sign in sign up
<<
Home , Central bank, Economic recovery, Financial crisis, Fiscal policy, Monetary policy, Net (economics)

Overcoming and Moving Forward

Yoshio Okubo Vice-Chairman, Japan Securities Dealers Association (JSDA)

ive years have passed since the global financial monetary , as part of the three-pronged ap- , but the of deflation is still present proach of “”, an strate- Fin the global . Japan’s recent signs of gy of the new government headed by Prime Minis- and improved senti- ter Shinzo Abe. This three-pronged policy consists ments provide an excellent opportunity to recon- of bold monetary easing, flexible , and sider the challenges of overcoming deflationary a growth strategy to promote private . expectations. This article argues that overcoming entrenched deflationary expectations rests pri- Markets have so far responded favorably to this marily on and that its success new policy initiative. The Nikkei 225 mar- will depend on credible fiscal to reduce ket rose by 38 percent in the first six months public deficits. The overall -term policy goal since Prime Minister Abe took office. The develop- is to encourage and foster inno- ments in markets have helped ease de- vation, which proves difficult under a deflationary flationary pressures caused earlier by larger scale environment. Such policies should be supported monetary easing in the U.S. and . The opti- by a regulatory framework that can ensure fair and mism in Japan’s stock markets has also been helped transparent functioning of markets, there- by the buoyancy of U.S. stock markets, where in- by enabling efficient pricing of in allocating vestors have become more sanguine about the re- scarce risk-taking capital. covery of the U.S. economy. There are now more signs that the recovery in Japan is gaining momen- Bold Monetary Policy tum, gradually spreading the optimism that the prolonged period of deflation will be finally over Monetary policy in major countries has played a in the near future. predominant role in responding to the global fi- nancial crisis. In the wake of the failures of many Lingering Nervousness large financial institutions, major central provided liquidity to the financial systems under In Japan, given the prolonged and entrenched de- unprecedented stress. They also assumed a deci- flationary expectations, it is not easy to completely sive role in macroeconomic management, resort- reverse such expectations. Nervousness and skep- ing to nontraditional policies both in terms of in- ticism still remain about “Abenomics” and these struments used and in terms of the scale in which new policies in the mind of some critics. These they implemented them. feelings seem to have been heightened by the recent in the stock and currency markets, which The of Japan (BoJ) had pursued a strategy, have been driven primarily by the concern that now being followed by other major central banks the program of large-scale purchases in the after the crisis, centered on very low rates U.S. will be tapered off much earlier than had been and (QE). With an aim of dis- expected. This nervousness has spread around the pelling prolonged deflationary expectations, the world, but it has been most pronounced in Japan, BoJ recently embarked on a significantly bolder where it is thought that a rise in long-term interest

