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Take a specific example: Japan.

In the last several years, the central bank of Japan has eased monetary supply for many trillions of dollars, but the CPI decreased in 2016.

My question: is there any negative effect for Japan to ease so much money?

My logic: 'printing' money have an inflationary effect, so if you print too much money, the CPI will rise high and that is simply bad. However, since the CPI is decreasing even though Japan eased so much money, I wonder there should be no problem for 'printing' even more so long as the CPI does not rise?

But the result of my logic sounds ridiculous. I believe the productivity determines the wealth of a country, but from my logic, if you can 'print' money without inflation, you will be rich too.

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You should be confused by Japan's version of QE. No one knows the long term implications, it has never been done before.

I don't know that much about Japan's QE other than the monthly totals, but the concept behind QE is simple.

Normally, when a central bank wants to stimulate economic activity, they will do so by reducing the returns on saving and therefore incentivize consumption. To do this, they need to lower market interest rates.

In the past, they usually did so by controlling the rate at which banks lend to each other, or to the central bank. In the US, this is the Federal Funds Rate. But what happens when you have reached the zero lower bound of the central bank's rate and you need to further influence market rates. In the case of the US and Japan, the answer, in part, was to have the central bank buy debt. But it was not just a small amount like they normally would to change their rate, QE saw the central banks buying huge amounts of debt.

This debt purchasing was designed to serve a singular purpose: drive down long term interest rates. Why would this be helpful? Well with low short term rates, the market for interbank lending would be very liquid, and would not risk the so called "crunch" of credit that occurred during the recession of 07-08. But that was done almost immediately as the crisis revealed itself.

When QE kicked in in earnest, long term rates did begin to go down, but it did not have the immediate effect that central banks thought it would. Unlike short term lending, the long term market is much more slow to adjust to changes in prices, and to some extent the Fed got around that issue in the US by providing forward guidance on their plan to continue QE "For an extended period of time". Even now in the US, QE rolls on, but under the guise of reinvesting the proceeds of original QE assets into even longer term securities.

But Japan started QE earlier! They practically invented it! Why didn't they recover as quickly as the US?

Well they kind of did. In 2010 they posted 4.2%gdp growth after -5.4 the year before. Unfortunately they didn't maintain it.

The reality is that most highly developed countries, (US, Germany, Japan, ect.) are in a period of stable but slow growth. In fact this is the norm in history. It was only the massive upheavals of the 20th century that allowed for massive GDP growth in developed countries. I think it is unreasonable to expect an average of 4% GDP growth in developed countries in the current epoch.

But we've also seen a positive side effect of more sedate GDP growth: lower inflation. There are plenty of theories as to why inflation is lower in developed countries than it has ever traditionally been. I like parts of all of them. One is that globalization and fewer barriers to international trade has lowered prices of goods and services globally by increasing efficiency.

Another theory is that the strategies of central banks are more effective at maintaining low inflation than they are at bringing down high inflation. In particular, inflation targeting regimes, such as the one currently employed by the Fed, seem to be effective at maintaining well anchored market expectations, and help to reduce market shocks.

As to whether a country can become richer by printing money without inflation the answer is: kind of...

There is interest rate risk to QE. If rates go up, QE loses money for the central bank. But since the central bank controls interest rates, they don't really have to worry about it. The Fed will make money on QE, and the BOJ will probably make money on their QE (although they bought non-government assets in addition to government, so I'm not as sure about those). Does making money on QE make the country richer? Not really. But does lowering the yields on government bonds make a country relatively richer? Yes. With cheaper government debt, the government is more able to conduct expansionary fiscal policy without having to worry about too much interest. In the case of QE it is even better because your own central bank owns the securities so you practically are performing seigniorage!

Of course this assumes that the government then uses this money to improve the production of the country, but if you throw enough money at it, it can't help but make your country richer.

Now, the final question is: what happens in the long term as a result of QE? Is there a risk of inflation as QE securities mature?

I've thought about that question a lot in the last few years, and I think that in the case of the US there is limited risk of inflation from maturing securities. The fed can roll them off at a very slow rate, and by tapering the reinvestment of the securities, they can ensure a slow, gradual decrease in the size of their balance sheet, and low inflation.

In Japan the issue of the types of securities is more of an issue. The US only did QE through government backed securities and mortgage backed securities (to a lesser extent) and both are flexible with their maturity schedules.

I have not looked at the maturity schedules of the BOJ's QE securities, but I hope that they have the same flexibility to reinvest at least some of the proceeds of maturing securities.

Regardless, monetary policy has certainly entered a new era of complexity, and there are risks to the new strategies in terms of accurately communicating the intentions of the central bank in a timely manner. The biggest risk of inflation isn't anything financial, it is the risk of the wrong signals being sent to the markets of the world by the communications of central banks.

I'll try to add citations at a later date (I have several which I was thinking of as I wrote this answer).

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  • $\begingroup$ Wow! Your answer is amazing, you give so much information. I got another question: what if the central bank gives money straight to the citizens, the so-called 'helicopter money'? If the central bank can do so without inflation, does it mean the country can get richer just by printing money? $\endgroup$ – shintaroid Mar 1 '17 at 9:30
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The first thing you must know in order to understand the situation is that under a fractional reserve monetary system:

Bank loans create money

The repayment of bank loans destroy money

In the up phase of a house price bubble, millions of people are borrowing like crazy to get on the property ladder, whilst after the bubble bursts, the enthusiasm for borrowing suddenly collapses. However, the high rate* of repaying all these mortgages will continue for years or decades to come. This means that if the central bank did nothing the money supply would start shrinking dramatically. QE is an attempt to counteract this fall in the money supply. If the rate* of money creation via QE is too slow then it is perfectly possible for the money supply to fall despite QE.

(*The word "rate" here, means rate of flow, not the interest rate.)

The idea that there is a "risk" of QE mainly comes from people who believe the "money multiplier theory" of the money supply, where an increase in base money automatically leads to an even bigger increase in the broad money supply. This theory is completely false despite being in many textbooks, as was confirmed by the Bank of England here.

This does not mean that there are no downsides to QE. QE does tend to artificially push up the price of various assets which may not be a good thing.

EDIT: This book is probably the most authoritative book in English about the behaviour of the Japanese central bank around the time of their property bubble. It's actually written by the guy that invented the phrase "quantitative easing".

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