Japan's Negative Interest Rate Policy: Analysis and Risks

Introduction

On January 29, 2016, the Japanese government instituted a negative interest rate for the first time in history. The stated objective of this policy was to "encourage banks to lend, business to invest and savers to spend," but the policy came under heavy criticism almost immediately. It is, ultimately, a high-risk policy that takes Japan into uncharted waters (Reuters, 2016). To call this policy unorthodox is an understatement, but it highlights the rather unique position that Japan occupies with respect to its economy. Economists in particular have been observing the effects of this policy closely, because it represents a new situation whose impacts can only be theorized. This paper outlines the context for this decision and analyzes whether it is a sound move by the Bank of Japan.

Background on the Japanese Economy, 1940s to 1980s

Understanding how this move came about requires an understanding of the Japanese economic context. After World War II, Japan embarked on a program of industrialization in order to modernize its economy. In part, this was a response to losing the war, where America's technological superiority was recognized by Japanese leadership as the decisive factor in the Pacific theater. The nature of industrialization in Japan was highly centralized — for many years it was the only industrialized nation not to follow the Western model of industrial development.

The Japanese model relied on the keiretsu concept. In this system, companies are grouped in mutually beneficial alliances. At the heart of each group is a major bank, which enables other members of the group to obtain financing, often on favorable terms. Multiple industrial concerns form the keiretsu, encompassing different major industries, and many of these companies would grow into conglomerates. The central government, through the Bank of Japan, exercised control over the keiretsu via the major banks at the heart of these groups. Within a given keiretsu, directors would sit on the boards of other member companies, so that corporate governance was designed to make each company within the group accountable to the others (Twomey, 2016).

The keiretsu allowed companies to flourish by investing in capacity, because they could all but guarantee a certain level of demand. This system was ideal for rapidly growing industrial capacity and served Japan well through the 1980s, when some of its faults began to show. The relative lack of competition was starting to hurt the ability of keiretsu to compete on global markets, particularly with the emergence of South Korea and other Asian nations. The Japanese economy, which had grown rapidly for several decades, began to slow. The keiretsu model, which included features that constrained the competitiveness of its companies, was no longer an engine for growth, yet it was too entrenched to be dismantled easily.

At the heart of Japan's growth story was technological development. The major industrial companies were well-run and enjoyed success because they could capitalize on the Japanese education system and on their preferential access to capital. However, some other features of the system were of questionable value. Major companies in Japan provided, for example, lifetime employment, and promotions were based on tenure rather than performance. Ultimately, this proved to be a problem: managers were not incentivized to excel, knowing that they would not be fired and would likely be promoted regardless of their results. Inefficiencies like this would eventually pose a challenge once Japanese companies could no longer compete strictly on technological superiority. As global markets opened up, many Japanese products became less competitive.

The Japanese economy grew rapidly in the 1960s, slowed in the 1970s, then roared back in the 1980s — in particular as Japan began exporting automobiles worldwide alongside growth in personal electronics. The problem was that this was not sustainable. The country relied on high tariffs to protect its domestic markets, but as major trading nations moved to lower trade barriers, this policy hurt Japan in two ways. First, domestic companies, shielded from competition, had not been forced to become competitive. Second, some Japanese markets had to be opened, allowing foreign products to enter.

Another fundamental issue is that unlike most other industrialized nations, Japan does not have a growing population. Most industrialized nations have birth rates below replacement level and rely on immigration for population growth. Economic growth since the dawn of industrialization has depended on two factors: a growing population and resource exploitation. Japan lacks significant natural resources, so resource-driven growth was never a viable long-term option. The domestic market, even when protected, was therefore a no-growth market. Japanese companies were always going to rely on exports to achieve growth, and if their products became less competitive globally, the country would experience economic stagnation. In the early 1990s, that is exactly what happened.

Background on the Japanese Economy: The 1990s

In the early 1990s, the Japanese economy entered a no-growth scenario. Coming on the heels of the 1980s boom, this was a shock and resulted in significant restructuring. This period became known as the "lost decade." The Japanese economy had at that point caught up with other industrialized nations. With few additional natural resources to exploit and a stagnant population, Japan could only increase its GDP through another technological boom cycle or through gains in productivity (Smith, 2012). The keiretsu system, as noted, was an impediment to productivity improvements. As it turned out, Japan was not at the forefront of the next major technological cycle; that was driven by the United States through the Internet.

