Standard economic theory predicts that monetary stimulus boosts inflation, which helps debtors. More specifically, it reduces the real value of outstanding debts. The nominal interest rate on future debts may rise, but the real interest rate should not rise. And if you are at the zero bound, nominal rates are likely to rise by less than inflation expectations.
Martin Feldstein recently argued the opposite; that a policy of monetary stimulus by the Bank of Japan would worsen their debt situation:
The interest rate on Japan’s ten-year government bonds is now less than 1% – the lowest in the world, despite a very high level of government debt and annual budget deficits. Indeed, Japan’s debt is now roughly 230% of GDP, higher than that of Greece (175% of GDP) and nearly twice that of Italy (125% of GDP). The annual budget deficit is nearly 10% of GDP, higher than any of the eurozone countries. With nominal GDP stagnating, that deficit is causing the debt/GDP ratio to rise by 10% annually.
Japan’s government is able to pay such a low rate of interest because domestic prices have been falling for more than a decade, while the yen has been strengthening against other major currencies. Domestic deflation means that the real interest rate on Japanese bonds is higher than the nominal rate. The yen’s rising value raises the yield on Japanese bonds relative to the yield on bonds denominated in other currencies.
That may be about to come to an end. Abe has demanded that the Bank of Japan pursue a quantitative-easing strategy that will deliver an inflation rate of 2-3% and weaken the yen. He will soon appoint a new BOJ governor and two deputy governors, who will, one presumes, be committed to this goal.
The financial markets are taking Abe’s strategy seriously. The yen’s value against the US dollar has declined by more than 7% in the last month. With the euro rising relative to the dollar, the yen’s fall relative to the euro has been even greater.
The yen’s weakening will mean higher import costs, and therefore a higher rate of inflation. An aggressive BOJ policy of money creation could cause further weakening of the yen’s exchange rate – and a rise in domestic prices that is more rapid than what Abe wants.
With Japanese prices rising and the yen falling relative to other currencies, investors will be willing to hold Japanese government bonds (JGBs) only if their nominal yield is significantly higher than it has been in the past. A direct effect of the higher interest rate would be to increase the budget deficit and the rate of growth of government debt. With a debt/GDP ratio of 230%, a four-percentage-point rise in borrowing costs would cause the annual deficit to double, to 20% of GDP.
The government might be tempted to rely on rapid inflation to try to reduce the real value of its debt. Fear of that strategy could cause investors to demand even higher real interest rates.hThe combination of exploding debt and rising interest rates is a recipe for economic disaster. The BOJ’s widely respected governor, Masaaki Shirakawa, whose term expires in April, summarized the situation in his usual restrained way, saying that “long-term interest rates may spike and have a negative effect on the economy.”
Feldstein’s right that the markets are taking Abe’s proposal seriously. The yen has plunged and inflation expectations have risen. But nominal interest rates have not risen. When you are at the zero bound you can modestly raise inflation without any impact on nominal interest rates. At a minimum, the Japanese government needs to raise inflation enough so that short term nominal rates are slightly above zero. Otherwise they are leaving 10,000 yen bills lying on the sidewalk.
Just to be clear, my views are somewhere between those of Feldstein and the more extreme Keynesians. I agree with Feldstein that Japan has big debt problems and big structural problems, and needs to address both. And that fiscal stimulus is foolish (as even Adam Posen recently argued.) Unlike Feldstein I also think they have an AD problem that calls for modestly higher inflation and NGDP growth. At a minimum they should be shooting for 2% to 3% NGDP growth, instead of the negative NGDP growth of the past 20 years.