When deflation's the problem, a little inflating isn't a bad idea.
While Japan's financial markets cheered the latest Bank of Japan initiative to boost the nation's money supply on Tuesday -- the yen even rose against the dollar -- commentators were quick to dismiss the potential impact of raising the level of excess reserves in the banking system to ?6 trillion from ?5 trillion and increasing monthly bond purchases.
In their heart of hearts, economists know that inflation is a monetary phenomenon, that when the price level is falling because of weak demand, not a burst of productivity growth, printing money can halt the decline in prices.
Yet in recent years, the focus has shifted from advocating a more stimulative monetary policy to structural reform of the economy as the policy prescription for what ails Japan. Bank of Japan governor Masaru Hayami has been telling his colleagues in the government that deregulating and restructuring Japan's economy was the price they had to pay for additional largesse from the central bank.
At least until Tuesday, when the bank ``rewarded'' the government for reforms not clearly specified by changing its guidelines for monetary policy operations. The central bank cited falling industrial production in response to a drop in exports, risks of the weakness spreading to other sectors of the economy, worldwide economic developments and intensifying deflation as reasons for its surprise action.
No one is suggesting that Japan doesn't need to pursue structural reforms. Over the years, the government has thrown enormous amounts of money at useless projects, with nothing to show for it but a deficit-to-GDP ratio pushing 10 percent.
Government and industry are in bed together, conspiring to keep foreign competition out, inefficient and insolvent domestic companies afloat, and mercantilism alive. Japan's economy is over- regulated and inflexible. The workforce is under-employed. The banking system is burdened with bad loans and all the central bank's zero interest-rate policy has done, the thinking goes, is discourage the implementation of a US-style slash-and-burn loan write-off and the inevitable shuttering of insolvent banks and businesses.
But is the lack of structural reform what's depressing Japanese economic growth? "If that's the problem, then why did the Japanese economy perform so well in the 1980s, when it was the envy of the world?" asks Bob Laurent, professor of economics and finance at the Illinois Institute of Technology's Stuart School of Business.
"You have to believe there's been some move toward restructuring since then." Japan and Europe both need structural reform to increase the potential growth rates of their economies. But that's not the cause of their current misery, according to Sandy Batten, senior analyst at CDC Investment Corp.
"Both Japan and the euro zone have numerous rigidities that, when eliminated, would enable the economy to function better and to grow at a faster trend pace," Batten says. ``Even if reforms were pursued quickly and diligently, it's unlikely growth would be revived. Why? Structural reforms work on the supply side of an economy. The most significant problems these economies face lie on the demand side.'' Batten says one obvious sign of inadequate demand is the decline in nominal Japanese GDP growth.
"Nominal GDP offers a proximate measure of the impact policy is having on an economy," Batten says. That nominal GDP growth is negative is "a clear sign of an insufficiently accommodative monetary policy and a root-cause of the economy-wide deflation." The chief gripe with the central bank flooding the banking system with more liquidity is the belief that the banks can't lend, which seems like a good match for the lack of loan demand, and will only deposit the non-interest-earning excess reserves at the central bank.
Gosh. At some point you'd think teetering Japanese banks would look at their cost of borrowing (zero) and yields on Japanese government bonds and realize this is a good deal.
"Banks are funding themselves at zero, so as long as there is some positive return on JGBs, and the BOJ gave them some kind of guarantee that it would not reverse course without notice, they should be buying government securities, which are not a charge against capital," says Paul Kasriel, head of economic research at the Northern Trust Corp in Chicago.
Private loan demand may be soft but one entity has a big appetite for credit.
"There is no shortage of JGBs to buy," Kasriel says.
The only thing Kasriel doesn't understand is why the central bank persists in setting a target for excess reserves.
"Just put the reserves out there, stuff them down their throats until something comes out the other side," he says.
What comes out the other side is demand for goods and services. While it won't be stellar without structural reforms, he says, the Bank of Japan can increase the growth rate of the money supply.
Already since the central bank increased the excess reserves target to ?5 trillion from ?4 trillion in March, the year-over-year growth rate in M2+CDs has moved higher from 2.6 percent to 3.3 percent in July. While that's still tepid, the arrow at least is pointing in the right direction.
The Federal Reserve doesn't have the same problem in the US.
Its broad money supply is growing at a 9 percent rate, both in the last three months (annualized) and from a year ago. The Fed is dealing with a moribund economy that it's treating with aggressive monetary stimulus.
The US economy is well ahead of the other industrialized countries when it comes to structural reform; its main problem right now is too many structures (capacity). There is no deflation in the US economy, even though the prices of high-profile individual goods -- computers, semiconductors and telecommunications equipment -- are falling.
Consumer prices have been falling for almost two years in Japan, yet quantitative easing is regarded as misplaced. At the same time, the Fed is encouraged to cut, and cut, and cut rates again, even with inflation accelerating (and no doubt by the same folks dismissing the central banks's actions).
Why is it that monetary ease is a cure for the country with inflation and a meaningless gesture for the country with deflation?
Caroline Baum is a columnist for Bloomberg News. The opinions expressed are her own.
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