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Monday, July 5, 2004

JAPANESE PERSPECTIVES

Apprentice Fukui and the prisoner of the Bank of Japan


As any sorcerer's apprentice will tell you, it is always easier to start something than to finish it. Exit strategies are by far the most difficult part of any game plan. The most recent and graphic case in point is, of course, the Americans in Iraq. But the same is equally applicable to monetary policy, as Bank of Japan Gov. Toshihiko Fukui will know all too well.

Mr. Fukui was once quoted as not being in possession of a magic wand that could sweep all monetary troubles away in one go. This indicates a sensible awareness of the problem faced by the sorcerer's apprentice.

How far that awareness will take him in devising a successful exit plan out of the "zero-interest-rate" policy, or quantitative easing policy as it is now called, will determine whether he is eligible to graduate from the BOJ school of magic.

With long-term bond yields now up tantalizingly close to the 2 percent line, all eyes are on how and when the BOJ means to extricate itself from the zero-interest-rate bind. That would seem the logical thing to do if the rising long-term rates are an indication of economic recovery and growing inflationary expectations, as the government seems to believe.

Yet it is not that simple. To allow the longer end of the yield curve to pull short rates out of the zero-interest-rate stranglehold could actually put a devastating curse on the central bank. This is because the BOJ itself has very large holdings of long-term government bonds. Rising long-term yields mean collapsing government bond prices.

Thus if the BOJ were to let go of the zero-interest-rate anchor now and allow rates to rise at will, it would end up suffering a serious erosion of asset values on its already ailing balance sheet.

Moreover, it is not just the Bank of Japan that would suffer from collapsing government bond prices. Private-sector banks have also been accumulating increasingly larger amounts of government bonds because they had nowhere else to put their money. Money which they had plenty of, thanks to the BOJ's policy of flooding the market with liquidity.

The theory was that the more excess liquidity private-sector banks had at their disposal, the more they would invest that money in the wider asset market, thereby bringing about greater credit creation and sustained economic expansion. What actually happened was that rather than going in for more lending activity, the banks ended up buying more and more government bonds.

Meanwhile, deflation-hampered companies were simply not interested in accumulating yet more debt. Banks were thus caught with no other option but to park their liquidity with the government. Which suited the government fine, given its accumulated debts equivalent to 140 percent of GDP.

Indeed, it had reached a point when it was no longer clear what the ultimate purpose of monetary policy actually was. Was it to get the economy going? Or was it to prop up government bond prices?

If it was to get the economy going, and policymakers well and truly believe the economy is now in fact on the mend, then the obvious thing to do would be to end the zero-interest-rate policy.

But if it was to support government bond prices, the BOJ would have to flood the market even more, now that prices are softening.

So Mr. Fukui finds himself caught between a rock and a hard place. Getting past this particular pain of Scylla and Charybdis is no easy task. The sorcerer's apprentice continues to have a tough time.

Noriko Hama is an economist and a professor at Doshisha University School of Management.


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