Japan has been struggling for the past two decades to grow its economy and raise prices. An anemic growth that began after the real estate and stock market bubble burst in the 1990s has held back wage growth, consumer spending and private investment. Meanwhile low prices, which are a direct cause of insufficient demand or spending, have made it difficult for businesses to earn profit at home, resulting in a cycle of no profit, no wage growth, no spending and more pessimism.
Taking a recommendation from a standard economics textbook, the Japanese government stepped in and spent money to help fill in the demand gap. And to finance its spending, the government borrowed – mostly from its own citizens. As a result, the public debt now stands at over 200 percent of its gross domestic product or annual output, and this debt level is the highest among developed economies.
A well-publicized study from two Harvard University professors, Kenneth Rogoff and Carmen Reinhart, claimed that 800 years of financial history proves that high government debt ratios lead to low economic growth. The authors wrote:
“Throughout history, rich and poor countries alike have been lending, borrowing, crashing — and recovering — their way through an extraordinary range of financial crises. Each time, the experts have chimed, ‘this time is different’, claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters.”
Well this time is indeed no different. The Japanese government has borrowed heavily to finance its spending and investment in hopes of jump starting its economy. But that effort failed.
So in a desperate and last ditch effort, the Japanese government turned to an unorthodox economic practice of printing money by buying bonds to inflate prices. The thinking is more money in circulation will raise prices, and higher prices will enable businesses to earn more profit and thereby raise wages to simulate consumer spending.
Bank of Japan Governor Haruhiko Kuroda wants prices to increase by at least 2 percent. And to achieve this target, Governor Kuroda stunned the financial markets by unexpectedly expanding its bond buying program. The bank plans to increase the money supply by around ¥80 trillion ($712 billion) each year totaling about 15 percent of annual output.
Will this work? A long time of student of Japanese economy, Professor Ben Bernanke of Princeton University, implemented a similar bond buying program when he became the Federal Reserve Chairman and confronted the financial crisis of 2008. Fed Chairman Bernanke believed when an economy is shocked by an asset bubble burst – in this case the collapse of housing prices and credit – and short term interest rate is at zero, the central bank should pump money and credit into the economy by buying bonds, which is now commonly referred to as quantitative easing (QE).
The effectiveness of QE is still being debated by academics and policy analysts. That said, the empirical result is clear. After five years following the financial shock, the US economy has recovered. The only other country which followed the US and aggressively bought bonds, the United Kingdom, also recovered. In contrast, the Eurozone and Japan have remained mired in stagnation with no signs of recovery.
The Bank of Japan’s expansion of bond buying is recognition that QE does work. Therefore, it is no surprise the Central Bank of Europe (ECB) is also preparing to ramp up its bond buying as early as next year. As consequence, the Japanese yen and the euro are expected to underperform relative to the US dollar and the British pound. History demonstrates increasing money supply weakens the currency.