June 2, 2013
Should the European Union Emulate Japan's Inflationary Monetary Policy?
Should the European Union Emulate Japan's Inflationary Monetary Policy?—Posner
For many years now Japan has been plagued by deflation, which has retarded its economic growth; since 1981 the average annual growth of Japanese GDP has been only 2.1 percent. Deflation implies that the value of money relative to goods and services is rising, which reduces consumption (and hence production) by inducing people to postpone purchases in the expectation that prices will be lower in the future. Recently the Japanese central bank at the behest of Prime Minister Abe increased the volume of Japanese money in order to increase the ratio of money to goods and services, and thus change deflation to inflation. Inflation can induce a temporary spurt in consumption, but not a permanent increase; although Japan has announced a goal of 2 percent annual inflation, I assume the major goal of the increase in the money supply is to increase exports and reduce imports, thereby stimulating domestic production (both of exported goods, but also of domestic substitutes for imports made more costly by the devaluation since their prices in yen rise) and so consumption, employment, and economic growth, as well as ending deflation. In addition, an increased supply of money should reduce interest rates, thereby stimulating borrowing and so further stimulating consumption.
Keynes urged devaluation of the pound against the dollar in the 1920s in order to stimulate the stagnant British economy, but the British Treasury refused because of Britain's very substantial foreign investments, which would be worth less if the pound were weaker. Apparently no similar obstacle was interposed to the Japanese devaluation.
It is not yet clear how effective Japan's devaluation will be either in reducing deflation or in stimulating production and employment. The reason is that Japan has many very inefficient labor regulations, along with a very aged population (the Japanese people have the greatest longevity of any nation's population), a combination that, by making for sluggish production and cautious consumers, depresses economic growth. The depressive effect may greatly limit the efficacy of the new policy. Abe wants to remove inefficient regulation, but the political obstacles may be formidable.
Europe is suffering from protracted economic stagnation too, so the question arises whether it might benefit from emulating Japanese devaluation. The obvious objection is that the major European countries (except Britain) have the same currency, the euro, so that devaluation would not alter relative prices among the euro countries—and they are major trading partners of one another. Then too for such a large part of the world's economy (roughly 20 percent) to devalue could well, depending on the size of the devaluation, induce retaliatory devaluation.
For devaluation to stimulate economic growth without provoking retaliation from outside the euro bloc might require that the economically weakest European countries, primarily Spain, Portugal, Italy, Greece, and Cyprus, abandon the euro and then devalue the local currencies that would replace it. But for a nation to abandon the euro would be very difficult, because as soon as the abandonment was realized to be imminent, euros would flow out of the country to avoid the devaluation that would ensue from the replacement of the euro by a local currency, and because all sorts of legal and financial tangles would ensue from the fact that contracts in euro countries are denominated in euros.
A devaluation of the euro, as distinct from abandonment of the euro by the economically weak European nations, would not involve these problems. And if it were a modest devaluation (modest enough to avoid retaliation by the United States, China, or other leading non-EU nations), it would increase the weak EU countries' exports outside the EU and reduce their imports from outside the EU, and thus strengthen the economies of the EU nations. The resulting spur to economic growth would reduce the rates at which the weak EU countries borrow, by reducing the risk of default, and so would reduce their fiscal deficits.
Devaluation is no silver bullet, however. To minimize the risk of retaliation, it cannot be too great. if it is small, it is unlikely to overcome the drag on economic growth that anticompetitive labor and other regulations, heavy taxes, inefficient state companies, corruption, and waste impose on an economy.
Abenomics and Japan's Stagnation-Becker
During the past 17 years, Japan has experienced sizable deflation; for example, the GDP price deflator declined on average by about 1% per year since 1995, and it declined during the past couple of years by 2% per year. Since many wages and other prices cannot be adjusted downward very easily, deflation tends to distort labor and other markets. To end deflation and stimulate the Japanese economy, Prime Minister Shinzo Abe has introduced a set of policies called "Abenomics".
These policies have "three arrows": massive fiscal stimulus, aggressive monetary policy a la the Federal Reserve's QE's 1-3, and improved competitiveness of the Japanese economy. It will take many years to greatly improve the competitiveness of the Japanese economy, so for the next few years Abenomics has to rely only on fiscal stimulus and aggressive monetary policy.
Given that Japan's ratio of debt to GDP is already the highest in the world at almost 2 to 1, Japan can hardly do much more in the way of fiscal stimulus without creating an even larger debt burden. The debt/GDP ratio has reached such a high level because fiscal stimulus was the main weapon used to try to jumpstart the Japanese economy during the 1990s and early part of this century. This policy was basically a failure since large fiscal deficits did not prevent the Japanese economy from growing slowly, and they did not prevent consumer and asset prices from consistently falling.
Short-term interest rates in Japan have hovered near a zero nominal rate during the past 20 years, partly because of the fiscal and other efforts to stimulate the Japanese economy. Long-term nominal rates have also been quite low. Abenomics wants the Central Bank of Japan to start purchasing bonds and other assets on a large scale with the intent of both lowering real long-term interest rates further, and greatly increasing bank lending and the money supply. Increased bank lending and a greater money supply would likely end the many years of deflation and cause prices to rise, with a goal of a 2 per cent annual increase in prices.
The hope is that lower long-term interest rates and greater availability of credit will also stimulate investment and innovation, and thereby increase the growth rate of the Japanese economy on a sustained basis. Lower real interest rates are also expected to reduce the value of the yen in international markets by making Japanese bonds and other assets less attractive to world investors. A lower real value of the yen-that is, lower after adjustment for the increase in Japanese prices-would increase consumer demand in other countries for Japanese exports.
Will Abenomics, and its main manifestation in more aggressive buying of assets by the Bank of Japan, succeed in increasing the economy's growth rate? Japan is trying to copy the Fed's large-scale asset purchases in the Fed's efforts to limit damage from the financial crisis, and get the American economy rolling again. The Fed's actions have had 3 stages: QE1, introduced during the early days of the crisis, attempted to prevent the American economy from slipping into a very serious depression. QE2 and QE3 were implemented after the American economy was in a major recession, and they were designed to reduce unemployment and increase the growth rate of American GDP.
Most economists, including myself, believe that QE1 was extremely important in providing liquidity to the American banking system at a time when liquidity was in scarce supply. But I have many doubts about the efficacy of QE2 and QE3 that further increased bank reserves, and lowered long-term interest rates even further. Although the evidence on the effects of these Fed actions is not conclusive, despite the aggressive actions the recovery of the American economy has been slower than in any previous recession. More than 4 years after the crisis erupted, unemployment is still about 7 1/2 % (compared to under 5% before the crisis), and the growth rate of GDP is still far below its long-term growth path.
Japan is not in a financial crisis, so the success of QE1 in providing liquidity to banks is not very relevant. Expansive monetary policy by Japan is likely to end its deflation and lead to price increases. That is the good news. The bad news is that the evidence so far on QE2 and QE3 is not reassuring that Abenomics' monetary loosening will significantly raise the long term growth rate of Japan's real GDP.