A note on Japan’s experiment with quantitative easing

Japan’s policy makers generally procrastinated considerably in terms of implementing any kind of stimulative measures, as well as prematurely reversing the benign impact of policies which had some earlier success. In terms of monetary policy, the BOJ did not actually embrace quantitative monetary easing until 2001, eleven years after their bubble had burst.


Marshall Auerback here. Just yesterday, Ed wrote a good post on quantitative easing. As much as I liked the post, frankly I think Ed omitted some crucial factors about Japan, which I will detail here for you.

Japan’s policy makers generally procrastinated considerably in terms of implementing any kind of stimulative measures, as well as prematurely reversing the benign impact of policies which had some earlier success. In terms of monetary policy, the BOJ did not actually embrace quantitative monetary easing until 2001, eleven years after their bubble had burst. Furthermore, the authorities waited until 1998, a full 8 years after the real estate crash, before embarking on a program of banking recapitalization, the upshot being that the traditional mechanisms through which credit was to be intermediated were still severely impaired. The benign impact of fiscal reflation was also undermined by a wrong-headed increase in the consumption tax in 1995, which was followed on by the Asian financial crisis, creating an additional exogenous shock to an economy still recovering from the throes of a major credit bubble collapse.

Japan’s lost decade can be divided into three sections: the 1991-93 recession, the temporary recovery of 1994-96, and the deep recession of 1997-99. Each episode offers important lessons.

The post-1989 collapse of Japan’s equity bubble was, at first, welcomed by the Bank of Japan. Even though stock prices were falling rapidly, land prices continued to rise for another year at least, and the Bank of Japan remained concerned about inflation pressures. The Bank of Japan actually boosted the discount rate from 4.75 percent to 6 percent in August 1990 and held it at that level until June 1991. As the collapse of equity prices intensified and land prices began to fall, the Bank of Japan reversed course and cut its discount rate rapidly by 275 basis points in the year following June 1991. Subsequent additional cuts of 150 basis points in 1993 brought the discount rate down to 1.75 percent by September 1993. Simultaneously, Japan pursued three major fiscal stimulus packages totalling 6 percent of GDP between August 1992 and September 1993.

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The effects on the economy of these extraordinary stimulative measures were limited. Growth recovered only slightly–to just over 1 percent in 1994–for several reasons. First, the Bank of Japan was late to initiate its easing. By the time of the first rate cut in June 1991, Japan’s nominal GDP growth, which in the long run should not be allowed to fall below policy interest rates, had dropped to about 2.5 percent, headed down to a negative level by 1994. That level was far below the 6 percent discount rate in place. Simultaneously, falling land and equity prices were erasing household wealth and resulting in a sharp curtailment of credit because of the heavy exposure of Japan’s banks to the commercial land bubble. This was especially damaging because Japanese companies are far more reliant on banks for financing than American companies, which have access to broader credit markets.

More broadly, deflation began to emerge, which boosted real growth numbers artificially. (Real growth is calculated by subtracting inflation from nominal growth or adding deflation to nominal growth.) Real growth of 2 percent, generated by zero nominal growth and 2 percent deflation, is too weak.

Japan’s large fiscal stimulus packages, which became legendary during the 1990s, were ineffective for several reasons. First of all, the packages were not as large as advertised, often inflated by double counting as stimulus government programs that were already slated to be undertaken. More importantly, the packages were poorly directed–largely toward unproductive public works projects and credits to small businesses that were no longer economically viable. Also, the need to move production facilities abroad grew as the economic environment in Japan deteriorated and deflation strengthened the yen, making goods produced in Japan too expensive in world markets, which should have induced greater moves to induce aggregate demand, but instead was deployed in inefficient “bridges to nowhere”, given the continued dominance of the construction companies and the like on the Japanese political system.

Japan’s sharp interest rate reductions and sizeable public works programs did help to boost the economy mid-decade. The real growth rate reached nearly 4 per-cent in 1996 and early 1997. Yet an ominous period of deflation that emerged mid-decade and dragged down nominal GDP growth was largely ignored by Japan’s policymakers. The deflation, coupled with a loss of public confidence tied to the Kobe earthquake in January 1995, resulted in an elevation of liquidity preference by Japanese households and firms.

The sharp rise in the demand for money was signaled by a rapid appreciation of the yen, which reached 79.8 per dollar on April 19, 1995. As Japanese households sought to raise cash balances, Japan’s external surplus created a strong demand for yen that was not offset by capital outflows. The sharp appreciation of Japan’s yen early in 1995 signaled a severe liquidity shortage, which resulted in a sharp drop in demand, even though market interest rates were low. In 1995, Japanese policymakers responded with another 125 basis points of rate cuts that brought the discount rate to 0.5 percent in September of that year. Another two major fiscal stimulus packages in 1994 and 1995, again totalling 6 percent of GDP, helped to sustain a recovery of growth until 1997.

