Japan’s monetary gamble


Japan matters because it is the world's third largest economy, but one in relative decline for two decades. National output, in cash terms, is no higher today than twenty years ago. The country has been weakened by deflation and choked by rising debt. For its new government, and prime minister Shinzo Abe, the Japanese economy has long needed a miracle cure to ensure a sustained recovery. Mr Abe has acted to provide it by boosting spending. Now the Bank of Japan - the country's central bank - has complemented his efforts by aggressively easing monetary policy. This is a policy gamble that Japan has long resisted. But, given the depressed state of the economy, its government and central bank had little option.

The aim of the Bank of Japan's governor, Haruhiko Kuroda, is "to banish the scourge of deflation" - where falling prices have depressed investment, consumer spending, and growth. Mr Kuroda's monetary easing is designed to achieve two per cent inflation in two years, by doubling the amount of money in circulation. This, he hopes, will change inflation expectations, encourage businesses to invest and consumers to save less and spend more. Up to now, incremental change in monetary policy has failed to make any difference. So this policy shift by the Bank of Japan - often seen as the world's most cautious central bank - to favour a huge money-printing exercise marks an historic change of approach. The European Central Bank took some five years to achieve a near doubling of its balance sheet. Now Japan's central bank aims to do that in two years.

The risks involved in Japan's monetary easing exercise should not be underestimated. Inflation expectations once reversed may be hard to control and to contain. Japanese savers, having seen the yen decline sharply against the dollar - by 20 per cent in recent months - may switch their savings overseas, and make it harder for Japan to finance its large budget deficit. While Japan's efforts to weaken its currency further, and thereby provide its exporters with a competitive advantage, may precipitate a global currency crisis, if other countries respond in a similar fashion.

Japan's aggressive attempt to stimulate its economy, by fiscal and monetary measures is now in marked contrast to the status quo stance adopted by the ECB. Despite a deteriorating economic background, the ECB last week again failed to lower interest rates, although its president, Mario Draghi, hinted it may do so shortly. Nevertheless, ECB interest rates are still higher than those in Japan, the US, or the UK. Euro area unemployment - at 12 per cent - stands at a record high, economic growth is contracting and inflation has dropped below the 2 per cent target rate that the bank has set. In such circumstances the ECB's excessive caution on an interest rate cut is hard to justify.