SYNOPSIS: The only remaining course for Japan is being ignored
Call it the Japan effect. I've seen it many times in the past five years: a Western analyst goes to Japan with an optimistic outlook, expecting to see light at the end of the tunnel for the world's second largest economy - and returns more despondent than ever. Now it has happened to me.
The basics of the situation have been familiar for years. In Japan, the classic liquidity trap is back with a vengeance: even at a zero short-term interest rate the supply of private savings exceeds the sum of domestic investment demand and the current account surplus. The result is an economy whose actual output lags ever further behind its productive capacity; the sharp drop in GDP last year has probably pushed the output gap into double digits.
It is true that for the moment the plunge has been slowed, that in 1999 the economy may even grow for a quarter or two. But this is not much of a payoff from the largest peacetime fiscal stimulus in history. The story of Japanese macroeconomics in the 90s is that of the pump that refused to be primed: of ever-growing budget deficits that stave off collapse but do not generate self-sustaining recovery. The difference this time is that the deficits are larger than ever, and so is the government's burgeoning debt; the sheer logic of solvency says that the stimulus cannot be made any larger, and indeed must surely shrink.
A few months ago it seemed as if the force of that logic, and the clear and present danger of a self-reinforcing deflationary spiral, had finally concentrated the minds of Japanese officials. There was a whiff of radical change in the air - or so it seemed from the other side of the Pacific. But to visit Japan, and to talk with those who would have to lead such change, is to be disillusioned all over again.
Broadly speaking, influential Japanese seem to fall into two groups. There are still many who do not understand how close the economy is to the edge. They point to the signs that output is leveling off; they suggest that a few twists in the tax code would lead to new investment here and there; and they argue that three or four years from now corporate restructuring will restore profitability, so where is the urgency? (The point that the process of restructuring itself will greatly increase deflationary pressures does not seem to register).
But there are also influential Japanese who do understand the dangers. The depressing thing is that, as far as I can tell, their clear-headedness does not translate into forceful policy conclusions. Instead, what one encounters is a diffident, even fatalistic attitude - an unwillingness to follow the logic of their own analysis, if it implies policies that seem "unsound".
If a zero short-term interest rate is not enough to generate an economic recovery, and if deficit spending has reached its limits, then there are only two serious remaining policy options. One is to extend open-market operations to those assets whose prices can still be driven up - most obviously, longer-term bonds and foreign currencies. The other is to try to bootstrap a recovery by convincing savers and investors that the future will bring not deflation but modest inflation, something that can best be accomplished by announcing an explicit inflation target, but could possibly be achieved through a less explicit policy of "quantitative easing" - essentially, producing attention-grabbing increases in the monetary base. In practice such policies are not alternatives but complements: unconventional monetary policy today should be used as the opening salvo of a campaign to convince the private sector that inflation rather than deflation will prevail tomorrow.
Such proposals are the natural implication of utterly orthodox monetary analysis, applied to Japan's unusual plight. If you believe that an economy is in a liquidity trap, and that fiscal policy has reached its limits - both propositions about Japan that are hard to deny - it is hard to avoid the conclusion that in such circumstances to adhere to conventional notions of monetary prudence is to flirt with catastrophe, and that policies that would normally be regarded as irresponsible become not only reasonable but essential.
But although this conclusion is hard to avoid, influential Japanese are still trying. Say to them that the Bank of Japan should announce a minimum inflation target of at least 2 percent, or that there should be a clear commitment to increase the monetary base at an annual rate of at least 15 percent, and you get the feeling that you have proposed an immoral act. In public the BOJ's leadership has adopted a posture that is best described as philosophical, full of skepticism about its ability to do much to turn the economy around. And since monetary policy in a liquidity trap must work mainly through its effect on expectations, such diffidence is not only an abdication of responsibility; it undermines the effectiveness of whatever monetary expansion actually takes place.
The trouble with Japan, in other words, is that while crucial policymakers now understand the nature of their problems, they still lack the intellectual courage to act on that understanding. What that means, I fear, is that things will have to get considerably worse before they get better. The good news is that this can probably be arranged, and sooner than you think.