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 55 rates would have an adverse impact on the health interest rates above 2 percent from the current level of the banks that have been the major holders of of slightly below 1 percent. The key to the success government bonds. With the level of outstanding of a bold monetary policy lies in ensuring the sta- government extremely high, there are also bility of long-term real interest rates, and will de- worries that the impact on the government’s bor- pend crucially on the ability of the government to rowing costs might further enlarge fiscal deficit. set its deficits on a sustainable path toward reduc- This concern seems to be amplified by the signs tion. If the ability of the government to ensure the of a stronger recovery that may edge long-term sustainability of debt were to be seen as fragile, the interest rates, adversely affecting a long-term re- perceived risk of the premature increase in interest covery prematurely. rates would be heightened, jeopardizing the favor- able impact of the bold monetary policy to sustain While are inherent in markets, the and support real economic activity. The effective- nervousness in the Japanese markets may be exag- ness of the bold monetary policy therefore cannot gerated for several reasons. Compared with other be separated from the credibility of fiscal policy in countries, the level of long-term interest rates is controlling deficits over the medium term. In this still the lowest in Japan. At the same time, the stock environment, the “exit” policy of the central banks and bond markets are in the process of digesting will not be an easy road back to the normal conduct the policy changes and it will take some time for of monetary policy, but will involve pressing the a new steady- to emerge. No signs have yet government to proceed with fiscal . emerged that would encourage inflationary ex- pectations to rise. In fact, an interesting analysis Preventing Deflation by the IMF’s World Economic Outlook1 argues that over the past decade or so, in advanced Following the global , prevent- has become less responsive to changes ing deflation has become a main policy agenda in economic slack and that long-term inflation in many countries. The bold monetary policies expectations have become more firmly anchored. pursued by major central banks reflect the sense This suggests that ongoing monetary policy ac- of urgency with which they aim to prevent defla- commodation is unlikely to have significant infla- tion and a return to , having in mind the tionary consequences as long as inflation expecta- prolonged deflation which has persisted after the tions remain anchored. This analysis is particularly bubble burst in Japan. Five years after the crisis, valid for Japan, where deflationary expectations however, the fight against deflation and recession are deeply entrenched. In addition, while the po- is not yet over in many countries. tential impact of the rise in long-term interest rates may have an adverse impact on the profitability of Deflation can be very dangerous. It threatens the banks, it is believed that the effect would be limit- stability of the economy and the society in the ed. In fact, encouraging banks to increase lending long-run. Deflation makes firms and in order to support investment by borrowers, and excessively risk-averse, due to the of discouraging them from sitting on held by households and firms. Inability to in government bonds, is an important part of the lower real interest rates toward zero hampers overall economic policy strategy. monetary policy. Households and firms who have outstanding debt suffer from the real increase in Obviously, it is premature to prescribe an “exit” the debt burden. With the prospect of decreasing from the unconventional monetary policy in Japan. , consumption is postponed and Deflationary expectations will have to be dispelled businesses become cautious in making investment and replaced by expectations of “ stability”, decisions given the perceived high real interest defined as an inflation rate of 2 percent. This pro- rate. Business sentiment is also adversely affected cess will certainly entail a rise in nominal long-term by greater uncertainties about the future of the

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 56 economy and the undervaluation of the market safety should not be underestimated. In the capitalization of firms in the . Risk- immediate aftermath of the financial crisis, pri- taking activities, necessary for innovation, are gen- vate sector net spiked as households and erally suppressed and the economy starts shrink- firms cut investment, and households saved more, ing, depriving the youth of job opportunities and resulting in a huge increase in budget deficit. on-the-job learning—an impact that could last a fell sharply while expenditures adjusted generation. Investments are likely to shift abroad slowly, serving as an automatic stabilizer in the due to high real exchange rates, further depriving economy. Fiscal policies have also been used more job opportunities at home. proactively to fight deflation and reduce unem- ployment. Expenditures on the social safety net When deflation is mild, however, such danger may have helped alleviate the burden that falls on the not be fully recognized by political leaders or by socially vulnerable, including the young and the the public. The danger of prolonged mild deflation unemployed. Fiscal expenditures on infrastructure is likely to be underestimated and fighting defla- projects helped upgrade the quality of public ser- tion might not gain policy priority. In fact, there vices, which may have been needed regardless of are some segments of society, such as pensioners, the economic situation. who may benefit from prolonged mild deflation. The public begins to accept a zero increase or mild Overall, however, the effects of fiscal policy on decrease in the consumer price index as price reversing deflationary expectations seem to have stability, not recognizing the real dangers. Defla- been limited. The ballooning deficits have raised tionary expectations become entrenched, leaving concerns about debt sustainability, and eventually the long-term real at a high level and eroded confidence in the ability of government to slowly depriving the economy of entrepreneur- sustain the level of public services and social safety ship and the risk-taking that is necessary to move nets including public pensions and medical in- the economy forward. Only when this deflation- surance. These greater uncertainties of the future ary process becomes a visible vicious cycle does its dampen household consumption and depress busi- danger become recognizable. ness sentiment. In the , the situation is more complicated and room for fiscal policy is lim- Exploring Policy Options ited. The withdrawal of fiscal is being re- quired in countries with financial difficulties in- or Debates will continue on the effectiveness of vari- der to steadily restore fiscal sustainability. In addi- ous policy options in preventing and overcoming tion, the use of fiscal policies is further constrained deflation. The assessment will not be easy as there by the level of real interest rates, which may have have been varying degrees of clarity of policy in- external effects on the economy. In an open econ- tentions, and in the strength of their implemen- omy, the effects of fiscal policies might spill over tation. In the absence of clear positive results of abroad through the appreciation of exchange rates. policies, the public may become impatient in the process, triggering political changes and bring- In summary, fiscal policies may have proven effec- ing about policy reversals which can exacerbate tive in the run, particularly in supporting the . In many cases, various policies are economy and maintaining the social safety net, but mobilized simultaneously and the outcome is the not in overcoming deflationary expectations in the product of all, influenced simultaneously by exter- long-run. nal developments. Under these circumstances, monetary policies Several points seem worth noting, especially in naturally assumed a predominant role in fight- light of Japan’s experiences so far. The role of fiscal ing deflation, as discussed above. There have been policy in supporting the economy and the social a series of debates on how much of the deflation

