The Fed should learn from the Bank of Japan’s mistakes

In the latest issue of The International Economy, we were asked to contribute to a symposium on “Is the world still at risk of the Japan Disease?” In our short brief, shown below, we emphasize the risks of U.S. monetary and fiscal policies following similar paths as the Bank of Japan and high deficit spending, which pose risks, while emphasizing that some aspects of Japan’s economic performance are quite positive but widely overlooked.

The Fed should learn from the Bank of Japan’s mistakes

We will focus on the U.S. Is it taking on Japan’s bad economic characteristics? Yes, but primarily in terms of monetary policy and mounting government debt. Like Japan, these pose significant risks to U.S. economic performance and longer-run potential. Presently, as soon as the U.S. emerges from the deep pandemic economic contraction, the timely unwinding of its emergency fiscal and monetary responses to the COVID-19 pandemic is critical.

Unlike Japan, the U.S. benefits from a growing population, reflecting in-migration (despite much needed policy reform) and a relatively high birth rate, particularly among new immigrants. But let’s not overlook some of Japan’s favorable economic trends that have been underestimated. Its sizable labor force participation of women and influx of foreign workers have offset its declining population and boosted its workforce. Those are certainly not “diseases.” Moreover, its productivity per working age population is among the highest of all advanced nations.

Even before COVID-19, reflecting Japan’s experience, the U.S. government’s debt burden was rising and projected to increase significantly, although not nearly as high as Japan’s 200 percent-plus of GDP. Similar to Japan, U.S. deficit spending has been driven by entitlement programs, specifically pensions and healthcare for the elderly, and its population is aging. Japan’s response has been to increase its VAT, which has harmed its economy.

Obviously, the spike in U.S. deficit spending in response to the deep economic and employment contraction—estimated to be $3.8 trillion in fiscal year 2020—adds significantly to current and future government debt levels. Even if government debt service costs, inflation, and interest rates remain low, current and future U.S. citizens will incur the costs of the government spending in a variety of ways, including mis-allocation of national resources and constrained potential growth.

Unfortunately, since the financial crisis of 2008–2009, the Fed has followed the Bank of Japan’s ultra-low interest rates and large-scale asset purchases, but not to the same extreme. But, like Japan, the Fed’s excessive monetary ease has not achieved its objective. The Fed’s QEII and QEIII pumped up prices of financial assets and encouraged risk-taking, but like the Bank of Japan’s experience, they failed to stimulate any acceleration in aggregate demand or economic growth or lift inflation to 2 percent. In both cases, the high-powered money created by the central banks has generated excess reserves that are sloshing around in the financial system and have not been put to work in their respective economies.

The Bank of Japan’s negative rates and massive Quantitative and Qualitative Monetary Easing asset purchases are harming commercial banks’ intermediation and imposing financial repression. The Fed must avoid this situation. Disturbingly, both the Fed and Bank of Japan are quick to justify their monetary policies, stating that if they had not pursued the policies they did, things would have been much worse. In our view, the Fed should learn from the Bank of Japan’s mistakes and understand the limits of monetary policy and be more circumspect about its efficacy. U.S. economic performance would benefit.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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