Japan Reflation Inspired by Braintrust Created by Shinzo Abe

Putting the final touches to his latest book in October, retired Yale University professor Koichi Hamada received a phone call at his Connecticut home. It was Shinzo Abe, whom he’d known for more than a decade and was running for a second shot at being Japan’s prime minister.

“I was really surprised,” Hamada, 77, who has campaigned for years for greater Japanese monetary stimulus, said in an interview from Wallingford, north of the campus where he used to teach. “I wrote him a summary of my views on the questions he asked about the role of monetary policy for recovery and reflation.”

Abe’s call, weeks before he retook power, underscores the rising role of a group of Bank of Japan critics who drifted to the margins of policy debates during the nation’s decade-and-a-half battle with deflation. Abe appointed Hamada to advise him on choosing the next BOJ governor. Etsuro Honda, 58, a Shizuoka University professor who wants a two-year window attached to the bank’s new inflation target, has a workspace next to Abe’s on the fifth floor of his office building across from parliament. Other reflationists summoned by Abe this year include Kikuo Iwata, 70, and Yoichi Takahashi, 57, who advocate a surge in Japan’s monetary base.

At stake is whether the group’s influence with Abe, 58, will prompt him to pick a BOJ leadership team that embraces stronger stimulus than outgoing Governor Masaaki Shirakawa, who repeatedly warned about the dangers of excess liquidity in his term. Success in rekindling inflation may either stoke a rebound in growth or add diminishing purchasing power as a new woe for the indebted nation, the world’s third-largest economy.

Dramatic Shift

“The reflationists have come in from the cold to sit right by the fireplace next to the prime minister,” said Takahiro Sekido, a strategist in Tokyo at Bank of Tokyo-Mitsubishi UFJ Ltd. who formerly worked at the Bank of Japan. “Their influence was limited until Abe came back, and right now we are on the verge of a dramatic shift in the nation’s monetary policy.”

Abe was a surprise winner of the Liberal Democratic Party’s leadership contest Sept. 26, a pick that broke with the precedent that former prime ministers limit themselves to cabinet positions or the back bench after their time at the helm. Five years after leaving office in the midst of the gathering global credit storm and with a debilitating intestinal affliction, Abe put monetary stimulus at the center of his campaign.

In November speeches, he called for “unlimited easing.”

Reflation Embrace

“It wasn’t until September last year, just before the party leadership election, that I realized he was going to go with this policy” of reflation, said Takahashi, a professor at Kaetsu University in Tokyo.

Takahashi, a former Finance Ministry official who advocates U.K.-style accountability for the central bank governor, says what he and like-minded colleagues are pushing isn’t revolutionary, though it may be untested in Japan, where deflation took hold in the late 1990s after an asset-bubble collapse.

“What we are using is a very standard theory of international finance,” Takahashi said in an interview this month. “If you ease monetary policy, the currency will weaken. If you do that, exporters will benefit and shares will rise. It will also encourage inflation and real interest rates will fall, which will also lead to higher share prices and improve capital spending and the economy will improve.”

Economic Outsiders

Economists in favor of reflation were “on the outside for nearly a decade” after the government switched focus to boosting the economy through deregulation instead of keeping pressure on the Bank of Japan, according to Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group AG in Tokyo and a former Bank of Japan official. “Lawmakers often paid lip-service to fighting deflation, but their heart wasn’t in it.”

Investors are cheering Abe’s brand of economics, with the Nikkei 225 Stock Average advancing for 12 weeks through Feb. 1, the longest winning streak since 1959. The index is up 22 percent in three months, the largest gain in 18 global stock market indexes tracked by Bloomberg, with Mazda Motor Corp. more than doubling on the improved export outlook.

The yen set a record with 12 weeks of consecutive declines against the dollar. The currency tumbled 14 percent from mid-November, when investors began reacting to Abe’s easing calls, to trade at 93.13 per dollar as of 12:10 p.m. in Tokyo today. Japan’s borrowing costs have stayed low, with the yield on five-year government debt touching the least since 2000 on Feb. 19.

“Ever since the new government took control, it feels as though Japan is filled with the spirit for economic revival,” Takahiko Ijichi, senior managing officer at Toyota Motor Corp., said Feb. 5.

Abe’s Regrets

Abe’s increasing embrace of the reflationist group followed regret over the BOJ’s actions when he was last in government, as chief cabinet secretary and as prime minister in 2006 and 2007.

The BOJ progressively withdrew support to the economy at the time, reducing cash provided to lenders in early 2006, then raising the benchmark rate in July 2006 and February 2007, anticipating the end of deflation. Abe said the first rate increase in almost six years was “appropriate,” a comment he repeated after the 2007 rate boost.

By last November, he’d changed his mind. “The BOJ made a mistake in conducting policy in 2006,” he said in a Nov. 27 speech, weeks before sweeping to electoral victory. The central bank’s actions started to drag on an economy that was showing positive signs, he said. Abe told parliament this month that the BOJ’s tightening was “too early.”

Deepest Slump

After leaving office in September 2007, Abe watched as the economy sank into its deepest recession since at least the 1950s in the aftermath of the Lehman Brothers Holdings Inc. collapse and ensuing credit storm. The LDP was ousted from office in 2009 after dominating Japan’s government for half a century.

When the nation was hit in March 2011 with its most powerful recorded earthquake, sparking a tsunami that devastated the northeast coast, a clutch of lawmakers called for the central bank to embrace direct financing of government reconstruction spending, taking a page from policies enacted in the 1930s.

At the forefront of the effort in the LDP, which was then in opposition, was Kozo Yamamoto, 64, who advocated a 20 trillion yen ($247 billion at the time) reconstruction program funded by BOJ debt underwriting. While he didn’t back the idea of the direct bond purchases, Abe brainstormed with Yamamoto on monetary policy.

