Richard C. Koo, Chief Economist of the Nomura Research Institute and of Balance Sheet Recession fame recently wrote a paper entitled “Central Banks in Balance Sheet Recessions: A Search for Correct Response.”
This post is Part 2 of two posts in which I respond specifically to his remarks on Japan’s Lost Decade. Here is Koo on QE’s effect on Japan’s exchange rates:
“An example of QE having the opposite of expected effect was provided by the Japanese case in 2003-04. At that time, Japan was the only country implementing quantitative easing as it increased monetary base from 100 in 2001 to 170 by 2004, all with zero interest rates. During the same period, the monetary base in the US increased to 130 and in the Eurozone to 120, and both had significantly higher interest rates than in Japan. Although the yen fell at first, the Japanese currency moved strongly higher in 2003, forcing the Japanese government to engage in the largest foreign exchange intervention in history amounting to 30 trillion yen to keep the yen from appreciating. This experience indicated that there is no guarantee that the exchange rate will weaken with a QE.”
Given Koo went to the trouble of using real effective exchange rates in Exhibit 8 when making the claim that there’s not much difference between the change in relative exchange rates among the big four currency areas since 2008 (I may have more to say on this later) I thought it was odd that he obviously switches to nominal exchange rates in this context. When comparing changes in relative exchange rates one obviously wants to take into account different rates of inflation. This is especially the case with a country as unusual as Japan, where there has been virtually persistent deflation since 1995 as measured by the GDP implicit price deflator, as this almost guarantees that the yen will appreciate in nominal terms over time relative to other currencies. The following is a graph of the BOJ’s estimate of Japan’s real effective exchange rate which is trade weighted with respect to 16 different currencies and takes into account their relative inflation rates:
Note that the real effective exchange rate increased sharply from the second half of 1998 through 1999. It plateaued in 2000 and began to noticeably drop in December 2000. Japan’s original ryōteki kin’yū kanwa (QE) was officially announced in March 2001, although there wasn’t a noticeable increase in the monetary base until December 2001.
The foreign exchange intervention that Koo mentions involved only U.S. dollars and ran from January 2003 through March 2004. The real effective exchange rate (which has a 25.82% dollar weight) actually rose from 104.75 in December 2002 to 106.77 in March 2004. Although the 30 trillion yen (actually 35 trillion yen) that the Ministry of Finance, (through the BOJ) spent buying dollars (and which were subsequently converted to U.S. Treasuries) was an extremely large foreign currency intervention in absolute terms (Japan is an important economy after all), it was approximately 40% unsterilized, and so was also effectively an important part of the 48 trillion yen expansion of Japan’s monetary base from March 2001 and January 2006 under QE. For those interested in the interrelationship between Japan’s QE and what John Taylor has termed the “Great Intervention” I recommend reading Tsutomu Watanabe and Tomoyoshi Yabu’s “The great intervention and massive money injection: The Japanese experience 2003-2004” (Journal of International Money and Finance, Vol. 32, February 2013, pp. 428–443) who conclude, among other things, that the unsterilized interventions during this time period had a greater effect on the yen-dollar rate than the sterilized ones.
In any case the real effective exchange rate fell from 116.25 in February 2001 to 91.09 by March 2006, when the BOJ announced the completion of QE, a decline of 21.6%. Although the monetary base was reduced by about 24.4% between January and November 2006, the real effective exchange rate continued to fall until July 2007, but later surged dramatically towards the end of 2008 as the global Great Recession set in.
Here’s Koo on the importance of government deficit spending in maintaining the money supply during a Balance Sheet Recession:
“It is indeed with fiscal stimulus that Japan managed to maintain its GDP at or above the bubble peak for the entire post-1990 period in spite of massive corporate deleveraging and commercial real estate prices falling 87 percent nation-wide. This was shown in Exhibit 4. It was also with concerted fiscal stimulus implemented in 2009 that G20 countries managed to arrest the collapse of the world economy triggered by the Lehman Shock.
From the perspective of central banks, the importance of deficit spending by the government is multiplied by the fact that it is also indispensible in maintaining money supply from shrinking when the private sector is minimizing debt. This comes from the fact that money supply, which is a liability of the banking system, starts shrinking when the private sector as a whole starts paying down debt. This is because banks are unable to lend out the money paid back to them by the deleveraging borrowers when the entire private sector is deleveraging at the same time. During the Great Depression, the US money supply shrunk by over 30 percent from 1929 to 1933 mostly for this reason (85 percent due to deleveraging, 15 percent due to bank failures and withdraws related to failures.)
The post-1990 Japan managed to maintain its money supply (Exhibit 7) and GDP (Exhibit 4) from shrinking because the government was borrowing the deleveraged and newly saved funds from the private sector (Exhibit 9).”
