Japan In The Front View Mirror

by Edward Hugh: Barcelona

This week the Japanese economy has suddenly become the centre of everyone's attention, and just today we have the news that the Bank of Japan has finally bitten the bullet, and gone for a further 0.25% increase in its overnight lending rate. However I cannot help having the unfortunate feeling that everyone is so busy eagerly looking forward (to the recovery, the end of the carry trade, or whatever) that they are making the glaring and rather irresponsible error of forgetting to check on what has been happening behind, and in the only all too recent past.

The G7, as everyone by now probably knows, has just reasserted it's faith in the view that the Japanese economy is well on course to recovery. According to the official statement:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Now this is a strange statement, since there are plenty of indications coming out of Japan that there are subtsantial doubts about this, and particular there are doubts about the resilience of domestic consumption in the current recovery, as Claus has already ably explained in two excellent posts (here and here). Since Claus will comment further on the details of the current decision, what I would like to do in this note is step back a bit, and reflect upon some aspects of the situation which should give us all cause for serious thought.

In particular there is the issue of deflation, and the danger that Japan may once more fall back into the deflation trap. I say once more, since at the present time I am already getting a strange feeling of deja vu, since few seem to remember that the current approach was tried and found wanting once before, back in 2000. Paul Krugman writing at the time had this to say:

So what if last Friday the Bank of Japan finally ended its "zero interest rate policy" (yes, ZIRP)? After all, it's only a quarter-point rise, in a faraway country that doesn't interest most Americans now that it no longer seems a dangerous competitor. And yet I would not be surprised if future economic historians look back at Friday's move as the beginning of the end for an era, and not just in Japan.

For one thing, this move by the Bank of Japan is a much bigger deal than you might think, because of its potential impact on expectations. By raising interest rates, even slightly, when the economy is still depressed, the B.O.J. in effect signals anyone in Japan who might be feeling stirrings of exuberance that it is likely to step on the brakes in earnest if the economy actually shows any signs of booming, or if consumer prices start to rise even slightly.

All of this is now of course simply history, but it is the sort of history for which many market participants - as opposed to academic economists who follow the Japan problem - seem to have remarkably short memories, and yet the consequences of that history remain, and are it seems, once more coming back to haunt us. As is well known the BoJ subsequently had to back away from the premature 2000 attempt to 'normalise' interest rates, but it seems that little has been learned from that experience. In fact, as is even less-well remembered, this failure constituted the second dent in the BoJs credibility as a deflation fighter. I say the second dent, since it is important to keep in mind that there was an earlier one, and this dent wasn't produced by the the failure to prevent the rise in asset prices that took place in Japan in the late 1980s and which gave rise to the eventual bubble. No, I am talking here about an episode which too place during the years between 1990 and 1995, during which period, according to a later consensus, the BoJ consistenly failed to act swiftly and decisively enough in lowering rates in order to try to prevent deflation occuring in the first place.

The locus classicus of this consensus is a short but influential paper by Ahearne et al (Preventing Deflation: Lessons from Japan's Experience in the 1990s. Alan Ahearne; Joseph Gagnon; Jane Haltmaier; Steve Kamin, Federal reserve Board, International Finance Discussion Papers, June 2002), which was widely read and quoted upon (and notably in the present context by Stephen Roach himself) during the the 2002-03 'deflation watch' period in the US, since it was seen as a central piece of acquired doctrine. Given the importance of all this I will now take the liberty of quoting the paper abstract in full (although reading the paper itself is strongly recommended):

This paper examines Japan’s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

Note the last sentence in particular: when the risk of deflation is high "stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity". And where exactly are we right now? Well it is hard to be certain, but certainly there is a widely held view that the risk of Japan falling back into deflation is not a negligable one.


Now one of the key episodes in the whole lamentable Japan deflation affair took place in the period between May 1994 and January 1995. As Ahearne et al note, the BoJ was at the time busying itself selling the idea that the worst of the long recession was over and that a new phase of economic recovery was on the point of opening up:

The BOJ maintained this (the low interest rate) policy stance unchanged through 1994, as hints of recovery began to emerge. In May 1994, the BOJ observed in its Quarterly Bulletin (pp. 32-33) that “Japan’s economic growth appears to have stopped weakening, against the background of progress in capital stock adjustment as well as the permeation of stimulative effects of monetary and fiscal policies to date.” By November, the BOJ noted that the economy was “recovering gradually,” with all categories of spending showing strength, and long-term interest rates moving up in apparent response.

Ring any bells anyone?

The anticipated recovery, of course, did not materialise as envisioned, there was a sharp slump in equity values and the BoJ was forced to respond by reducing its official discount rate to 0.25% in September 2005, at which level it remained until being lowered essentially to zero in 1999.

There is another difficulty which is also associated with the current consensus narrative on Japan, and that is associated with the current value of the yen. In a useful piece in the Financial Times yesterday, David Pilling (who is generally an excellent Japan watcher) drew attention to the way in which many would seek to put pressure on the Japanese authorities to do something to facilitate an upward movement in the value of the Yen:

There is one more element to add to this potent mix. In the past few weeks, Tokyo has come under pressure from European – though not US – officials over the weak yen which, in trade-weighted terms, is at 20-year lows. Some European finance ministers have linked the issue to Japanese interest rates being 5 percentage points below those in the US and the UK. As well as making Japan’s exports “unfairly” competitive, the criticism goes, the wide differential has fuelled the so-called carry trade, encouraging people to convert cheap yen into higher-yielding foreign assets.

