How Not to Fight Inflation

Shinzo Abe, the former Japanese Prime Minister, was assassinated last week in the city of Nara. During his second stint in power, from 2012 to 2020, Abe embarked on a domestic agenda known as Abenomics. Japan had been plagued by a long period of deflation and anemic growth, and Abe’s policies aimed to reverse both trends. I wanted to understand whether he succeeded, and what lessons the Japanese experience fighting deflation might impart to policymakers and central bankers who are currently battling the opposite problem. (Tools that are deployed by the government to fight inflation include monetary policy, by which central banks manipulate interest rates and the over-all supply of money, and fiscal policy, which involves how the government taxes the public and spends money.) To talk through these questions, I recently spoke by phone with Richard Koo, the chief economist at Nomura Research Institute, in Tokyo. He was previously an economist at the Federal Reserve Bank of New York. During our conversation, which has been edited for length and clarity, we discussed how Abe damaged his own economic agenda, what the COVID era has revealed about the dangers of relying too strongly on monetary policy, and why economists might find it harder to fight inflation now than they would have decades ago.

What problem did Abenomics set out to solve?

Abe was very concerned that Japan was falling into deflation, and he listened to those economists who argued that, if the Bank of Japan printed tons of money, this problem would go away—all the problems rested with the Bank of Japan’s refusal to do so. That was the argument that a lot of American economists were also making about Japan. Many American economists at that time were saying, “The Bank of Japan is nuts. They should print money and just get this problem out of the way.”

Many people in Japan were saying that [printing more money] was not going to work very well, but Abe, listening to those you might call reflationists, forced the Bank of Japan to do that by making [Haruhiko] Kuroda its new governor, in 2013. And Kuroda used what is now known as his bazooka asset-buying program by just putting tons of liquidity into the market.

At that time, the yen was very strong. With Abe’s Prime Ministership, the exchange rate moved significantly toward a weaker yen, all on the assumption that, with the Bank of Japan pumping tons of money into the system, the supply of yen would grow faster relative to the supply of U.S. dollars, and therefore the yen exchange rate would depreciate. That was the anticipation. And, if Japan started having inflation, the yen should also depreciate. Those were the arguments. In a textbook world, if one country starts printing money like crazy and the other one refuses to do so, then you would expect the one that’s printing money to have an exchange rate that would depreciate.

That was how the market reacted at that time. The yen did depreciate. And that is considered one of the greatest achievements of Abenomics—that the yen was moved away from this very strong position to a much weaker one. But there was an assumption that inflation would come and the economy would improve as a result. That didn’t happen. Until recently, the Japanese inflation rate never reached two per cent, in spite of astronomical monetary easing. Because the economy continued to remain weak, Kuroda, under pressure from Abe, kept on pumping money into the system. The total liquidity in the Japanese economy was almost the size of the Japanese G.D.P.

So he tried to solve the problem, and the exchange rate responded. But inflation rates remained well below target, and the economy also remained lacklustre, indicating that the monetary policy was far from effective—the Japanese economy was nowhere near the textbook world. I would argue that Abenomics did a little at the beginning in terms of correcting this extraordinarily strong yen, but the rest was not a problem that Abenomics could solve.

Didn’t Abe also have a more aggressive fiscal policy than his predecessors? And, more broadly, do you think the failure to really jump-start the economy happened because Abe and the Bank of Japan did not go far enough, or is it because they were trying the wrong plan?

It was the wrong policy to use. They should have used fiscal policy, not the Bank of Japan’s monetary policy. Fiscal policy was the second arrow of Abenomics, and it was put there by his close ally, [Taro] Aso, who was the finance minister. Aso told Abe that monetary policy alone was not going to be enough. You need fiscal policy. That’s why the second arrow was inserted, and that played a very important role in keeping the Japanese economy afloat.

Unfortunately, Abe promised to raise the consumption tax, and raising the consumption tax is the opposite of a fiscal stimulus. It’s actually austerity. Even though Aso tried to convince Abe that this was not a good idea, Abe chose to do it. That was put in place in 2014, and the Japanese economy immediately lost steam.

Why was that the case? For the past thirty years, the biggest problem in Japan has been that the household sector is still saving money, as it did for the past five thousand years, but the corporate sector, which used to borrow money, stopped borrowing after the bursting of the bubble [in the nineties], and continues to refuse to borrow money today. When the bubble burst, commercial-real-estate prices fell eighty-seven per cent nationwide. Not just a little corner of Manhattan, a little corner of Chicago. The entire country was down eighty-seven per cent. Almost the entire Japanese corporate sector had huge balance-sheet problems because they had all this debt outstanding at the original level, but the assets were way down.

How do you repair your balance sheet? You pay back your debt. Even with zero interest rates, Japanese companies have been paying down debt every year since about 1998. If the companies are paying down debt at zero interest rate, there’s nothing a central bank can do, because, even if you bring rates down to slightly below zero, this corporate sector has no choice but to climb out of its negative-equity territory as quickly as possible. Individually, Japanese companies and some Japanese households are doing the right thing repairing their balance sheets, but collectively there will be no borrowers. In the national economy, if someone is saving money or repairing balance sheets, you’d better have someone on the other side borrowing and spending money to keep the economy going. If everybody’s saving money or repairing balance sheets and no one’s borrowing money, then the economy will just collapse. And the private sector has no choice; they have to repair their balance sheets as quickly as possible. Only the government could have come in to borrow that money and spend it—that’s basically fiscal policy.

People like Ben Bernanke understood this. It’s a balance-sheet recession, the kind of recession that is driven by people repairing balance sheets. And people like Aso also understood this, so he tried to convince Abe not to raise the consumption tax. But it went through anyway, and the economy lost steam. Just before COVID, Japan raised its consumption tax again, and the Japanese economy lost steam again. If you look at this whole period, those mistakes on fiscal policy, I’m afraid, kept the Japanese economy from realizing its potential.

One critique of U.S. policy over the past couple of decades, especially after the Great Recession, is that monetary policy had to step in because fiscal policy was not sufficient, for political reasons or whatever else. Is that why fiscal policy didn’t take a bigger role in Japan?

There are two answers. Whether it’s in the United States or in Japan, average people don’t want to hear about large government budget deficits, right? Especially if you have Republicans in power in the United States, they say you don’t want to use your grandchildren’s credit card and things like that. We were told this in our economics classes during our college days. I don’t know how old you are, but I’m sixty-eight. I remember going through economics classes in the seventies and eighties, and we were all taught that such a deficit is a bad thing. And Abe, who was the same age as I am, probably studied the same thing—that government should not be borrowing money. The private sector should borrow the money and keep the economy going.

Once every several decades, when the bubble bursts and asset prices collapse but liabilities remain at their original values, people who were leveraged find that their balance sheets are underwater—they are technically bankrupt. All of these guys have to repair their balance sheets. Once you get into that situation, if the government refuses to come in to borrow but the household sector and corporate sector are all saving money, then the economy really collapses. That’s basically what happened during the Great Depression, from 1929 to 1933.

The lesson from the Great Depression was that if there are no private-sector borrowers, even at zero interest rate, then the government must come in and borrow the remaining circle of savings and put that back into the income stream. Ben Bernanke understood that, and he issued a very strong warning, but unfortunately that was not the case in Japan, and the government, plus a lot of people in academia, thought that the budget deficit was a bad thing. Japan already had a budget deficit of over two hundred per cent of the G.D.P., so they said, “No, we cannot use fiscal stimulus anymore. We have to use monetary policies.” That’s the path that Abe took.