Introduction
For about two decades, the Japanese economy has been stagnating. The average growth rate for the period between the year 1993 and 2003 was just above one percent (Taylor 2003, p.35). Whether measured by the GDP or the consumer price index (CPI), the inflation rate has been negative for almost two decades (Hayashi, & Prescott 2007, p. 212). There are many problems that scholars consider responsible for this situation.
In fact, they have regarded the period as the ‘lost decade’ in Japan. Among these problems are the burst bubble and the nonperforming loans (Mishkin, & Posen 2004, p. 36). Since then, critics have held policy mistakes responsible for failure to find a viable solution for the deflation that has lasted for two decades.
For instance, the consumption tax rate, as well as the repeal of income tax cut enacted in April 1997, is also one of such fiscal mistakes that have made it impossible to deal with the problem. With this hint in mind, this paper aims at evaluating the reasons why the numerous efforts by the Japanese government and the Bank of Japan (BOJ) have failed miserably in rescuing the economy of the country.
Considering deflation as a repercussion of failure in monetary policy, this report highlights the flaws in the monetary policies that the BOJ has implemented so far. Despite its numerous efforts, the BOJ has miserably failed when it comes to stopping the inflation rate from turning negative. The paper will also give a personal opinion on the possible ways in which Japan can deal with the deflation problem.
The Deflation and Japanese Monetary Policy
Bubble and Burst
Many researchers consider the bubble period in the Japanese economy, which lasted during the years 1985-90 as the main source of the Japanese stagnation experienced in the 1990s (Taylor 1999, p. 426). Since the dawn and the burst of the bubble, the economy got into a difficult position characterized by nonperforming loans (Kuttner, & Posen 2010, p.233).
This nonperformance resulted into a crisis in the banking industry. According to some economists, a mistake in monetary policy that occurred then is responsible for the powerless monetary policy of the years that preceded the burst bubble. As claimed by Ito, this was majorly because “the transmission channel from the interest rate policy to the real economy was no longer operational” (2008, p. 147).
Therefore, it is crucial to consider the most likely causes of the deflation, which people consider as the monetary policy mistakes of the bubble years. There is an urgent need to come up with the likely reasons why there is no success yet in rescuing the Japanese economy from the deflation.
The Japanese economy was obviously experiencing a bubble economy between the years 1983 and 1989. During these years, “both the stock price index and the land price index quadrupled” (Summers 1996, p. 629). For instance, the stock prices index in 1983 was 10000 yen, which quadrupled to 40000 yen by 1989 (Hoshi, & Kashyap 2005, p. 169). The economic growth rate at the time was slightly higher than 5 percent.
The tax revenues were increasingly closing a fiscal gap, which plagued the Japanese economy for about two decades. At the time, economists and policy makers throughout the world were praising the Japanese economy citing that its performance was excellent (Summers 1996, p. 629).
However, few of them raised concern considering that even the bankers and financial analysts were not weary of the fact that the high valued stocks and land could not be linked with their cash-flow earnings (Hoshi & Kashyap, p. 170).
Considering that the inflation rate had grown to 8 percent in 1979 during the second oil crisis, its fluctuation to a low range of about 0-3 percent in the 1980s was a sign of prosperity. It earned praises from a number of policy makers, financial analysts, and economists (Ito 2008, p. 135). The CPI inflation rate remained low throughout the bubble period.
Asset prices were doubling over the years while the CPI inflation rate remained considerably low at the same time. This prompted a difficult choice for the BOJ since it did not straighten up until the close of the 1980s.
As a result, the BOJ did not target asset prices since the burst bubble made the monetary policy more difficult to implement. As claimed by Iwata (2002, p. 127), “the yen appreciated from 260 yen/dollar in February 1985 to 150 yen/dollar in the summer of 1986.
Some part of this was a movement toward equilibrium while the other part was overshooting”. This sharp appreciation rate resulted to a recession because of the slump in exports. The Japanese also experienced imported disinflation because of this growth in yen in comparison to the dollar.
Asset prices and monetary policy
Upon considering the failure to address the issue of deflation in the last two decades, questions as to what the BOJ should have/have not done make the literature in the issue. For instance, the question as to “whether or not the BOJ should have prevented the bubble is among them” (Hayashi, & Prescott 2007, p.216).
If the deflation experienced since then was because of the bubble, the BOJ should have taken effective measures against the increase in the asset prices. The question raises a big debate as to the mandate of the central bank in controlling the prices of assets.