The country came under considerable criticism for its macroeconomic policies during the lost decade. In addition to losing its technological edge and suffering from a stagnant population, Japan was also hampered by a high savings rate. At the end of the 1980s, the country faced a financial crisis. For the first time, Japanese people felt apprehension about their future as mass layoffs took their toll on the national psyche. The savings rate increased substantially, and by the late 2000s Japan had by far the highest savings rate in the G7. Massive amounts of wealth were held by the country's elderly. This was attributable in part to macroeconomic policy: savings passed down to children were taxed as regular income, which discouraged the elderly from transferring that wealth, and if they did transfer it, they would typically wait until the child was retired in order to minimize the tax burden (The Economist, 2009).

Another policy response in the 1990s was massive fiscal stimulus. After the stock market and real estate bubbles burst at the end of the 1980s, Japan faced a massive financial shock. The government responded with a series of stimulus initiatives, including public works spending and loan programs. These efforts did little for the Japanese economy, in part because the public works projects often added little real value (Yang, 2009). Interest rates were also dropped to rock bottom.

This policy put Japan into the realm of the liquidity trap. The Japanese central bank had lowered its rates rapidly in response to the bursting of the 1980s bubble, then added various stimulus programs that proved ill-conceived. Moreover, it quickly became apparent that Japan was no longer technologically superior and would need to restructure its economy — a process that would take years. By the mid-1990s there was a slight uptick in growth, and the government promptly raised its consumption tax (Yang, 2009). This crushed consumer spending. The economy lapsed back into recession, and with interest rates already at the zero bound, the central bank had no further room to stimulate by cutting rates (Krugman, 1998).

Structural economic reform was necessary, but fiscal policy alone was insufficient to prop up Japan during this period. With monetary policy already exhausted, Japan's recession dragged on throughout the lost decade. Critical time was lost before the government adopted measures to address the bad debt — a hangover from the real estate and stock market bubbles — that was holding the economy back (Kobayashi, 2009).

Others have argued that the fiscal stimulus failed because the packages were not large enough. This reasoning is rooted in the Keynesian rationale that increased government spending spurs economic growth, extrapolated to mean that if spending did not work, more spending was required (Nanto, 2009). The problem with this argument is that spending always has a multiplier, and good projects have better multipliers than bad ones. Most observers concluded that the projects the Japanese government undertook in the early 1990s were poor choices.

The Modern Context

After the lost decade, Japan began to enjoy some economic growth. This appears to have been driven largely by an increase in exports to China — particularly automobiles — combined with deep cuts in public expenditure and a rise in domestic spending as the millennial generation came of age. The exports to China, which began in earnest in mid-2003, appear to be the major cause of Japan's economic recovery in the mid-2000s (Jones, 2005). It is therefore unsurprising that this growth collapsed in late 2008, when growth in the rest of the world did as well.

Japan never fully recovered. Even during the mid-1990s, Japan suffered deflation, with the CPI declining for six consecutive years through 2004. This underscores that Japan's growth was largely driven by its exports to China and other Asian countries. Both net exports and private spending, which were strong in 2004, slowed in subsequent years (IndexMundi, 2016). The recovery was therefore short-lived and largely illusory. A collapse in 2008–2009 was followed by a brief increase in 2010, but in 2011 the economy fell again — and it was at that point that the central bank dropped interest rates to zero. With rates back at the zero bound and structural issues unresolved, Japan once again risked finding itself in a liquidity trap.

The lack of meaningful recovery from the 2008 crisis contributed to the current situation. While the U.S. Federal Reserve also kept its rates near zero for an extended period, it faced criticism in some quarters for not raising rates at least slightly — if only to maintain flexibility in the event of another slowdown. Japan's situation has interesting parallels: it faced a real estate crisis that precipitated the lost decade, struggled to find a way out, and deployed both aggressive fiscal and monetary policy with limited success. Structural issues clearly continue to play a role.

There are, however, important differences in the banking system. The keiretsu arrangement meant that a handful of major banks have always been the key drivers of the Japanese economy, and that Japan's corporate landscape was dominated by large conglomerates. This differs from the U.S. economy, where small and medium enterprises remain influential and banking is more competitive. In essence, the U.S. economy is better equipped to adapt to changes in economic policy. Japan's economy remains overly reliant on its major banks and on the adaptive capabilities of large conglomerates — a dynamic that has significant implications for the potential effectiveness of a sub-zero interest rate policy.

