Japan moves into negative interest rates; will unconventional policy pay off this time?

So Japan has joined the select group of central banks that have lowered their policy interest rate into negative territory (-0.1%). The European Central Bank pioneered negative rates (-0.2%) in 2014, followed by Sweden (-1.1%) Denmark and Switzerland (both -0.75%).

Leon Berkelmans explored the case for negative rates here. I'd argue Europe and Japan have taken this step because no one can offer anything better to lift their economies out of their post-2008 torpor. For the individual countries, mildly negative rates may do no great harm, but nor are they the policy breakthrough that restore the power of monetary policy. As a cure for global weakness, they are just as likely to be harmful as beneficial.

Why don't these initiatives signal the demise of the long-standing constraint of the 'zero lower bound' that supposedly stops interest rates from going negative? In practice, the tiny negatives which have been implemented so far aren't much different from the near-zero policy rates that are common among the advanced economies: they don't represent a breakthrough in policy, except perhaps psychologically.

In Japan's case, the move confirms to the Japanese public that the Bank of Japan (BoJ) is still trying hard to get inflation up (the target is still 2% but, like a mirage, this keeps receding into the future). At the same time, however, the new measure is also an uncomfortable reminder that previous experiments with unconventional policies haven't worked so far. It was BoJ governor Haruhiko Kuroda who invoked the Peter Pan logic of the power of confidently held expectations: Peter told Wendy that she would be able to fly, if only she believed she could. There is a corollary here with inflation which is, after all, largely driven by inflation expectations; if everyone believes inflation will run at 2%, price-setters will start increasing their prices and it will come true. But it's hard to make people believe inflation is taking off when past policy initiatives haven't gotten off the ground.

What would happen if these tentative sorties into negative territory were pushed far enough to offer borrowers the opportunity of funding that was not just free, but where their debt diminished perceptibly over time — say a negative rate of 5-10%? That would certainly seem to be an incentive to borrow and invest.

But first a technical problem would need to be solved. [fold]

Borrowers need to be funded by lenders but who would lend if the negative return erodes their capital over time? The relevant academic analysis focuses on the role of currency holdings. Won't investors, faced with the prospect of getting negative returns on their bank deposits, respond by storing their savings under the bed in the form of currency? For some readers, the vision of Scrooge McDuck diving into the cash in Money Bin #23A may come to mind. How to make currency accumulation an unattractive option? With this challenge in mind, many ingenious schemes have been dreamt up to make sure that currency, too, loses its value over time. While these might solve the technical problem, they miss the underlying issue. Investors, faced with the choice of lending at a negative rate or investing in the many real or financial assets (such as equities) that offer some prospect of a return on their investment, will choose the latter.

Buying existing assets doesn't add to GDP; it just bids up asset prices. But does it alter the savings/investment imbalance that many think is at the heart of chronic weak growth? The impact on savings could go either way: negative interest rates might reduce the incentive to save, but if savers are targeting asset accumulation for retirement, they will have to save more rather than less. Would the higher asset prices (say, houses) raise the incentive to build new houses? It might in the short term, but if the underlying problem is low prospective returns on investment, this problem needs to be addressed directly rather than circumvented by setting off another asset price bubble. Japan's asset-bubble collapse in 1990, that ushered in the 'lost decades', is the cautionary reminder.

Of course investors could buy foreign currency or foreign assets offering a positive return. This action will depreciate the exchange rate and that will help exports and discourage imports, thus boosting the local economy. Does this sound like the answer? It has worked for the euro (which is down 20% since negative rates were introduced). Already the yen has lost a couple of per cent. Exchange-rate considerations were the main motivation for Denmark, Sweden and Switzerland: their negative rates discourage capital inflow and restrain unwanted appreciation against the euro. Alas, this is the classic 'beggar-thy-neighbour' policy: boosting your own economy at the expense of your trading partners.

One of the characteristics of the various versions of 'unconventional monetary policy' (quantitative easing, as well as negative rates) is that they have a substantial exchange rate impact; always a case of 'beggar-thy-neighbour'. Even with conventional monetary policy, the exchange rate is one channel through which policy works. It may be that the exchange rate is, in fact, the main transmission channel of unconventional monetary policy, without doing much to stimulate the domestic economy via other transmission channels. The G7 countries — the main users of unconventional monetary policy — have tried hard to downplay this aspect, in the face of accusations of 'currency wars'. No clear consensus came out of this debate, which was overtaken by issues of volatile capital flows. But heated complaints would surely arise again if negative rates were to be used in a substantive way.

This debate is, in any case, a distraction from the main problem. The weak recovery from the 2008 crisis may be attributed to the debt obsessions which prevented sustained fiscal stimulus that would have given the recovery some momentum. The time for conventional fiscal stimulus has passed. Monetary policy is already doing all that can be expected of it to assist the recovery. So what should policy do?

One option is to do nothing, in the hope that the normal self-equilibrating forces of the economy will in time shift growth closer to potential. But the BoJ move illustrates the pressure on policy-makers to 'do something'. What are the active options? Countries could use the opportunity of low interest rates to undertake infrastructure. Or they could undertake structural reform to raise the expected return on private investment. Neither of these are easy options. For infrastructure, the Japanese public would ask how many more 'bridges-to-nowhere' are needed. In emerging economies, where the need for more infrastructure is undoubted, implementation is often the bottleneck. As for structural reform, advocates of this should be required to solve the politicians' lament: 'we know what to do: we just don't know how to get re-elected after we've done it.'

Image courtesy of Flickr user Japan Kuru

Stephen Grenville