As contested by a number of economists such as Blinder (1998, p. 54), asset prices should, in all regards, be part of the price stability. Therefore, it is in the mandate of the central bank to ensure that price stability.
It is possible to summarize the difficulty such as the one BOJ experienced in employing monetary policy to prevent the bubble as follows: first, it would have been difficult for the central bank to know whether the asset prizes were growing as because of a bubble or because of fundamentals. The second thing is that when the bubble takes force, it would take high interest rates to pop it.
Therefore, increasing the interest rates would throw the real variables into extremely volatile fluctuations (Hayashi, & Prescott 2007, p. 225). Because of this, some skeptics such as Bernanke and Mishkin advocate for supervisory policy rather than monetary policy when it comes to dealing with such a situation (1997).
This means that the BOJ started creating mistakes as early as during the bubble years. There was no way for any monetary policy devised in the last two decades to succeed (Bernanke, & Mishkin 1997, p. 101).
On a different perspective, other economists hold the claim that, considering that the bubble was created, the effects that it had would have been moderated through an effective monetary policy (Hayashi, & Prescott 2007, p. 231). The question that emerges here is whether the BOJ was accountable for the curve of 1992 to 1995. The bank acted slowly based on the fear of rekindling the bubble.
Similarly, the BOJ may have waited for so long only to implement the ZIRP considering that it was an unprecedented policy and a risk to take (Okina, & Shiratsuka 2010, p. 39). The same economists are of the view that the monetary policy would have been better and would have possibly eased the deflation pressure upon adopting the ZIRP earlier by the BOJ.
The newly independent BOJ replaced the old institution in 1998. Then, “there were high hopes that it would be effective in dealing with the deflation for the last time” (Posen 2008, p.21). The institution, just like its predecessor, lost credibility and suffered confidence problems.
Assumptions and poor judgment made it impossible for the institution to work, as the board members and the governor were too eager to restore normalcy without paying keen attention to the prevailing economic conditions.
Disclosed minutes revealed that the members were divided into three after the adoption of the ZIRP. Majority of the members did not see the need to adopt any further actions by then. The laxity resulted to further increase in the deflation until 2006 (McKinnon, & Ohno 2007, p.54).
In the year 2009, the Japanese government accepted that there was a resurgence of the deflation problem. Considering that the central bank had temporarily handled the problem, the BOJ was pressured to act about the situation.
In an unplanned policy board meeting held in December the same year, the bank announced that it would inject an amount of up to 10 trillion yen as loans to commercial banks at a rate of 0.1 percent (Kuttner, & Posen 2010, p. 242). A further government pressure on the BOJ ensured that it responded by increasing the amount set aside for the program to 20 trillion yen.
However, while this move may seem to head towards the right direction in dealing with the situation, economists are skeptical that they will suffice in battling the deflation (Richards, & Robinson 2011, p. 269). For instance, the BOJ predicted that prices would fall for at least another two years. However, it was not clear why BOJ expressed such confidence that the deflation problem was to be solved in that time.
It was such assumptions that were made in the 1990s and early years of the 21st century, which made it impossible for the BOJ to construct effective monetary policies aimed at dealing with the problem of deflation. Instead of coming up with the effective policies, the BOJ seems to be only making assumptions that hope for the best (Richard, & Robinson 2011, p. 272). This assumption was definitely flawed.
It was based on half-truths considering that the previous deflation of a similar magnitude had lasted since 2003 to 2006. At the time, people regarded the strong growth of the world economy as the force that rescued the Japanese economy.
This is because the world economy grew at a rate that increased the demand for Japanese products. This also led to the rise in commodity prices, as well as a modest yen (Kuttner, & Posen 2010, p. 246). Since that is not likely to happen again, it would be very risky for the BOJ to put hopes on such an occurrence rather than devising policies that would rescue the situation before it becomes worse.
Conclusion
The bubble of the 1980s and the ineffective monetary policy during the time and afterwards are responsible for the deflation that Japan has succumbed to in the last two decades. Despite the numerous efforts by the BOJ to restore normalcy, the deflation has persisted. It only takes short breaks in between after which it reappears later.
It is only through monetary policy that the problem can be handled conclusively since it is a monetary phenomenon. The BOJ has not been capable of handling the problem of the assumptions and misjudgments that lead it to devise ineffective monetary policies.
