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Strange qualms

14 Feb 2013 By Andy Mukherjee

The Bank of Japan has a morbid fear of directly financing fiscal deficits. But this “no monetisation” creed sits ill with the $1 trillion or so of public debt – roughly a fifth of the Japanese GDP and about 14 percent of the net outstanding public debt – which it has already turned into money. The next BOJ governor, who will take over when the incumbent Masaaki Shirakawa steps down on March 19, should be more realistic.

The BOJ owns about $1.3 trillion in government bonds, which it has paid for by creating money. Of this money, about $375 billion is voluntarily held by banks as excess reserves. If banks suddenly find a more exciting use for these funds, the BOJ will be forced to raise compensation on excess reserves from its present level of 0.1 percent. And if that is not enough, the central bank will have to sell liquid government bonds in the market and extinguish an equivalent amount of money.

But the private sector has no control over the remaining $1 trillion or so of public debt owned by the BOJ. On the central bank’s balance sheet, these assets are backed by three near-permanent liabilities: currency issued by the central bank; zero-interest balances banks are required to keep with the monetary authority, and the BOJ’s capital and loss reserves.

None of the three liabilities pays anything. None can be redeemed: bank notes can only be exchanged for different bank notes; financial institutions can’t recall mandatory balances, and the private sector has no claim on the BOJ’s capital. This is how a modern central bank monetises debt – by creating a large, positive net worth for itself while loading up on government bonds. The crude method of a government dumping its debt on its central bank is history. 

While the Federal Reserve has been an even bolder pursuer of unconventional policies than the BOJ, the extent of debt monetisation in the United States is quite low compared with Japan. If depository institutions were to baulk at the 0.25 percent interest they receive on their balances with the Fed and draw down their entire $1.6 trillion in excess reserves, the Fed would have to sell almost all the treasury securities it owns, removing an equivalent amount of money from the economy.

US Federal Reserve economist David Lebow introduced this method of measuring debt monetisation almost a decade ago. Interestingly, even as the value of monetised public debt in Japan has risen to 20 percent of GDP from 12 percent in 1997, there has been no upheaval in the bond market. Yet, the BOJ orthodoxy believes that if bond purchases by the central bank are seen to be motivated by a desire to help the government finance itself cheaply, investors would demand higher interest rates.

The BOJ is not loath to share this view with others. An August 2012 report by the International Monetary Fund cites central bank officials as telling the IMF staff that “in the absence of fiscal reforms further increases in JGB purchases (by the BOJ) could be viewed as monetisation of the fiscal deficit and push interest rates up.” But there is no evidence to support this claim. The government announced an additional 2 percent of GDP in fiscal stimulus in January, and the BOJ said it would buy unlimited amounts of bonds, starting 2014. Yet, 10-year Japanese government bonds currently yield 0.75 percent.

The real danger of monetisation is that the government, once it’s allowed to bypass the discipline of bond markets, would become a reckless borrower. But this argument doesn’t hold for present-day Japan. The government’s large deficits have compensated for two decades of private-sector deleveraging. If the state had lived within its means, nominal GDP, which is only 10 percent lower than it was in 1997, might have collapsed.

Monetisation of public debt has posed little danger to Japan so far, and is unlikely to be much of a threat before the economy exits deflation. Then the private sector might have reason to complain about being crowded out by government borrowings.

The BOJ could be even bolder by implementing a proposal by Koji Ishida, a member of the central bank’s monetary policy board, to scrap interest on excess reserves. If banks still leave idle money parked at the BOJ, it will only mean that lenders have no desire to swap zero-interest cash for anything else. And that will send a strong signal to both the government and the BOJ that the Japanese may be ready for more helicopter money.

For the BOJ to hold back on monetary expansion now in anticipation of future problems is not prudence. It’s just an irrational fear the next governor must overcome.


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