On June 17, 1998, the Bank of Japan and the Federal Reserve entered the foreign exchange markets selling billions of dollars to avoid a weaker yen. Asia feared the competitive disadvantage of a weaker yen, and President Clinton was going to visit China, which had complained of the weaker yen as an increasing source of pressure on China to devalue. As it turned out, the joint American-Japanese defense of the yen was probably the high point of folly of deflationary currency defense in a deflationary world economy.
Almost exactly a year later, on June 14, 1999, the Bank of Japan entered the foreign exchange markets buying billions of dollars to avoid a stronger yen. This reversal of an action deemed essential just twelve months earlier marked the end of a year that saw the transition from deflationary currency defenses to efforts at global reflation. Those efforts have included weaker currencies for many of the world's struggling economies, with Japan being a prime example.
The Deflation Environment
The events that were to follow the ill-advised yen defense of June 1998 created a grossly imbalanced global economy, in which the actual and residual deflationary effects of currency defenses forced the Federal Reserve to ease monetary policy so much that the U.S. economy began to overheat. Now, in June 1999, we have reached a point where the Fed must begin to tighten. The corollary is that other central banks must continue their easier monetary policies. These policies were symbolized earlier this year, for emerging markets, by Brazil’s abandonment of its currency peg and, for industrial countries, by the Bank of Japan’s efforts to push Japanese interest rates to zero and the European Central Bank’s interest rate cuts while it tolerated a weaker euro.
The currency-floating reflationary environment has enabled some economic recovery in emerging markets. In April, Treasury Secretary Robert Rubin acknowledged that one of the major lessons of the global financial crisis that began in Thailand in June 1997 was that we need to avoid providing funds to emerging markets for the purpose of defending indefensible currencies. Mr. Rubin’s sensible observation was that the provision of funds for that purpose simply didn’t work. A more profound reason to avoid such policies, in a world where excess capacity and deflation are present, is the self-reinforcing deflationary impulse that results from tighter monetary and fiscal policies aimed at the unwise, and usually unsustainable, defense of a currency.
Doubters can still observe conditions in China and Argentina, the last two holdouts for rigid exchange-rate orthodoxy. Argentina’s economy is entering a deeper recession in the months running up to this October’s presidential election. In China, deflation is accelerating--having reached an official 4 percent rate by May. That is a sharp change from officially recorded flat prices at the start of the year. China is also being forced to backtrack on economic reforms and the sale of government enterprises to slow the job losses that follow in a deflationary environment where there is no growth in the private sector to absorb the millions of workers being pushed out of the public sector. Meanwhile, China has closed the offshore renminbi market, which trades China’s currency in markets outside China and affords some small loophole for funds to flow out of the country. Allowing China’s currency to float would not totally alleviate the combination of major social and economic strains in China and continuing deflationary pressure, but surely that policy would be preferable to fictitious maintenance of a fixed exchange rate for China’s nontraded currency.
The events that followed the June 1998 intervention to thwart the market’s attempt to reflate Asia by depreciating the yen are well known. Russia was forced to devalue its currency and to default on some of its external debt in August, while Brazil and other emerging markets struggled with the contagion effect. By September, the rush out of illiquid assets and into the most liquid distorted markets so much that carefully designed spread trades turned violently against Long-Term Capital Management, which was pushed to the brink of bankruptcy.
Fiscal Fixes in Japan
Somewhat less remarked upon than the general turmoil surrounding the near-collapse of Long-Term Capital Management was the emergence of a threatening deflationary signal for Japan. As Japanese investors joined the flight to absolute liquidity that accompanied the Long-Term Capital Management crisis, the yen ominously strengthened, reinforcing deflationary pressure in Japan. The first move came after the Russian crisis in August, with the yen strengthening from 143 to the dollar down to 133 to the dollar. Then, early in October, in a final capitulation to the environment that frightened investors out of most markets, the yen appreciated again, from 133 yen per dollar to 115 yen per dollar. After a brief rise back over 120, the yen continued to appreciate—reaching 108 yen per dollar early in 1999.
Rapid currency appreciation in a deflationary environment is especially dangerous because most government officials instinctively think that a strong currency is a sign of a strong economy. Unfortunately, that is not true. A strong currency may also be a sign of increasing deflationary pressure and may itself add to that deflationary pressure in a dangerous self-reinforcing spiral. That was the problem Japan faced in the fall of 1998. Observable nominal interest rates, pushed down by increasing deflationary pressure, fell to 0.7 percent on ten-year bonds during November 1998. But real interest rates were rising, because deflationary pressures were increasing faster than market interest rates could fall, thereby pushing up the real cost of borrowing.
