Japan has been put in the stocks by bien-pensant global political opinion. At the head of those throwing rotten fruit at the Japanese government, Bundesbank President and ECB board member Jens Weidmann. He has accused Prime Minister Abe of attacking the independence of the Japanese central bank and politicising the exchange rate, warning darkly of the danger of a round of competitive currency devaluation.
This is wrong on a whole number of counts and says much more about the failure of the ECB to do enough to resuscitate the European economy than it does about the supposed errors of Mr. Abe’s ways.
What has caused this ire? The Bank of Japan has announced that it is doubling its inflation target to 2% with immediate effect and to this end has committed to an open-ended program of monthly asset purchases. Alongside this the government has decided on a(nother) fiscal stimulus programme representing some 2.5% of GDP.
Let’s start with the politics. The first thing to note is that in democracies it is perfectly normal for the government to set the inflation target and leave it to the independent central bank to achieve it. This is the practice in the UK or Sweden, for example. The ECB represents something of an anomaly here, in that it is independent not only in policy terms, but also in setting its own definition of price stability. The second is that by increasing the inflation target to 2% – from a vaguer “goal” of 1% – the Japanese government has now set it very close to the target the ECB has set itself (close to but below 2%) and pretty much exactly at the historical average achieved by the ECB in the euro area during its reign. And the third is that the asset purchase programme is precisely the sort of quantitative easing (QE) that many of the world’s central banks, including the ECB, have implemented in an attempt to relate their economies when interest rates are at or close to zero. It is thus very hard to see, from a political and operational point of view, what problem a central banker, or anyone else, could have with this policy shift.
And then there is the economics to consider.
Japan has been struggling with sluggish economic growth and persistent mild deflation (falling prices) for many years. This means that the central bank has been failing for years in its task of ensuring price stability (as normally defined as low and stable positive rates of inflation). The monetary and fiscal authorities together have failed to ensure output levels close to potential and thus full employment. Standard economic textbook analysis suggests that aggressive expansionary monetary and fiscal policy are precisely the correct response to such a situation. Which brings us to the criticism of exchange-rate manipulation or even of launching a currency war. This is fatuous. Depreciation of the currency is indeed one of the expected effects of expansionary macroeconomic policies. That is precisely one of the channels by which macropolicy stimulates both real and nominal demand. When the Bank of Japan purchases financial assets it increases the supply of yen, depressing (ceteris paribus) the value of the currency both internally (raising inflation) and externally (leading to currency devaluation). Along with expansionary fiscal policy it also raises inflationary expectations, and this also puts downward pressure on the currency. Meanwhile, currency depreciation stimulates exports and also raises domestic prices. In other words, by way of various channels that feed on one another, we expect the outcome of a policy such as that recently announced by the Japanese government to be higher real output and higher prices in Japan and a lower exchange rate of the yen.
This makes it abundantly clear that the criticism that Abe is attempting a 1930s-style beggar-thy-neighbour policy of strategic currency devaluation is misplaced. Other countries, not least members of the euro area, should be applauding attempts to stimulate demand and kindle mild positive rates of deflation in Japan; both will have an expansionary effect on Japan’s trading partners. This must be set against the restrictive effect of the lower value of the yen. And even that needs to be seen in context. The crisis saw a spectacular increase in the value (real effective exchange rate) of the yen; the recent depreciation marks a relatively small correction. And what caused that massive appreciation? Primarily the expansionary fiscal and monetary policies launched by the American, European and other governments and central banks in order to jump-start their crisis-hit economies. I don’t recall any European of US politician or commentator advising against this policy at that time on the grounds that it constituted currency manipulation.
So what is behind the fuss (apart from the usual mix of economic ignorance and journalistic parroting)? The ECB has been sunning itself in recent months in the glory of having prevented the break-up of the euro and having – along with some other factors – decisively reduced the interest-rate spreads that were throttling the crisis-hit euro area countries. This is indeed a major break-through, as I noted, with due caution, when the OMT programme was announced. It is not my intention to take away any of the credit that the ECB deserves for taking, belatedly, this step and doing so under much more difficult political conditions than in the US or UK, for example. Chapeau!
It is vital, nonetheless, not to lose sight of the fact that the economic performance of the euro area has been extremely poor since 2011, much worse than the US and to some extent the UK. Unemployment is at record levels; output is below pre-crisis levels and is still declining. In the US unemployment is falling and the economy growing at about its trend rate. This differential in turn largely reflects differences in the macroeconomic policy response. First and foremost is the difference in fiscal policy: severe austerity in the UK and most of the euro area, merely an end to stimulus in the US. But monetary policy has also played a key role. Assessing the differences in the extent of unconventional monetary policy in different economies is not an exact science (see among others Johannes Schweighofer on these pages, and studies by CEPS and BRUEGEL). But there can be little doubt that the ECB has been far more sluggish in supporting economic recovery than the Fed and the Bank of England. Consider:
- it is often forgotten but nevertheless true that the ECB hiked interest rates twice in the spring of 2011, just when fiscal austerity was starting to bite, not least helping to worsen the situation for the crisis-hit peripheral economies,
- the total balance sheet expansion by the ECB – as a rough proxy for unconventional monetary policy – in response to the crisis was initially substantially weaker than in the US and particularly the UK. It then declined substantially as a share of GDP from the start of 2009 to mid-2011, from which much lower starting point, it belatedly expanded rapidly (see figure taken from the Bruegel report mentioned above).
- By insisting on seniority – that is guaranteed repayment in preference to private-sector holders of the same assets – for all assets acquired as part of its stabilisation efforts the ECB increased the perceived risks of these assets to other investors.
- Finally, at least until the announcement of OMT, and then only weakly, the ECB failed to communicate clearly to markets that the measures it was taking would be pursued for as long as it took and to the extent required to achieve certain pre-stated goals. It is entirely unthinkable that the ECB would follow the FED (with its dual mandate) and commit to maintaining measures until unemployment had fallen below a certain threshold.
In conclusion, Japan is adopting policies that the West adopted in the wake of the economic crisis but which, in Europe, were much too swiftly and uncompromisingly abandoned in favour of austerity. What lies behind Weidmann’s ill-informed attacks, as usual parroted by an uncritical media, is the sense that the ECB is looking isolated. The economic and political environment is changing and the ECB is increasingly looking like a dinosaur. Particularly if Japan’s policy proves successful – and the initial signs are encouraging – Europeans might start to asking whether it is really such a good thing to have the “most independent central bank in the world”.