“At first he wondered whether what I was saying was right,” Yamamoto said in a Jan. 28 interview. “I said, if he specialized in the economy, he could build a new image.”

Study Sessions

Abe began attending study group sessions on monetary policy, hosted by Yamamoto, with economists including Hamada, Gakushuin University Professor Iwata and Tokyo University’s Takatoshi Ito, an inflation targeting-advocate rejected in 2008 as a BOJ deputy governor candidate. Other discussants with Abe included Nobuyuki Nakahara, an intellectual father of the BOJ’s first stab at quantitative easing, in 2001, when he was a board member.

“Their ideas entered his head like water soaking into the desert,” Yamamoto said in an interview this month. The current administration’s economic platform “started from there,” he said.

Abe began echoing publicly the view of economists including Iwata and Takahashi. In a broadcast on BS Fuji television in October 2011 he said that the central bank ought to enlarge the monetary base -- or the amount of cash in circulation plus financial institutions’ reserves at the BOJ -- to get out of deflation. Abe declined an interview request from Bloomberg News last month.

Minority View

Honda, who has known Abe since they met at a wedding reception around 30 years ago, toured the country last year making speeches about the benefits of reflation. This, Honda said, impressed Abe enough to request him to explain his ideas - - and to make him a special adviser, tasked with collecting information to assess potential BOJ governor candidates.

“There are not so many supporters of reflation in Japan -- we are in a minority,” Honda said in an interview this month, adding he keeps sending Abe ideas on how to promote the issue to the general public.

Hamada, who has known Abe since 2001, interviewed him in June last year as part of his own research. In “America Understands The Japanese Economic Revival,” the book he was working on when Abe phoned him, Hamada says that blaming the declining population for deflation is groundless, and that BOJ easing in February last year showed that monetary stimulus works by influencing expectations.


Hamada advocates changing the BOJ law to make the bank more responsible for employment and allow the government to set inflation targets. “Legally, we don’t have any assurance that the Bank of Japan will not go into restrictive policy and continue 15 years of deflation,” he said.

Abe said this week that the law could be revised if the BOJ fails to “take responsibility and produce results.”

Abe was set to decide on his nominee for BOJ governor next week, with contenders including Ito, Haruhiko Kuroda, Kikuo Iwata, Kazumasa Iwata and Toshiro Muto.

Kikuo Iwata, who once taught economics to Honda, said last month that the yen’s strength and deflation can be overcome through monetary policy alone and has proposed that the BOJ governor should be prepared to resign if inflation targets are missed.

Kuroda, Muto

Kuroda, 68, head of the Asian Development Bank, said this month that the nation has many tools to achieve a 2 percent price target. Kazumasa Iwata, 66, a deputy BOJ governor from 2003 to 2008, has consistently argued in favor of buying foreign bonds, a tactic the LDP suggested last year. Abe told parliament this week that the need for such purchases will “basically disappear” once a new central-bank leadership is installed.

Muto, 69, a deputy at the same time as Kazumasa Iwata, has changed his view on easing since his tenure at the bank, when he said keeping interest rates too low could be problematic. In an interview last month, he said ending deflation is the top priority, even if there are side effects.

To be sure, some economists with Abe’s ear take a more moderate monetary stance.

“Japan’s deflationary economy cannot be resolved through monetary policy alone,” Yukari Sato, an upper house LDP lawmaker and former Credit Suisse First Boston economist, said in an interview last week. “It provides an entry point for resolution, which will also require support for demand via fiscal stimulus that will stimulate private demand.”

Fiscal Health

Susumu Takahashi, chief economist and chairman of the Japan Research Institute who is a member of the government’s Council on Economic and Fiscal Policy -- a gathering of business leaders, academics and policy makers including the BOJ governor -- stresses the importance of fiscal consolidation.

“We have to balance ending deflation with growth and improving the nation’s fiscal health,” he said in an interview Feb. 13. “A loss of discipline will lead to the snapping of the ’three arrows’ of Abenomics.”

“Bold” monetary policy, a “flexible” fiscal stance and a growth strategy to stimulate private investment, are the three elements that Abe advocates.

Some economists question whether Abe’s approach to ending deflation offers anything new.

“The market is moving and that’s making people happy, but there are a lot of question marks,” said Shunsuke Motani, a former senior economist at Deutsche Bank AG and the founder of independent research firm Sphynx Investment. “This is not the first time the BOJ has tried money printing: In the early 2000s there was a roughly 70 percent increase in the monetary base and it had absolutely no effect on prices.”

Public Support

Masamichi Adachi, senior economist at JP Morgan Securities Asia in Tokyo, says it will take more than monetary and fiscal stimulus to change the country’s economic trajectory.

“Abe needs companies and households to believe sustained growth will come through innovation in products and services,” he said. “People need to be convinced that this country is changing, not cyclically but simultaneously.”

The public though is applauding. The support rate for Abe’s cabinet rose to 62 percent this month from 54 percent in January, according to a poll of 1,603 people by the Asahi newspaper.

The policy shifts, even if carried out, must grapple with the challenges of a shrinking population and slump in manufacturing jobs to the lowest level since 1961.

‘Wishful Thinking’

“I suppose a change is a good but it would be wishful thinking to say I expect positive news will reach us,” says Sonoko Okada, 71, who set up her clothes and cosmetics shop 45 years ago in Maebashi, a prefectural capital north of Tokyo. “There is no way for Japan’s economy to snap back after a long, long period of stagnation.”

Taro Yamada, 40, a part-time worker in Maebashi, is more hopeful.

“I bet Abe can restore Japan,” he said earlier this month. “If the Abe government can’t do it, we may not have anyone left to fix Japan’s economy.”

(Updates yen in 13th paragraph.)
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