The bank has also shown laxity when it comes to employing alternative measures to deal with the problem majorly because of the fear of the possible resurgence of the bubble. The inefficiency of the BOJ to control the prices of assets has been another problem that has resulted to the increase in the value of the Yen, thus, supporting the deflation as a result.
Opinion
Both inflation and deflation are monetary phenomena. As a result, they depend upon the manner in which the central bank creates money. To achieve success in ending the deflation that has existed in Japan for over two decades, the Bank of Japan (BOJ) should aim at creating and implementing monetary policies aimed at raising money growth.
The current policy of limiting the base money created to the amounts required by the public should be avoided. Instead, the BOJ should adopt what can be regarded as an explicit target for raising more money to deal with the problem of deflation finally. What should be done to deal with the deflation for the last time remains the biggest question in this regard.
In a personal opinion, the BOJ should devise and make it known to the public a comprehensive and anti-deflationary monetary policy. The policy should neither be composed of only a quantitative easing measure such as that which the bank adopted recently nor an intensified purchase of government bonds. The strategy should also set out to clarify an inflation target.
BOJ needs “to ensure that its determination in meeting such targets is known by even showing willingness to employ measures that are considerably unconventional such as negative interest rates on bank balances” (Kuttner, & Posen 2010, p. 246). The unenthusiastic interest rates would result to resources outflows, which will guarantee the off-putting pressure put on the yen.
This would result in the much-needed inflationary pressure. In fact, “if the deflation persists even after the above measures have been employed, the BOJ will have to employ exceptional policy measures similar to those undertaken by its neighbors to intervene in the exchange market to control by reducing the value of the yen” (Kuttner, & Posen 2010, p. 246).
The involvement of Forex to ensure that the Yuan relates to the dollar has led to the unwanted monetary expansion, as well as the inflationary pressure in China. However, this is only the choice that Japan has now.
Considering that such intervention might result to complaints from the financial arena, the Japanese ministry of finance, which is charged with the Yen’s exchange rate policy, should look for a cooperative solution with the involved parties to ensure a cutback in the value of the Yen.
References
Bernanke, S & Mishkin, F 1997, ‘Inflation targeting: A new framework for Monetary policy?’, Journal of Economic Perspectives, vol. 11 no. 2, pp. 97–116.
Blinder, A 1998, Central banking in theory and practice, MA: MIT Press, Cambridge.
Hayashi, F & Prescott, E 2007, ‘The 1990s in Japan: A lost decade’, Review of Economic Dynamics, vol. 5 no. 1, pp. 206–35.
Hoshi, T & Kashyap, A 2005, Solutions to the Japanese banking crisis: What might work and what definitely will fail. In Reviving Japan’s Economy, ed. Ito, Patrick, & Weinstein, 147–95, MA: MIT Press, Cambridge.
Ito, T 2008, The Japanese economy, MA: MIT Press, Cambridge.
Iwata, K 2002, Deflation spiral hassei no kanousei [in Japanese, trans. Possibility of having a deflation spiral]. In R. Komiya, Kinyu Seisaku rongi no Soten [in Japanese, trans. Issues in the monetary policy debate], Nihon Keizai Shinbun publications, Tokyo.
Kuttner, K & Posen, A 2010, Inflation, monetary transparency, and G3 exchange rate volatility. In Adapting to financial globalisation, ed. Hochreiter and Hennessy, 229–59, Routledge, London.
McKinnon, R & Ohno, K 2007, Resolving economic conflict between the United States and Japan, MIT Press, Cambridge.
Mishkin, F & Posen, A 2004, ‘Inflation targeting: Lessons from four countries. New York: Federal Reserve Bank of New York’, Economic Policy Review, vol. 3 no. 3, pp. 9–110.
Okina, K & Shiratsuka, S 2010, ‘Asset price bubbles, price stability, and monetary policy: Japan’s experience. Bank of Japan’, Monetary and Economic Studies October, pp. 35–76.
Posen, A 2008, Restoring Japan’s economic growth, Institute for International Economics, Washington, DC.
Richards, A & Robinson, T 2011, Asset Prices and Monetary Policy, Reserve Bank of Australia, Sydney.
Summers, L 1996, ‘How should long-term monetary policy be determined?’, Journal of Money Credit and Banking, vol. 23 no. 1, pp. 625–31.
Taylor, J 1999, Monetary policy rules, 405–30, University of Chicago Press, Chicago.
Taylor, J 2003, ‘Low inflation, deflation, and policies for future price stability. Bank of Japan’, Monetary and Economic Studies February: pp. 35–51.