[R-G] [BillTottenWeblog] Bernanke's speech shows where BOJ failed

[Bill Totten]

by Richard A Werner

The Daily Yomiuri (January 29 2009)


US Federal Reserve Board Chairman Ben Bernanke gave an interesting
speech at the London School of Economics in mid-January. Unusual for
speeches by the head of a major central bank, Bernanke was fairly direct
in his message and coherent in his analysis. He also gave some insights
into what seems to be his actual thinking. If he does mean what he said,
then this speech could be of significance for the world economy - and
also of interest in Japan.

The Bank of Japan has for almost twenty years insisted that it did not
have the tools to end the banking-bust depression, could not help the
deflation, was basically powerless, and that it depended on some
structural reform that was supposed to be implemented by others - the
government in particular. By contrast, Bernanke emphasized that the Fed
had the tools available to battle the financial and economic crisis, and
was using them without delay.

Bernanke has written about Japanese deflation and the policies of the
Bank of Japan in his academic writings and has sharply criticized the
Bank of Japan for its inaction and for allowing a banking crisis to be
transformed into a multiyear economic downturn and depression.

Bernanke explained what he had written in his analysis of the Bank of
Japan's policy many years ago in his lecture, namely that a central bank
could eventually boost asset prices by creating money and putting it
into circulation through purchases of assets and direct lending, and
could in this way support and stimulate the economy. He used the term
quantitative easing, which had become well known in the context of the
Bank of Japan. Indeed, it is a term that was originally used in Japanese
(ryoteki kanwa) in the early 1990s by critics of the Bank of Japan.

I have been one of the main users of this term because I wanted to
contrast such needed policy from traditional ways of monetary
stimulation or the monetarist way of referring to boosting the money
supply. I wanted to emphasize that using the price mechanism of interest
rates was not likely to help and therefore quantitative monetary policy
was required.

What's wrong with the BOJ?

While the expression quantitative easing had been mainly used by Bank of
Japan critics, this changed in 2001 when the Bank of Japan proclaimed it
would try what critics had then been demanding for almost a decade - one
can't fault the bank for rushing into new things ... Thus in March 2001,
the Bank of Japan announced it was officially going to change its
monetary policy by switching from its alleged use of interest rates to
adopting quantitative easing (using the term ryoteki kanwa and
translating this as quantitative easing in its English announcements).

However, the Bank of Japan's use of this term created much confusion
because the policy it adopted in 2001 and many subsequent years was not
the true quantitative easing that critics such as myself had demanded.
The quantity that needs easing is the quantity of credit creation. This
is necessary and sufficient for a recovery in a situation like this. The
Bank of Japan, however, chose to merely increase the reserves of banks
held at the central bank. This is a traditional monetarist policy
prescription, which boosts a measure called high powered money, but the
measure is pointless. I had warned many times that this was likely to fail.

What good does it do the economy if banks deposit more money in the
central bank? More credit creation is needed. That can only come from
the central bank or through the normal route - from commercial banks
through the extension of bank loans. But the Bank of Japan failed to
boost credit creation. Thus its quantitative easing policy failed. As a
result of this failure, the Bank of Japan's leaders would in the
following years give speeches stating that the critics had been proven
wrong. They would claim they tried quantitative easing as critics
recommended, and it failed!

However, we witnessed only the tatemae (facade) of quantitative easing,
not the honne (actual fact). Before 2001, the Bank of Japan did not
actually want to reflate the economy. As Bank of Japan leaders have said
on the record, they were quite happy about the recession because they
used it to put pressure on the government to change laws and introduce
US-style deregulated free-market capitalism.

Despite its official conversion to quantitative easing in 2001, this
stance did not change. The central bank kept the quantity of credit
creation tight. Thus, despite the nominal rise in high-powered money,
the economy remained mired in recession. There was a brief recovery in
2006 - and again this is a case in point - it was based on a temporary
recovery in credit creation. However, this policy was reversed by the
Bank of Japan as soon the first shoots of recovery had become visible
and Japan has been heading back into deflation ever since. One can only
hope that the Bank of Japan will follow former Fed Chairman Alan
Greenspan's recent example and admit that the current global crisis has
disproved and discredited the deregulated free-market model.

Monetize fiscal policy

What is interesting about the Fed's current policies is that there seems
to be some real - in the correct meaning of the term - quantitative
easing going on. Credit creation by the Fed is ballooning. This is done
by direct purchases of assets by the Fed and by direct lending by the
Fed. The Fed has now also started to purchase mortgage-backed
securities. It seems that Bernanke is not using smoke and mirrors. What
he says seems to be what he actually thinks and plans to do (his honne)
- quite a revolutionary approach to central banking.

Many observers and experts are currently wondering whether the world is
now going to go down the road that Japan has traveled over the past
eighteen years - a road that includes rising unemployment, deflation,
falling asset prices and a shrinking economy. The potential for this to
occur exists because the credit bubbles in Britain, Ireland, Spain, the
United States and a number of other countries operated on the same
mechanics as the Japanese bubble economy of the 1980s. Excessive credit
creation used for speculative purposes drove up asset prices, but it was
predictable that it all had to turn into bad debts, busting the banking
system and resulting in a credit-crunch recession.

The policy response taken by the key central bank may be where the
parallels end. The current measures taken by the Fed and their scale are
unusually aggressive and contrast sharply with the policies adopted by
the Bank of Japan since 1991. The Fed also is monetizing fiscal policy,
while the Japanese central bank has so far refused to do so. Thus at
present, one can say that the US economy is likely to recover far more
quickly than the economies of other countries, notably Japan. Where
central banks continue to let credit creation stagnate, and where they
refuse to monetize fiscal policy, economies will continue to shrink. At
the moment, this includes Japan and Britain.

The British government's fiscal stimulation has been entirely unfunded,
which means that all the government bonds issued to fund it have
deprived the banking system of liquidity. Hence bank lending will
continue to slow. For Britain and other post-bubble economies such as
Ireland and Spain, we must expect a long slump, perhaps even on a
Japanese scale. But that depends on the goals of the respective central
banks.

One lesson we should learn is that there should be more public debate
about the role of central banks in creating the current global crisis
and the role they should play from now on. Over the past thirty years,
central banks worldwide have become more independent from governments
and parliaments. Yet, despite their increased power, macroeconomic
performance has deteriorated and the world has seen an unusually large
number of banking and economic crises.

In almost all cases, the crises were due to bubbles caused by excessive
credit creation for speculative purposes - something I had warned needed
monitoring and restricting by central banks. But the central banks chose
to let credit creation rip. Only if the goal of central banks had been
to create and exacerbate business cycles could we say that they have
done a good job.

It seems clear, therefore, that the topic of central bank independence
should be reviewed, for this independence has not had the desired results.

_____

Werner is professor of international banking at the School of
Management, University of Southampton, and author of the books Princes
of the Yen (2003) - whose Japanese version En no Shihaisha (2001) was a
bestseller - and New Paradigm in Macroeconomics (2005).

http://www.yomiuri.co.jp/dy/business/20090129TDY19104.htm


http://www.billtotten.blogspot.com
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