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May 15, 2003

How Fukui Should Deal With Deflation
by Andrew Smithers

On the 20th March, a new Governor of the Bank of Japan took over. The previous incumbent's tour of duty was marked by economic stagnation. This can be seen either as an example of policy failure, or of the limits of central banking power. After the debates of the last 50 years, it has become generally agreed that central banks can satisfactorily manage economies which are prone to inflation; what remains to be decided is whether economies can also be managed under conditions of deflation.

The retired Governor, Masaru Hayami, has repeatedly claimed that central banks are powerless to stimulate demand in the conditions in which Japan has found itself. But he is not an unbiased observer. Furthermore, he never seemed to have sufficient confidence in his view to test it by prolonged and rapid quantitative easing, which is the policy measure advocated by those optimists who believe that central banks can create recovery despite deflation.

Quantitative easing requires rapid expansion of the monetary base and, while there have been periods in which this has occurred, they have been relatively brief and they have not been sustained. As Chart 1 shows, Japan's base money rose rapidly from August 2001 to April 2002 but, on a seasonally adjusted basis, there has been barely any growth since then.

The failure to try quantitative sustained easing does not of course prove that it would have been successful; it just leaves the question open. This is unfortunate on two grounds. First, the policy might have succeeded, thereby avoiding the pain and waste of resources which has been Japan's sad experience in recent years. Second, if it had been tried and had failed, it would have opened a debate on the need for new policies. As it is, policy is indecisive while the debate remains unsettled.

The real opposition to a more aggressive policy of monetary easing does not come, of course, from those who fear that it would fail, but from those who fear it would succeed. There is little opposition to policies whose opponents are truly convinced that they will fail and thus justify their intellectual position, unless they can argue that such policies will do harm in the process of failing. Such claims have only been advanced rarely and half-heartedly.

The constituency which fears success has several different members. It contains, among others, those who hold views and recommend policies, which are at odds with the mainstream economics.

There are, for example, those who recommend cutting back capacity, as a way to encourage recovery, while mainstream economists recommend, when economies are operating below full capacity, that demand should be stimulated. The apparent alternative of cutting back capacity is seen as both ineffective and wasteful. It is ineffective because cuts in capacity are accompanied by cuts in employment, which reduce demand and leave the problem of surplus capacity unresolved, while adding to the evils of unemployment.

Holders of such views would be disappointed if demand was stimulated and the economy then recovered. This is partly because they dislike the idea of being proved wrong, but in many cases it is also because they seem to have a political as well as an economic agenda. They appear fearful that economic recovery by orthodox means will remove the pressure for political and social changes which they would like to see.

Another group is concerned that monetary ease will not only end deflation, but that it will usher in a period of inflation. Some dislike the idea of any inflation and others fear that it would be hard to control.

Finally, there are those who, correctly in my view, see monetary ease as leading directly to a weaker exchange rate and fear, I hope wrongly, that the resulting rise in Japan's current account surplus will lead to international trouble and ill will.

The fundamental problem for Japan is that it naturally generates more savings than it can profitably absorb in its own economy. It needs, therefore, to export these excess savings and this can only happen if the external current account surplus rises, as the export of capital and the external surplus are one and the same thing.

The scale of the problem is, however, very large. There are two serious elements of disequilibrium in the way the economy is currently operating. They are the budget deficit and the level of investment.

The former is running at 8% of GDP and must ultimately fall by a large amount. The fall needed in the latter is of similar proportions. Japan invests a much higher proportion of its GDP than other developed countries, but its potential growth is much less. This combination is unstable and, since growth is limited by Japan's demography, investment must fall.

Not only has Japan had, for many years, one of the lowest birth rates in the world, but also it has had virtually no immigration. As a result its workforce is falling. Whereas the number of those of working age in the US will probably rise by around 1.5% p.a. over the next decade, the numbers in Japan will fall by around 0.5% p.a., unless there is a major change in immigration policy.

As a result it is virtually certain that the US will grow much more rapidly than Japan. The only alternative would be for Japan to improve its labour productivity much faster than America. In recent years there has been a difference between the rate at which productivity has changed in the two countries, but it has been in favour of the US rather than Japan.

If, just for illustration, it is assumed that both countries will improve their labour productivity by 2% p.a., then the rate of growth of the US will be around 3.5% p.a. and that of Japan around 1.5%. The impact of population growth is so large that even if we alter the assumptions in Japan's favour, it is unlikely that the US will not grow at least twice as fast as Japan.

If Japan grows at half the US rate, it must spend much less on new capital or the return on that investment will be extremely poor. At the moment Japan invests much more of its GDP than the US. Even if public sector spending is ignored, as being an area where poor profitability is unimportant, the level of Japanese investment is clearly excessive. Capital spending by the private sector is 4 percentage points of GDP higher in Japan than in the US and, if the investment in Japan is to be profitable, it must fall to a much lower level than the US to compensate for the much lower rate of potential growth.

