Wanted: Informed Commentary on Japan
David Andolfatto
Department of Economics
Simon Fraser University
January 22, 2003

Colin Donald’s recent commentary on monetary policy in Japan (Wanted: Banker to ‘inflate’ Japan, FP Wednesday, January 22, 2003, FP17) constitutes a good example of the common misperceptions that are held in regard to the power of a central bank and the desirability of inflation.
 
Mr. Donald’s facetious want ad soliciting candidates for the position of governor of the Bank of Japan calls for an ‘aggressive and creative’ central banker to save Japan from ‘implosion.’ The successful candidate is to be granted a license to print money and is expected to take great liberty with this power. While the ad does not specify precisely on what the candidate is to spend the new money, one can easily conjure up the image of a giddy new central banker running through the streets of Tokyo randomly dispersing bags of crisp new yen to an overjoyed and grateful population.
 
Unfortunately, this is not the way it works. While the Bank of Japan (BOJ) does indeed possess a license to print money, it normally does not (except with special permission from the Ministry of Finance) have the power to spend it on anything other than government securities. Consequently, the image described above must be altered to that of a central banker running through the streets of Tokyo asking people to exchange their government bonds for crisp new yen. Since government bonds are usually priced at a discount (i.e., they yield a positive rate of interest), an ‘aggressive’ central banker has the power to make bondholders happy by bidding up the price of bonds (which then puts downward pressure on market interest rates).
 
Now what is interesting about Japan is that market interest rates on government securities are essentially zero. As it turns out, this is precisely the interest rate that is paid on paper money. In other words, when the interest rate is equal to zero, money and bonds are for all intents and purposes close to perfect substitutes. In this case, all that even the most aggressive central banker can do is implore the population to hold more of one zero-interest government security (money) relative to the other zero-interest government security (bonds). Since the two assets are viewed as perfect substitutes, such an alteration in the wealth portfolios of individuals is unlikely to have any effect at all (individuals will simply treat their new money as zero-interest government bonds).
 
Now before dismissing all of this as typical ivory tower pap, let us take a look at some of the evidence. After years of arguing that it was powerless to stimulate the economy (owing essentially to the argument I outlined above), the BOJ finally capitulated to calls for a more ‘aggressive and creative’ action in April of 2001 by implementing a policy called ‘quantitative easing.’ Since that time, the BOJ has pumped out yen (bought up government debt) at an unprecedented rate of roughly 40 percent per annum. To the surprise of all but those who understand the arguments made here, inflation is still nowhere in sight.
 
The ability to generate an inflation resides in that sector of the economy with: (1) the legal power to acquire newly printed money in exchange for its own worthless promises; and (2) the legal power to spend this new money on goods, services and transfers. This special sector is called the fiscal authority (as distinct from the monetary authority) or, in Japan, the Ministry of Finance. The ‘worthless’ promises alluded to above are government bonds that promise to deliver paper yen which are to be acquired by issuing ever increasing amounts of new government debt. History is full of examples in which the fiscal authority exerted such power to the detriment of all but a few special interests. Those that view inflation as an economic panacea must first confront the hard facts of economic history that argue otherwise.