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 57 is a monetary phenomenon. Certainly, there are aimed at establishing a sustainable fiscal structure non-monetary factors—such as demographic fac- and at ensuring the credibility of fiscal manage- tors, technological changes and intensified inter- ment. The BoJ also made it clear that its purchases national cooperation—that exert downward pres- of government bonds would be carried out solely sure on the general . Nevertheless, it has to achieve the target and not in any also been clearly recognized that monetary policy way to finance the fiscal deficit. has a crucial role to play in reversing deflationary expectations. Finally, central banks need to overcome ideologi- cal hurdles in pursuing unconventional policies. The BoJ has been taking a bold approach. Since No central would want to be seen as com- the spring of 2013, it has replaced the gradual and promising its independence, and many of them incremental approach with a bold one in pursuing are naturally hesitant about embarking on non- the explicit inflation target of 2 percent. In April, it orthodox policies, particularly on QE through announced that the and the central aggressive purchases of government bonds. There bank’s outstanding amount of Japanese govern- are “hawks” that would be willing to criticize any ment bonds and ETF holdings would be doubled departure from the orthodoxy within and outside in two years, with the average remaining maturity their circle. These hawks can be politically strong in of the bank’s bond purchases extended to more many countries, particularly where the memories than twice as long. of high inflation or excessive bubbles are still fresh. In the case of eurozone countries, the The challenges facing central banks in fighting orthodox philosophy seems to be combined with deflation are enormous. First, short-term interest the fear that such policies may eventually lead to rates are close to zero and do not effectively serve countries with strong fiscal discipline bailing out as operating targets. Even if there is room for cut- countries with less fiscal discipline. This heightens ting interest rates, the effect on the cost of new fi- the challenges for the European in nancing would not be as large when households carrying out bond purchasing policies, as neces- and firms are cutting the existing debt by active de- sary. Ultimately, many central banks will have to leveraging. The operating method therefore needs navigate through rough waters of skepticism and to depend on unconventional policies, including criticism. QE, with the monetary base serving as the operat- ing target. Fostering Business Investment and Second, monetary and fiscal policy become closely Innovation intertwined in a deflationary environment. In such an environment, household and corporate sectors Overcoming deflation means bringing the econ- tend to record surpluses while the government omy back to a steady path of growth, based on sector runs deficits. The QE approach can be tak- private sector consumption and investment par- en by the central bank confidently only if it has a ticularly on robust business investment, embrac- reasonable basis to judge that its independence is ing entrepreneurship and fostering innovation. respected and that its actions are in no way inter- Business investment requires mobilizing scarce preted as monetizing fiscal deficits. The credibility risk-taking capital of private sector investors. The of a medium-term fiscal consolidation program is role of capital markets is to mobilize such scarce therefore a prerequisite to bold QE, as discussed capital and allocate it to innovative firms and proj- above. In the case of the BoJ, its policy decision ects. For capital markets to function effectively was made possible by a joint statement with the there should be sufficient risk-taking capital and a Japanese government, in which the government willingness to utilize it, with the depth and liquid- stated that it would steadily promote measures ity of the markets, supported by robust institutions

