How Japan can recover
Lars E.O. Svensson Financial Times, Personal View, Sep 25, 2001
The key to economic stability is for consumers to anticipate price rises rather than deflation, says Lars Svensson – Sep 25 2001
Japan has already lost a decade to economic stagnation and deflation. It may easily lose another. The zero interest rate policy implemented so far is not sufficiently expansionary to induce a recovery. Neither is the most recent further expansion of the monetary base – the “quantitative easing” announced in August – because the current excess of liquidity makes this like pushing on a string.
But there is a foolproof way to jump-start the Japanese economy. This would involve setting a target for the level of consumer prices -a target that rises over time in line with a small positive inflation target; driving down the value of the yen immediately and pegging it at a level considerably weaker than its current value; and keeping the yen pegged until prices reach their target level.
Japan needs to raise prices for at least two reasons. First, the zero or negative inflation rates of recent years have increased the real value of debt, worsening the balance sheets of companies and banks. Second, the country needs to replace expectations of deflation with expectations of modest inflation in order to get people to spend their cash instead of hoarding it. A target price level that is above the current level and rises over time can serve both these purposes.
Japan can hit this target by driving down the yen and pegging it at a clearly “undervalued” level, such as 140, 150 or even more yen to the dollar. This is easy to do, since the Bank of Japan, the central bank, can print unlimited quantities of yen. Indeed, there is a big difference between defending a fixed exchange rate for a strong currency under appreciation pressure (when foreign-exchange reserves rise) and for a weak currency under depreciation pressure (when foreign-exchange reserves fall and eventually run out). After a day or two the credibility of the peg will have been established.
This would directly stimulate Japan’s economy, making its exports more competitive on world markets. More important, however, it would stimulate domestic spending by replacing expectations of deflation with expectations of inflation.
This policy would lead to expectations of inflation because investors would realise that the yen could not stay permanently undervalued. Once the currency is pegged, however, the only way to correct an undervaluation is through inflation. Realising this, investors would also realise that there is inflation, not deflation, in Japan’s future.
Right now Japan has zero or very low interest rates. But these do not stimulate the economy sufficiently, in part because expectations of deflation drive up the real interest rate – the market rate minus expected inflation. Changing expectations of deflation to expectations of inflation would therefore reduce the real interest rate.
The proposal also has an exit strategy. Once the price-level target has been reached, Japan should turn to a policy similar to that followed in other advanced countries such as the UK, New Zealand and Sweden: a floating exchange rate, and monetary policy aimed at achieving a low but positive inflation rate. This also avoids overshooting the price-level target and causing excessive inflation.
This proposal could be followed unilaterally by Japan without co-operation from countries in the region or from the US. Furthermore, any objections to the proposal or to an undervalued yen from the region or the US would be mistaken. Expansion in Japan requires a lower real interest rate, and an undervalued yen is the unavoidable mirror image of a lower real interest rate. An undervalued yen would give Japanese exporters a short-term competitive edge, but resumed economic growth and increased aggregate demand would increase Japan’s imports from the rest of the world. This is not a beggar-thy-neighbor policy. In the medium and long term, the region, the US and the world would all gain.
Other proposals for Japan have focused on introducing an inflation target and/or driving down the value of the yen. This proposal is consistent with those but it provides better benchmarks, in the form of a target level for consumer prices, a peg for the yen and an exit strategy for the peg. The peg also provides an arena where the Bank of Japan and the Ministry of Finance can quickly demonstrate their resolve to end stagnation and deflation and thereby gain credibility.
Crucially, this proposal does not reduce in any way the need for an urgent clean-up of the financial sector and thorough structural reforms in Japan. Such reforms must be undertaken in any case, but doing so would be less painful in a growing economy rather than a stagnating one.
So far, Japanese authorities seem to have set myopic bureaucratic interests and technical details above the welfare of their country, in a situation when leadership and resolve is required. The BoJ and the MoF should instead co-operate and replace stagnation and deflation by growth and low inflation. This foolproof way makes that possible.
The writer is professor of economics at Princeton University.