Japan May Regret Starting A Difficult Inflation Fire
Japanese policymakers might learn the hard way that one must be very careful about what you wish for. Having engaged in the most unorthodox monetary policy experiments to engender some inflation into the Japanese economy, they might find it difficult to get the inflation genie back into the bottle once the inflation process has been restarted. Indeed, as markets become increasingly alert to the very real risk of long-run monetary financing of Japan's highly compromised public finances, there might be no turning back on the road to high Japanese inflation.
Since taking office last Christmas, Shinzo Abe, Japan's new prime minister, has vowed to do whatever it takes to extricate the Japanese economy from the chronic deflation from which it has long suffered. To that end, he has pledged to increase Japanese inflation to 2 percent within the next two years, and he has shaken up the leadership of the Bank of Japan to ensure that Japanese monetary policy is pursued in a manner consistent with that inflation goal. At the same time, despite the truly appalling state of Japan's public finances, Mr. Abe's government is engaging in a short-run Keynesian-style fiscal stimulus with the aim of reviving flagging consumer and investment demand.
The centerpiece of Japan's efforts to revive inflation is the Bank of Japan's pledge to print money on a scale that makes similar efforts in the United States and the United Kingdom pale. Over the next two years, the Bank of Japan proposes to increase the size of its balance sheet by a staggering US $1.4 trillion. It will do so through the purchase of Japanese government bonds and other financial instruments at the rate of around US $70 billion a month. These purchases are expected to almost double the size of the Bank of Japan's balance sheet from 35 percent of GDP at present to over 60 percent of GDP by the end of 2014.
As was to be expected, the prospect of massive Japanese money printing has sent the Japanese yen reeling. Over the past five months, the Japanese yen has lost as much as 25 percent of its value as measured against both the US dollar and the Euro. This large move in the yen has provoked charges by the Chinese government that Japan is engaging in a currency war that deliberately aims at cheapening its currency to boost its exports at the expense of its neighbors. However, at the recent IMF Spring Meetings, the move in the Japanese yen was accepted by Japan's main industrialized country partners as part of Japan's effort to boost inflation. This gives Japan the green light for further rounds of yen weakness.
A real risk to Japan's unprecedented monetary policy experiment is that it is being conducted in the context of highly compromised public finances. A measure of how compromised are those finances is the fact that Japan's gross public debt now stands at 240 percent of GDP or around 2 ½ times the equivalent US ratio. Similarly disturbing is the fact that Japan's budget deficit, excluding interest payments, remains at around 7 percent of GDP. This makes it all too likely that Japan's public debt ratio will continue to deteriorate at a rapid rate.
In the past, Japan has managed to finance its large budget deficits through a very high domestic savings rate. However, those days are long behind it as suggested by the sharp decline in recent years in Japanese household savings as its population rapidly ages. Among the industrialized countries Japan's population is now aging at the fastest pace. This holds out the prospect of a sustained further decline in the Japanese savings rate as an aging Japanese public runs down its savings to finance its retirement.
A basic question that should be keeping Japanese policymakers awake at night is who will be buying the Japanese government bonds that will be needed both to finance Japan's large budget deficit and to roll over the very large amount of government debt that will be falling due over the next few years. In the context of extraordinarily low long-term government interest rates, a plummeting currency, and rising domestic inflation, one can hardly expect foreigners to step in to replace Japan's aging population as a major buyer of Japanese bonds. This raises the specter of the Bank of Japan being forced to continue buying enormous quantities of Japanese government bonds to prevent a rise in Japanese government borrowing rates that would only make the Japanese public finances even more unsustainable than they are at present.