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 58 and practices, allowing efficient and fair pricing of The situation differs in other countries, particular- risks and returns. ly in Europe. Many banks have been struggling to raise capital to meet stricter capital requirements, Deflation erodes the core function of capital mar- limiting their ability to provide financing on risky kets in several ways. In a deflationary environ- investments. In the wake of the global financial ment, the totality of risk-taking capital becomes crisis, hostility toward financial institutions has smaller as excessive becomes a ratio- naturally grown stronger, due to the excessive risk- nal behavior. When prices are generally expected taking behaviors or inappropriate conduct prior to decline, risk premiums become larger to the crisis. Such hostility is especially strong in with the rise in the and the proba- countries where large financial institutions were bility of becomes higher. Most importantly, bailed out with public funds. The purpose of the fi- the general lackluster stock market performance, a nancial reforms initiated by G-20 coun- measure of general recognition of these risks in the tries is to prevent financial institutions from taking economy, and the undervaluation of the capitaliza- excessive risks that could jeopardize the stability of tion of listed reduce the confidence of the system and to ensure their soundness. While business leaders, who become excessively risk- it is important to reform the to averse and hesitant to take forward-looking deci- prevent future crises by preventing excessive risk- sions on investment. taking by individual financial institutions—partic- ularly by systemically important financial institu- Bold monetary policy through QE has therefore tions, it is also important to distinguish risk-taking had a favorable impact on the ability of capital by individual institutions with the risk-taking ac- markets to play a significant role in creating an tivities in capital markets within the economy as a environment for reviving business investment. In whole. this regard, setting a clear inflation target, typically 2 percent, is particularly helpful in reversing de- The reforms to prevent excessive risk-taking by flationary expectations and embracing adequate financial institutions should be accompanied by risk-taking in a . efforts to strengthen the role of capital markets to allow risk-taking capital to be allocated to invest- The faster recovery of the U.S. economy, both in ment, stimulating innovation and growth. The terms of international comparison and in terms of appetite of investors to take measured risk and historical experiences, is due in no small part to endorse entrepreneurship is not unlimited in any the monetary policy strategy of preventing defla- circumstance, but it is particularly limited in the tionary expectations and ensuring vibrancy of its wake of financial crises. Strengthening investor capital markets. Thanks to bold monetary policy, protection and ensuring integrity and transparency the deflationary impact was contained, with no in financial markets is the only way to preserve the significant decline in general price levels. The re- depth and liquidity of capital markets, enable effi- forms to improve the function of capital markets cient pricing of risks and foster entrepreneurship. have been pursued largely independently from the reforms made to strengthen capital requirements For capital markets to function efficiently, a robust of financial institutions while preserving the regulatory framework must be in place to ensure depth and liquidity of capital markets. The exis- fairness, integrity, and transparency. Regulating tence of a broad range of risk-taking investors and capital markets is a complex exercise. It involves entrepreneurs has also helped to keep the market not only supervising financial institutions ac- working well. Had the financial intermediation cording to their changing risk profiles, but also been predominantly based on banks, it would monitoring their conduct and behavior to pro- have taken much longer for the U.S. economy to tect investors. It is important to work with many start its recovery. governmental and non-governmental institutions,

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 59 including judiciary authorities, exchanges, clear- They include implementing internationally-agreed ing houses, self-regulatory organizations and other regulatory codes and standards, as well as address- stakeholders. It requires the collaboration of a va- ing other emerging issues related to new trading riety of stakeholders supported by the rule of law, technologies, increased complexity of financial good market practices and institutions to provide products, and the reliability of financial bench- efficient market infrastructure within individual marks, among others. Addressing these issues re- jurisdictions. In addition, given the rapid integra- quires international cooperation with strong po- tion of financial markets, international harmoni- litical leadership. Going forward, G-20 leaders will zation and consistency in regulatory policies are continue to have a major stake in this process. indispensable. Embracing openness and avoiding nationalism are key to ensuring sufficient liquidity References and depth of the markets. Otherwise, regulatory would take place, making regulation less International Monetary Fund (2013), World , effective for all investors around the world. Washington, D.C.

Financial markets are changing rapidly, with tech- Endnotes nological innovation and international integration 1 See International Monetary Fund (2013), Chapter 3. continuing to pose many new policy challenges.

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 60