The collapse of Japan’s economy that had begun with the consumption tax increase in 1997 reaccelerated. Third-quarter growth was a negative 1.2 percent at an annual rate, while fourth-quarter growth was a negative 3.3 percent at an annual rate. A sharp drag from falling net exports was responsible for a big part of the slowdown. In the third quarter, net exports contributed a percentage point to Japan’s growth, but by the fourth quarter, net exports subtracted 1.4 percentage points, thanks in no small part to the sharp appreciation of the yen.
Japan elected to fight the deflationary impact of a stronger currency and collapsing domestic demand with the usual large fiscal stimulus package. A fiscal stimulus of 16 trillion yen was added in the summer of 1998, followed by a stimulus of 24 trillion yen in December 1998. Of the announced 40 trillion yen in additional fiscal stimulus in 1998, the actual net stimulus probably totaled about 25 trillion yen, or 6 percent of GDP, a huge injection of public spending.
So great was the supply of government bonds needed to finance the massive increase in public works programs in Japan that Japanese interest rates began to rise markedly in December 1998. By February 1999, yields on ten-year Japanese securities had risen from the lows of about 0.7 percent in November 1998 to 2.4 percent. The abrupt increases reflected signals from Japan’s powerful Ministry of Finance that the government’s ability to support its own bond market was somewhat limited.
But the sharp rise in interest rates and the threat to Japan’s struggling economy, along with the threat of higher financing costs on the government’s huge debt, led to an all-out effort initiated at the end of February 1999 to push interest rates down. The Bank of Japan pushed short-term interest rates to virtually zero, essentially providing free money to any banks or financial institutions willing to purchase government securities. The Ministry of Finance and its many financial arms announced that they would resume purchases of Japanese government bonds, thereby underscoring the uneasy truth that Japan’s government bond market is largely government controlled. The government issues the bonds, and the government buys many of the bonds. In that environment, it was possible to push interest rates back down to 1.3 percent in April, before they began to rise again in May under the unrelenting pressure of the increased bond supply from a government that was financing huge spending programs.
Japan’s fiscal arithmetic is among the world’s most unpleasant. Its deficit will reach 10 percent of GDP this year, while its debt, normally measured, is over 100 percent of GDP. When measured to include unfunded government pension liabilities, the debt approaches 200 percent of GDP.
We have probably reached a point in Japan where even the government will be unable to dominate the bond market totally, either by simply buying the bonds it issues or by inducing others through interest-free loans to buy the bonds. Japan’s Trust Fund Bureau, which has been a major purchaser of government bonds, is funded by Japan’s Postal Savings System, which takes in money from millions of small depositors as they do their postal business. But the inflow of funds to the Postal Savings System has begun to fall short of the System's other obligations, and it will not be able to provide funds for the Trust Fund Bureau to purchase Japanese government bonds. In addition, the year 2000 will witness maturation of 120 trillion yen of deposits in the Postal Savings System--an amount that is nearly a third of GDP--carrying yields of 6 to 8 percent. At current yields of 1.7 percent on ten-year bonds, a large part of that money may well seek other outlets, either abroad, where yields are considerably higher, or simply in cash, where safety is absolute and deflation provides an attractive return.
Japan’s exchange-rate policy began to change amidst the intensification of the deflationary crisis that came with the slowdown in growth and the approach of limits to the Japanese government’s attempt to spend its way back to growth. Despite government stimulus worth 6 percent of GDP, and virtually zero interest rates, Japan’s private economy continues to be very weak. Households, fearing layoffs and seeing lower wages (currently 4 percent below last year’s levels), are spending little. Companies with excess capacity are cutting back on investment. Japan’s exporters have lost market share in weakened Asian markets because of an overly strong yen, while total exports are falling. The huge supply of government bonds that accompanies Japan’s massive fiscal stimulus packages is beginning to cause indigestion in the bond market, even though the government buys much of the bond issue.
In addition to the foregoing extraordinary combination of monetary and fiscal policies, the government initiated another effort, aimed at keeping small and medium-sized companies afloat. In October 1998, it began a program of loan guarantees. Banks that were preparing to cancel risky and defaulted loans to small and medium-sized businesses discovered that the Japanese government was prepared to guarantee loans that were extended for another six to twelve months. The government-guaranteed loan extensions carried no interest payments until the end of the extension period. Banks had little to lose by rolling over the loans, even though they knew they were unlikely to be repaid because many of the loans were used not for investments but to meet payroll and other normal cash-flow needs. Between October 1998 and March 1999, loan guarantees of 20 trillion yen (about 5 percent of GDP) were extended. In May 1999, the government announced plans to continue the program and will probably extend another 20 trillion yen of loan guarantees into t he second half of 1999. This program will become inviable when the borrowers are unable to repay their loans and ask for more and the government has to acknowledge an as-yet-unacknowledged 20 to 40 trillion yen of increased liabilities.