Exhibit 9 displays data taken from the Summary Table of the BOJ’s Monetary Survey. This particular series of data is only available from April 1998 through April 2008. An earlier series excludes foreign banks and a later series, which begins in April 2003, includes claims on other financial corporations, which the earlier two series do not. What Koo terms “credit extended to the public sector” is the sum of “claims on government (net)”, “claims on local government” and “claims on public nonfinancial corporations”. Since public non-financial corporations are part of the non-financial corporate sector this is inconsistent with Japan’s flow of funds. It is also inconsistent with the newer Monetary Survey data which includes claims on public non-financial corporations as part of “claims on other sectors”, which is comprised of claims on the non-financial corporate, household and the nonprofit sectors.
The following graph shows nominal GDP (NGDP), the M2 measure of money supply at year’s end, credit market debt (loans and securities and other than shares and denoted CMD), the amount of credit market debt excluding the financial sector, and the amount of such debt listed in the Summary Table of Japan’s Monetary Survey subdivided by sector at year’s end and with public non-financial corporate debt included with the non-government category. The aggregate credit market debt data comes from Japan’s Cabinet Office.
Japan’s depository institutions do have a substantial proportion of the non-government credit market debt excluding financial sector credit market debt with the share rising from 57.6% in 1998 to 62.4% in 2007. And the share of government credit market debt held by depository institutions rose from 23.2% to 26.2%. But the overall share of credit market debt excluding financial sector credit market debt fell from 45.6% to 43.8%. So Koo’s claim that money supply growth is constrained by the supply of debt that can be placed on the asset side of depository institution balance sheets seems wanting.
What would we discover if we had equivalent data for financial sector credit market debt? Well the newer series shows that claims on financial sector fell from 43.1% of all financial sector credit market debt at the end of 2003 to 30.4% at the end of 2007. So were we able to include financial sector credit market debt over this time period it would likely reduce the share of total credit market debt held by depository institutions and it would result in an even stronger downward trend in the depository institution share of total credit market debt.
And thanks to deflation Japan makes the perfect counterpoint to the widespread delusion that money supply growth is dependent on debt growth. In most countries the existence of inflation means that most nominal quantities tend to grow over time giving rise to spurious correlations. This of course also applies to money supply and total nominal credit market debt. But in Japan total nominal credit market debt has declined repeatedly since 2000. Here is the graph of Japan’s M2 money supply and total nominal credit market debt indexed to 100 in the year 2000:
One thing you won’t hear from Koo is that Japan’s growth following its original QE was a lot stronger than most people realize. To fully appreciate the significance of this it’s important to examine Japan’s fiscal policy stance during the Lost Decade. In my opinion the most objective way of judging fiscal policy stance is the change in the general government structural balance. The structural balance is adjusted for the business cycle and thus any changes should represent policy rather than the state of the economy. The IMF provides estimates of Japan’s general government structural balance from 1994 on so we can compute the changes from 1995 on:
With the exception of calendar years 1997 and 2001 fiscal policy was expansionary during 1995-2003. Do we know anything about the fiscal policy stance prior to 1995? An excellent summary of the Japanese discretionary fiscal stimuli programs is Anita Tuladhar and Marcus Bruckner’s “Public Investment as a Fiscal Stimulus: Evidence from Japan’s Regional Spending during the 1990s” (IMF Working Paper No. 10/110, April 2010). Appendix Table 8 lists two fiscal stimuli for 1993 and one each for 1992 and 1994, so fiscal policy was obviously expansionary for the entire 1992-96 period. It also lists nine fiscal stimuli and three tax cuts during 1995-2002, but none during 2003-07. The fiscal tightening in 1997 is explained by the fact that Japan raised its consumption tax from 3% to 5% on April 1, 1997. The fiscal tightening in 2001 seems to have been passive. The expansionary fiscal policy of 2003 represents a carryover of the effects of the 2002 fiscal year, which ended on March 31, 2003.
Considering that the BOJ’s call rate wasn’t lowered below 1% until July 1995 and didn’t get below 0.25% until November 1998, Japan’s fiscal policy seems a bit backwards. Away from the zero lower bound there’s absolutely no rationale for doing fiscal stimulus unless one wants to see the spectacle of competing policy levers cancel each other out, and yet Japan did eight fiscal stimuli and three tax cuts during 1992-98. On the other hand, if one truly believes in the Keynesian concept of the liquidity trap, then one would want to do fiscal stimuli when the policy rate is pinned to the zero lower bound, and yet Japan practiced five consecutive years of consolidation during fiscal years 2003-07, a time when the policy rate was never as high as 0.5%.
So with that background out of the way, and recalling that Japan’s QE was announced in March 2001 and didn’t really kick into gear until December 2001, how did the Japanese economy do? Here’s a graph of Japans’ annual CPI inflation and harmonized unemployment rate:
Note that aside from the consumption tax induced increase in 1997 Japan’s inflation rate dropped nearly every year from 1991 through 2002 and then edged upward until there was consecutive years of consumer price inflation in 2006-07 for the first time in nearly a decade. Unemployment increased nearly every year through 2002 and then dropped in 2003 for the first time since 1990, and then continued to drop every year through 2007. And it’s worth noting that even the Nikkei 225 gave its thumbs up during 2003-07, with the index rising from less than 7900 in April 2003 to over 18,000 in June 2007, which is still by far the greatest stock market rally in Japan since the beginning of the Lost Decade(s).
