PAMELA BOYKOFF, HOST:

I don't want anyone to run away.

STACEY VANEK SMITH, HOST:

(Laughter).

BOYKOFF: But today's episode is about monetary policy - not just any monetary policy, the future of monetary policy. There is one country that is leaps and bounds ahead of anyone else in experimenting with this future. And it's Japan. The late '80s, it was boom time. The stock market, the property market - they were all on fire. The gardens around the Japanese Imperial Palace were valued higher than all of the real estate in California.

VANEK SMITH: Of course, the boom did not last forever. The 1990s brought a really hard reality check to Japan.

BOYKOFF: The stock market fell drastically. Commercial real estate prices fell 87% from their peak.

VANEK SMITH: Yeah. And banks and companies started using all of their money to pay down debt and cover their losses instead of using that money to invest in new things.

BOYKOFF: I talked to Richard Koo, the chief economist at the Nomura Research Institute. He told me the economic damage was worse than that of the Great Depression.

RICHARD KOO: The amount of wealth the Japanese lost as a result of what happened to asset values were three times the value of Japan's 1989 GDP. In the case of the United States, it was one year's worth of 1929 GDP. So our damage was three times larger.

VANEK SMITH: This period, the bursting of this huge asset bubble, led to one of economists' worst fears - namely, deflation. That's falling prices. When prices start falling, people stop buying things.

BOYKOFF: Like, say you need a new washing machine, Stacey, but you think it'll be cheaper next month. You'd wait, right?

VANEK SMITH: Yes, I would. And then people stop buying washing machines. And washing machine companies make less money, and they lay off workers. Or they go out of business. And that leads to even less spending and more deflation.

BOYKOFF: So all of that, that's why economists call this a deflationary spiral because once you get in it, it's really hard to get out. It's really damaging for an economy. I'm Pamela Boykoff.

VANEK SMITH: And I'm Stacey Vanek-Smith. And this is THE INDICATOR FROM PLANET MONEY. On today's episode, Japan's desperate fight against deflation and how it's helping economists around the world prepare a toolkit for the future.

(SOUNDBITE OF MUSIC)

BOYKOFF: Stacey, Japan was in and out of deflation for two decades. By 2013, the country was getting desperate. They really wanted to kick-start some inflation to get the economy growing again.

VANEK SMITH: Economists believe that a low level of inflation - for example, around 2% - is healthy. And inflation just means that, you know, prices are going up. And if prices are going up at that moderate pace, at 2%, it encourages people to spend money - you know, 'cause if you want to buy a barbecue and it might be more expensive in two weeks, you want to buy the barbecue now. And that kind of thing keeps the economy moving and keeps it out of that deflationary spiral that we were talking about.

BOYKOFF: The way countries usually control that inflation is through monetary policy. So when a country wants to spark inflation, its central bank lowers short-term interest rates, the amount it cost to borrow money overnight or for a few days or a few months. This makes it cheap for people and companies to get regular loans so they can spend money or invest. And as people buy stuff - you know, cars, houses - they make things; they build businesses - all that activity drives up prices. That's inflation.

The problem in Japan in 2013 was that its short-term interest rate had already been at or close to zero percent for years. So they had to figure out what other tools they could use to make prices grow.

VANEK SMITH: And at that time, they were pioneers in tackling this issue. But now this is a concern in a lot of countries because interest rates are at or really close to historical lows in Europe and in the United States.

BOYKOFF: The head of Japan's central bank, known as the Bank of Japan or BOJ, Haruhiko Kuroda, he was the pioneer. I sometimes think of him as, like, the cowboy of monetary policy.

VANEK SMITH: Oh, I love this, like the John Wayne of trying to shoot the deflationary spiral.

BOYKOFF: Yeah, exactly. So when he took over the BOJ, he had this radical plan to try and spark inflation. Kuroda believed the key to getting prices to rise was as psychological as it was economic.

VANEK SMITH: Right, this idea that people have to believe that prices will go up. So Kuroda starts telling the public, we are going to do whatever it takes to generate 2% inflation, and we're going to do this in about two years. And this was Phase 1 of his plan. Short-term interest rates might already be at zero, but the central bank had this other powerful tool at its disposal. They could buy stuff.

BOYKOFF: Maybe not really fun stuff like cool cars or trips to Hawaii, but things bank sell - bonds, stocks, real estate funds. When central banks buy stuff, it pumps more money into the economy, and it helps get it going.

VANEK SMITH: Now the BOJ flooded the Japanese system with money. They bought so many bonds and stocks and real estate funds, they ended up buying way more stuff in Japan than the United States' Federal Reserve ever did.

BOYKOFF: I spoke to Heather Montgomery. She's an economics professor at the International Christian University in Tokyo. She said Kuroda really did change things up.

