The financial markets are not taking Martin Feldstein’s worry seriously

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.

HT:  Felipe



7 Responses to “The financial markets are not taking Martin Feldstein’s worry seriously”

  1. Gravatar of Basil H Basil H
    19. January 2013 at 08:10

    Professor Sumner,

    You often times argue, I believe, that deflation and variable inflation is not a bad thing in and of itself, but rather is a reflection of variable NGDP. To quote from your Adam Smith Institute piece:

    “In fact, many of the problems generally associated with inflation are actually linked to NGDP volatility.”

    If this is the case, then why is Japan’s implicit 0% NGDP target. NGDP was almost precisely flat from 1990 to 2008 (correct me if I’m mistaken). Shouldn’t NGDP expectations have stabilized, and there should be no AD problems?

  2. Gravatar of Steve Steve
    19. January 2013 at 09:25

    Bloomberg headline:
    “Abe’s Stimulus May Trigger Japan Default, Fujimaki Says”

    First paragraph:
    “Prime Minister Shinzo Abe’s fiscal and monetary stimulus measures may trigger a collapse of Japan’s economy as early as this year, according to Takeshi Fujimaki, a former adviser to billionaire investor George Soros.”

    Here are Fujimaki’s ACTUAL quotes from the article:
    “Large-scale spending is ridiculous given the amount of debt Japan has accumulated, while I think highly of Abe in regards to his intention to weaken the yen to support growth,”

    “I prefer to see a crash of Japan’s debt sooner than later because there’s no other way to revive Japan’s economy…The biggest merit for that is we won’t have to repay debt that we can never repay. Otherwise, young people will have to work like coach horses just to pay tax.”

  3. Gravatar of Steve Steve
    19. January 2013 at 09:28

    Kyle Bass made the Feldstein argument on CNBC yesterday. He’s the guy who convinced the University of Texas to take physical delivery of $1 billion in gold bars.

  4. Gravatar of Tommy Dorsett Tommy Dorsett
    19. January 2013 at 10:54

    Scott – Feldstein’s line of reasoning boils down to the argument that a fiat money central bank cannot inflate away domestically denominated debt. And that not only flies in the face of standard macro theory, it cuts against numerous historical episodes of inflationary finance. I’d givehist a grade of F. Total fail.

  5. Gravatar of Answering Tyler’s question on Japan with old blog post « The Market Monetarist Answering Tyler’s question on Japan with old blog post « The Market Monetarist
    19. January 2013 at 12:37

    […] Scott Sumner also comments on Japan and it seems like we have more or less the same advise. Here is Scott: “Just to be […]

  6. Gravatar of ssumner ssumner
    20. January 2013 at 07:20

    Basil, Japan did better after 2000, partly because wages partly adjusted. But I’ve also argued that money may not be neutral, even in the long run, when nominal wages have to fall.

    Also note that falling NGDP is making their debt problems worse. And what happened after 2008 was a huge policy error.

    Steve, If Japan does fiscal stimulus but not monetary stimulus, it will be a disaster.

  7. Gravatar of Saturos Saturos
    20. January 2013 at 22:19

    Basil, also note that they did not have an explicit 0% level target. Which means that these factors may come into play:

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