The case for Fukui: a long-time Tokyo observer argues why a reformer, and not a deflation fighter, is Japan's best bet

International Economy, The, Spring, 2003 by Richard Katz

WHY KOIZUMI NAMED FUKUI

Prime Minister Junichiro Koizumi did not prefer Fukui, but he had no viable alternative. Originally, Koizumi wanted a "deflation fighter" from the private sector. But, as Koizumi's relations with business leaders soured, he found no takers. Besides, business leaders thought it dangerous to choose a neophyte.

The main alternative was Nobuyuki Nakahara, a fervent advocate of "inflation targeting." Formerly the head of Tonen Energy, Nakahara served on the BOJ's nine-person Policy Board where his proposals for greater purchases of JGBs as well as foreign bonds were often outvoted 8-1. Even those who liked Nakahara's policy stance, including many in Washington, regarded him as too loose a cannon to be effective. Fukui, by contrast, inspired confidence among bureaucrats, business executives and many politicians.

A key turning point came in January when former Prime Minister Kiichi Miyazawa personally warned Koizumi that inflation targeting could raise long-term bond rates (and thus lower bond prices) long before inflation showed up. That would hurt the government's ability to finance its debt, impose a stiff capital loss on the banks' [yen]80 trillion ($666 billion) stake in JGBs, and depress the economy. Koizumi then publicly repudiated inflation targeting.

FUKUI DOMINATES TROIKA

Along with Fukui, Koizumi appointed two deputy governors: Toshiro Muto, a former vice finance minister, and Kazumasa Iwata, a top economist at the Cabinet Office.

Iwata, a career academic, has neither the political base nor the personal heft to sway the Policy Board toward inflation targeting. Muto is a heavy-hitter and a longtime confidante to Koizumi. Nonetheless, Fukui will dominate. Traditionally, the BOJ governor is a real power, not a figurehead. Moreover, as a 40-year BOJ veteran, Fukui commands the enthusiastic loyalty of most of the senior staff.

Muto's highest priority is making sure that the BOJ keeps buying lots of JGBs in order to keep long-term rates down. Even though the government debt is already at 140 percent of GDP and rising, ultra-low rates keep the interest bill lower today than it was back in 1986. Within limits, the BOJ will have to comply to maintain financial stability. Sooner or later, the BOJ will lift its self-imposed limits on buying JGBs.

WEAK DEMAND CAUSES DEFLATION, NOT VICE VERSA

If monetary stimulus had the power to revive Japan by itself, it would have done so long ago. At first, some proponents said ultra-low interest rates could revive Japan. The BOJ lowered overnight rates to less than 0.5 percent back in 1995 and at virtually zero since 1999.

When that didn't work, some monetarist economists claimed that "quantitative easing" would do the trick. They argued that, whenever a central bank increases the "monetary base," i.e., the small slice of the money supply that it directly controls, then the broader money supply and nominal GDP rise in tandem. That textbook trend used to hold for Japan, but since the late 1990s, that normal linkage has broken down. Since March of 2001, when the BOJ agreed to try quantitative easing, it has hiked the monetary base 40 percent. Interest rates certainly responded; a 10-year JGB now yields a record low 0.75 percent. But the rest of the broad money supply, which reflects the economy's need for money, barely changed. Meanwhile, bank loans, prices, and nominal gross domestic product all keep falling (see Figure 1).