Abeconomics and the Japan Deflation: Kuroda’s speech to the LSE

by George Hatjoullis

Haruhiko Kuroda, Governor of the Bank of Japan, has made yet another speech on the subject of Abeconomics ( I persist with this characterisation and not the more popular Abenomics because this is what the blog began using). This one is notable for a number of reasons. First, his analysis of the Japan deflation, and the nature of deflation, is exactly the same as the one used in the Gestaltz blogs on Abeconomics and in the Economics series offered by the blog. Second, he mentions the Takahashi policy of the 1930s without elaborating on the distinctive features. This has been covered in earlier Gestaltz blogs and is thrust of the critique of Abeconomics offered in these blogs. Third, he dismisses the fear of the consumption tax. Finally, the tone of the speech is quite self-congratulatory. The english language version of the speech can be found (http://bit.ly/OHcE5I) and is well worth reading. It is easily accessible to anyone that has followed the Economics series of blogs.

Deflation is not simply about price falls. It is a state of mind. It is a state of entrenched expectations that the general level of prices will fall. It is leads to a preference for holding money (cash and deposits). It leads to a state of constantly positive real interest rates, even if nominal interest rates are zero. The real interest rate is the nominal interest rate minus the expected inflation rate. If the expected inflation rate is consistently negative then real interest rates are always positive and the central bank can do very little to change this. The entrenched deflation expectations sap the disposition of economic agents to do more than hold money and suppresses economic activity.

The solution to this state, according to Kuroda, is to keep nominal interest rates at close to zero whilst forcing up inflation expectations to be positive. The real interest rate is then forced down into negative territory and stimulates economic activity. Inflation expectations are raised by setting a target of 2% inflation in two years (from the inception of Abeconomics) and promising to expand the supply of central bank money as far as is necessary to achieve this target. Of course, expanding central bank money is of little use unless it leads to a growth in bank money. This requires an expansion of commercial bank lending. Kuroda is satisfied that inflation expectations are picking up and that commercial bank lending is gradually growing. Nominal interest rates have remained low in part because of the BoJ official rate but largely because of the substantial BoJ purchases of government debt capping any rise in yields. If yields were to rise in anticipation of inflation it would be difficult to force real interest rates negative.

The consumption tax will be raised from 5% to 8% in april and based on experience it is feared this may derail the inflation expectations progress. Kuroda believes the past experience was not simply due to the consumption tax but the specific conditions that accompanied the tax and that neither these conditions nor equivalent conditions are present. The economic impact of the tax rise is thus expected to be temporary.

His concluding remarks are worth reproducing:

“… Japan’s economy has been following a path toward achieving the 2 percent price stability target…[but]… we are only halfway there… the economy is associated with upside and downside risks, we… make adjustments as appropriate. By firmly continuing with such policy, I am convinced that we can achieve the 2 percent price stability target and overcome deflation.

In the past 15 years, Japan was not sleeping because it wanted to. It was only that, even if one person or one firm wanted to take on new challenges, rewards meeting such challenges could not be expected under a macroeconomic environment of persistent deflation… The day that Japan’s economy can contribute more and more to the global economy is at hand.”

The BoJ governor should speak with conviction. He is, after all, trying to change a nation’s way of thinking about the direction of movement in the general price level that has persisted for at least 15 years. The change is as much about believing him as anything more substantial. There is no doubt that substantial progress has been made. However, there are risks and it is hard to shake a way of being that has dominated for so long.

The Takahashi policy he refers to in his speech was far more fundamental than anything this Abe administration has tried. Takahashi engaged in deficit financing. He printed money and gave it to the government to spend. This increases the stock of bank money without relying on commercial banks to lend or anyone wanting to borrow. An equivalent policy today would be simply to cancel the government debt held by the central bank. There are many legal and institutional obstacles to deficit financing precisely because it is so effective at raising inflation expectations. It is the ideal tool in this situation. The problem is it is a bit like morphine. Once governments get a taste they cannot stop even when the policy is no longer appropriate, and hyper-inflation can ensue. To go from chronic deflation to hyperinflation is not a good idea. It is also not necessary as the deficit financing (dose of morphine) can be controlled. If Kuroda’s optimism proves unwarranted then Japan may need to revisit Takahashi.

Another policy option open to Japan is the Swiss option. The Swiss authorities, finding that incessant demand for Swiss Franc deposits was introducing deflation, opted to asymmetrically fix the Swiss Franc. They declared a level and told the international community they would provide as many Swiss Francs as anyone wanted at this price. They increased their foreign currency reserves as much as the international community required and allowed the stock of commercial bank deposits of Francs held by overseas agents to grow as fast as required. Japan can do the same if the Yen, like the Swiss Franc, continues to be seen as a ‘safe haven’ in times of trouble and strengthens undermining the Abeconomics project.

There is reason to be concerned about the success of Abeconomics despite Kuroda’s bullish tone. The weakness of the Yen and the rally in the Japan stock market has been driven by international investors. Domestic investors have moved very slowly to rebalance their portfolios to reflect a positive inflation environment. The characteristic of deflation is a predisposition to hold cash and near cash assets. Until there is evidence that this behaviour has changed, Kuroda is premature in declaring victory and may have to seek even more unconventional policies. His speech makes clear that the fact that ex post measures of the price level have not fallen dramatically does not mean deflation is not a serious and persistent problem. By the same token, just because the CPI rises does not mean deflation expectations have been structurally reversed.