Japan's central bank needs an overhaul too

Japan's likely next leader could begin to square the country's deflation problems with calls for drastic change to the central bank's monetary policy and suggestions he'd look outside the establishment when appointing a governor.


There is a logical corollary to the UK government’s bold decision to appoint Mark Carney, a Canadian, as governor of the Bank of England. That is to make Paul Tucker, the UK central bank’s deputy governor and an unsuccessful candidate for the top job, the next governor of the Bank of Japan.

This modest proposal is made mostly in jest. But after 15 years in which the BoJ has failed to defeat deflation, the institution could do with some fresh thinking. Sadly, it is inconceivable that Japan would appoint a foreigner to lead one of its most important institutions. Even in Tokyo, however, it is not entirely unrealistic to imagine an "outsider” – someone not steeped in BoJ orthodoxy – being drafted in.

That, in effect, is what the man most likely to become Japan’s next leader is proposing. Shinzo Abe, a former prime minister, is poised to return to the job if his party wins next month’s election. Abe has set the cat among the pigeons – or, in monetary policy terms, the doves among the hawks – by proposing some radically new thinking.

He wants the government to set an inflation target – he initially suggested 3 per cent – and for the central bank governor to be held accountable if that goal is missed.

To reach the target, he says the BoJ should pursue "unlimited” monetary easing. Abe has rowed back somewhat in recent days, especially from his ideas that the bank should buy construction bonds. He maintains, however, his threat to amend the Bank of Japan Law if the bank does not co-operate. He has been lambasted for his supposed assault on central bank independence. Yet there is much merit in his position.

At times, the BoJ has given the impression that it does not regard deflation as such a bad thing. It has objected to setting an inflation target – it has reluctantly adopted a more timid "goal” – on the grounds that it might fail to meet it since normal policy tools are ineffective in a deflationary environment. It has also been reluctant to be seen to be financing government spending directly because this would shield the government from taking tough decisions, such as raising taxes, cutting spending and forcing a restructuring of industry.

Not all of what the bank says is wrong. But the upshot is that Japan is still stuck in deflation, albeit mild. A chance to resolve this stand-off comes when Masaaki Shirakawa’s five-year term as governor ends next April. Abe, assuming he wins, will then be in a position to pick the next governor and two deputies.

Yoshihiko Noda, the current prime minister, calls Abe’s proposals "absurd”. Yet the idea of the government setting a mandatory inflation target is no radical departure from central bank orthodoxy. It is exactly what happens in the UK. Sir Mervyn King, governor of the Bank of England, is held accountable. Over the years, he has had to write 14 letters to British chancellors past and present explaining his failure to hit a 2 per cent inflation target.

Richard Jerram, chief economist of the Bank of Singapore, who spent years in Tokyo frustrated at Japan’s overly timid anti-deflation policy, is heartened. "I find myself almost pinching myself,” he says. "Finally they want to get someone in who believes in monetary policy as a driver of inflation.”

Inflation is not a panacea. But it is a useful tonic. Imagine what Japan’s economy would look like if, instead of enervating deflation, it had had inflation of, say, 2 per cent for the past 15 years. Jerram calculates that the economy would be about 40 per cent bigger in nominal terms than it is today. That would make its ratio of debt to gross domestic product look far more manageable. Tax revenue would also be higher, and the yen most likely weaker, boosting exports. Abe’s proposal – christened the "Abe trade” – has sent the yen down and share prices up.

Several candidates have been mentioned for governor. Among the more interesting are Heizo Takenaka, economics tsar under former prime minister Junichiro Koizumi, and Kazumasa Iwata, a former deputy governor who advocates stronger anti-deflationary measures and the purchase of foreign bonds to drive down the yen.

Another possibility is Eijiro Katsu who, as top finance ministry bureaucrat, helped push through a law to double sales tax to 10 per cent by 2015. Implementation of the rise is contingent on certain growth targets being met, for which, in turn, a dovish monetary policy will be helpful.

There is a neat circularity here. The BoJ was given independence from the finance ministry in the late 1990s. Ironically, that was just the time when the economy could have done with closer co-ordination of fiscal and monetary policy to tackle deflation. Instead it got a hamstrung finance ministry and an independent central bank with a less than relevant anti-inflationary remit. Abe, even if he waters his ideas down, could begin to square the circle. And if not, there is always Tucker.

Copyright The Financial Times Limited 2012

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