes, coming on top of a sinking U.S. economy, now pose a real threat to world financial stability. So it's not surprising that the Bank of Japan is under mounting pressure to stem a deflation that drove prices down 0.7% las year. Indeed, Tokyo's central bank cut interest rates twice in February, slashing a key short-term money rate to a mere 0.15%. It could lower rates even further, to zero, at its next meeting on Mar. 19.

OPEN THE SPIGOTS? But critics of the Bank of Japan, led by Princeton University economist Paul Krugman, say that's not nearly enough. The answer is monetary reflation--otherwise known as printing yen, and lots of them. Krugman and his supporters, including some politicians in Japan, want the Bank of Japan to formally commit to deliberately fostering inflation in the economy. In Krugman's words, the Bank of Japan must "credibly promise to be irresponsible." To carry through on that promise and get the economy functioning again, he argues, the bank needs to open the monetary spigots and flood the paralyzed financial system with liquidity. With enough money sloshing around, the theory goes, banks are sure to lend and consumers to spend.

So far, that argument has fallen on deaf ears. With interest rates close to zero, Bank of Japan Governor Masaru Hayami says the central bank has already eased monetary policy "to a degree unprecedented in the history of central banking." And he scoffs at the suggestion that monetary reflation is the magic elixir to cure the economy's ills.

Hayami has a point. While a drastic easing of monetary policy could give a fillip to Tokyo's stock market, it's unlikely to provide a lasting lift to the economy unless it's accompanied by wholesale financial and fiscal reforms. Japanese banks are saddled with some $250 billion in problem loans. No matter what reflationists say, battered banks are unlikely to increase their lending until Tokyo comes up with a plan to rid the banking system of bad credits. Instead of loaning out the extra money that a reflationary policy would give them, crippled commercial banks would simply park cash in government bonds, as they have been doing for past 10 years.

Japanese consumers, too, are obsessed with saving rather than spending. They're worried about losing their jobs and having enough for retirement. And unless the government acts to beef up worker training and bolster the state-run pension program, consumers will hold on to their yen. In fact, they may hunker down even more if they think there's a risk that inflation will eat into the money they've already socked away. "Aggressive inflation targeting would be more likely to stifle demand than enliven it," says David L. Asher of the American Enterprise Institute.

What's worse, there's a risk that aggressive easing on its own could do more harm than good to the global economy. If the money the Bank of Japan pumps into the economy isn't used at home because of banks' and consumers' reluctance to open their purse strings, the dough is likely to find its way overseas, where it will be converted into dollars, euros, and other foreign currencies. The result would be a sharply weakened yen. While that would benefit Japanese exporters, it would hardly be good news for the rest of the world at a time of slowing growth.

To be sure, some weakening of the yen is necessary if Japan is ever to work its way out of its economic troubles. But a free fall in its currency is the last thing Japan needs. If that were to happen, the radical reflation advocated by Krugman could end up looking a lot like Tokyo's export-led policies of the 1970s and '80s. And that's the sort of beggar-thy-neighbor move an already hurting world economy could really do without.

By Rich Miller

With Brian Bremner in Tokyo

— With assistance by Brian Bremner

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