Article Review: Japan’s Growth Strategy is All Wrong
Abstract
The article Japan’s growth strategy is all wrong is about the policies implemented by the Japan government led by Prime Minister Shinzo Abe that is viewed to jeopardise the country’s low interest rate environment that is conducive for spending and investment. The purpose of the student in writing this paper is to present the economic problem faced by Japan as an implication of the policies executed by the government, applying the concepts and principles that I have learned in my Economics.
The article entitled Japan’s growth strategy is all wrong is about the policies implemented under Japan Prime Minister Shinzo Abe’s governance is viewed to jeopardise the country’s one great advantage of having the world’s lowest interest rate on government debt and private borrowing. Likewise, in the article, the potential problems associated with the use of the so-called quantitative easing, the policy that the government of Japan has adopted to get the economy out of the “no-growth and deflationary trap” situation, were presented like weakening of yen that will have impact on the country’s trade balance (BBC News, August 2011), and subsequent effect on the price level and budget deficit.
In this article review, the purpose is to discuss the economic problem faced by Japan as an implication of the policies executed by the government, applying the concepts and principles that I have learned in my Economics (e.g. Aggregate Supply-Aggregate Demand model and Keynesian Cross). The discussion is organized as follows: in the next section, the student tackle the economic problems that the economy is facing followed by the policies implemented by the Government to solve the problem.
The problem of the Government of Japan was how to boost growth in the economy. The economy is in a situation of falling prices for more than a decade. On the positive side, this kind of environment has given Japan the advantage to borrow from private sources and pay its 10-year government bonds at very low interest rate (i.e., less than 1% that is the lowest interest rate all over the world!). However, the trade-off of low rate of interest on private borrowing and government debt is the stagnation of the economy. The government’s pressing problem in stagnating nominal GNP (gross nominal product) is attributable to deflationary trap.
Deflationary trap is a situation wherein there is persistent deflation or declining price level in the economy which can spiral down to zero per cent interest. According to the Federal Reserve Bank of San Francisco, deflationary trap occurs when the banks limit credit that results to the decrease in the availability of money in circulation, thereby lowering investment and spending. The decreasing availability of money eventually lowers aggregate demand, hence the further lowering of the price levels. In particular, when the economy is caught in a deflationary trap, there is a decline in the spending in the whole economy as the consumers are unwilling to purchase goods at current prices because of their expectations of falling prices in the coming days. The consumers’ incentive to delay their purchases and consumption because of the anticipation that prices will fall further; this has the effect of reducing the overall economic activity. The declining consumer spending depresses the productive capacity leading to a fall in investment, that further result to falling aggregate demand (Figure 1); a deflationary spiral! Figure 2 depicts the deflationary spiral in a Keynesian Cross model.
Figure 1: Aggregate Supply-Aggregate Demand Model
with Deflationary Trap
Figure 2: Keynesian Cross and with Deflationary Trap
Paul Krugman (2010) explained this deflationary trap as follows: when people have expectations of declining prices, they will be unwilling to spend and borrow. It is because if prices are decreasing, holding money is synonymous to investment yielding a high return. Anyone who is considering borrowing money be it for spending or investment purposes will weigh up that the value of the loan in yen will have to be repaid in yen that are valued more than the yen being borrowed. If the economy is running well, this can be compensated by simply keeping the rate of interest at low level. However, if the economy is in bad condition, even a zero interest rate may not be low enough to attain full employment in the economy. This situation leads to a economy that is still in a depressed state since people will continue to anticipate falling prices, and deflation will continue as the economy stays depressed.
Krugman further emphasized the problems associated with a deflationary economy. Declining price levels tend to worsen the debt-position of debtors. This is because the expectations of future deflation increase the real burdens of their debts. How likely will this be? According to Irving Fisher as cited by Krugman (2010), when debtors’ debt burden increases, they will be forced to reduce their spending, while creditors aren’t likely to increase their spending by the same amount. The deflation exerts a depressing effect on spending by raising debt burdens that can lead to another kind of vicious circle, that is, depressed spending due to increasing real debt results to further deflation.
Moreover, in a deflationary environment, wages (the price of labor) also fall. However, employers cannot simply cut down nominal wages because of the downward nominal rigidity of wages (Christiano, Eichenbaum, & Evans, 2005). This result to the rise in the level of unemployment as firms resort to laying off of workers.
Generally, the effect of deflationary trap is the economic stagnation, that is, no growth in the aggregate output of the economy measured in terms of the gross national product.
Government Policies to Solve the Problem
Macroeconomics taught the student that the government can affect the economy through the conduct of monetary policy or fiscal policy. Conventionally, the government through the Central Bank conducts monetary policy by altering the interest rate target for the inter-bank interest rate of which the interest rate target is achieved through open market operations (buying or selling of short-term government bonds from financial institutions like banks). During deflationary periods, government may choose to use monetary policy by raising the amount of lending and activity by cutting interest rate. Lower rate of interest encourages people to spend. However, if the rate of interest can go no lower than its prevailing rate (possibly if it is already near zero), the only alternative available is to pump prime the economy by injecting money; this is quantitative easing.
In the case of Japan, the government used the quantitative easing strategy that was deemed appropriate to stimulate economic growth according to Prime Minister Shinzo Abe. This is to address the problem of no-growth economy. The rationale of the government is that since the prevailing nominal interest rate is already near zero (Bank of Japan has maintained short-term rate of interest close at zero), the Bank of Japan can no longer adapt strategies that will further lower it (liquidity trap). So, the last resort of the government is to use quantitative easing strategy with the goal increasing the supply of money (Lam, 2011).
