And does Japan’s ruling party know what it’s doing? A top economist raises serious concerns—and takes aim at the Fed.
When Japan’s finance minister says jump and the Bank of Japan responds, does that mean its independence is a sham? Or is the real show being directed by the bank itself?
Influential economist Richard Koo says that the BOJ’s recent move to double the size of its short-term financing program after Finance Minister Naoto Kan called for action against deflation was more for show than anything else.
In a refreshingly frank interview with The Diplomat, Koo excoriated the Democratic Party of Japan—and foreign media and academics—for failing to grasp certain key economic principles. He also claims that it wasn’t the Bank of Japan, but the US Federal Reserve that was panicking over the future of its independence, and suggests that Fed Chairman Ben Bernanke may have adjusted his views to fit in with Koo’s during recent congressional testimony to avoid a confrontation that might have further threatened the bank’s status.
But first to BOJ policy specifics, and what Koo describes as the bank’s meaningless move on March 17 to boost to 20 trillion yen the reserves for three-month loans to banks.
‘With quantitative easing under the circumstances we have now, you can double and triple the liquidity in the system but there will be no takers,’ Koo says. ‘But there’ll be no harm done, and if certain parts of the political spectrum are happy as a result, then, you know, why not?’
In other words, while the Bank of Japan appears to have done something, pleasing certain sections of the DPJ in the process, it hasn’t really done anything at all.
‘If the money supply isn’t increasing, that means all the liquidity the Bank of Japan pumped into the system is stuck in the financial system,’ Koo says.
It's not coming out to enter the ordinary market or even the foreign exchange market for that matter. If the money comes out, that means someone borrows and spends it—then you’ll have an impact on foreign exchange, an impact on long term rates, all of that. But the fact that’s not happening means it's all basically a mirage.
The DPJ doesn't know that! Most academics think it's a great thing! And the foreign press, especially, think that the BOJ should be doing more. The IMF thinks the BOJ should do more.
So why are all these people apparently missing the point?
For years Koo, now chief economist at the Nomura Research Institute, has been talking about the lessons to be learned from Japan’s ‘lost decade’—the years of recession that followed the bursting of the nation’s economic bubble of the late 1980s. In his book, The Holy Grail of Macroeconomics he argues that when an economy is pole-axed by crashing asset prices, companies no longer want to borrow money to invest because of the need to repair their weakened balance-sheets. If there are no borrowers in the market, monetary policy becomes ineffective—you can supply as much money as you want at close to zero-interest rates, but there won’t be any takers. Essentially, this suggests that there are two kinds of recession: a regular business-cycle recession, which can be tackled using monetary policy, and what Koo calls a balance-sheet recession, a far deeper kind of post-bubble recession like the Great Depression, that requires the use of fiscal policy.
If Koo’s right about this, then he’s found a way to reconcile large parts of monetarist and Keynesian economics, a feat that could indeed be considered the Holy Grail for disciples of the dismal science.
As I indicated in my book, it's one of those recessions that happens once every God knows how many decades, where monetary policy is largely dead in the water. I mean there are no borrowers. And if the money multiplier is zero negative, what can monetary policy do? Those people in the financial sector in Japan are fully aware of this difficulty. But politicians, academics and media who are never faced with the real situation only remember what they are taught in universities, where neoclassical economics always assumes there are plenty of borrowers. They tend to bash the Bank of Japan for not doing more.
If the Bank of Japan says, “We're going to go for an inflation target,” then something has changed dramatically, because everybody knows that the Bank of Japan has no tools to achieve an inflation target with the monetary multiplier zero negative.
But for the DPJ government, this is their first time, and with deflation their immediate instinct is to blame it on the BOJ. So they're going through a learning process too, I think. And at some point they'll realize that with the money multiplier dead in the water there's no point in bashing the BOJ.
Learning from the Past
In his book, Koo recalls the controversial quantitative easing experience of the Bank of Japan in the early noughties. The move had little apparent impact on the economy, with some observers saying this showed the ineffectiveness of the approach, while others claimed it wasn’t handled correctly.
