BoJ governor has lessons on how to beat deflation

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Asked about his hobby, Masaaki Shirakawa once famously replied that it was central banking. Now governor of Japan’s central bank, Mr Shirakawa has ample opportunity to put his academic interests into practice.

In 2006, then a senior Bank of Japan staffer, the rather shy governor was instrumental in designing the bank’s exit from a policy called quantitative easing, an alternative to cutting interest rates that were already at zero.

That unorthodox policy was aimed at stabilising the bad debt-infested banking system and getting the country out of deflation by hosing markets with liquidity.

At the time, the bank was criticised by some economists for being too hasty in dismantling the unorthodox policy before the last vestiges of deflation had been expunged. Even now deflation could creep back next year.

It was said to be too scared of non-existent inflation and imaginary asset bubbles. As Alan Greenspan, former chairman of the Federal Reserve, had made clear, bubbles were best mopped up after they had burst, not pricked along the way.

These debates were once esoteric, applying only to an economy – albeit the world’s second biggest – that had taken a deflationary turn. But now, following the collapse of bubbles in the US and Europe, governments and central banks are trying to prop up dysfunctional banking systems and reflate collapsing economies. Their frantic policies are aimed at avoiding the debt-deflation trap of Japan’s “lost decade”.

Mr Shirakawa, in his first interview with a foreign newspaper since becoming BoJ governor in April, offers a different perspective on what has occurred and what should now be done.

Although he describes western governments’ capital injections as “a crucial step toward rebuilding the balance sheets of financial institutions”, he is clear that such measures are “not a magic formula”. They cannot spare economies the pain of dealing with the excesses that led to the bubble in the first place.

“One school of thought said that the central bank should be engaged in mopping up operations only after the bursting of the bubble,” he says, referring to Mr Greenspan. “But can a central bank afford to leave policy rates unchanged as long as price inflation remains low?” His answer is no, an implicit criticism of the policies that led other central banks to keep interest rates low in spite of growing evidence of overheating housing, equity and capital markets.

The consumer price index is “very important information”, he says. But it is not enough. “We have to watch carefully whether broadly defined imbalances are accumulating. Very often in the recent decade we experienced a situation in which imbalances are accumulating despite the fact that the inflation rate is quite subdued.”

Alarm bells should have gone off, he says, when the global economy was growing at an unsustainable 5 per cent a year from 2003-07. “During that process, the imbalances, broadly defined, accumulated. Now is the process of eliminating the imbalances.

“Once the bubble burst, the economic cost is so huge. Given the capital shortfall at financial institutions, monetary policy tends to lose its effectiveness,” he says of the consequences of waiting until disaster has struck.

Now the damage is done, he advocates “prudent” fiscal policy to stabilise the banking system and ensure that “negative feedback” between the financial system and real economy does not make the recession worse than necessary. But the economy will still have to grind out the excesses – high house prices and unsustainable household debt – that inflated the bubble in the first place.

Nor is the deflation that could accompany such an adjustment as bad as commonly thought, he says. The BoJ was pilloried for entertaining the notion of “good deflation” by economists who saw a sustained fall in prices as nothing short of a vicious destruction of wealth. But, again, Mr Shirakawa is unrepentant that the BoJ did not take greater risks to stamp it out.

“Japan recovered with mild deflation in terms of consumer price index,” he says. While the cumulative fall in consumer prices from 1997 to 2005 was less than 3 per cent, he says, the cumulative drop in property prices was a disastrous 60-80 per cent. Yet the expansion following that experience “was the longest in the postwar period,” he adds, referring to the six-year growth spurt from 2002, albeit at an annual average of about 2 per cent. “We have to seriously think why Japan enjoyed the longest expansion with mild deflation.”

The US and Europe are now in the midst of a period of savage asset deflation of their own. The implication of what Mr Shirakawa is saying is that there can be no quick fix.

“Based on our experience, the world economy or the US economy needs the elimination of excesses,” he says. During that workout period monetary and fiscal policy may be able to soothe the pain. But there will still be pain.

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