Another False Start
The Bank of Japan is standing in the way of reform.

Mr. Malpass is the Chief International Economist for Bear Stearns.
February 19, 2002, 7:30 a.m.

apan's latest policy talk — there have been open discussions of ways to stop the country's deflation — and the Bush administration's new economic advice to Japan are not enough to help Japan stop its deflation or start growing.

Of course, Japan could stop its deflation almost overnight by adopting a price-rule monetary policy. But the Bank of Japan is standing in the way of any such reform.

In recent days, several important officials have commented on Japan's monetary policy:
A week ago, Finance Minister Masajuro Shiokawa said the central bank should increase its monthly purchases of bonds (a way to inject yen liquidity). A day later, the Bank of Japan decided not to make any changes.

On February 12, Glenn Hubbard, the head of the Bush administration's Council of Economic Advisors, said "there's no way Japan can export itself out of its problems without fixing non-performing assets and changing monetary policy." Yet after a February 13 meeting of Japanese economic officials, Bank of Japan Governor Masaru Hayami said that some had urged the central bank to inject more liquidity, but "I told them we're doing the most we can do at this point."

It's clear that structural issues, non-performing bank loans, weak leadership, the fiscal deficit, and the size of Japan's national debt are not to blamed for the country's ongoing economic crisis. That blame can rest squarely on the shoulders of the central bank and its deflationary bias.

And that's a shame. Remember, Japan's economy — despite its recent shrinkage — is still the world's second biggest, with a substantial size advantage over Germany. And the prospect of a growing Japanese economy would buoy equity markets elsewhere.

The near-term market issue is whether Japan will actually move to a new monetary policy. But Japan has a clear history of false starts regarding improvements in this area. Like clockwork, Japan will give the impression of constructive monetary policy changes, and then promptly reinstall a deflationary policy. For example:

In March 1999, the Bank of Japan injected overnight liquidity, cut the interest rate fractionally, and allowed a public discussion of a shift from interest-rate targeting to quantitative targeting. Then it reversed the impact.

In March 2001, the BOJ finally shifted to a quantitative target, but set a deflationary level of liquidity injections and left it unchanged for five months.

In September 2001, Japan injected liquidity through the end of the month, then promptly removed it in October.

To grow, Japan has to break deflation expectations without raising inflation fears. This is not as hard as it sounds. Economic history is full of examples of smooth, pro-growth transitions from price-level instability to price-level stability.

The key steps are for the central bank to: 1) admit to a deflation problem; 2) take primary responsibility for it; and 3) commit to preventing future deflation and inflation by adjusting liquidity to provide yen stability.

The BOJ's Hayami does get it right when he points out that Japan is already awash in liquidity. But this liquidity would allow the country's economy to grow fast if the central bank committed to a new course and broke the deflation expectations.

But the pattern says the Bank of Japan won't embrace any real change for the better.