We actually tried all of this back in 2001 to 2006, right? And we increased to 30 trillion yen the reserves—that's 6 times the legal reserve requirement. So that means the money supply should have increased by 500 percent and we should have had a 500 percent inflation rate. And absolutely none of that happened.
And we see the same thing in the UK today, the same thing in the US today, a massive increase in liquidity which [Bank of England Governor] Mervyn King once said, “We’re not like the Japanese. We’ll do it quickly and in massive amounts and we’re going to get the money supply going.” But he's not saying that anymore. He's realized that it doesn't work.
Ten years ago it was the LDP that was going after the BOJ and [economy minister Heizo] Takenaka was trying to threaten removal of the BOJ's independence.
Except for people like Takenaka, who never understood anything, a lot of people in the LDP began to realize what I'm saying, and they stopped applying pressure to the BOJ.
Koo says he helped influence the debate within the LDP on such matters, partly through his proximity to former Prime Minister Taro Aso.
Aso was in the Koizumi government from the beginning to the end and he was the one who kept Takenaka from running amok. On very many occasions it was Aso who came out on the side of the Bank of Japan and told Takenaka to shut up, and Takenaka had no theoretical reason to argue back because the demand for funds wasn’t there.
Koo claims that the LDP eventually came round to his way of thinking and stopped trying to meddle with monetary policy and put pressure on the BOJ.
But back to today’s DPJ-led government, which is struggling to find cash for its campaign pledges by cutting waste amid nose-diving tax revenues. Financing additional measures to boost domestic demand would mean yet more public debt, which is already approaching 200 percent of GDP (way above the level of even Greece). Hence the desire for an economic tool (monetary policy), to tackle deflation that doesn’t require the issuing of more bonds. And if the central bank doesn’t take a ‘mutually compatible’ stance with government policy on this matter (as stipulated in the independence-limiting Article 4 of the Bank of Japan Act), then at least there’ll be someone to blame.
But when it comes to the issue of Japan’s national debt, Koo flatly rejects the notion that it presents any kind of financing problem.
At the moment, with long bond yields at 1.36 percent on the 10-year JGB, all these arguments that Japan has a financing problem are absolute nonsense. If the long bond yield is 14 percent like it was in 1997 then I know that this country has a horrendous financing problem. But at 1.3 or 1.4 percent, the market is saying “Please go on, we need the JGB.” A country with the lowest government bond yield having financing problems? I mean these people [who say that] really have nothing better to do.
As for the notion that Japan has already used fiscal policy with little effect other than to run up the huge national debt in the first place, Koo makes the point in his book that the use of fiscal policy during a balance sheet recession is absolutely vital for propping up an economy. It’s the only effective way of boosting the money supply, since any extra liquidity pumped into the financial sector will have no takers.
It might not look as if fiscal policy helped Japan much after the bursting of its economic bubble, but the alternative would have been catastrophic, Koo says. He calculates that 1.5 quadrillion yen was wiped off Japanese assets in the wake of the bubble—that’s 3 times the size of the nation’s economy. Without fiscal stimulus, Japan’s GDP should have shrunk to between a half and a third of its size, he claims. But in fact, GDP did not fall below its bubble peak, something he describes in the book as ‘nothing less than a miracle.’
When fiscal consolidation was attempted in 1997 and 2001 under the Hashimoto and Koizumi governments, it came too early, according to Koo. The result was that the economy suffered, tax revenues fell and the budget deficit actually increased. Koo therefore believes that fiscal stimulus should remain in place until it’s clear that companies have repaired their balance sheets and started borrowing again instead of paying down debt. That’s the signal for an exit strategy to be employed.
Because we have such difficult economic circumstances not just in Japan but in the so-called Western world, I think we have to make the assumption of fiscal stimulus at least for the time being.
Complicating matters, though, is the fact that the focus of the balance sheet problem now is outside Japan.
That makes it difficult to say OK at this point we stop doing this, because something is happening outside the country not inside the country. So I’d like to see the DPJ come up with some sort of grand domestic demand expansion program of sorts.
Either way, Koo suggests that the DPJ needs to learn the key lessons from Japan’s recent economic past and to come up with a clearly defined exit strategy.