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Japan’s biggest policy mistake came in 1997 when the government raised its consumption tax from 3 to 5 percent. The aim was to help compensate for the large run-up in Japanese debt that resulted from the series of unproductive fiscal stimulus packages expended largely on wasteful public works projects. The combination of higher consumption taxes, the continued fall in land prices that persisted in preventing Japan’s banks from operating as financial intermediaries because of their heavy exposure to real estate losses, and a rapid return to deflation in 1998 resulted in a virtual collapse of the Japanese economy.

Japan’s poorly timed attempt to redress its large budget deficit and rapidly rising public debt provided a compelling reminder of the lessons that John Maynard Keynes taught in the General Theory of Employment, Interest, and Money. Fiscal stringency in the form of a tax on consumption in an economy weakened by massive wealth losses and an erosion of confidence that results in a virtual liquidity trap is an extraordinarily harmful policy. Japan’s nominal GDP growth rate was below zero for most of the five years after 1997, with most of its positive real growth resulting from the technical application of GDP deflators averaging about -1.5 percent. In a deflationary economy, it is important to watch nominal, not real, GDP growth.

Japan persisted in believing that monetary policy was extremely accommodative because of low nominal interest rates and the Bank of Japan discount rate at 0.5 percent. But with deflation at 1.5-2 percent and negative nominal GDP growth, a 0.5 percent interest rate was actually restrictive.

After five years in a deflationary economic wilderness, the Bank of Japan switched during the spring of 2001 to a policy of quantitative easing–targeting the growth of the money supply instead of nominal interest rates–in order to engineer a rebound in demand growth. Simultaneously, the energetic and innovative Junichiro Koizumi was elected prime minister in April 2001, and he undertook aggressive measures to recapitalize Japan’s banks, which were still heavily burdened by non-performing loans.

The need to recapitalize Japan’s financial sector had been evident since late 1997 when Yamaichi Securities–a midsized Japanese securities house–collapsed, followed by failures of some regional banks in 1998. The persistent problem was non-performing loans whose total value rose as high as 20 to 25 percent of Japanese GDP. While substantial public funds had been made available to Japanese banks in 1999, balance sheet restructuring was undertaken only slowly and reluctantly, partly because of the stigma attached to revealing long-concealed losses and fears of losing control to foreign investors. A lack of transparency in the balance sheets of Japanese banks and a passive approach by the Japanese government to restructuring those balance sheets contributed substantially to the prolonged period of economic stagnation. Deflation exacerbated the problem by further depressing the land prices to which Japan’s balance sheets were closely tied and by elevating real interest rates. When cash–a riskless asset–was earning the deflation rate of 2 percent or higher, few wanted to leave their deposits in banks whose solvency was in question because of heavy exposure to the collapse in land prices and that offered interest rates to depositors that did not compensate for those perceived risks.

The move by the Bank of Japan to quantitative easing and the large increase in liquidity that followed helped to stabilize land prices by 2003. The Japanese economy then enjoyed modest growth averaging around 2 percent per year. The Bank of Japan held interest rates at zero until early 2007, when it boosted its discount rate back to 0.5 percent in two steps by midyear. Since then, however, the slowdown in global economic activity and persistent deflation stayed the Bank of Japan’s hand from further rate increases and raised the possibility of even returning to rate cuts in 2008 as the outlook for the Japanese economy worsened.

By contrast, everything that Japan did in terms of banking recapitalisation and quantitative monetary easing has been effected by the Bernanke Fed within a year of the credit crisis enveloping the U.S. economy. And President-elect Obama has already promised major fiscal stimulus early next year. The one aspect of the Japan analogy which does suggest ominous problems for the U.S. is the latter’s exceptionally high debt to GDP ratio of 350 per cent which contrasts negatively with Japan’s huge accumulated savings surplus at the time their bubble burst. Of course, one could easily turn that argument around and suggest that the savings surplus gave Japan’s monetary and financial authorities a significant margin of error in policy making, a margin which they comfortably exceeded through a combination of political inertia and economic incompetence.

It is possible that, for the time being, the existence of record leverage caused the U.S. stock market to undershoot its current quite disastrous fundamentals. Of course, these fundamentals could get worse over time, warranting a yet deeper stock market decline. The economic contraction could be more severe and sustained than anything in the post war period. The price level could fall for the first time in the post war period. The financial crisis could become far more severe. And the market cap to GDP ratio is still well above the post war lows. All this bad stuff has not yet happened, so I’m not trying to say it can’t happen. But there has never been so immense a policy response in history.

History says that, for the time being, this stock market probably overshot to the downside relative to current economic conditions and investor psychology when it hit 750 on the S&P about 10 days ago. The explanation probably lies in record leverage. I should add that the largest group of leveraged investors – the hedge funds – are probably now, in aggregate, net short. Let’s wait a bit before we start rendering definitive judgements about what we should do.

Your comments are welcomed.

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