There are growing calls for Japan to inflate its way out of its economic troubles. Should it heed them?

AS JAPAN'S economy gets sicker, so the calls for a radical approach to resuscitation get louder. A chorus of senior politicians, bureaucrats and economists has suggested that a dose of inflation might be just what the country needs.

That Japan needs to do something to rev up its economy is not in doubt. On July 21st Masaru Hayami, the Bank of Japan's governor, suggested that its recent, gloomy economic reports had been too optimistic. Two days later, Moody's suggested it may lower Japan's top-notch credit rating. So might a spot of inflation help matters?

The idea that it might has been gaining ground thanks to two economists. One is Kazuo Ueda, who sits on the Bank of Japan's policy board. The other is Paul Krugman, professor of economics at the Massachusetts Institute of Technology.

To be fair, all Mr Ueda really wants is to avoid a deflationary spiral. Wholesale prices are already falling in Japan, as in most other rich industrial economies; but the same is not yet true for consumer prices. He and others at the Bank are worried that they might now fall too.

His answer to this is to suggest that the central bank should have an explicit inflation target—say, between zero and 2%. At the moment its guidelines eschew such targets. Introducing one should actually increase inflationary expectations and, hence, demand. If they think prices are likely to rise a bit, people may buy today rather than tomorrow. In short, a Japanese inflation target might lead to behaviour opposite to that employed by most other central banks that follow such targets: fostering it, rather than restraining it.

Mr Krugman's approach is more radical than Mr Ueda's. He wants outright inflation. In recent papers*, he has argued that most analyses of the cause of Japan's plight—too much corporate debt, unwillingness of banks to lend, over-regulation—are, at best, unproven. Japan, he argues, is in a classic liquidity trap. Overall demand consistently falls short of the economy's productive capacity, and saving consistently exceeds investment—despite near-zero interest rates. That means that monetary policy has become ineffective at boosting demand. Yet interest rates cannot fall any further, as it is impossible to have nominal rates below zero.

How to solve this dilemma? A Keynesian government spending spree? Tax cuts? Neither, thinks Mr Krugman, is sufficient, though he believes they might help. He considers monetary policy a better tool. And since nominal interest rates are so low, that means bringing real interest rates down by generating inflation of, say, 4% a year. Moreover, it has to be done on a long-term basis—for 15 years, say—in order to raise inflationary expectations. Otherwise potential borrowers will expect the central bank once again to stamp on prices, driving up real borrowing costs. The central bank, says Mr Krugman, with his gift for the bon mot, must “credibly promise to be irresponsible”.

The devil in the detail

Although they have different aims in mind, the two economists agree that the central bank should target inflation. But how would it get prices up—and would the economy really benefit?

In most modern economies governments no longer literally print money. Instead, they buy financial assets, such as government bonds. Most of the proceeds end up with commercial banks. But if this were done in Japan, it is unclear, given their dreadful balance sheets and poor capital ratios, that the banks would lend the money to others—even if firms and households wanted to borrow. So the real economy might see little boost.

Moreover, savers, faced with negative real interest rates, are likely to plonk their cash overseas, an option made easier by changes in the law last April. If they did this, monetary growth and credit creation would slow once more. The more so because, without cheap deposits, banks would have to borrow more expensively in the capital markets.

That makes it highly uncertain how much money the Bank of Japan should try to inject. Japan's output gap is reckoned to be about 5% of GDP and growing, meaning that production is falling increasingly short of capacity. To create inflation, the central bank needs to print enough money to fill that gap. Yet monetary aggregates are already expanding in Japan. The broad measure of money (M2 + CDs) is growing at an annual 3.5%.

Inflation might thus prove surprisingly hard to create even with a large monetary expansion. And even if it were managed, would it cure Japan's woes? Although neither Mr Krugman nor Mr Ueda presents it in this way, some other economists argue that inflation is a splendid way to transfer wealth from savers to borrowers, of which Japanese companies are among the biggest. Yet while it is true that inflation would improve corporate earnings, it is not clear that it would improve their net indebtedness.

One reason is that increased inflationary expectations would mean higher long-term interest rates. To reduce the real burden of debts, inflation must increase by more than the extra interest costs that borrowers have to pay.

Then there is the issue of what happens to the yen. A huge increase in the money supply would almost certainly mean a further collapse in the currency. That could trigger a sharp fall in the currencies of other Asian countries, driving up the value of their foreign debts and pushing their economies into deeper depression. Mr Krugman largely ignores this in his first article, and all but dismisses it in his second. “Such fears cannot be completely discounted and if the 29-year-olds in London who rule the world think that something is true, for a few hours or days it is,” he writes.

It is certainly true that if Japan were to create modest inflation, and the yen were to fall gently, that might benefit all of Asia by helping to get Japan's economy growing again. But the risk is that, in order to be effective, the Bank of Japan would have to create so much money that the yen goes into free fall, throttling its neighbours. The question, as so often, is how much is too much?





* “Japan's Trap”. MIT, May 1998; “Further Notes on Japan's Liquidity Trap”. MIT, June 1998 (web.mit.edu/krugman/www).