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January 28, 2003

Japan Needs Aggressive Monetary Change
by Andrew Smithers

The Bank of Japan's Governor, Masaru Hayami, retires in March. He has opposed the use of monetary policy to encourage economic recovery. A change in policy is thus badly needed. Speculation about who the Prime Minister will appoint is rife. He has announced that he wants an anti-deflation hawk. It is vital that he should be true to his word.

Four arguments are used to oppose policy change. First, that with interest rates at zero, monetary policy cannot be eased further. Second, that it can be eased, but won't work. Third, that it would work too well and create uncontrollable inflation. Fourth, that it would hinder moves towards reconstruction and reform.

The first argument is clearly nonsense. Once short-term interest rates have fallen to zero, a central bank can bring down medium and then long-term ones as well. If this doesn't produce growth then foreign bonds can be purchased. There is no effective limit to the expansion of the monetary base.

No policy carries with it an absolute guarantee of success. But this does not excuse a failure to try a policy, which has strong and authoritative support. Those who oppose monetary ease on the grounds that it won't work are probably worried that it will, thus underlining the failure of past policies.

The argument that it will succeed too well is less often heard, but has some real substance. Buying bonds or any other assets expands a central bank's balance sheet and with it the monetary base. At some point the expansion of the monetary base should cause money supply to expand and set off the economic recovery.

But the relationship between the monetary base and money supply is highly elastic in Japan today. The expansion of the monetary base needed to get monetary growth may be enormous.

There is a risk, therefore, that if the monetary base was expanded enough to get the economy going, the central bank would not then be able to reduce it fast enough to limit inflation to, say, 3% p.a. Nonetheless, this is far from meaning that all control will have been lost and that hyperinflation will result. This risk is part of the case that central banks should seek to avoid asset bubbles. In a post-bubble economy they may be unable to keep inflation at a low-targeted level and have to choose between the undesirable alternatives of deflation or above-target inflation. But the past cannot be undone. To avoid deflation and continued stagnation or worse, it may be necessary for inflation to run at 6% or so for a few years.

The fourth argument, which holds that needed reforms will not be carried out if the economy recovers through inflation, assumes that excess capacity should be reduced by scrapping, rather than by increased demand.

These arguments rarely even attempt to have a theoretical underpinning. When they do it is usually to vague notions of Schumpterian "creative destruction". Japan has had 12 years of destruction, with little improvement in productivity.

This school believes that if excess capacity was scrapped through the closure of the more inefficient companies and plants, then the profitability of the survivors would improve. In practice shutting down less profitable companies would make matters worse, not better, for the survivors.

The least efficient plants are shut first, so unemployment rises faster than capacity falls. But the effect is not just to cut capacity; it also cuts domestic demand, which declines with employment. Unless the savings rate falls, and it usually rises as job losses mount, demand will fall even faster than capacity. The result is that capacity utilisation does not rise as capacity is scrapped, but actually falls. As capacity utilisation falls, competition becomes even more intense and profits fall.

For one company in isolation, cost cutting helps but, if it becomes general, profits fall. This is why profits decline in recessions despite the ferocity with which costs are being cut. If the Prime Minister is drawn in by these fallacious arguments, then he will appoint a new Governor who will not take decisive action to end Japan's long stagnation. Happily, Koizumi's recent comments suggest that he is increasingly concerned to end deflation and wants the new governor to be dedicated to such a policy. If he makes the right appointment, then the prospects for Japan's economy and stock market will be greatly improved. The yen would, however, weaken and so, in due course, would bonds.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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