In 2012, in response to a weakening economy, Japan undertook policies intended to devalue the yen and make exporters more competitive. This set of policies, colloquially known as Abenomics, allowed some exports to rise — notable beneficiaries included Panasonic and Toyota (Einhorn, 2016). However, there was no clear driver of sustained economic growth, and no sector emerged to carry the economy for more than a few quarters at a time. This challenged policymakers, who remained unsure where to direct their efforts in order to build durable growth.

Just prior to the announcement of the negative rate, the yen had strengthened by 5.6% at the start of 2016. As a result, the exporters benefitting from Abenomics saw their gains threatened as their products risked becoming less competitive. Lingering structural issues also remained, including calls for labor law reform and deregulation. There was still discussion of increasing the consumption tax, which would further cool economic activity. Part of the rationale for moving to the negative rate was to force investment off the sidelines.

Conclusion

The move to institute a negative interest rate is a risky one on Japan's part. It appears to be born of desperation. With fiscal policy that is actively inhibiting the country's attempts to grow its way out of trouble, Japan is working against itself. Monetary policy alone has borne responsibility for whatever growth Japan has achieved, and the country has been up against the zero bound for years without gaining meaningful traction. It is not surprising that the Bank of Japan went off-script in trying to avoid yet another lost-decade scenario. The problem with the plan is that a great many things have to go right for it to work. Japanese banks need to be motivated to lend, and businesses need to identify projects worthy of investment. Given that the current policy rate plus company risk premium implies only a tiny reduction in discount rates, it is not necessarily likely that anybody in Japan will meaningfully increase investment in response. There is a real risk that the attempt to mobilize sideline capital will go nowhere.

If it does fail, Japan is left in a difficult position. The country has increased its risk of deflation and may experience adverse unintended consequences — such as people selling yen for dollars or holding their wealth in cash. These are not the intended effects of the policy, and capital mobilized in Japan would still need to be put to good use, but there are not necessarily many good uses available. Japan has an aging, shrinking population and limited natural resources. Long-run economic stagnation is, in some sense, a structural outcome. The country still carries economic and commercial structures that are remnants of the keiretsu system, and these constrain growth as well. Overall, Japan is taking on considerable risk, still needs structural reform, and may not succeed with this experiment.

Given the risks and the slim likelihood that this policy will actually spur growth, the negative interest rate is not likely to be a success. Even if everything goes right and the rate achieves its intended effects, it will take months or more likely years for success to become apparent. Japan may not have that long — particularly if deflationary pressures mount, fiscal policy remains contractionary, or economic growth slows further. It would be extremely difficult to maintain the policy long enough to give it a genuine chance to work under those circumstances.

Traditional policy measures, of course, are no longer available. There were no further conventional interest rate cuts to be made, leaving only unconventional monetary policy as a means of spurring investment. The country needed a mechanism to take money off the sidelines and put it back into the economy. But the practical obstacles are formidable. This move is unlikely to unlock consumer savings, because most of that wealth is in the hands of elderly savers who are unlikely to change their consumption habits in response to this policy. Moreover, urban Japanese consumers have little physical space for additional consumer goods — trying to stimulate the economy by encouraging more consumption of goods is not a strong economic strategy. The best opportunities lie in business investment in innovation and in foreign investment that could increase profits for Japanese firms and have a positive effect on the stock market.

There is therefore good reason to believe that the positive outcomes from this plan will not materialize. If they do not, Japan will have taken on deflationary risk and the risk of economic contraction for nothing. Most economists appear to agree that the negative rate strategy is unlikely to succeed, will unsettle markets, and will produce adverse, unplanned consequences. If any success does occur, it will require months or years — and Japan may not be able to sustain the policy that long. The major issues inhibiting Japan's growth remain unresolved. Even if this policy granted temporary relief — which is unlikely — the Japanese economy would still need to continue its structural overhaul to achieve long-run, sustained success. That is precisely why the policy is high risk and, on balance, should not have been undertaken. Negative interest rates are unorthodox for good reason: they offer only a small potential win over a long time frame, at the cost of high risk in the meantime. The negative interest rate policy is not recommended.

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