Monetary easing the wrong cure for Japan's deflation

Andy Xie says Bank of Japan's aggressive move will spur speculation and risk the yen's collapse

PUBLISHED : Wednesday, 10 April, 2013, 12:00am
UPDATED : Friday, 30 September, 2016, 2:13pm

The Bank of Japan shocked the market with its aggressive bond-buying programme aimed at achieving 2 per cent inflation in two years.

Inflation generally lags behind a loose monetary policy by one to two years. With a declining population and labour force, and a median working age of 45 and rising, the lag will be even longer in Japan.

But if the central bank is anxious to see results soon, as it appears to be, and keeps escalating its "quantitative easing", it may cause panic among Japanese financial institutions and savers. When that happens, the yen's value will collapse, like the Russian ruble did in 1998.

This is what foreign speculators are waiting for. They will close their short positions, buying yen at very low levels. If Japan goes down that path, it will be taken to the cleaners by the speculators.

As I have argued before, yen depreciation is necessary to solve Japan's deflation. Over a five-year time frame, the yen could reach 150 against the dollar.

This forecast is based on Japan's deteriorating trade account, which in turn reflects its declining competitiveness. When the yen's value is in line with Japan's competitiveness, its deflation will end. In such a framework, the yen's decline would be gradual.

The Abe government has a different goal. It wants to revive Japan's economy through monetary policy, taking a leaf from the US Federal Reserve's book. The desire to end deflation should be interpreted in that context - it would lead Japan to catastrophe.

Monetary policy won't revive Japan's economy. A rapidly ageing population that is at the same time declining in total numbers means that Japan cannot grow by making more of the same. New growth can come only from innovation, not monetary stimulus. Ending deflation could be helpful, but it cannot be the entirety of the government's plan. An expanding money supply leads to inflation through three routes: a supply shortage, imports or expectations. With a declining population, the first method doesn't work.

To create inflation through imports, Japan must continuously depreciate its currency. Taking into account the share of imports in Japanese consumption, it may take a 10 per cent annual deprecation of the yen for the country to end deflation. To achieve a 2 per cent inflation rate, the amount would be even bigger.

Lastly, changing expectations is a dangerous game because the consequences are unpredictable. Japan has had a strong home bias in its savings deployment. It was the main reason for its deflation. A rising trade deficit is likely to offset this bias. In fact, Japan's deflation is already on its way to being solved without the extra policy push.

However, the BOJ seems to be in "shock and awe" mode. It wants to see a quick and large devaluation to stimulate the economy. Unfortunately, if it works, Japanese people will lose out, big time, to the speculators.

The Japanese people are very slow in changing expectations. The yen's movements so far reflect international speculators' escalating short positions in anticipation of Japanese panic. The BOJ's dance with international speculators may appear beneficial in the short term, but the result could be catastrophic for Japanese people.

Japan has been poorly led. Mediocre leaders have dominated the economy and politics; the current crop are no exception.

They may appear decisive but in reality they may not know what they are doing. The BOJ is aping the Fed without understanding the differences between Japan and the US.

A long-stagnant society tends to go into a crisis when it tries to reform. Maybe a collapsing yen and the resulting hyperinflation would push Japanese society to wipe away the establishment and find new leadership. The price to pay would, unfortunately, be horrific. To avert collapse, the BOJ should scale back its aims. Japan should target stable prices rather than 2 per cent inflation. The former doesn't require the BOJ to buy bonds so aggressively. In turn, the yen's decline would be gradual. It is the best scenario for Japan and the world.

Japan's erratic and haphazard policy casts a long shadow on its neighbours. If the dollar-yen level shoots up to 150 quickly, a repeat of the 1997-98 crisis is inevitable. The American quantitative easing since 2008 has already inflated prices in the region, with property value doubling in dollar terms.

The yen's devaluation will be a huge deflationary shock to an overheating region. A rapid cooling could be more than the region could take.

This would in turn hit the Japanese economy, whose exports depend on the region. The vicious cycle will have unintended political consequences, which could unsettle the region and the world for a long time to come.

Japan rarely changes. When it does, it tends to go to extremes. Each time, this had had disastrous consequences for East Asia. Let's pray that this time it won't.

Andy Xie is an independent economist