Global, Japan: Reinventing Central Banking
Robert Alan Feldman
With the apparent revival of financial bubbles (e.g. the US bond market), the debate on monetary policy has boiled over again. Has bubble-blowing taken the place of serious monetary policy? My colleague Steve Roach has taken a strong stance on this issue, and says that “modern day central banking is on the brink of systemic failure.” (See Global Economic Forum, February 17, 2004, and Weekly International Briefing, March 1, 2004)
While I agree with many of Steve’s points, I think that this approach ignores some crucial linkages of monetary policy to other policies. Thus, in designing correct monetary policies, we must take these linkages into account. Analysis of the Japanese case makes these points more concrete. [1]
Phrase by Phrase
The easiest way to make the necessary points is a textual exegesis on Steve’s essay of February 17, “Central Banking Discredited.”
“It all started, of course, with the Bank of Japan.” It did not start with the Bank of Japan. It started with the Plaza and Louvre Accords. In the context of global currency policy, this was done in part to offset the negative effects of the sharp appreciation of the yen in the mid-1980s, but also due to intense pressure from the US. Moreover, it was not just central banks who were involved. Rather finance ministries were also crucial -- indeed were dominant. The issue of coordination between currency policy, fiscal policy, and monetary policy was also there from the start.
“ . . the BoJ . . . made a series of well known policy blunders in belatedly coming to grips with the aftershocks of the post bubble climate.” I would agree that the failure to raise interest rates in 1988 was a blunder. However, the failure to cut rates quickly after the collapse of the equity bubble in 1990-91 was not necessarily a mistake. From pure macro considerations, inflation was still on its way up in 1990-91, as aftereffects of the 1980s bubble kept product and factor markets tight. Land prices were still rising. In addition, financial institutions continued to miscalculate their levels of non-performing assets, and to throw good money after bad to more and more questionable borrowers. The financial regulatory authorities (at the Ministry of Finance) were light-years behind the curve, and the BoJ had no legal powers in this area. Finally, even if one believes that macro-policy action was needed in the aftermath of the drop of equity prices (which were acknowledged by virtually everyone at the time to be too high anyway), the BoJ acted earlier and more aggressively than did fiscal policy. Indeed, PM Miyazawa waited until August 1992 before triggering any major fiscal response; BoJ rate cuts began in July 1991.
In short, both the fiscal authorities and the regulatory authorities had their heads in the sand in 1990-92, and the BoJ is getting the blame. Not to mention the corporate leaders who overbuilt capacity on flimsy forecasts and the bankers who lent below their cost of funds because of “good customer relationships.”
The “zero-interest-rate-policy (ZIRP) is reflective of a monetary authority that has all but abdicated control over the real economy and the financial system.” When the BoJ attempted to escape from ZIRP, in August 2000, the result was disastrous. Moreover, the BoJ’s quantitative easing (i.e., the doubling of base money over the last six years) has kept the wolf from the door as other policymakers correct their errors — albeit at the cost of moral hazard in keeping some zombies alive. In addition, the BoJ has become more active in triggering improvements in financial system oversight. Finally, the BoJ has ratcheted up its quantitative easing when the financial regulatory authorities have strengthened their policies.
Far from abdication, the BoJ has used its powers cleverly in a positive sum, tit-for-tat game with other parts of the government. The regulatory stance has tightened, and the focus of both the bureaucracy and the Diet on industrial revival has sharpened substantially, in part because the BoJ has proven that it is doing all it can, but that others must do their parts too.
“The US monetary authority has gone overboard to convince financial markets that it has learned the painful lessons of Japan.” The Fed is undoubtedly in a high-gear campaign. The problem is that the Fed learned the wrong lessons. [2] Let me review briefly the critiques that I made in August 2002, in response to the Ahearne paper). [3]
First, the Fed conclusions are based on a standard one-good macro model, when in fact it is relative price distortions (e.g. of land prices, traded goods prices) and product market and labor market rigidities that prevent market clearing. These latter rigidities are the source of deflation in Japan. (Rigidities are not necessary the source of disinflation in the US, of course. Rather, as my colleague Dick Berner points out, the decision by the Fed to save the world from the Asian crisis with the “Greenspan put” encouraged continued excess capacity in Asia.)
