I wrote several years ago that Japan is a bug in search of a windshield. And in January I wrote that 2013 is the Year of the Windshield. The recent volatility in Japanese markets is breathtaking but characteristic of what one should come to expect from a country that is on the brink of fiscal and economic disaster. I dont mean to be trite, from a global perspective; Japan is not Greece: Japan is the third-largest economy in the world. Its biggest banks are on a par with those of the US. It is a global power in trade and trade finance. Its currency has reserve status. It has two of the world’s six largest corporations and 71 of the largest 500, surpassed only by the US and comfortably ahead of China, with 46. Even with the rest of Asias big companies combined with Chinas, the total barely surpasses Japans CNN. In short, when Japan embarks on a very risky fiscal and monetary strategy, it delivers a serious impact on the rest of the world. And doubly so because global growth is now driven by Asia. Japan has fired the first real shot in what future historians will record as the most significant global currency war since the 1930s and the first in a world dominated by true fiat money.
The solution that Abe and Kuroda arrived at, to the applause of mainstream economists, is massive quantitative easing. Let’s look at a paper just published by UC Berkeley Professor Christina Romer, former chairwoman of the President’s Council of Economic Advisors. (Hat tip Barry Ritholtz at The Big Picture.) I will summarize, but you can read the paper here.
Basically, Romer (with a nod to Krugman, et al.) suggests that Abe and Kuroda have initiated what she calls a regime shift and that “it just might work.” And then she proceeds to compare what Japan is doing to the policies of Roosevelt in the early ’30s. Quoting from the introduction:
Last week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. As I will describe in more detail later, it took dramatic actions and pledged convincingly to do whatever it takes to end deflation in Japan. The theoretical reasons why this regime shift may be important are well understood by economists. Persistent deflation and anemic growth suggest that Japan continues to suffer from a shortfall of demand. But their policy interest rate is already at the zero lower bound. Furthermore, riskier, long-term rates are also very low – suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates. As discussed by Paul Krugman, Gauti Eggertsson and Michael Woodford, and others, if unconventional monetary policy can raise expected infl ation, this can push down real interest rates even though nominal rates cannot fall. This, in turn, can raise aggregate demand by stimulating interest-sensitive spending.
And in the conclusion she suggests that bold policies must be aggressively pursued:
In a recent paper, David Romer and I discuss that such views are potentially very destructive. We show that what are widely viewed as the two largest errors in Federal Reserve history – inaction in the wake of banking panics early in the Depression, and inaction in the face of high and rising inflation in the 1970s – were both borne of unwarranted humility. Fear that policies might not work or might be costly led policymakers to conclude that the prudent thing was to do nothing. Yet there is now widespread consensus that action would have been effective in both these periods.
We have nothing to fear but fear itself: this is the heart of Keynesian thinking. And if it is good for Japan then what of the rest of the world?
Earlier in the paper, Romer writes, after discussing recent US Federal Reserve policy actions:
But the truth is even these moves were pretty small steps. With its most recent action, the Fed has pushed the edges of its current regime. And I am sure that given the opposition in Congress and the difference of opinion within the FOMC, even those measures were a struggle. Nevertheless, the key fact remains that the Fed has been unwilling to do a regime shift. And because of that, monetary policy has not been able to play a decisive role in generating recovery. To paraphrase E. Cary Brown’s famous conclusion about fiscal policy in the Great Depression: monetary policy has not been a strong recovery tool in recent years not because it did not work but because it was not tried – at least not on the scale and in the form that was necessary to have a large impact.
Wow. Double wow. Breath-taking triple wow. Read this paper. Absorb it. And then bookmark it and come back in five years. I give Romer this: she shows no unwarranted humility in this paper. She goes “all in” in backing this Japanese policy.
But I do agree with Professor Romer about one thing: this is the most serious and radical economic experiment undertaken in my lifetime by a major economic power. And the rest of the world must pay attention. If this has succeeded in working five years from now, if Japan is growing and its debt relative to GDP is shrinking and the rest of the world has allowed the yen to drop in half, then let me state here and now that I will have to rethink my understanding of economics.
But ironically, if I were Abe and faced with the question, “What do I do now with what I have inherited,” I am not sure that I could do anything else. He is a politician and a Japanese one at that. The Japanese are serious hometown players, as are the citizens of most countries. You do what is best for your hometown and don’t worry about the neighbors all that much. You want to stay friends, but your first responsibility is the hometown.
If you’re Abe, what are your choices? They are nothing but ugly. Perhaps the best of a very, very ugly-bad lot is that you have to try and inflate away that debt. Monetize as much as you can and then just “poof” it away. You destroy your currency in the process, but you have to destroy something. And maybe your derring do gives your exporters a boost and a competitive advantage, so you at least salvage that. Why not export your deflation? And then gamble that maybe Romer and Krugman are right. It could work! Damn the torpedoes, full speed ahead!