On November 15, 2012, Shinzo Abe, then the leader of Liberal Democratic Party (LDP), announced his request to the Bank Of Japan to create a moderate inflation of 2-3%. The market reacted immediately since many thought the LDP would win the general election, which would make Abe the next prime minister. The interest rate of ten-year government bonds began to decline and the inflation expectation to surge slowly. By the beginning of March, the Nikkei exchange reached over 12,000 yen (41% increase from the day prior to Mr. Abe’s public request) and the value of yen reached over 95 (15.5% increase). After the appointment of Haruhiko Kuroda as the new chairman of the Central Bank, the Nikkei reached above 13,000, and the value of yen is about to surpass 100 yen per dollar.
Does this mean that Japan has finally woken up from her more-than-fifteen-year economic drowsiness (officially the Japanese economy has been in a state of deflation since July 1998)? Japan is said to have never truly recovered from the outcome of the bubble-burst in the late eighties and the subsequent recession. There were occasional moments of recovery, but they were short-lived and often disappointing. Especially after the Lehman shock on September 15, 2008, the Japanese economy, in spite of her indirect involvement in it, suffered great deflation and economic downturn more than other countries that were directly involved.
The U.S., for example, has recovered to the economic strength that is prior to the recession. By 2011, the level of the U.S. real GDP surpassed that of 2008. Europe, though it struggles due to the Euro-crisis, was doing much better than Japan by 2011. Along with Britain and Italy, Japan’s real GDP did not come back to the level of pre-2008.
Of course, Japan has suffered the horrible earthquake in 2011, which might have played some role in escalating deflation and economic downturn. But regarding financial reactions to the recession, there was a significant difference between Japan on the one hand and the U.S. and Europe on the other. The U.S. Federal Reserve, for example, poured so much money into the market to maintain the cash flow. The Bank of Japan executed some monetary policies, but they were limited in scope. While the U.S. monetary base increased by threefold, the U.K. by fourfold, and Japan only by one-and-half-fold.
Largely due to the monetary policy of other developed nations, Japanese yen begun to surge rapidly. Even putting aside complex economic theories like the Mundell-Fleming model, the general rule of currency exchange is supply and demand, as in many other economic activities. The value of the yen rose simply because there was so much more dollar and euro, and not enough yen in the market.
Due to the historic surge of the value of yen, many export-based Japanese companies began to struggle. Though the Japanese economy on paper is not dominated by export industry (less than 20%), many medium and small size companies are part of the supply chain for large corporations. So the influence of exchange rate is far from minimal.
The BOJ has been passive in its monetary policy. The high officials of the BOJ accepted the deflation model for the Japanese economy. They were even reluctant to endorse 1% inflation target (they refused to call it a “target”). As a result, deflation continued, and economic recovery was postponed.
The catalyst and brain behind Abe’s aggressive monetary and financial policies is the not-too-orthodox economic school called “Reflationist.” The school argues that economic recovery from the current recession is only possible through a moderate inflation purposely created via a series of monetary policies. Since there is a deflation gap (a gap between potential GDP and real GDP), the demand must be stimulated. In order to do so, the Reflationists like Prof. Koichi Hamada of Yale University argue that the central bank needs to aggressively purchase long-term bonds and other high-risk financial commodities. This would result in an increase of monetary base in the market. Mr. Kikuo Iwata who has been appointed as a vice-chairman of the central bank is one of the major figures in the Reflationist school.
Whether the strategy of Prime-minister Abe and the Reflationists succeeds to completely wake up the Japanese economy is a question that awaits its answer. I shall deal with a few of the critics of Abe and Reflationists’ monetary policy in the next editorial.