The Futile Nature of Quantitative Easing

A view from Japan on why QE has not been and will not be successful...

THE EXPANSIONARY monetary policy implemented by the Bank of Japan (BOJ) in February, including the introduction of "the price stability goal in the medium to long term," has been effective in boosting stock prices and depreciating the Yen, writes Dr. Takayuki Tanaka, professor of fiscal and monetary policy at Senshu University in Tokyo.

Some economists support this policy change by the BOJ in its "strong intention to overcome deflation". At the same time, they argue that if the goal of 1% inflation is increased to 2%, which is the same as the goal of the Board of Governors of the Federal Reserve System (FRB), the Japanese economy could overcome deflation and achieve higher growth.

However, some other economists doubt the effectiveness of that kind of policy. I am among them.

So-called "unconventional monetary policy", which has been conducted by central banks in advanced countries, has been subject to a zero percent lower-bound interest rate restriction. Conventional means of lowering the policy interest rate to stimulate the economy cannot be used any more. Alternative policy options are:

1. Increasing the balances of current accounts held at the central bank (reserve deposits by commercial banks); 
2. Purchasing unconventional assets;
3. Certificating policy time horizons, and so on. 

However, the efficiency of these alternatives is generally limited.

In such a situation, how did the monetary easing by the BOJ cause stock prices to rise and the Yen to depreciate? This easing involved the same transmission mechanism contained in QE2 (Quantitative Easing Part 2) conducted by the FRB to affect the US market, which was also successful in increasing stock prices and depreciating the US Dollar. However, there is no evidence that it stimulated the US real economy, and it was criticized for creating excess liquidity that overflowed from the US causing bubbles in emerging nations.

QE2 seems to have taken on the appearance of a "Keynesian beauty contest". In speculative markets, any event recognized by a majority as a factor to move the market can in fact move the market. For example, if the majority of market participants believe an event will lower the value of the US Dollar, then they will scramble to sell the Dollar and it is likely to actually fall.

In short, because a majority of market participants viewed the actions of the FRB as an event likely to depreciate the Dollar, the value of the Dollar actually fell and that boosted the stock market. The reason for the surge in the stock prices was not related to the original expected effect of QE2, that is, the purchase of a large number of Treasury bonds lowers the risk premium of assets and increases bank lending. Rather, the market sentiment of "active FRB vs. hesitant BOJ in overcoming deflation" promoted Dollar depreciation and Yen appreciation.

Why is there no evidence that this stimulated the US real economy? The answer is because additional domestic spending was not expected and capital spending did not increase in spite of the Dollar depreciation and stock price increases. A large amount of the money that had no place to go may have flowed into the emerging markets.

Following the BOJ easing in February, because of the introduction of the "price stability goal" and an increase in the size of the Asset Purchase Program in an unexpected timing, market participants utilized the very sentiment associated with the BOJ becoming as active in overcoming deflation as the FRB to depreciate the Yen.

In short, unconventional monetary policies in both the US and Japan do not have any expected easing effect from a theoretical perspective; however, they give the appearance of a "Keynesian beauty contest" especially in the FX market.

Although these policies have little stimulus effect on the real economy, they do seem to have few harmful side effects. Therefore, it seems realistic and rational to continue using these policies. However, these kinds of policy have two problems.

First, excessive reliance on "policies to control expectations" might have harmful effects. Policies designed to influence expectations can be divided into three categories. The first is establishment of a policy time horizon as cited above. If a central bank commits itself not to raise the policy interest rate in the future, market expectations of future short-term interest rates are that they will decline and as a result current long-term interest rates decline. It stimulates the real economy in a minor way.

The second is the formation of inflationary expectations as a strategy to overcome deflation. In his 1998 paper, Professor Krugman proposed that the BOJ should set a policy target of "continuing 4% inflation for 15 years" to influence inflationary expectations and overcome deflation. However, because a "long-term high-inflation" strategy cannot eliminate the problem that nobody believes that a central bank would continue such an irresponsible policy (the problem of time inconsistency), Krugman withdrew his proposal.

Another possibility is "committing to a moderate inflation rate as a goal," which has been adopted first by the FRB and then by the BOJ recently. Theoretically, unless a central bank sets a higher inflationary target than it normally sets and market participants believe it will be achieved, it will not work. Therefore, in the future, if the BOJ uses the word "target" instead of "goal" or raises the goal from 1% to 2%, it will not overcome deflation nor stimulate the real economy.

The third is inducement of speculative market participants to behave in a way that creates the appearance of a "Keynesian beauty contests," which was successfully conducted in the case of QE2 and the BOJ easing last February. If the BOJ raises the goal to 2%, it can achieve success only in this meaning just once more; however, the real economy will not be stimulated.

Given the limited effectiveness of monetary easing, wide acceptance of the view that more aggressive easing would help the economy is dangerous, because it may conceal the fact that the real economy needs structural reform.

Additionally, the "policies to control expectations" must be subject to further consideration. In modern economics, the role of "expectations" is important. However, the fact that expectations affect economic behavior including consumption and capital spending is one issue; whether a central bank or government can control expectations is another.

Even if a central bank can control expectations, it is controversial whether controlling expectations should be justified as a policy or not. Consider the likely path of future growth for the economy. A policy that restores the economy to this growth path when it derails significantly (i.e. a bubble) would be appropriate. However, a policy that affects expectations significantly, apart from the probable path of future growth of the economy (i.e. formation of a bubble), would not be approved. If the latter policy were conducted successfully, it would create a misallocation of resources.

Compared with these policies, enhancement of "the fund-provisioning measure to support strengthening the foundations for economic growth" that was decided by the BOJ on March 13 is rated higher as a means of overcoming deflation from the viewpoint of strengthening the real economy.

The second problem associated with continued unconventional monetary policy is that it could threaten confidence in the government bond market and delay the development of a solution to the fiscal deficit problem. In particular, as an unconventional policy, the purchase of government bonds by a central bank is dangerous. Even though the purpose of the policy is purely monetary easing, if market participants recognize that the central bank is financing the government deficit, the price of government bonds will plummet, long-term interest rates will soar, the Yen will depreciate and high inflation will occur.

The general government gross liability as a percentage of GDP in Japan currently exceeds 200%, meaning that speculative market participants might be waiting for an opportunity to sell JGB. In other words, the situation of a "Keynesian beauty contest" may easily result. The fear that the current account surplus will turn to deficit in the near future might increase this possibility. Once long-term interest rates soar, the fiscal deficit will multiply and prevent further financial reconstruction. The recent Yen depreciation could reflect market participants taking the risk into account.

In the US, this risk is not as large as in Japan. As the key global currency, the US Dollar has retained its strength in spite of the large US current account deficit.

The central banks should recognize that unconventional easing ultimately has serious detrimental effects on the confidence of investors in government bonds and thus monetary policy must be conducted cautiously. At the same time, the government must reconstruct the national finance system.

This article was originally published in Japanese by Nikkei on March 16 2012.

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