May 8, 2023
Japan’s monetary trilemma is a warning to the world
The Bank of Japan’s new governor, Kazuo Ueda, has assumed his role at a fraught moment. The BOJ is looking down the barrel of a new kind of trilemma: Inflation is too high, financial stability is too uncertain, and the government of Japan is saddled with too much debt, the cost of which is profoundly impacted by the BOJ’s policy rates.
By legal mandate, the Bank of Japan is primarily tasked with achieving price stability—avoiding inflation and deflation. However, as with many other central banks, it has two additional unwritten mandates. The first is “financial stability”: a mix of regulatory authority and emergency powers that give it the capacity to intervene in markets in the event of a systemic shock. The second is what might be called a “fiscal separation mandate”: a commitment to avoid conducting monetary policy in ways that substitute for or badly distort fiscal policy.
These three mandates have become dangerously intertwined such that making progress on one may require ceding ground on the others. And while the specifics of the Japanese case are inevitably unique, it’s only a matter of time before the difficult choices facing the BOJ show up in Washington, London, Brussels, Frankfurt, and beyond.
The Bank of Japan has struggled with price stability since 1989
Prior to the COVID-19 pandemic, the BOJ was in a long-running struggle against deflation, which prompted it to pioneer an extraordinary combination of exceptionally low interest rates and quantitative easing (QE).
Japan’s problems with low inflation began with the real estate and stock market bubble of the late 1980s, which ended with a financial crash that put the economy into a tailspin. That crash shocked companies and households into saving as much of their income as possible. Events were so severe that the “precautionary savings” mindset has never really abated, resulting in persistently low domestic demand, and downward pressure on prices.
However, in the post-bubble years two other global factors kept prices down, in Japan and across the developed world. Technology and global trade fundamentally changed the cost and location of producing goods and services. A typical product sold in the year 2020 was produced using far less labor than the equivalent product in 1990 and was more likely to be produced in an emerging market. Less demand for labor meant that household incomes in developed markets struggled to rise even as GDP went up substantially. Less labor pricing power and lower household incomes meant less upward pressure on overall prices. Put simply, technological advances together with increasing amounts of global trade were deflationary.
And Japan was early to face an additional challenge to price stability: a rapidly aging population. Japan’s prime working age population started to decline in the early 1990s. There is no expert consensus regarding the relationship between population growth and inflation, but in Japan’s case there’s a plausible argument that a declining population added to deflationary pressure. In a rapidly aging (and declining) population, the demand for goods and services may decrease more quickly than the supply.
Fast forward to 2023, and inflation has replaced deflation as the prevailing issue in Japan. Inflation is well above the BOJ’s 2% target, but policymakers still need to factor in the trends that kept inflation too low for decades: very high savings rates, global trade and technology, and an aging population. Two of the three are applicable well beyond Japan, and as the BOJ’s experience shows, they’re challenging to deal with—even before factoring in the central bank’s two other mandates.
Financial instability after years of low interest rates
Globally, instances of financial instability have become more frequent as central banks have raised interest rates to combat inflation in the US, Europe, and elsewhere. Further instability isn’t a certainty, but the events of SVB, First Republic, and others suggest it’s a good bet. Against that backdrop, Japan may be the poster child for an unpleasant paradox: the low interest rates and quantitative easing which rendered the Japanese financial system remarkably stable for almost 20 years may have sown the seeds of extraordinary financial instability to come.
Why a poster child? Because the BOJ started its “exceptional” policy interventions as early as 2001, which implies that the banks, borrowers, and securities markets have internalized historically abnormal BOJ policy settings as “normal.” The result has been stability but not normality. Trading volumes in government bonds (JGBs) have become anemic to the point where the benchmark 10-year bonds don’t trade at all on some days. And over this period, Japanese markets have been operationally hollowed out. The largest of the global brokers have reduced trader headcount and moved trading staff offshore due to minimal activity. There is little or no “living memory” among JGB market participants of how to operate amid volatility. And operational infrastructure may not be up to the task either: There’s reason to doubt that Tokyo market makers invested in state-of-the-art trading and risk management systems.
Finally, the “real economy” is vulnerable to higher rates and increased volatility—especially real estate, “mom-and-pop” businesses, and “zombie firms” with high debt.
The third imperative: fiscal separation
The third mandate—set by law in some countries and by tradition in most—is that central banks are committed to minimizing interference with fiscal operations. Rule One of fiscal separation is don’t lend to your government. The theory is that governments which borrow money that is “funded with a central bank’s fountain pen” lose all fiscal discipline, and that people stop believing that their government will return to anything like properly balanced budgets. They also stop believing that the central bank cares about price stability.
Alas, Rule Two is that there is always some linkage between monetary and fiscal policy, irrespective of commitments to “non-interference.” Why? Because governments which fund themselves in their home currencies do so at interest rates which are immediately and continuously impacted by central bank policy rates, and expectations about changes in those rates. When central bank rates go up, governments pay more to refinance maturing bonds and to finance any new deficits.
Japan, again, may provide the world with a test case that will either mitigate concerns, or magnify them. Japanese government debt as a percentage of GDP is the highest in the G7, according to the IMF, followed by Italy and the US. If the BOJ makes a material change to its interest rate policy, the flow-through to the fiscal accounts will be substantial.
Japan on the horns of a trilemma
The BOJ is in a difficult spot: a trilemma where strictly adhering to any one of its mandates may require sacrificing the other two. If it raises rates aggressively to fight inflation, financial stability will be threatened, and the fiscal consequences may be large enough to provoke political counter-reactions. By contrast, a focus on maximizing financial stability implies keeping rates too low for too long, and may result in ongoing, elevated inflation. Lastly, a compulsive focus on “non-interference” in fiscal affairs—for example, by staying out of the market for government bonds—could spark financial instability.
So now what?
Schadenfreude is not the appropriate response. Japan’s challenges are or will be common to much of the G7, if not the entire West. The West should be working constructively with Japan as it strives to balance its three mandates. Its success will be ours too, and we all need to learn what we can from the steps the BOJ takes and the consequences that follow. Our own “trilemmas” are not far behind.
Mark Siegel is a contributor to the GeoEconomics Center and Managing Partner at Chancellors Point Partners LLC. He previously worked in banking and investment management.
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