In 1997 Milton Friedman commented on Bank of Japan policy following Japan’s deflationary spiral of the early 1990s:
Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”
The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.
There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.
Austerity measures adopted in Europe are failing and central banks are likely to attempt Friedman’s option in a number of guises. Already, as Gary Shilling points out “competitive quantitative easing by central banks is now the order of the day.” The Bank of Japan last year expanded its balance sheet by 11 percent, the Federal Reserve by 19 percent, the European Central Bank by 36 percent and the Swiss National Bank by 33 percent. Even countries with relatively strong balance sheets, like Switzerland, are forced to respond to prevent appreciation of their currencies from harming exports.
Inflation will remain moderate only so long as central bank balance sheet expansion is offset by deflationary pressures from private sector deleveraging. That is the difficult task ahead: to maneuver a soft landing by balancing the two opposing forces. Failure to do so could lead to a bumpy ride.
Chasing managed inflation to to build an economy is nutty. It stimulates consumers to spend but does not stimulate long term investment. The investor who borrows will only be stimulate if he is confident that inflation will continue and so erode his debt. The saver will equally not want to save unless the interest is high and they are confident that the interest will continue to be high. These distortions in productive investment and productive saving are caused by governments continually manupulation the money supply. The only sensible way ahead is to wring this distortion out of the economy and it can only be done by austerity. Japan, of course, is the classic eaxample; many of its citizens have waited for much of a working lifetime for their government to give them the chance to be independently wealthy.
What makes QE and opposition to austerity even odder is that the financial tidal wave coming is the payment of pensions to an ageing population – eroding the savings in pension funds by targetted inflation is not the way to maximise the savings of the old.
It is also interesting to watch how all this self balances.
The argument is that austerity prevents young people from getting jobs – this is the long term effect.
Old people see their savings eroded so they work for longer having at least some of the mercantilist effect of keeping young people out of work.
We seem to agree that long-term private sector investment is needed for future growth. My view is that long-term investment will remain muted for as long as the current instability lasts — possibly decades — despite low interest rates. The only way to restore stability is to address the massive private and public sector debt overhang that threatens a deflationary spiral. There are two options to address public debt: (1) use austerity measures and fiscal surpluses to repay debt; and (2) fund fiscal deficits by expanding central bank balance sheets. The former risks a deflationary spiral, the latter risks inflation if private sector deleveraging slows.
Austerity has a poor track record which is being reinforced by experiences in Europe. QE would cause a spike in gross public debt but zero increase in net public debt — the government is effectively purchasing its own bonds. My view is that option (2) offers less risk and a shorter time frame than option (1).