As for the extent to which the BOJ will be forced to take a mutually compatible stance with government policy in the meantime, Koo is sure that when it comes to matters of substance, BOJ Gov. Masaaki Shirakawa will stand his ground.
Deep inside that guy is hard as a rock. On the outside he may appear soft and nice, but he knows what he's doing, and he's not going to be thrown around by people who don’t know anything about monetary policy.
Koo says the Bank of Japan is relatively independent under Shirakawa, although he qualifies the remark by saying in the case of the BOJ it depends a lot on who the head of the bank is.
When asked to put some kind of figure on the level of independence he says the BOJ would be close to 90 on a scale with a base score of 100 for the old Bundesbank, Koo’s model of an independent central bank.
There are varying degrees of so-called independence. The Deutsche Bundesbank, when those guys were around, they were really independent, they listened to nobody and they just kept on doing what they thought was the right thing to do. Compared to that, both the Federal Reserve and the Bank of Japan today are more concerned about the political scene and the possible backlash—congressmen talking about the independence of the central bank and things like that. But the Bundesbank in those days didn't give a damn about politicians whatsoever.
Fear at the Fed
Indeed, speaking of the Fed, Koo says it has fallen well below 90 on this kind of scale. While coy about putting a figure on it, he agreed it would probably be somewhere between 50 and 90. What he sees as the Fed’s disastrous handling of its duties means the extent of its freedom to operate is now very much in question.
The pressure the Fed feels for allowing the bubble to reach that crazy state and not going after any of those banks with their regulatory tools, I mean they really dropped the ball. And dropped it very, very badly. Allowing Lehman Brothers (OTC:LEHMQ) to collapse when there's a systemic banking crisis right in front of us? I mean that’s stupidity to the extreme in all three areas—not sufficiently tight on monetary policy, not using bank regulators to contain the bubble and allowing Lehman to collapse. They have a very serious credibility problem.
As an indication of the pressure that’s still on the Fed chairman—and the respect that his organization has lost in Congress—Koo points out that he himself was invited to testify as part of the semiannual Humphrey-Hawkins testimony in which the Federal Reserve chairman reports on monetary policy and the state of the economy.
Mr. Bernanke didn’t have to sit next to me and testify. But I was supposed to testify right after Mr Bernanke. But the fact that people like Barney Frank are bringing in outsiders for Humphrey-Hawkins testimony, when Humphrey-Hawkins testimony was supposed to be exclusively for the Fed chairman to explain every six months to the Congress, suggests that those people are not very happy with the Fed.
But the session scheduled for February 10 didn’t take place because of a huge snowstorm. It was rearranged again without Koo, although he had already handed in his testimony (.pdf). But it’s here that Koo makes the startling implication that Bernanke ‘adjusted’ his comments in the rescheduled testimony from his initial position to views that he knew better fit in with Koo’s.
When I listened to him this time around, I almost thought he read my testimony. He said nothing that contradicted what I said in that testimony and that led me to believe that he did read it. The other private sector participants, like John Taylor, are Washington regulars. But the fact that Barney Frank invited me from Tokyo—well, if I were Bernanke knowing how little respect [I] command in Congress, I’d read this Richard Koo's work to make sure I don't have to confront this guy’s work, because I might end up on the wrong side of Barney Frank.
His answers were much more attuned to what I've been saying all along. So I was very surprised. Especially when these Republican guys with nothing better to do were trying to force Bernanke to say let’s cut the budget deficit now…I was watching the whole thing on the TV here in my house in Tokyo and Bernanke wouldn’t be drawn into it. He kept on saying, “This program has to be a long-term program. The exit strategy has to be a long-term thing. Ten years from now we’re going to do this.” You know, that kind of tone. And that's quite different from what the guy used to say.
For Koo, this is evidence that Bernanke is not beyond redemption. But he still has a huge task to restore the credibility of his organization and to maintain its relative autonomy. So from Koo’s perspective, the debate on central bank independence should actually focus on the Fed.
‘Compared to the BOJ,’ Koo says, ‘Right now the Federal Reserve is in far greater danger of losing independence.