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Japan’s experiment could lead to salvation or disaster

THE AGGRESSIVE MONETARY POLICIES pursued by the major central banks escalated with huge moves announced by the Bank of Japan’s (BoJ) new governor Haruhiko Kuroda [pictured]. The decision to double Japan’s monetary base within two years was truly unprecedented. Expressed as a share of GDP, the scale of the BoJ’s expansion is twice as big as the US Federal Reserve’s exceptional programme of purchasing $85bn in Treasury bonds and mortgage-backed securities each month.

In spite of many differences, the ultimate aim of all the monetary plans is to revive growth. However, while the Fed’s main specific target is to reduce unemployment, the BoJ is primarily focusing on ending Japan’s debilitating deflation, and achieving a positive annual inflation rate of 2%.

It is clear 2013 will see an extraordinary acceleration in the pace of global money creation. The long-term impact of this radical policy change could be far-reaching. The monetarist policies which have replaced the Keynesian orthodoxy since the late 1970s are now being temporarily abandoned. We are not returning to full-blooded Keynesianism, with its focus on aggressive fiscal policies, as public sector debt and deficits are prohibitively large and must be scaled down.

However, since the recession of 2007-08 has caused enduring damage to growth in most developed economies, governments are hoping active monetary policies will play a central role in stimulating demand. But keeping official interest rates near zero for more than four years, as well as adopting aggressive quantitative easing programmes, has failed to restore growth rates to normal levels, though the lack of success has failed to prompt a reassessment of the approach.

Rather, both governments and central banks seem convinced the right answer is to create even more new money, at an increasingly aggressive pace. The strategy is clearly risky. Even if stimulating demand produces benefits, one cannot disregard the potential adverse effects of a prolonged period of zero interest rates and massive money creation on the willingness to innovate and take risks.

The policy is likely to create bubbles, financial distortions and future inflation, without guaranteeing a meaningful long-term improvement in the pace of growth. But, in the short term, the financial markets will remain very dependent on repeated injections of liquidity. Share prices are still relatively high, particularly in the US. But all the main stock markets have recorded net declines since the middle of March, especially in Western Europe, reflecting concerns that economic prospects are becoming less rosy. There are renewed signs that risk appetite is declining.

The Cyprus bailout crisis was resolved quickly. But the strains were traumatic for a brief period, and reminded the markets that recurring instability will remain a permanent feature of the eurozone. Although Cyprus accounts for a tiny share of eurozone GDP, the acute tensions have highlighted the reluctance of Germany, and other core members such as Holland and Finland, to bail out unconditionally weak countries that get into trouble.

The decision to penalise, as part of the settlement, large depositors at Cypriot banks is a precedent that may have adverse long-term implications for wider banking sector stability. Until now, large depositors have effectively been protected beyond the legal limits set by various deposit insurance schemes. But after seeing Cypriot depositors lose some of their money and become subject to capital controls, other depositors will feel vulnerable, particularly in countries likely to face problems.

The weakest link
The eurozone remains the weakest link in the global economy. Having declined since the start of 2012, GDP dropped by 0.6% in the fourth quarter of last year. Forecasts for 2013 are being revised down, and an annual GDP fall of 0.4% is widely expected.

In spite of the Cyprus bailout, new pressures are building up. Eurozone unemployment, at 12%, is high, with rates in excess of 26% in Greece and Spain, and with high youth jobless rates. The political paralysis in Italy remains unresolved, and the markets may become uneasy if there are no signs of progress towards forming a stable government. Spain, Portugal and Slovenia are facing problems, and there are risks of contagion. The European Central Bank (ECB) kept official rates at 0.75% at its April meeting. With the economy stuck in recession, a cut to 0.5% is widely expected in the next two to three months. The role of the ECB in maintaining stability remains critical. But dealing with the underlying problems will require difficult political decisions.

The US economy is performing more strongly than the eurozone, but recent indicators have been mixed and mediocre. The housing market continues to improve, with the increase in house prices (for the 20-City Composite Index) accelerating to 8.1% in the 12 months ending in January 2013. But US GDP growth remains slow, at an annualised rate of only 0.4% in the last quarter of 2012. More worryingly, the labour market weakened sharply in March; only 88,000 new jobs were created, fewer than expected. Since US fiscal policy is becoming more restrictive, with spending cuts coming into effect, the Fed will persevere with its expansionary policies. QE3 will not be scaled down this year.

In the UK, the forecasts accompanying the March Budget confirmed the difficult circumstances facing the economy. Growth will remain weak, and mending Britain’s public finances will take even longer than previously envisaged. At its April meeting, the MPC kept official interest rates at 0.5% and the QE programme at £375bn. But the markets expect an increase in QE in the next few months. It is widely anticipated that Mark Carney, the next Bank of England governor, will take major policy initiatives. There is hope that adopting more aggressive monetary measures will secure more rapid growth. But the risk is that higher inflation will squeeze real incomes and more than nullify the benefits.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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