Audio Debate On Japan’s Inflation, Interest Rates, and Low Growth
You Can Lead a Horse To Water...
This audio (URL at the bottom) presents a debate sponsored by Econvue between John Greenwood and myself on why Japan’s interest rates have been so low for so long and why deflation and low inflation have been so persistent. Greenwood’s view is classic monetarism: that inflation is always a function of growth in the money supply, that a central bank can expand the money supply, and thus inflation, as much as it wants to. If the Bank of Japan has not achieved its target, that’s only because it has not created enough money. Hence, while virtually zero interest rates for a quarter century make it look as if the Bank of Japan’s (BOJ) monetary policy is loose, it is actually tight.
Why Central Banks Abandoned Money Supply Targeting
I thoroughly disagree with his stance and do central banks. To my knowledge, there is not a single major central bank that any longer makes money supply its operational target. That’s because it no longer works. As explained in an IMF piece, “Many central banks [used to target] the growth of money supply to control inflation. This approach works if the central bank can control the money supply reasonably well and if money growth is stably related to inflation over time [emphasis added—rk]. Ultimately, monetary targeting had limited success because the demand for money became unstable—often because of innovations in the financial markets.” The US abandoned money supply targeting three decades ago. As the New York Times reported, “Alan Greenspan, the central bank's chairman, said the Federal Reserve would stop relying on growth in the money supply—its traditional tool—and begin relying on interest rates...In an appearance before the Senate Banking Committee today, Mr. Greenspan said the central bank was jettisoning the money supply approach because changes in the way Americans invest their money meant it could no longer predict how much economic growth would be produced by a certain amount of growth in the money supply. ‘The relationship has completely broken down,’ Mr. Greenspan said.”
Even Milton Friedman, who once declaimed, “Monetary policy is not about interest rates; it is about the growth of the quantity of money,” publicly acknowledged the failure of his most famous doctrine a few years before his death in 2006. Friedman admitted, “The use of quantity of money as a target has not been a success…I’m not sure I would as of today push it as hard as I once did.”
Why The Linkage Broke Down In Japan
In Japan, the linkage between money growth and inflation seemed to work in textbook fashion up until the mid-1990s. Then, as the charts here show, it broke down. This is one of the main reasons the BOJ has had trouble creating sustainable inflation and has felt the need to keep interest rates at near zero for more than a quarter century.
Greenwood assumes a central bank can hike the money supply as much as it wants and that money supply growth will create the inflation and nominal GDP growth it seeks. That’s not correct. Money supply refers to bank reserves and deposits in the banks by companies and consumers. While we call it money supply, we could just as accurately call it money demand. Just as automakers cannot sell 10 million cars for $30,000 each if consumers don’t wish to buy that many at that price, the same is true of the money supply. No central bank can cause the money supply to grow, say 5% per year, if consumers and companies are not borrowing from the banks, spending the money on various goods and services, and making deposits. Moreover, even if the money supply does grow, its impact on nominal GDP (real GDP plus inflation) also depends on consumer and company behavior. Demand for goods and services is low in Japan and that’s caused by problems that no amount of money-creation by the BOJ can overcome. Yes, a correct monetary policy is necessary, but it’s not sufficient.
A look at how monetary policy works will make it clear why Japan’s circumstances made BOJ actions less potent. A central bank buys securities, like Japan Government Bonds (JGBs) from banks or other holders. The cash this injects into the financial system is called the “monetary base.” But if that cash just stays in the banks, little happens to the money supply. It is the process of borrowing, spending, and new bank deposits by companies and consumers that multiplies the monetary base into the broader money supply and then into growth in nominal GDP. Before 1997, for each yen of growth in the monetary base, the money supply grew approximately 10 yen and so did nominal GDP.
Because of slack real demand in Japan, that relationship broke down around 1997 and did so more severely than in other rich countries. Before 1997, the monetary base, money supply, and nominal GDP all grew in proportion. But then the linkage collapsed. Since 1997, the BOJ has multiplied the monetary base 13-fold. Yet, the money supply increased just 2.25 times. And nominal GDP barely grew at all.
The chart at the top of this post gives a closeup of the delinkage between money supply and GDP. And the chart below adds the monetary base to the picture.
Bear with me for one more technical point. The money supply includes both the monetary base and all the deposits made by companies and consumers as they buy and sell goods and services. But, if we just look at the latter and exclude the monetary base, we find that the entire rest of the money supply has actually decreased since BOJ Governor Haruhiko Kuroda began his “big bazooka” in 2013. And that’s that reflects a decrease in business and household demand for money. As the expression goes, you can lead a horse to water, but you cannot make it drink.
Weak demand, not poor monetary policy, is also why interest rates have been near zero for more than a quarter century. If neither businesses nor consumers want or need to borrow to invest in more plants and equipment, or in buying homes, cars, and appliances, then demand for credit will be less than the available supply of savings. As a result, interest rates will fall to the floor. Today, more than a third of all loans charge less than 0.5% interest, and about 16% charge less than 0.25%! One wonders if that’s even enough to pay the cost of tracking these transactions. So, the real question is why the demand for goods and services has been so weak for so long.
Why Aggregate Demand Is So Low
Median real (i.e. price-adjusted) household income has been falling since the mid-1990s due to wage austerity, hikes in the consumption tax, and cuts in social security (see chart below). As a result, consumer spending today is no higher today than it was in 2014 before the first of the two consumption tax hikes in the past decade. And that was true in 2019, even before Covid hit.
With consumer spending so lax and Japan less competitive on the export market, companies feel no need to expand their capacity (factories, offices, stores, equipment, etc.) no matter how low the interest rate. Real capacity today is only 7% higher than it was in the year 2000. As detailed in a recent blog, corporations are raking in cash equal to 15% of GDP, but are investing only 8% of GDP. Instead of investing, companies have used their profits to buy securities, like government bonds, which lie fallow. Why would a car company expand capacity in Japan when domestic sales are falling and they are increasingly meeting overseas markets via overseas factories rather than exports?
Slack real demand is not a problem that creating money alone can solve. This is when well-designed fiscal stimulus is needed, for example, tax cuts for households, public works to aid decarbonization, etc. And this is when various structural reforms are needed to reverse the last three decades where Tokyo shifted money from households to companies. Kishida has said the latter is what his “new capitalism” is all about, and we’ll have to wait until year’s end to see whether his concrete proposals match his lofty goals.
To hear the exchange between Greenwood and myself, click on: