Japan’s Brave New Monetary Era
The Bank of Japan’s new governor, Haruhiko Kuroda, didn’t disappoint investors with his announcement yesterday: He plans for the biggest, fastest unconventional monetary stimulus any large economy has ever seen. By definition, financial markets never expect “shock and awe,” but they expect it least of all from the hyper-cautious BOJ. For once, for the first time anybody can recall, “shock and awe” is what they got.
On balance, this bold move is the right one. Prime Minister Shinzo Abe and his government now need to do their part. There’s no risk-free exit from Japan’s economic woes. Nonetheless, with a combination of long-term fiscal control, supply-side reform and an end to deflation -- Kuroda can deal only with the third piece -- Japan’s prospects can finally improve.
Kuroda’s program of additional quantitative easing is enormous. The BOJ’s balance sheet is scheduled to expand by 30 percent of gross domestic product between now and the end of 2014. For comparison, since the U.S. Federal Reserve embarked on QE, its balance sheet has grown by less than 15 percent of GDP -- and it took almost five years, rather than less than two, to do so.
No less important is the announced shift toward buying long-term debt. Up to now, the BOJ’s bond buying has been not just small but also confined to short maturities. Short-term public debt isn’t much different from money, and swapping one kind of money (short-term bonds) for another (reserves at the central bank) is mostly pointless. The new bond-buying program, like the Fed’s, will focus on longer-term debt -- raising long-term bond prices and suppressing long-term yields, thus encouraging investors to buy other long-lived assets instead, including equities. That way, the stimulus is much stronger.
This reasoning, of course, exposes the main risk. Kuroda wants to shatter Japan’s deflationary mindset, and cause investors to expect a modest increase in inflation to 2 percent -- an outcome devoutly to be wished. But what if investors think the BOJ has simply lost its grip and that much higher inflation is on the way? Then long-term yields would probably surge, not fall, in both nominal and inflation-adjusted terms. For Japan, whose public debts stand at more than 200 percent of GDP, the consequence could be an outright fiscal collapse.
Kuroda has drawn two lines to lessen this danger and keep inflation expectations in check. He has ruled out permanent monetization of public debt -- the most inflationary form of monetary stimulus. In other words, like the Fed, he’s promising to reverse the QE in due course. Second, for now at least, the BOJ won’t be buying foreign-currency securities, signaling it has no intention to drive the yen much lower (though the central bank doubtless won’t be too upset by a moderate decline).
Over the coming weeks and months, Kuroda (and everybody else) will be watching the currency and long-term yields to see whether the mix he’s proposing -- massive unconventional easing but with significant gestures of restraint -- will move inflation expectations to 2 percent, but no higher. For now, we think he has got the balance right.
When Abe, the new prime minister, began pressuring the BOJ to raise the inflation rate, he said this was just one of three “arrows.” Abenomics was also to include further fiscal expansion and a program of supply-side reforms to spur private investment and growth. He needs to think again about the second and get moving on the third.
Abrupt fiscal contraction would be unwise but Abe should put much greater emphasis on medium- and longer-term restraint. After years of indecisive and ill-timed fiscal stimulus, Japan has become far too vulnerable to a fiscal calamity, and even now rising debt-service costs are a threat to more productive forms of government spending. Abe has said fiscal expansion isn’t forever, but he should signal greater resolve to address the debt issue. An increase in the sales tax due later this year should go ahead, and plans for longer-term spending cuts should be announced and, so far as possible, enacted promptly.
Abe has promised to say more about the third arrow -- supply-side reform -- in a few months, when several bodies that are charged to come up with proposals are due to report. This exercise may well produce a lot of talk and no action. Japan’s calcified and overregulated economy needs supply-side radicalism as much as it needs Kuroda’s monetary kind. For the first time, the BOJ is doing its part. Abe and the rest of his government must now do theirs.
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