Second, the Fed model does not consider the effect of monetary policy on the supply side of the economy — i.e., low interest rates keep zombies in business and worsen deflation.
Third, financial system regulatory policy — a key element of the monetary transition mechanism — is not considered at all by the Ahearne et al. paper.
Fourth, the political economy of decisions is ignored in the Ahearne et al. paper. (Note that the new BoJ law of 1997 increased BoJ independence, in part because the nation realized that the excessive pressure for low rates in the 1980s was part of the reason for the bubble. Sometimes democracy gets it right!)
Finally, easy monetary offers palliatives, and can postpone real treatment. My conclusion from the Japanese experience remains as I stated in August 2002: “Macroeconomic convenience is not substitute for microeconomic sweat.”
Applying the Real Lessons from Japan
In short, in my opinion, “act early and aggressively with monetary policy” is the wrong prescription for industrial economies with latent deflation. The right prescription is to identify the sources of deflation, and to design a consistent set of macro- and micro-economic policies that will address these sources. The problem is not monetary policy per se, but rather how to combine monetary, fiscal, and structural policies to achieve growth in a globalizing economy.
Despite important differences about the short term outlook for the US, my colleagues have many areas of common concern about the US economy.
(1) The US needs better energy policy. Not only has dependence on imported oil risen sharply over the 30 years since the first oil crisis, but the infrastructure for energy delivery has deteriorated. With the growth of China implying that energy prices have nowhere to go but up, the very wasteful use of energy by the US is a key risk for the global economy. Markets, infrastructure regulations, and technology must all be mobilized. Gasoline prices must rise — perhaps double — if a real start on excess energy dependence is to be addressed. Grid integration needs to proceed further, as does investment in vulnerability prevention. The US’s great strength, technology development, will have to ramp up significantly.
(2) The US needs better fiscal policy. The US has gone back to the “guns and butter” approach of President Johnson in the 1960s, because no politician is brave enough to propose that new defense needs require cuts elsewhere. This cowardice can only end in a spike of yields. Nor is it right to blame the politicians alone. They only reflect a self-interested electorate.
(3) The US needs higher private savings rates. The excessive dependence of foreign capital leaves the US financial markets hostage to unstable global capital flows.
(4) The US needs a better legal system and a better medical system. The legal profession has a stranglehold on productivity. There are too many “rights” and too many lawyers, with the result that overall productivity growth suffers. In the medical area, far too much expenditure is concentrated on the last few months of life, reducing the health efficiency of the remaining funds.
(5) The US is tilting toward protectionism, which is self-defeating. The US should rather use trade adjustment assistance, education, and retraining policies in the labor market, and concentrate on educational upgrading.
I will leave critique of European policy in the microeconomic area to my colleagues from that region. However, my reading of their work suggests that the conclusion would be identical. The ECB may have its problems, but these problems are nowhere near as important as the structural and fiscal problems facing Europe.
The Real Lesson about Deflation
Addressing structural problems in the Japanese, US, and European economies would go a long way, in my view, to ending the deflationary threat. Economic theory has long passed the stage where inflation/deflation are regarded as “always and everywhere a monetary phenomenon.” As economic structure changes and globalization proceeds, optimal allocation of resources changes. Unless economies actively create new industries and re-allocate resources toward them, unemployment will remain, and deflation will worsen.
The real lesson from Japan over the last painful 15 years is not that central banks need to target asset prices. Rather, the lesson is that monetary policy cannot be used as a substitute for growth policy. If countries ignore growth policy, there is little that monetary policy can do to save them, regardless of the target, from either inflation or deflation.
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