Technically, the strategy is performed by the Central Bank through buying of pre-determined amount of bonds from financial institutions like commercial banks, insurance companies and pension funds without reference to the rate of interest. With quantitative easing, the Central Bank injects cash to commercial banks causing excess liquidity. This is to encourage private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. The Bank of Japan conducts quantitative easing by purchasing bonds, asset-backed securities and equities as well as extended terms for commercial paper purchasing operations (BBC News, October 2011). On April 2013, the bank announced the expansion of its Asset Purchase Program by 1.4 Trillion Dollars in two years time with the hope of bringing the economy to inflation (2% inflation) from its current deflationary state.
How exactly quantitative easing works? The Central Banks’ purchases of government bonds from the private sector companies. The purpose of the purchases is to inject money directly into the economy in order to boost nominal demand (Bank of England, 2013). The purchases increase the demand for government bonds that in turn raises the value of bonds making them expensive to buy and hence less attractive investment. This implies that the company that sold the bond may utilize the earnings from such investment to lend to individuals or invest in other companies rather than buying more of the government bonds. The increased lending activities through banks, insurance firms and pension funds will cause the interest rate to fall, creating more spending, hence boosting the economic growth.
Effectiveness of Quantitative Easing Strategy as to Boost Economic Growth
The student learned from economic theory that quantitative easing works by (1) increasing the cash holdings of banks thereby allowing them to lend more to private individuals and company; (2) lowering the interest rates. In practice, interest rates do drop but it is difficult to determine if the fall in the interest rate translates into a boost in the actual economy (Liu & Mumtaz 2012).
According to the International Monetary Fund, Central Bank policies on quantitative easing particularly in developed economies have contributed to the reduction of systematic risks as well as to the improvements in market confidence and bottoming out of the recession in the G7 countries in 2009.
Despite this identified effectiveness of the strategy, the associated potential problems are quite alarming especially for Japan, a country with government debt of roughly 230% of GDP and annual budget deficit of nearly 10% of its GDP.
Though quantitative easing is viewed to bring the economy to 2% inflation, it is also viewed to be ineffective in stimulating demand especially if the banks would be hesitant to lend money to households and businesses (Thornton, 2010). Also, the fact that there is a lag for the effect of money growth and inflation to set in (time lag), inflationary pressures associated with growth of money from quantitative easing could build before the central bank acts to offset them. Inflationary risks are mitigated if the system's economy outgrows the pace of the increase of the supply of money from the easing. For example, if a nation's economy were to spur a significant increase in the level of output at a rate that is higher than the amount of monetized debt, this could equalize inflationary pressures. But this is only possible if the participating financial institutions like commercial banks lend the excess cash instead of hoarding it. Anyway, the central bank has always the alternative to restore the bank reserves especially during periods of high economic output. This is usually done by raising the interest rates or other means, effectively reversing the easing steps taken.
Another potential problem with quantitative easing is that basic macroeconomics tells us that increasing the money supply tend to depreciate a country's exchange rates versus other currencies (Baumeister & Benati, 2011). Obviously, this feature of quantitative easing is favourable for the Japanese exporters and for the debtors whose debts are denominated in yen. This is because the devaluation of yen also devalues the value of debt. On the other side, the devaluation will adversely effect for creditors and holders of yen since the real value of yen holdings fall (Ueada, 2011). Further, Japanese importers will be negatively affected as imported goods will become very expensive.
Conclusion
The no-growth state in a deflationary environment prompted the government of Japan through the Bank of Japan to adapt quantitative easing strategy to stimulate growth in the output of the economy of Japan. The article being reviewed emphasized the potential ineffectiveness of the policy as the said strategy is believed to be a threat and not a solution to the current problem.
References
Krugman, Paul (2010). “The Conscience of a Liberal” Accessed from http://krugman.blogs.nytimes.com/2010/08/02/why-is-deflation-bad/
Bank of England (2013) “Quantitative easing explained”, http://www.bankofengland.co.uk/monetarypolicy/pages/qe/default.aspx
Baumeister, C. and L. Benati (2011), “Unconventional Monetary Policy and the Great Recession,” ECB Working Paper Series, No. 1258, October 2010.
Bernanke, Ben S. and Alan S. Blinder (1992), “The Federal Funds Rate and the Channels of Monetary Transmission,” American Economic Review, Volume 82, Issue 4 (September), pp. 901–921.
Christiano, L., M. S. Eichenbaum, and C.L.Evans (2005), “Nominal Rigidities and the
Dynamic Effects of a Shock to Monetary Policy,” Journal of Political Economy, Volume 113, Issue 1, pp. 1–45.
Lam, W.R. (2011), “Bank of Japan’s Monetary Easing Measures: Are They Powerful and Comprehensive?,” IMF Working Paper 11/264 (Washington: International Monetary Fund).
Liu, P, and H. Mumtaz, (2012), “Changing Macroeconomic Dynamics at the Zero Lower Bound,” forthcoming Bank of England Working Paper
Ueada, K. (2011), “The Effectiveness of Non-Traditional Monetary Policy Measures: The
Thornton, Daniel L. (2010). "The downside of quantitative easing".Federal Reserve Bank of St. Louis Economic Synopses (34).
"Japan government and central bank intervene to cut yen". BBC News. 4 August 2011.
“Bank of Japan increases QE by 10 trillion yen”. Banking Times (4 August 2011).
"Bank of Japan increases stimulus and keeps rates low". BBC News. 27 October 2011.
