Japan: Poster child for NGDP Targeting

This take on Japan provides the clearest demonstration that nominal spending, determined by the Central Bank´s monetary policy, is crucial to the macroeconomic outcome. It is also a reminder that no matter how much ‘fiscal stimulus’ a government provides, if monetary policy does not provide support, there´s nothing to be gained and a lot to lose in terms of high debts and deficits. Finally, the Japanese experience demonstrates the danger inherent in a monetary policy geared, unwaveringly, to the attainment of ‘price stability’ or ‘inflation targeting’ on steroids.

The Big Picture

The chart illustrates how the Japanese economy evolved during the decades following WWII. We identify three stages of the growth process. In stage one, from the 1950s to early 1970s, Japan was ‘catching up’ or narrowing the gap relative to the US. From that point up to the end of the 1980s the gap remained relatively constant but began to widen after 1990, that marks the beginning of Japan ‘lost decades’.

The next chart indicates the average growth rates of real GDP during those same periods.

The drop in the growth rate in the 1970s and 1980s is not mysterious. That was a feature observed in almost all advanced economies, with the US being a notable exception. In France, for example, growth averaged 5.1% in the 1950s and 1960s, dropping to 2.8% in the 1970s and 1980s. In Germany the equivalent figures are 6.3% and 2.4%, while in the US the change was much smaller, with growth falling from 3.9% to 3.2%.

The ‘downsizing’ of Japan

In the seventies and eighties there was “Japan Inc.”, an appellation that evoked reverence, awe and also disdain towards Japan, particularly from Americans. During that time, most news articles spoke of Japan´s “miraculous” growth, its large trade surplus and, more importantly, the threat this posed to the US, having taken the place of the “Russian threat” prevalent during the fifties and sixties.

As usually happens, the conditions that in the end were behind the ‘downsizing’ of Japan were being laid down since the early seventies.

The first change was the end of the Bretton Woods system of fixed exchange rates among major economies in 1971, when Nixon closed the ‘Gold Window’ and the dollar depreciated. In early 1973 the system was formally abandoned and the ‘free float’ regime began.

Among the industrial economies, Japan was especially vulnerable to fluctuations in the Yen/USD exchange rate for several reasons:

1)      The dominant role of the dollar in Japanese exports and imports

2)      The importance of the US as a trading partner

3)      The fact that many Asian currencies were linked to the dollar

For those reasons there´s an expression in Japan – Endaya Fukyo – to designate growth recessions induced by yen appreciation.

According to the ‘script’, growth drops in 1971 with yen appreciation as observed in the chart.

To neutralize the growth impact of yen appreciation monetary policy turns expansionary, with money supply growth (M2) increasing and the Bank of Japan´s (BoJ) call rate being reduced.

Growth picks up again in 1972 and 1973 but inflation also increases, further impacted by the oil shock of late 1973. In 1974 recession hits and inflation skyrockets to 24%.

Worries about inflation and its effects on the real economy, including the worst bout of labor unrest since the war, quickly turned price stability into a priority of economic policy. In fact, Japan was the very first country to adopt, albeit implicitly, an inflation targeting regime.

The new policy worked. For the rest of the decade growth was rising and inflation was brought down. As Shakespeare would say: “All´s well that ends well”. Unfortunately that was not to be. The “seeds of destruction” in the guise of ‘price stability’ had been planted.

The 1980s start off with the ‘majestic’ rise of the dollar. From Japan´s perspective, recalling Endaya Fukyo, that would be good news. Unfortunately there was the “Japan Inc.” syndrome in the US, harboring the fears of threats to US hegemony. Much like we hear today about Chinese ‘currency manipulation’ and threats of trade sanctions against the country, in the early eighties it was all about Japan, whose large trade balance was prima facie evidence of an undervalued currency. Quotas, ‘Voluntary Export Restraints’ and other protective measures were either imposed or threatened to be imposed against Japan.

