Abeconomics, deflation and the Japan conundrum
by George Hatjoullis
Shinzo Abe was returned to power as prime minister of Japan in December 2012 on a promise of returning the nation to prosperity. A major element of the prosperity programme was to raise achieved inflation to 2%. The idea of a politician winning a landslide victory on a platform of higher inflation sounds a little odd from a ‘western’ perspective. However, anyone with even a glancing knowledge of Japan since 1989 will grasp that it makes complete sense. The enduring problem for Japan has been deflation.
Inflation and deflation are normally discussed in terms of ex post outcomes of various price indices. However, both are fundamentally ‘states of mind’. It is the expectation of inflation/deflation that does the economic work. Price index outcomes will feed back and effect these ‘states of mind’ or expectations but there is much more going on. Deflation might be defined as structurally negative inflation expectations. People fear falling prices even if actual price falls are not spectacular. It would be safe to say that Japan has been in a state of deflation, so defined, for a long time and Abe is attempting to break this destructive state of mind.
The problem for Abe is that he is beginning with a huge outstanding government debt. Suffice it to say that if Japan were to suddenly find itself a member of the eurozone, then the resulting sovereign debt crisis would end the euro project. The debt is, in part, the result of various attempts by previous administrations to stimulate the Japan economy. A fair chunk of it is owned by the Bank of Japan.
Official Japan nominal interest rates are basically zero. This has been the case for some time. The BoJ has engaged in some quantitative easing. The Ministry of Finance under various administrations has tried borrowing to fund government spending. Yet here Japan still is with structurally negative inflation expectations. Will Abe do more of the same? Why will this work? More important, what if he succeeds and yields on the outstanding and new debt suddenly shoot up because inflation is back? This conundrum seems to be exercising economists and commentators quite a bit.
The solution lies in a policy action that is deemed anathema in economic textbooks. It was discussed in relation to the UK in a very tidy article by Gavyn Davies published in the FT on October 14, 2012(http://on.ft.com/SU1ucg) and which is well worth reading. The FT were gracious enough to publish a letter from myself (December 8, 2012, http://on.ft.com/ZuuQQL) suggesting that this policy option was the only viable option left to Japan and that Japan was probably the only country in which such a policy is appropriate at the moment. The only option left for Japan is of course debt cancellation by the Bank of Japan.
The normal response from conventional economists is a shriek of horror and the mouthing of the word inflation. Well yes, i sincerely hope so! How might this work? Structurally negative inflation expectations bring a particular form of economic behaviour. People like to hold wealth in cash or near cash assets. The expected return is the negative inflation rate plus any nominal interest they might earn. Indeed if inflation expectations are structurally negative then the demand for fiat money continuously exceeds supply. This is why prices keep falling. There is a simple solution. Supply the fiat money that is demanded.
The BoJ could announce that it is to give the MoF an unlimited and indefinite overdraft. The MoF could use this overdraft to buy back as much debt as it deems necessary. It could use the overdraft to fund some or all future government expenditure. This is pure monetary financing. It is economically equivalent to debt cancellation. The fiat money supply grows by the amount of the overdraft. Bond yields are kept in check by government purchases and the knowledge that future issuance may not be forthcoming. The system gets all the fiat money is desires. The BoJ balance sheet balances. Inflation expectations go positive. Job done.