To get the economy into equilibrium, therefore, there must be large falls both in Japan's budget deficit and its investment ratio. For this to occur without economic catastrophe there must be a large compensating rise in demand from elsewhere in the economy. There are only two places from which this can come. One is domestic consumption and the other is net exports. If it is to be the latter, there will have to be a large rise in Japan's current account surplus.

In practice, a rise in exports will have to provide at least the major part of the extra demand that is required. This is because there will not be a natural reduction in the savings of the Japanese people until some years have passed. The fall in the birth rate, which is already causing a decline in the workforce, did not begin till some time after the Second World War had ended, as Japan's baby boom came later than it did in Europe or America. The result is that Japan has a proportionately large number of people in their fifties, it being 50 years or so after the baby boom, and there are also lots of people in their late twenties, who are the baby boomers' children.

These groups need to save for their retirement and the elder group are typically in the high savings age, when their children have left home and they are through the expense of university. If the present generation of workers do not have high savings, they will be unable to support themselves in retirement. In ten to fifteen years the working population will have fallen sharply and the number of retired will have risen. The latter will have to generate enough savings to support themselves when they have ceased to work, as a massive and unsustainable burden will otherwise fall on the shrunken workforce.

But while the current generation need to save, they cannot expect these savings to be profitably invested at home and if they are invested unprofitably, savings will have to be even higher. Japan is thus faced with a dilemma; she must either alter her population structure by massive immigration, or lower her exchange rate so that she can generate a large increase in her current account surplus.

This dilemma is not an easy one. Massive immigration is a most unpopular idea in Tokyo and a large current account surplus is disliked in Washington and Brussels. So far the typical response has been one of denial. Because neither solution is acceptable, many prefer to deny the existence of the problem.

It is helpful here to compare this with the situation in Europe, which faces a similar, though less acute, choice. Europe has a potential escape route, which is not open to Japan, in that a large proportion of its population of working age are not employed. Changes in labour laws and practices are thus a solution to Europe's problem that is not available in Japan. As the current debate in Germany over reform of the labour market is showing, however, denial is as common in Europe as it is in Japan and the resistance to change is fierce.

As denial is such a common response to Japan's problems, it is sadly far from certain that the correct policy measures to deal with them will soon be implemented. It is therefore sensible to consider two things. First, what measures should ideally be introduced and second, what is likely to happen in practice.

With regard to the correct policy measures, I am strongly in agreement with the authors of two recent articles in Central Banking, Tim Congdon and Richard Werner. Both of them have argued, in my view correctly, that the best way forward for Japan is to use monetary rather than fiscal policy to stimulate demand and to aim to expand money supply directly, rather than indirectly through an expansion of the monetary base. Although there may be marginal differences in the approach recommended by each of us, the basic thrust of our arguments is in each case the same.

Monetary base expansion is recommended on the grounds that it will lead, in time, to expansion of the broad money and that will in turn lead to economic recovery. It is, however, agreed that step one of this process does not necessarily lead quickly to an acceleration in money supply. Those of us who favour a change in funding policy argue that it will achieve broad money growth more surely and quickly than can be achieved by the actions of the central bank.¹

The route by which a change in funding policy would lead to a surer and more rapid rise in money supply than can be achieved through quantitative easing can be explained in several different ways. It can be seen, for example, as a way to reduce the risks run by the banking system. Increases in the commercial banks' holding of government debts, will cause money supply to rise. If the banks buy bonds, however, they will have the risk of interest rates rising. If the government issues only Treasury bills, or borrows directly from the banks on an overdraft type basis, the banks will not have such risks. If banks have a profitable and riskless outlet for lending then they will be naturally willing to expand such assets rapidly and, this will increase money supply.

In practical terms, however, this policy is unlikely to be implemented in the near future, despite the fact that it was supported by the then Vice-Minister of the Ministry of Finance Haruhiko Kuroda, who set out his views in a talk he gave to a meeting of the US National Bureau of Economic Research that was held in Tokyo in September, 2002. At the moment, the best policy that can reasonably be expected by Japan's well wishers is that the new team at the Bank of Japan will revert to the policy of monetary base expansion that was briefly in place from August 2001 to April 2002. In an interview in this journal in August 2002 Milton Friedman argued that such a course of action would be successful, in time, provided that it was vigorously pursued for a prolonged period.

While I have greater confidence in a policy which would directly expand the monetary aggregates, an attempt to create recovery through monetary base expansion has two virtues. First it might succeed. Second it will be difficult to obtain agreement for the less familar policies that Tim Congdon, Richard Werner and I have recommended, until the relative orthodox approach of quantitative easing has been tried.

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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