After twenty years of slow economic growth, Japan’s Sept. 26, 2012 election centered on Shinzo Abe’s promise to shake up monetary policy. Once in office, Abe appointed Haruhiko Kuroda to head the Bank of Japan. In short order, the Bank of Japan went from defending its monetary policy during those two lost decades of slow growth and bragging about the number of different types of assets it was buying to a serious program of quantitative easing on steroids, with a commitment to buying bonds and other securities equal in value to over half of GDP every year.
One of the announced objectives for this massive asset purchase program is to bring inflation quickly up to 2% per year. The idea is that the zero interest rate the Bank of Japan has maintained for a long time would be a more powerful stimulative for the economy if businesses and consumers were comparing it to a higher inflation rate. The logic is similar to the logic driving economists such as Olivier Blanchard, Larry Ball, and Paul Krugman to recommend raising inflation target to 4% in other countries in order to supercharge the stimulative effect of zero interest rates.
The key concept is that of a “real interest rate,” or an interest rate stated in terms of a basket of goods instead of the usual interest rate stated in terms of money.
Japan may succeed at bringing annual inflation up to 2%; indeed, it has made some real progress toward that goal. But suppose Japan succeeds in getting inflation up to 2%; would that be enough? The US economy has struggled mightily despite the fact that it went into the Great Recession with a 2% annual rate of core inflation. Japan could try to target an even higher rate of inflation, as Blanchard, Ball and Krugman recommend, or Japan could leave behind quantitative easing and higher inflation targets to make the leap to next-generation monetary policy.
The key to next-generation monetary policy is to cut interest rates directly instead of trying to supercharge a zero interest rate by raising inflation. Of course, cutting interest rates below zero pushes them into negative territory. But Switzerland, Denmark, Sweden and the euro zone have already shown that can be done. There is a widespread myth that cutting interest rates much deeper than -0.75% would inevitably cause people and firms to do an end run around those negative interest rates by taking their money out of the banking system as paper currency. Not so!
It is easy to neuter cash taken out of the bank as a way to defeat negative interest rates simply by removing the guarantee that the Bank of Japan will take that cash back at face value. You can find the details of how such a cash-neutralizing policy works here, here and here. This is an idea I have taken on the road that has withstood close examination and grilling by central bankers and economists all over the world. A common reaction is surprise at how easy the practical details are relative to the many much more difficult things central banks already do.
If the guarantee that the Bank of Japan (or other central bank) will always take cash back at face value is removed, it leaves no way to avoid negative interest rates without stimulating the economy. If people take cash out of the bank, store it, and then spend it, that stimulates the economy. If a firm takes a pile of money facing a negative interest rate out of the bank to build a new factory, that stimulates the economy. And even if, say, Japanese households take money that would otherwise earn a negative interest rate out of the bank to buy foreign stocks and bonds, it stimulates the Japanese economy, when excess yen in the hands of the foreigners who sold those stocks and bonds ultimately make their way back to Japan to buy Japanese products, boosting net exports.
Japan is wasting time by trying to raise inflation because it doesn’t need to raise inflation. Raising inflation is an indirect way to get the same effect that can be achieved directly by cutting interest rates. Switzerland, Denmark, Sweden and the euro zone have gingerly dipped their toes in the water of negative interest rates. Japan should go all in.
The alternatives to negative interest rates all have serious downsides. For example, increasing government spending is a bad idea: Japan already has more debt in comparison to its GDP than any other major economy—more than two years worth of GDP. (And saying that the Bank of Japan can just keep buying all that debt ad infinitum should be a last resort.) Worse, Japan has already been down the path of high government spending and has already exhausted most attractive government investment opportunities.
What about ramping up quantitative easing even more? Quantitative easing works in the right direction, but to get the needed effects requires dosages so large that no one knows what side effects it might have. By contrast, economic theory is reasonably clear about how interest rates affect the economy, even when they are negative.
Even if Japan makes the leap to next-generation monetary policy, it will still have serious economic problems. Many economists and politicians argue that monetary stimulus is a distraction from necessary supply-side reforms (often called “structural reforms”).
But it is a lot easier to move workers and capital from low productivity activities to higher productivity activities in a boom, than in a stagnant economy in which people worry about getting the next job or finding the next business opportunity.
Having an economy made worse by monetary policy is not a very reliable aid to jumping over political hurdles to supply-side reform. Instead, a substandard economy due to substandard monetary policy is often a temptation to more government spending and more debt. Japan should fix its monetary policy first, by eliminating any floor on interest rates. Then it can and should face its supply-side problems squarely.