And as long as I’m on the subject of Japan’s unemployment rate it needs to be repeated frequently that mindlessly comparing it with other countries is a huge mistake. Japan’s Okun’s Law coefficient or the percentage points that GDP falls for every one point increase in the unemployment rate, has been estimated to be as high as five, or more than double that of the U.S. This is due in part to the fact that the self employment rate in Japan is also high, and that for various reasons institutional employers are more likely to cut back on hours and productivity than let employees go. And finally, Japan’s natural rate of unemployment is unusually low with the OECD’s current estimate of Japan’s Non-Accelerating Inflation Rate of Unemployment (NAIRU) equal to 4.3%. In short, what constitutes a high unemployment rate in Japan is very different than what constitutes a high rate of unemployment most other countries.
And let’s take a look at Japan’s real GDP (RGDP) during this period:
Yes, there does appear to be a period of decent growth during 1994-97 but considering Japan hadn’t really hit the zero lower bound yet and fiscal policy was expansionary throughout 1992-97 except for the last three quarters of 1997, it would be surprising if there wasn’t. What’s more interesting is the even longer period of above average growth during 2003-07 when the BOJ’s call rate was below 0.25% except for the last eleven months of 2007, and fiscal policy was contractionary for all but the first quarter of 2003. But when you recall that this latter period overlaps comfortably with the period of Japan’s QE things seem far less mysterious. It seems one can’t find evidence of Krugman’s liquidity trap no matter how hard you try.
And in fact before moving on to one last section on Koo and Japan’s Lost Decade, I want to dispel another myth about this period that Krugman himself has served to inculcate. That is the myth that Japan’s relatively good economic performance during 2003-07, which some have called the “Koizumi Boom”, was driven by net exports. Here’s what Krugman said about this is in February 2009:
“…Koo writes about the gradual rebuilding of private balance sheets, preparing the ground for recovery; and Japan did in fact have a fairly convincing bounce-back from 2003 to 2007.
The chart above is a quick-and-dirty summary of the sources of Japanese growth from 2003 to 2007. It shows the change in real GDP, the change in real consumer spending, the change in real business investment, and the change in real net exports, all as percentages of 2003 GDP. What we see is nothing special happening to consumption, which grew more or less at its long-term trend growth rate, and only a modest investment boom. Exports were the driving force behind recovery.
And needless to say, we can’t all export ourselves out of a global slump…”
This is wrong on a number of different levels, and since I know that Krugman knows better, I can’t quite forgive him for saying that. To see why here’s Japan’s net exports during this period:
So why are Krugman’s results so different from mine? In nominal terms both exports and imports soared during 2003-07. But thanks to a sharp increase in the average price of Japanese imports only exports increased dramatically in real terms.
This is fine from the standpoint of real growth accounting, but the issue at hand was, and is, aggregate demand, which is measured strictly in nominal terms. To claim that net exports drove Japan’s growth during this period is to claim that the source for the increased aggregate demand came from abroad when in fact it came from the Japanese QE, which succeeded by not only stimulating foreign nominal demand for Japan’s exports through a reduced real effective exchange rate, but also by dramatically increasing Japan’s nominal demand for imports.
Knowing how to correctly measure aggregate demand is key to understanding why expansionary monetary policy is a positive sum game rather than a zero sum, or even a negative sum game, as people like Koo claim.
And finally, here is Koo on the Japan’s supposedly successful withdrawal of QE in 2006:
“So far the only successful removal of QE was the one engineered by the Bank of Japan in 2006, when its first-ever quantitative easing in history was ended after five years. This removal went without a hitch because the QE was all at the short end of the market. The removal of reserves at the short end under zero interest rates had very little impact on the rest of the yield curve. For example, the yield on 10-year JGBs jumped by about 40 basis points right after the announcement of the end of quantitative easing, but the yield returned to the original level after a few months.”
I’ve already dealt with Koo’s bizarre views concerning the volatility of the money multiplier when the central bank finds it necessary to raise the policy rate near the zero lower bound in a previous post. What I want to do here is reiterate that, contrary to Koo’s opinion, the Japanese quick and severe withdrawal of QE must in retrospect be regarded as an enormous failure.
Here’s a graph of RGDP of Japan, the U.S., Germany and the U.K. indexed to 100 in 2007Q1:
The BOJ reduced the monetary base by 24.4% from January to November 2006 and economic weakness followed within months. Japan was one of the first major economies to have negative RGDP growth when it fell in 2007Q3. RGDP fell 4.7% at an annual rate in 2008Q2, and 4.0% at an annual rate in 2008Q3, causing Japan to suffer serious consecutive quarterly declines in RGDP before the U.S. did the same. RGDP proceeded to fall 12.4% at an annual rate in 2008Q4 and 15.1% at an annual rate in 2009Q1. All told RGDP fell 9.2% from peak to trough.
In short Japanese RGDP fell sooner, faster and further than every other major country this recession. It’s hard not to connect the dots between this result and the BOJ’s sudden and sharp withdrawal of QE, given one literally followed upon the other within months.