No wonder the Japanese felt that to allow the yen to depreciate against the dollar was a ‘no no’. What evidence do we have for that? The next chart shows the behavior of the yen and DM against the dollar during the eighties. While the German DM depreciates significantly against the dollar, despite Germany running a significant trade surplus with the US, the yen doesn’t move much!

But note that as soon as the dollar begins to depreciate against all major currencies following the Plaza Accord, the yen appreciates. Note also that while the DM took a ‘round trip’, returning to the initial level, the yen appreciates 40% relative to the 1980 level!

So, in 1985/87 the policymakers at the Finance Ministry and BoJ had to confront the problem of stimulating the economy. Faced with a steep appreciation of the yen and the resulting drop in growth, the call rate was reduced to the lowest historical level and money growth increased significantly, particularly following the Louvre Accord to rein in dollar depreciation, in which case the BoJ had to intervene buying dollars thus increasing the domestic money supply. The charts illustrate.

Asset prices, particularly stock and real estate prices reacted strongly. According to this 1988 quote from an anonymous BoJ member: “Our intention was to first give a boost to stock and real estate prices. With the rise in those markets, export oriented industries would have the opportunity to adapt to an expansion determined by the domestic market. The wealth effect from the rise in asset prices would increase consumption and then investment.  An expansive monetary policy would thus induce an increase in economic growth”.

The next chart shows what happened to stock prices, which tripled between 1986 and 1989 (real estate prices increased even more).

Partly from ‘misfortune’ and partly from bad monetary policy things began to unravel during 1989. In January of that year the government introduced the consumption tax (‘CT’). Inflation quickly jumps from 1% to 3%.

With that and conscious of the consequences of previous bouts of inflation, the BoJ “forgets” about its domestic induced growth strategy and quickly increases the call rate from 2% to 6%. Money growth is also reduced. The effects show up pretty quickly.

Inflation is brought down and stays down, frequently visiting negative territory. In 1997, following an increase in the ‘CT’ inflation rises briefly.  Real growth is permanently reduced, rarely rising above 2% and frequently being close to zero or even negative.

And most people, including policymakers at the BoJ, look at the near zero rates and conclude monetary policy is as expansionary as it can get! But if you look at money growth you clearly see that monetary policy has been quite ‘tight’ since the early nineties!

But a situation that persists for so long cannot simply be attributed to policymakers´ incompetence. More likely it reflects the policy objective itself! As evidence for that view, few doubt that a central bank can control nominal spending pretty closely. Furthermore, most would also agree that it is spending that drives the economy. So let´s take a look at how nominal spending (NGDP) has behaved.

Following the rise in inflation in 1989-90, the BoJ reduced the growth of nominal spending. Following the ‘CT’ induced rise in inflation in 1997 the BoJ – which had just been granted independence – thought it wise to reduce the level of spending. No wonder Japan´s economy has performed so miserably.

At times during this period, prodded by outsiders – Milton Friedman, Ben Bernanke, John Taylor, to mention a few – on occasion the BoJ paid lip service to the need for monetary expansion. In 2001, for example, it introduced QE and promised to maintain QE (and rates at zero) until inflation was stably above zero, as expected by most members of the policy committee. By 2006 it deemed that the objective had been attained.

Earlier this year the BoJ set a 0% – 2% inflation goal. Note the wording – goal, not target – because it deems the latter to be ‘too rigid’. And has promised to maintain monetary expansion until it “judges that the 1% goal is in sight”. But note that the BoJ emphasizes expectations, not realized inflation. And the whole world knows that concerning inflation the BoJ is ‘trigger happy’.

Meanwhile, due to the failed attempts over the years to revive growth, fiscal deficits and public debt have exploded. So now the ‘hot discussion theme’ in the Diet is about tax increase. On June 26, the lower house of the Japanese Diet passed a bill to double the ‘CT’ to 10%. If the bill is successfully passed through the upper house the tax will increase to 8% by April 2014 and to 10% by October 2015.

Quite likely, as in previous occasions, the BoJ will aggressively react to the resulting rise in inflation! Yes, the name of the game in Japan is ‘unconditional price stability’, no matter if ‘hell freezes over’.