Easing Out of Quantitative EasingRichard C. Koo
The Bank of Japan removed its so-called quantitative easing in March, ending a controversial policy that was first put in place five years ago. The policy increased reserves in the banking system from the 5 trillion yen required to support bank lending to nearly 35 trillion yen, at a time when interest rates were already at zero. This massive injection of excess reserves was supposed to show Japanese citizens that there was plenty of money available, and that an end to deflation was just around the corner, according to academic economists who pushed for the idea. Policy watchdogs such as the IMF were also supportive of the idea.
It's no surprise, then, that the BOJ's decision to end the policy was met with skepticism from academic circles and the IMF. They complained that the BOJ should have kept the easing in place until it had hard evidence inflation was really at hand. Princeton University economist Paul Krugman, for example, suggested that the central bank should have waited until the inflation rate hit at least 2%. Today it's just above zero.
This sort of disagreement, however, stems from the fact that many economists are still operating on the assumption that companies are maximizing profits. They don't understand that until very recently, Japan was in a balance-sheet recession, where companies minimized debt in the face of a collapse in asset prices. The decline devastated the balance sheets of these companies and forced them to slash debt.
With households saving money, but the corporate sector no longer borrowing, a huge deflationary gap was created in the economy. The catastrophic implosion that could have followed was averted only by government borrowing (see BW Online, 3/3/06 "How Japan Fell into the Hole").
Since the main driver of this type of recession is corporate-debt minimization, no amount of monetary easing could turn the economy around. Companies with impaired balance sheets simply aren't interested in borrowing more, regardless of the interest rate. As a result, there was no acceleration in bank lending or money supply during the last five years -- indicating that quantitative easing didn't work.
In other words, policies based on the assumption that companies are maximizing profits don't work when companies are minimizing debt. One could even argue that the BOJ agreed to quantitative easing only because it could do little harm when there was virtually no demand for funds from the private sector.
The government's borrowing, on the other hand, kept the economy going year after year and by last year provided companies with enough revenues to produce presentable balance sheets. Now companies have become sufficiently confident to borrow for the first time in 10 years.
This welcome development, however, has meant that the excess reserves sitting in the banking system could fuel a credit binge. The 30 trillion yen of excess reserves, for example, was enough to support monetary growth for the next 92 years!
If those reserves were to make their way into the money supply, inflation would skyrocket well beyond the 2% suggested by Krugman. The Bank of Japan, therefore, had no choice but to remove the excess reserves.
Other proponents of quantitative easing worried that the BOJ's tightening would take the wind out of the Tokyo stock markets and cut the inflow of funds from the so-called carry trade -- where investors borrow in yen at low interest rates, then buy other currencies to invest elsewhere. The fact that Japanese shares gained after the BOJ said it would end quantitative easing suggests that the market understood the irrelevance of the policy. After all, the introduction of easing back in 2001 didn't boost share prices, so there was no reason to think its removal would hurt them. And since there have been no disturbances in foreign markets, it seems that the impact of the yen carry trade has been exaggerated.
It could be said that quantitative easing has been the biggest financial non-event in the 21st century. On the other hand, the dismantling of the policy means that the world's three most important central banks -- in the U.S., Europe, and Japan -- are now tightening. These actions, together with stronger economies and higher oil prices, are adding to higher interest rates all around the world.
Although the direction of oil and other commodity prices is hard to predict, the Japanese contribution to higher global interest rates is likely to be limited in the coming years. Even though corporate borrowing is finally greater than corporate debt repayment, it is still less then 2% of GDP. Many executives who spent most of the past decade struggling to pay debts are in no mood to increase borrowing anytime soon. The fact that Japanese corporate cash flow is at an all-time high also reduces their need to borrow.
Moreover, Japanese companies are rebuilding their financial assets at double the rate of their fund procurement, or at 4% of GDP. Corporate build-up of financial assets -- a form of savings -- increases the funds available to the financial market and tends to push interest rates down.
Companies are rebuilding their assets today because they liquidated so many over the past decade to offset losses elsewhere. This means the corporate sector is still a net supplier of funds to the economy and is not yet in the position to absorb household savings and put them back into the income stream.
To be sure, the corporate sector's net supplier position has fallen from the high of 6% of GDP in 2003 to 2% in 2005, indicating that normalization is happening. On the other hand, the fact that those companies are still rebuilding financial assets means that the normalization, especially of interest rates, is likely to be a gradual process.