Monetary policy in Japan: Finally on track


A dealer works at a foreign exchange trading company as a screen displaying the Japanese yen's exchange rate against the U.S. dollar is seen in the background, in Tokyo December 3, 2013.

Article Highlights

  • Japan’s central bank is finally taking action as a remedy for 2 decades of stagnation.

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  • A Japanese turnaround would be good for the US in both economic and national security dimensions.

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  • A revival of growth in Japan ultimately will contribute to increased prosperity and security for the United States.

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Japan’s central bank, the Bank of Japan, is finally taking the action long suggested by outside economists as a remedy for two decades of stagnation: a prolonged period of substantial monetary expansion to end deflation and reverse the drag on business and consumer spending induced by deeply embedded deflationary expectations.  Under the leadership of its governor, Haruhiko Kuroda, the bank increased its purchases of Japanese government bonds in April, with a stated aim of lifting inflation to 2 percent.

There are signs of initial success, as core inflation (consumer prices without volatile food and energy components) rose in November to 0.6 percent over the past year — still low, but the largest gain in 15 years. The idea is that sustained price gains will eventually feed through into higher wages, then into stronger spending by consumers who no longer wait for prices to fall, and ultimately into more vigorous investment and hiring by Japanese businesses.

Among those suggesting to the Bank of Japan that monetary policy could reverse deflation if applied in a consistent and determined fashion was the Federal Reserve chairman, Ben S. Bernanke, who as a Princeton professor in 1999 wrote that the reasoning the Japanese central bank provided for not acting was “confused” and “inconsistent,” among other criticisms.

Mr. Bernanke gave a more polite version of his advice in 2003 while serving as a Fed governor (again, before he became chairman), noting that a healthy Japanese economy would contribute to “a stronger, more balanced and more durable” global recovery and urging the bank to be open to “fresh ideas and approaches,” such as more active monetary policy to reverse deflation.

The criticism is understated but striking, since students in Econ 101 learn early on that creating money with the electronic equivalent of the printing press, and handing it to the government to spend, will eventually lead to higher prices (though it could take a long time, as we have seen in the United States).  Yet the Bank of Japan dug in with its opposition while outsiders urged action — perhaps, as Paul Krugman hypothesized, because the bank feared that it would not succeed and then lose face.

Central banks in the United States, Europe, Japan and other advanced economies are independent of the government to insulate them from political pressures to juice economies on an electoral cycle, which might give rise to undesirably high inflation. It was not foreseen, however, that the Bank of Japan would be stubbornly independent and incompetent in allowing for 15 years of deflation.  This history highlights the importance of the direction taken by Mr. Kuroda.

A Japanese turnaround would be good for the United States in both economic and national security dimensions.  The economic benefits would include increased American exports and better returns for American investors. These gains will be amplified if Japan follows through on Prime Minister Shinzo Abe’s promises of wide-ranging structural reforms that include opening the economy more broadly to competition, including competition from foreign companies. One mechanism for such liberalization would be the conclusion of a Trans-Pacific Partnership agreement that would reduce barriers to trade and investment in Japan, the United States and many other nations.

On the security side, a more vigorous economy would support a revitalized Japanese defense presence that would reinforce American efforts to counter China’s military expansion.  Even while Prime Minister Abe clumsily revives World War II memories, it remains the case that “irresponsible” Chinese behavior threatens a range of United States allies in the region, including not just Japan but also the Philippines and Vietnam. A more confident (and better armed) Japan would contribute to regional stability and in that way further a fundamental American interest.

It is somewhat perverse, then, that Japan’s efforts to revive its economy have been faulted by 60 senators and hundreds of members of the House of Representatives, who have signed letters calling for “strong and enforceable currency manipulation disciplines” in the Trans-Pacific Partnership talks.

A possible source of confusion is that many of the signers most likely have in mind that they are calling on President Obama to be mindful of Chinese currency policy, even though China is not among the nations involved with the Trans-Pacific Partnership negotiations. The weakness of the Japanese yen instead appears to have been an important factor behind the generation of these letters, with Ford Motor Company’s chief, Alan Mulally, especially outspoken in complaining that the value of the yen provides an unfair advantage to his Japanese competitors (though this would not be the case for the considerable production of cars by Japanese companies in United States factories, since these are largely made with American-sourced parts and assembled by American workers).

The yen has indeed reached a five-year weak point against the dollar and euro, with the depreciation beginning in October 2012 when the Bank of Japan announced that it would expand its asset purchases (a policy that was expanded further by Mr. Kuroda in April).  It is not surprising that more expansive Japanese monetary policy leads to a weak yen — this is textbook economics (see, for example, Chapters 14 to 17 of the textbook I use at the University of Maryland:  International Economics, Ninth Edition, by Paul Krugman, Maurice Obstfeld, and Marc Melitz).  In addition to Japanese monetary policy, a strengthening United States economy and a move toward gradual monetary tightening by the Federal Reserve would be expected to contribute to a weaker yen against the dollar.

In other words, the weak yen is the natural consequence of the appropriate policy response that Japan has finally put into place after years of urging by American policy makers and economists alike — a response that is fundamentally in the best interest of both Japan and the United States. This is no more an instance of currency manipulation than the assertion that the Federal Reserve under Mr. Bernanke in undertaking three rounds of quantitative easing sought to weaken the dollar to create a trade advantage for the United States.

For sure, the Fed’s aggressive monetary expansion would be expected to affect the value of the dollar, but the intent was to strengthen the United States economy.  Mr. Bernanke told the House Financial Services Committee in July that he viewed Japan’s actions similarly, even while expressing more sympathy for the idea that China has sought a weak currency.

Congressional efforts to include currency manipulation in future trade agreements are a political problem for President Obama, for whom a completed Trans-Pacific Partnership agreement eventually could be seen as one of his few second-term economic accomplishments.

Beyond the politics, however, there could be unintended consequences for the United States economy. Imagine the future situation in which enforceable currency manipulation provisions in a United States trade agreement are used by Brazil — which complained about the impact of the Fed’s quantitative easing in leading to a stronger Brazilian currency — as leverage to get the Fed to raise interest rates to the detriment of the United States economy.

In undertaking a sustained and aggressive monetary expansion, Japan is finally filling an economic prescription written nearly 15 years ago — with the prescribing doctor no less than Ben Bernanke in his pre-Fed role. The weak yen that results from the Japanese policy actions will pose a challenge for some American companies that compete with Japanese exporters. But a revival of growth in Japan ultimately will contribute to increased prosperity and security for the United States.

Phillip Swagel is a professor at the School of Public Policy at the University of Maryland and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.

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