SYNOPSIS: The world's second-biggest economy is facing a needless slump because of the passivity of its monetary authorities
I have long been pessimistic about Japan's near-term prospects, believing that its economy requires a more aggressive and less conventional stimulus plan than the government has so far been willing to contemplate.
Until now, however, the situation seemed depressing but not alarming, with the main risk being stagnation rather than collapse. Surely, I imagined, so wealthy and sophisticated a nation will always be able and willing to do whatever is necessary to avoid disaster.
But in the past month or so the near-passivity of Japanese authorities in the face of slumping bond prices and a sky-high yen has made me wonder. It is starting to look entirely possible that the managers of the world's second-largest economy will simply stand by, paralyzed by an odd mixture of pride and intellectual confusion, as their nation goes into a deflationary tailspin.
Exactly why the yen has risen by 25 per cent since early October, and the yield on Japanese government bonds risen so sharply, can be disputed. Surely neither reflects a sudden surge of optimism about the future of the Japanese economy. The most likely explanation is that special events - the collapse of Russia, the announcement that some public agencies will not buy as many bonds as expected - started a sort of cascade of margin calls, in which highly indebted holders of both yen and dollar bonds were forced to sell their assets, driving prices down and thereby leading to further margin calls. If true, this story suggests that markets are a lot less liquid and efficient than economists like to believe.
But whatever the reasons for these market moves, their effect is clear: they impose new deflationary pressures on an economy that was already looking dangerously weak. And that means that the case for a radically expansionary monetary policy, always strong, has now become over- whelming.
Eight or nine months ago, when I and others were arguing that Japan should engage in aggressive monetary expansion and even deliberately target a positive rate of inflation, the main objections were that such a policy would be ineffective (although in that case what harm in trying?) and that it would risk an excessive depreciation of the yen. Bet ter, went the conventional view, to rely on fiscal expansion plus bank reform to get the economy moving.
But look at the situation now. If nothing else, the rise in bond yields, the awesome size of prospective deficits, and the realisation by rating agencies that Japan's debt already exceeds its gross domestic product mean that fiscal expansion has reached a limit. If the current push is not enough - and it is not - there will not be another.
The claim that bank recapitalisation will unleash massive new lending has always been a questionable proposition, and looks no more convincing now. Anyway, the contractionary effect of the strong yen and higher interest rates will probably swamp the effects of the government's stimulus plan; and falling bond and dollar prices will wipe out bank capital even as the government tries to put more in. Surely at this point the risks of printing more money are far outweighed by the risks of not doing so.
What is truly puzzling is why Japan's financial authorities have not regarded these market events as a call to action. Why did the Bank of Japan wait until the yen had risen to Y110 to the dollar before intervening, and then do so only on a small scale - rather than buying dollars aggressively months ago? Why hasn't it bought enough Japanese government bonds to keep yields from soaring?
Don't ask where the money would come from: it could and should simply be created. There would be no reason at all to "sterilise" these operations by selling other assets. On the contrary, the situation offers a perfect opportunity to effect a salutary expansion of the monetary base.
One can only guess why none of this is happening. Is Japan's Ministry of Finance so committed to promoting the yen's role as an international currency that it does not care if that currency is backed by an imploding real economy? Does it still fear, after eight years of slump, that expanding the monetary base will reinflate the asset market bubble? Has it developed some novel economic theory under which a strong yen and high interest rates are expansionary?
Whatever the reasons for inaction, the story is starting to look like a tragedy. A great economy, which does not deserve or need to be in a slump at all, is heading for the edge of the cliff - and its drivers refuse to turn the wheel.
Originally published on the Official Paul Krugman Site, 1.20.99