The False Growth Surge in Japan
The combination of an announced 40 trillion yen of standard fiscal stimulus, consisting mostly of public works projects, 20 trillion yen of loan guarantees, and virtually zero interest rates provided enough adrenaline to create a misleading surge in Japanese growth during the first quarter of 1999. Early in June, the Japanese government announced that first-quarter growth reached an annual rate of 7.9 percent, a level usually associated with a booming economy. The surprising growth is dangerously misleading since it includes a nearly 50 percent increase in public investment, Japan’s euphemism for public works projects. The number is further inflated by Japan’s exaggerated seasonal adjustment figures. The raw GDP for the first quarter actually dropped an annualized 26 percent, but the seasonal adjustment pushed it up to an increase of 33.9 percent; hence the reported growth figure of 7.9 percent.
In addition to the odd seasonal adjustment factors, the government makes arbitrary use of deflators or a deflation adjustment, which tends to push up the reported real-growth numbers. For example, both personal consumption and housing investment carried deflators of minus 2.2 percent, and that amount was added to the reported growth figures. Although personal consumption and housing investment are about two-thirds of GDP, the overall GDP deflator was put at 1.1 percent. Some commentators noted the strong increase of 5 percent in private consumption, but half of that was attributable to the deflator, and another significant portion derived from the imputation of consumption of housing services applied by Japanese statisticians in calculating the GDP growth rate.
The 7.9 percent positive growth number for Japan in the first quarter is not surprising, then, given the aggressive massaging of the raw data. When the full range of factors is considered--the statistical anomalies; zero interest rates; government stimulus packages totaling over 5 percent of GDP; 20 trillion yen, or 5 percent of GDP, in loan guarantees, with guarantees worth another 5 percent of GDP to come--it is not surprising to see a first-quarter bulge in the reported and historically volatile GDP statistics for Japan.
The uneven pattern of Japanese growth, as efforts at stimulus are recorded, is recurrent. In the first quarter of 1996, growth was reported at a 12.3 percent annualized rate. In the next quarter, growth collapsed to a 2.0 percent annual rate, but it later revived, on the back of additional stimulus packages, and reached a 7.0 percent annual rate in the first quarter of 1997. Unfortunately, that misleading strength caused the government to prescribe a large increase of 2 percentage points in the consumption tax, along with more cost sharing on government health and pension programs, in the second quarter of 1997. During that quarter, growth collapsed at a 9.6 percent annual rate; it revived briefly in the third quarter to a 4.0 percent annual rate and had been negative at an average 3.0 percent annual rate ever since--until the first quarter’s 7.9 percent positive "surprise."
Most likely, the second quarter will see negative growth again, for a number of reasons. First, the large government stimulus packages will be wearing off, and consumers will continue to endure the uncertainty associated with rising layoffs and falling bonuses. Wages have fallen by 4.0 percent over the past year, while the unemployment rate, officially, is rising to 5.0 percent, though it is much higher among younger workers. If part-time workers were being counted as unemployed, the unemployment rate would approach 10 percent. Finally, seasonal adjustment factors must add up to zero by the end of the year, so the huge first-quarter boost from seasonals will have to be "paid back" during subsequent quarters.
The surest sign that even the Japanese government doubts the strength implied by the large positive surprise in first-quarter growth is the abrupt reversal of exchange-rate policy. If the economy were really strengthening, a stronger currency would make sense. But as the yen appreciated in the aftermath of the reported strengthening of the economy, the Japanese government, to avoid a strengthening of the yen, entered the market to sell yen and buy dollars. That was not surprising since, even in the nominally strong first quarter, Japan’s net exports subtracted 1 percentage point from growth, after having subtracted 1.5 percentage points from growth during the fourth quarter of 1998. A good part of the blame for this weakness in Japan’s net exports lies with the stronger yen, which is still, on a trade-weighted basis (the most relevant criterion for trade), over 20 percent above the lows of last June.
The Problem for Japan’s Fiscal Policymakers
The large positive first-quarter growth surprise creates an awkward problem for Japan’s policymakers. Because the growth was a result of odd statistical procedures and an all-out effort at economic stimulation, the problem of sustainability arises. Japan’s banks are still actually shrinking their balance sheets and failing to make loans, despite the offer from the Bank of Japan that they can borrow at zero interest rates. Banks are choosing to borrow at the zero interest rates and then to buy government securities with maturities of less than two years and with yields of 10 basis points. The only loans being made are under the auspices of the government’s loan-guarantee program, and even with the program, overall loans are shrinking. Japan’s economy has received a heavy shot of adrenaline while on an artificial life-support system, but the moribund private sector has failed to revive.
The key question is whether the private sector will come back to life before Japan’s government runs out of the ability to borrow at low interest rates. The test will come, probably in the fall, when the government plans to initiate yet another stimulus package of some 10 to 15 trillion yen. At that time, the supply of government bonds coming to market from past and continued programs will be cresting, even as the ability of the government to absorb the supply will be falling. Rising interest rates, generated either by absolute supply pressures or by downgrades of the quality of Japanese government bonds by rating agencies, will further exacerbate the huge costs associated with the government’s massive program of borrowing to finance attempts to shore-up the economy.
The one encouraging sign is Japan’s reversal on exchange-rate policy. Despite government protestations that an economy with a current account s urplus and a strong currency must be all right, Japan’s mandarins are beginning to recognize that the strong-yen policy is too deflationary for the economy to bear. Appreciation of the yen was first protested in January when the government intervened at 108 yen per dollar. Subsequently, official comments and resumed capital outflows pushed the yen down to 124 yen per dollar in May. However, signs in May that the Fed was preparing markets for a rate increase (which caused U.S. bond and stock prices to begin to fall) put Japanese global investors on hold. In a country with a current account surplus of about $10 billion per month, any interruption of capital outflows causes the currency to appreciate, as it began to do in Japan in June. In effect, on June 14 the Japanese government decided to replace private capital outflows with capital outflows in the form of official dollar buying. Approximately $6 billion of dollar purchases constituted about two-thirds of one month’s total capital outflows.
Especially over the next few months, Japan has no reflationary alternative but to push the yen down. Fiscal stimulus has been placed on hold until the fall, and perhaps indefinitely, by virtue of the limited ability of Japanese markets to absorb the huge supply of government bonds. The Bank of Japan can do no more with interest-rate policy, having pushed short-term rates to zero and witnessed a steepening yield curve whereby long-term rates have begun to rise again. Pushing the currency down and encouraging a rise in net exports are the only weapons left.
Rebalancing the Global Economy
The global economy is entering an important phase of the rebalancing effort needed to reverse the 1998 overheating of the U.S. economy that was required to offset overly deflationary policies in much of the rest of the world. Some of the 1998 tension associated with these imbalances has been relieved by the widespread currency- floating adopted in emerging markets and by the wise decision of the European Central Bank to cut rates while allowing the euro to depreciate against the dollar. Even the cautious Bank of England, witnessing a dramatic reversal of the chaotic sterling devaluation of November 1992, cut rates by 25 basis points at its meeting early in June to avoid excessive appreciation of sterling. The euro exchange rate against other currencies has turned out to be an overvaluation for core economies like Germany and Italy and an undervaluation for "peripheral" economies like Spain and Ireland. The European Central Bank has wisely chosen to avoid risking further deflationary pressure in Germany by allowing the euro to drift down against the dollar. Of course, the euro’s sharp depreciation against the yen has further exacerbated Japan’s overvaluation problem.
The big question mark in the global demand- rebalancing act remains in Asia, and especially in Japan. The signs are not encouraging. If the Bank of Japan continues to buy dollars aggressively while offsetting the impact on Japan’s monetary conditions, the yen won’t weaken and the contribution from its external sector will not help to support the economy. China may, for its part, elect to unlink its currency and pursue reflationary policies that, while not the answer to all of its myriad problems, will at least reverse the intensifying deflationary pressure now plaguing that huge developing economy.
The Federal Reserve will probably continue to raise interest rates until it is clear that the threat of overheating in the U.S. economy has abated. Right now, U.S. inflation is in the process of rising from a low of about 1.5 percent in the first part of this year to what will probably be 3.0 percent by year end. While not spectacular, that change in the inflationary environment will require a rise in yields on long-term bonds from the lows of around 5 percent that were achieved at the height of the deflationary crisis in October 1998 to around 7.0 percent, which would be consistent with the normal 4.0 percent real component and 3.0 percent inflation component of thirty-year yields in the U.S. economy. Markets have been anticipating this with some vigor and pushed thirty-year yields over 6.0 percent by mid-June.
As bond yields have begun to move higher, the U.S. stock market has taken note and retreat ed about 4 percent from the highs achieved in April. With luck, the corollary will be a cooling down of U.S. demand growth that results in a more extended period of U.S. economic expansion. That won’t occur, however, unless other central banks ease aggressively to offset the tightening required of the Federal Reserve.
John H. Makin is a resident scholar at the American Enterprise Institute.