Now let's just think about all this for a moment. Japan is being encouraged to raise rates, not primarily because of the internal needs of the Japanese economy, but in order to address possible problems being caused by the very low (some would say undervalued) level of the yen, and to help ease concerns about the impact of the ensuing carry trade. Fine. But what I ask if this tightening (or as some would say 'normalising') process only serves to send Japan back into deflation again? Well at the very least we would be back with ZIRP, and with it would come another prolonged period of carry-trade activity, with the likely additional consequence that the yen would be lead to weaken even further, as confidence in the BoJ and the Japanese economy suddenly ebbed, and as a further outflow of funds from Japan occured.

And just in case all this isn't enough, we might like to think about the work of Lars Svensson. Lars is Professor of Economics at Princeton University, and is one of the experts on that strange phenomenon known as the liquidity trap, which is of course intimately related with the deflation question, and about which much heart searching has been going on in recent years. So what does Lars have to say about possible policy methodologies for exiting from a liquidity trap (which is of course one of the problems which has been ailing Japan):

"In an open economy, the Foolproof Way (consisting of a price-level target path, currency depreciation and commitment to a currency peg and a zero interest rate until the price-level target path has been reached) is likely to be the most effective policy to raise expectations of the future price level, stimulate the economy, and escape from a liquidity trap. It is the first-best policy to end stagnation and deflation in Japan."
From the abstract of the paper Monetary Policy and Japan's Liquidity Trap (January, 2006).

Now let's leave aside at this point the throny question of whether the 'foolproof path' is as foolproof as it actually seems in the absence of any convincing analysis as to why the problem is such a protracted one in Japan (as well as the associated issue of just who exactly the 'fools' are that Lars would seek to protect us against in framing the idea in this way), the important point to note here is that the best advice one of the world's leading experts on how to handle Japan's problems can give is that they should systematically depreciate the currency, and then hold it down with some sort of peg. He is absolutely clear, allowing a rise in the value of the yen would simply raise expectations of a continuing weakness in prices (and remember this was also Krugman's point back in 2000) and hold Japan firmly in the grip of deflation. So those who now talk about the yen being currently 'undervalued' would do well to bear this in mind. Simply egging the yen upwards will only perpetuate deflation and send Japan careering back towards the re-introduction of ZIRP, which would of course only fuel the carry trade even more, and so on, and so on.

In closing, just three simple points. The first comes from David Pilling's piece mentioned above:

On one side of the debate, many academic economists argue that it is ludicrous even to consider raising rates now. Stripped of energy costs – the normal practice in other advanced economies – Japanese prices are still falling. Few textbooks, to put it mildly, advocate tightening at such a juncture.

Rarely has the distinction been more stark, there is a complete disparity between the advice and thinking of theoretical macroeconomists, and that of policy makers, central bankers, and market analysts. We are, of course, about to get to see who is in fact right (economics has the virtue of being a science which refers to a real world, so spin can only go so far), and my only hope is that one way or another the consequences of any error being committed at the present time are not too serious.

Secondly, lurking behind all this, as I have been indicating, lies the mirky question of why precisely deflation has been plagueing Japan for so long now. Only yesterday Stephen Roach served us up what must still be the consensus view on the situation:

The difficulty Japan is having in extricating itself from a post-bubble deflation may well be emblematic of deeper problems that continue to afflict the world’s second-largest economy. This same difficulty may also be having an important bearing on Japan’s competitive prowess. The damage from the bubble may well have been so wrenching and so fundamental to the system that it simply may be asking too much of Corporate Japan to rise quickly from the ashes and hold its own against the rapid emergence of China, the intense determination of Germany, and the solid gains evident by exporters elsewhere in the developing world.

So the problem stems, on this account, from the difficulties being encountered in extricating Japan from post bubble headaches. But this bubble burst some 18 years ago now. Really I fail to find this a very plausible account, and especially in the light of the fact that in recent years Japan has introduced wide reaching and extensive structural reforms (so yes, the centrality of structural reforms hypothesis is also under test here). As is by now well known to all our regular readers, Claus and I have been advancing another hypothesis, related to demography, Japan's ageing population, and the secular downward trend in the internal consumption GDP share. There is a hypothesis, it seems to fit much of the data reasonably well, and yet there is a a remarkable lack of enthusiasm for even considering this possibility. One notable exception here is MS's Robert Alan Feldman, who as Claus has been noting (and here), has been struggling with the 'something funny' feeling about the Japan consumption pattern. Methinks he is on the point of getting to the heart of the matter. Keep on scratching Robert!

Finally, there is the issue of what will happen to BoJ credibility if they have actually gotten this all wrong. Here I can do no better than cite Hidenao Nakagawa, secretary general of the Liberal Democratic Party (as quoted in this Bloomberg article)


The government's ``chilly, tacit acceptance of the move was based on the reasoning that the BOJ would be left accountable for any subsequent slowing of the economy,'' said Shinichi Ichikawa, chief strategist at Credit Suisse Group in Tokyo.

So the BoJ will remain accountable. Be warned! You are all playing with fire here, and I hope you realise it, since the livelihood and well-being of many millions of people depends on getting this one right.