The potential exists for groundbreaking changes in Japanese economic policy – and I sense that Western journalists, caught up in the current celebration of central bankers, are missing the bigger story. In my opinion, a higher inflation target by the Bank of Japan is not particularly interesting. After all, the Bank of Japan can’t hit the current “goal” of 1 percent inflation. I don’t have much faith that renaming the “goal” a “target” and increasing it to 2 percent will be like waving a magic wand. But something much more significant is afoot – the possibility of explicit cooperation, albeit perhaps forced cooperation, between fiscal and monetary authorities. The loss of the Bank of Japan’s independence to force the direct monetization of deficit spending is the real story.
Floyd Norris at the New York Times begins a recent article on Japanese monetary policy with a quote from then-Federal Reserve Governor Ben Bernanke:
…under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Now we may find out if Mr. Bernanke was right. Japan appears to be ready to do whatever it takes to end its long run of falling prices. The Bank of Japan took limited action on Thursday, and more is expected in the new year.
Norris then proceeds with a generic review of Bernanke’s point that monetary policymakers are not without tools even at the zero bound. Norris includes mention of Bernanke’s “helicopter drop” reference, but fails to put it in proper context. The proper context is in terms of the cooperation between fiscal and monetary policy. This is my central complaint; that reporters have a tendency to not carefully read this speech.
Notice that Bernanke does not say a “determined monetary authority.” He says a determined “government.” Bernanke clarifies this earlier in the speech:
Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
The problem, in my opinion, is that reporters tend to report this speech without explicitly (or even implicitly) defining the importance of fiscal policy. And we know that Bernanke himself does not believe that monetary policy can stabilize the economy in any and all times. From the most recent post-FOMC press conference:
For example, I hope it won’t happen but if the fiscal cliff occurs, as I’ve said many times, I don’t think the Federal Reserve has the tools to offset that event and, in that case, we obviously have to temper our expectations about what we can accomplish.
What does this have to do with Japan? Norris acknowledges the political pressure change on the Bank of Japan:
This week the Liberal Democratic Party, which had ruled Japan for nearly its entire postwar history until it was swept from power three years ago, won a landslide victory. Shinzo Abe, the prime minister from 2006 to 2007, will get another chance.
Mr. Abe devoted a decent part of his campaign to criticism of the Bank of Japan, the country’s central bank. He wants the bank to pursue inflation, and to effectively print money until it gets it. At one point during the campaign he spoke of a 3 percent inflation target, although he seems to have cut that back to 2 percent.
Fine, political pressure is interesting, but the inflation target is just one part of the plan, and I would argue not the most important part. From another New York Times reporter, Hiroko Tabuchi:
In his campaign speeches, he [Abe] called on the bank to set an inflation target of 2 to 3 percent and to buy more bonds to finance government stimulus efforts, another facet of his growth strategy. He warned that he would push to amend laws regarding the central bank to allow the government a bigger say in setting monetary policy. [emphasis added]
The implications are clear. From the Financial Times:
Mr Shirakawa, the BoJ governor, has warned that “monetising” government debt could undermine confidence in Japan’s fiscal discipline, resulting in higher interest rates that would make it much harder to finance the deficit.
What would Bernanke say about the impact of joint monetary and fiscal policy? From his 2002 speech:
Each of the policy options I have discussed so far involves the Fed’s acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices…A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.
…Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets.
US monetary policy would have been much more effective if complemented by fiscal policy. Same goes for Europe. Abe appears to be poised to try something along that route:
In an appearance on Fuji TV on Sunday, Mr Abe, who this week is set to become Japan’s seventh prime minister in just more than six years, said a new approach was essential to defeating the deflation dogging the economy.
“It has to be different from the traditional methods – the traditional methods have not been able to defeat deflation for more than a decade. That’s no good,” he said.
And Abe is determined to make it happen – even if it requires stripping the central bank of its independence:
…Mr Abe has already made clear that Mr Shirakawa will be replaced when his current term as governor ends in April and that his successor will be a candidate more willing to push aggressive easing. “We want to have someone who supports our thinking,” he said on Sunday.
Or he will push for legal changes such that the Bank of Japan to once again falls under control of the fiscal authorities.
Japan might very well be heading toward the end-game of permanent zero interest rate policy: Explicit monetizing of deficit spending. That is the real story here – it goes far beyond just inflation targeting.
Bottom Line: Inflation targeting is not the whole story in Japanese monetary policy. It is a facet of a much greater story. A story of a modern central bank stripped of its independence. Of a modern central bank forced to explicitly monetize deficit spending. Ultimately, it is the story of the end game of the permanent zero interest rate policy.
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