Let's start with what almost everyone now accepts. Japan is clearly a depressed economy, operating far below its potential output - indeed, even if optimistic Japanese officials are right and the economy grows a bit this year, the output gap will continue to widen. Conventional monetary policy has been pushed to its limit, and is not enough. Fiscal policy has also been pushed to its limit, if rising bond yields and warning from bond-rating agencies are any indication, and it too is not enough. Banks will be pushed into accepting new capital injections, but this is unlikely to do much to increase spending. And there are no other "respectable" policy instruments in the government's toolbox.
What remains is the option of monetization: of having the BOJ expand the monetary base, most obviously by buying JGBs, with the deliberate intention of generating expectations of moderate inflation. This policy idea does not come out of thin air. Japan is in a classic liquidity trap, and as I have tried to argue, the idea that managed inflation is the answer to such a trap emerges directly out of the most conventional macroeconomic models ( Japan: still trapped ). Nor is this a matter of abstruse mathematics, which cannot be explained in common-sense terms: it is possible to explain Japan's plight, and the reasons why inflation is the natural answer, in terms of extremely simple parables ( Baby-sitting the economy ). And if Japan does not act aggressively to reflate soon, it runs a very serious risk of going into a deflationary spiral.
Yet while the idea of monetization has finally begun to pick up some real political momentum, its opponents - both Japanese and non-Japanese - remain dead-set against it. Their arguments make amazing reading. Consider the following lines of argument, all of which may be found in a Reuter's report from last week:
1. Monetization will lead to inflation: Because money-financed deficit spending led to uncontrollable inflation in the 1940s - in an economy that was engaged in massive military spending, and by then operating at full capacity - critics of monetization argue that it will lead to uncontrollable inflation now. Um, isn't the current problem deflation? Isn't this, as Ralph Hawtrey said in 1931, a case of "crying 'Fire, fire!' in Noah's Flood"? (See my piece The hangover theory )
2. Monetization will encourage the government to run ever-larger deficits: Japan's government is now running huge deficits because it is trying to stimulate the economy with fiscal policy. Are the critics - like Jardine Fleming economist Chris Calderwood, who wants to "put a strait-jacket on Japanese fiscal policy" - saying that it should stop doing so, without any alternative way to maintain demand? Then I guess they are saying that Japan should simply accept a depression in the name of behaving responsibly. I would have thought that monetization, both because it is an alternative to fiscal policy and because a stronger economy would increase revenues, would help reduce the size of prospective government deficits - and conversely, of course, it is the dangerous size of those deficits that makes monetization now the last, best option for avoiding depression.
3. Monetization will weaken the yen, hurting other Asian economies: I believe that this threat was overrated (see Further notes on Japan's liquidity trap ) even last spring, when my ideas were first circulated. Anyway, since last spring the yen has become far stronger, as have the currencies of non-Japan Asia - indeed, Korea is now worried about an excessively strong won. And since when does a deeply troubled economy - which happens to be the world's second-largest - help the world by giving up what increasingly seems to be its only remaining macroeconomic policy tool?
4. Monetization will prevent the yen from becoming an international currency: It still astonishes me that this concern really influences the policies of an economy as troubled as Japan. After all, all serious estimates suggest that the international currency role is worth very little to the country that issues that currency - for example, even if the euro displaces the dollar on a large scale, the loss to the United States will be no more than 0.1-0.2 percent of GDP. Compared with rescuing Japan's domestic economy from its crisis, this consideration should be seen as trivial. Yet the Reuter's story quoted former MOF official Kosuke Nakahira as opposing monetization because it "would go against the principle of making the Japanese yen one of the three major international currencies ... a very important issue for Japan's long-term policy or strategy, particularly now that we have the euro as a potential international currency". The truth is that the internationalization of the yen is a vanity project, with essentially no bearing at all on the welfare of ordinary Japanese. And those ordinary Japanese have a right to ask exactly whose vanity is being served at their expense.
5. Monetization will reduce the pressure for reform: "The risk is that the public sector always comes up with a bit more and this forestalls restructuring and a sense of crisis" says Mr. Calderwood. This is the old idea that depressions are actually good for you, that pain is character-building for economies. (See No pain, no gain? ) But in case nobody has noticed, Japan is not currently having a salutary "sense of crisis": it is having a genuine crisis, one which is due not to lack of reform but to lack of demand.
6. Monetization isn't something serious countries do: Here, I believe, is the crux of the matter. Monetization, says Mr. Calderwood, "risks lowering Japan from the division of sensible developed countries to the lower division of countries with bizarre, archaic financial structures". In other words, Japan should continue to run its monetary and fiscal policy conventionally, because that is what respectable countries normally do.
Well, this observation may surprise some people, but Japan is not in a normal situation. It is in deep trouble, of a kind that has not been seen in the world for 60 years. Indeed, one might be tempted to describe Japan's plight as bizarre and archaic - except that it is really happening, and is happening now. And given the peculiar character of Japan's problems, it must respond to them with policies that are the product of hard thinking - not of reflexive conventional wisdom.
What it comes down to is this: those who are urging Japan not to monetize, despite the compelling economic logic in favor of such a move, are like well-bred friends of a financially troubled family who urge the husband not to take the only job offer he has, on the grounds that it would be beneath his dignity, that it is not respectable for gentlemen to stoop to trade. That gentleman should tell his friends that the first step on the way back to respectability is to start earning a living again.
At this point, monetization is Japan's only plausible route back to prosperity. Unless the critics have an alternative to offer, they should stop urging Japan not to take it.