HEATHER MONTGOMERY: He believed that monetary policy could achieve inflation and growth. He clearly messaged it very differently and gave it in a package that I think was a lot easier for the public to understand. And too, you know, we have to recognize that the scale of the purchases was a lot bigger.

VANEK SMITH: It turned out that this plan, raising expectations and buying all this stuff, it was not enough. So the Bank of Japan had to add something new for Phase 2. Interest rates are already at zero. So Japan said, we will go negative.

BOYKOFF: So most normal banks like you use, Stacey, or I use for checking and savings, they store some of their money at the central bank. And the bank might give them some interest on deposits, just like we get interest on a savings account.

VANEK SMITH: Yes. But when there is a negative interest rate, instead of paying the regular banks or storing the money for free, the central bank will actually start charging them to store money. It's kind of a way of being like - hey, do not let your money sit here and collect us with us. Go lend it out; go make it circulate in the real economy.

BOYKOFF: These negative interest rates, though, they had an unfortunate side effect.

MONTGOMERY: Who it's been especially hard for is the regional banks, who still rely a lot on what you might call old-fashioned bread-and-butter banking - you know, taking in deposits, paying some interest rate on that and making loans.

BOYKOFF: With the economy in deflation, the banks weren't making a lot of money on loans. And now they also got charged for storing money at the central bank. This whole thing, it became really painful for the banks in Japan. And healthy banks are key to keep any economy going.

VANEK SMITH: Right. The Bank of Japan had to fix this. So they rolled out their most ambitious plan yet - Phase 3.

BOYKOFF: Don't get scared, Stacey, but it involves the yield curve.

VANEK SMITH: Oh, the yield curve. This is Cardiff's territory. Cardiff is the yield curve guy.

BOYKOFF: Where is Cardiff when you need him? What is he just, like, bunking off somewhere?

VANEK SMITH: I think he's on vacation.

(LAUGHTER)

BOYKOFF: So the yield curve is this chart that economists love.

VANEK SMITH: This is true.

BOYKOFF: And it looks at how short-term interest rates, like the ones we talked about before, compare to long-term ones. Like, how much cheaper is it to borrow money and pay it back in three months compared to keeping it for 30 years?

VANEK SMITH: For Phase 3, the Bank of Japan decided to use all of its power, all of its muscle - its ability to buy and sell stuff at will - to control the relationship between short- and long-term interest rates to be the master of the yield curve, breaker of chains. And they wanted to find a balance where money was still cheap to borrow - like, banks could borrow money cheaply in the short term, but they could also make money in the long term.

BOYKOFF: I like to think of it this way. If there was a god of surfers and he could create the perfect wave with just the right peak and just the right trough, that would be what the BOJ is trying to do here with the yield curve.

VANEK SMITH: So Phase 3 is still going on, and it's gone pretty well. Since it was introduced, Japan has consistently avoided deflation. And it has achieved, you know, what you could think of as inflation light, nearing 1%. But despite buying lots of stocks and bonds and trying all of this innovative policy, Japan has gotten nowhere near its 2% inflation goal. Earlier this year in an interview, Kuroda basically said, please be patient.

BOYKOFF: His experience, Kuroda's ambitious cowboy attempts and how they've gone, for a lot of economists, that underlines just how tricky monetary policy is right now. It's a powerful tool, but it's not the Holy Grail.

VANEK SMITH: The Phase 3 of Japan's plan, tinkering with long-term interest rates rather than just short-term interest rates, this is unconventional territory. And other countries are really watching this because in the past few months, two governors of the Federal Reserve here in the U.S. have suggested that if we have another recession and short-term interest rates hit zero, they might be willing to consider using a tool like this one depending on, of course, how this goes.

BOYKOFF: You know, Stacey, it's a big, bad, low interest rate world, and central banks are still figuring out how all these new policies play out in the real economy.

VANEK SMITH: It's like the world's most confusing Western.

BOYKOFF: Yeah. But you throw in the yield curve and the Bank of Japan and...

VANEK SMITH: The god of surfing?

BOYKOFF: The god of surfing. I mean, he would be great in a movie.

(SOUNDBITE OF MUSIC)

VANEK SMITH: This episode was produced by Constanza Gallardo, fact-checked by Emily Lang and edited by Paddy Hirsch. THE INDICATOR is a production of NPR.

(SOUNDBITE OF MUSIC)

Copyright © 2019 NPR. All rights reserved. Visit our website terms of use and permissions pages at www.npr.org for further information.

NPR transcripts are created on a rush deadline by Verb8tm, Inc., an NPR contractor, and produced using a proprietary transcription process developed with NPR. This text may not be in its final form and may be updated or revised in the future. Accuracy and availability may vary. The authoritative record of NPR’s programming is the audio record.