Japan verges on a reflation revolution

FT.com

Suddenly it is game on in Tokyo – and the world is watching. For the past 15 years Japan has been trying to shrink its way out of its problems. That did not work. Now it is about to try the opposite approach.

Japan's "lost decades” have long been an awful warning to the world of the damage that a spectacular boom and bust can inflict on an economy's long-term prospects. Now Japan could become another kind of example. If the pedal-to-the-metal reflationary policies of Shinzo Abe, the recently elected prime minister, succeed, there will be a profound impact on post-crisis policy making everywhere.

History shows that Japan rarely does things by half-measures. The financial bubble of the 1980s was probably the biggest in history. At its peak the Tokyo stock market was worth more than half of global market capitalisation.

The contraction was equally intense. Twenty-three years after the Japanese bubble burst in 1989, the Nikkei Index was flirting with new bear market lows. Weak growth and deflation have meant that Japan's nominal gross domestic product is no higher now than it was in 1992.

Even so, macroeconomic policy has remained contractionary. Just last year Yoshihiko Noda, the former prime minister, pushed through a bill to double consumption taxes.

Unfortunately the reward for such rectitude has been an explosion in the debt to GDP ratio. Tax revenues have collapsed and social spending has soared – a phenomenon now familiar in Europe.

Monetary policy has done little to support growth. The Bank of Japan's balance sheet is barely larger now than in 2005. Its unconventional crisis-fighting operations have been fairly cautious, consisting largely of buying short-term bonds from the banks in order to increase liquidity. The mood music from BoJ officials was that they did not believe that monetary policy could or should be deployed more aggressively.

When a group of investors visited the BoJ last spring to hear about the central bank's self-created inflation "goal” (the Japanese text was left deliberately vague), they were treated to a 45-minute discourse on demographics. The message was clear – deflation was the fault of Japan's inadequately fertile womenfolk, not the elite officials of the central bank.

Fifteen years ago, Milton Friedman memorably ascribed Japan's economic woes to "a decade of inept monetary policy”. He also warned against the error of identifying easy money with low interest rates. The high interest rates of the 1970s, he said, were a signal that monetary policy was too loose, not too tight. Likewise the low interest rates of Japan today – as in the US of the 1930s – show that monetary policy is too tight, not too loose.

Sooner or later a Japanese politician was going to get the message.

That politician turns out to be Abe, whose landslide victory last month followed a campaign based on a promise to boost the economy.

Already he has started to revive public works spending – a sensible move, given Japan's aging infrastructure and the risks of natural disasters.

However, the greatest emphasis will be on monetary policy. Abe has demanded much greater aggression from the BoJ, threatening to remove its independence if it fails to deliver. He wants an explicit inflation target and a weaker yen, secured by an "accord” between the government and the central bank.

Here he is breaking at least two taboos of central banking. The first is that a more competitive exchange rate should not be a policy target, as that would constitute "manipulation” – an activity widely frowned upon, not least by the US Congress.

In truth this is humbug. Everyone knows that currency depreciation is a crucial mechanism for reflating demand-starved economies. Sir Mervyn King, outgoing Bank of England governor, hinted as much in interviews.

Since the collapse of Lehman Brothers in 2008 the US has benefited from a weaker dollar.

Elsewhere, the Swiss central bank has drawn a line in the sand that it will not allow the franc to cross; the Koreans have effectively been managing the won rate for years. But these are not major currencies.

Japan is the first G8 country to breach this monetary correctness.

The second taboo is to re-establish political influence over monetary policy. It has become axiomatic that central banks should be independent entities, insulated from the grubby machinations of politicians.

Again, the reality is more complex. Sophisticated operators such as Sir Mervyn, Ben Bernanke and Mario Draghi – his counterparts at the US Federal Reserve and European Central Bank – take account of the wider political and social context.

Furthermore the benefits of independence – greater transparency and predictability bringing lower interest rates – were more obvious in the inflation-racked 1970s and 1980s than in today's world of excess capacity and rock-bottom interest rates.

More fundamentally, is it safe to assume that monetary policy is an apolitical activity and that central bankers are objective arbiters of what is best for the national interest? The Japanese experience suggests not. Monetary policy is inherently political since it affects the balance of interest between savers and borrowers and, in Japan's case the old and the young.

Neither are central banks disinterested parties. Like all bureaucratic entities, they aim to expand their prestige and influence. For the BoJ to admit that its previous strategy was misconceived would leave it open to Friedman-like accusations of responsibility for Japan's long malaise.

What if Abenomics works? Imagine Japanese exporters recovering market share, tax revenues surging, stock prices in a multi-year bull market, and the doomsters predicting bond market apocalypse getting it as wrong as the Mayans. "Turning Japanese” would be then be something to envy, not fear.

The writer is a Tokyo-based analyst at Arcus Research.

Copyright The Financial Times Limited 2013.