The tsunami that has devastated coastal areas of northeastern Japan has a recent precedent — the tsunami of Dec. 26, 2004, in the Indian Ocean that killed some 230,000 people. But there is no precedent for the wave of money that flowed out of the bank of Japan in the first three business days after disaster hit.
As of Friday, Japan’s central bank had thrown a reported $475 billion into money markets. This is more than the U.S. Federal Reserve plans to inject over a year of its controversial program, “Quantitative Easing 2.”
Why is the Bank of Japan doing this, and is it a good idea?
The idea that a central bank would use its power to create money out of nothing when panic threatens financial markets is neither new nor controversial among economists.
The Bank of England practiced this 200 years ago. Walter Bagehot’s 1873 book “Lombard Street,” a seminal work on financial markets and central banking, clearly explained both the rationale for such intervention and how to do it.
In our country, the Federal Reserve Act was passed in 1913 because the public perceived correctly that the lack of a “lender of last resort” hurt the national economy during panics like the one in 1907.
The Fed repeatedly has stepped in to provide liquidity when panic threatened, including after the 1987 stock market crash, the attacks of 9/11 and the financial debacle that began to unfold in mid-2007. While the Fed’s actions over the past four years are controversial to say the least, few criticize its injections of money in 1987 or 2001. Moreover, many condemn its failure to maintain liquidity in 1919 and from 1929 to 1933. So the Bank of Japan pumping in cash when a catastrophe causes great fear and uncertainty is not, in itself, a bad idea.
The size of the intervention raises questions, however. While reports on the total size of the BOJ’s intervention vary, they totaled at least 38 trillion yen or $475 billion by week’s end at Friday’s exchange rate. The U.S. economy is about 2.5 times as large as Japan’s, so the equivalent amount here would be nearly $1.2 trillion. It would take extreme circumstances to justify the Fed adding such a sum in one week. Calming the markets is the Bank of Japan’s objective, but to many, the scale may suggest panic within the bank rather than confidence.
Moreover, while central bank money creation can foster short-term stability in financial markets, it is limited in terms of overcoming longer-term problems. Yes, Keynesian theory prescribes low interest rates as a tool for getting an economy out of a recessionary rut, increasing output and reducing unemployment. That is the Fed’s strategy right now under Ben Bernanke. But Japan has had low nominal interest rates for most of the past 20 years and precious little growth.
Maintaining some desired exchange rate is a concern for many central banks, even if it is seldom addressed overtly in the U.S. A disaster like Japan’s could affect the value of yen relative to other currencies in at least two ways.
First, foreign investors might conclude Japan is no longer a profitable place to invest money and would sell stocks and bonds for yen and then convert those yen into U.S. dollars or euros. This would increase the supply of yen in foreign exchange markets — or, looking at it from the other side, increase the demand for dollars and other foreign currencies. This would make dollars and euros more valuable relative to yen. That would be fine from the point of view of the Japanese, who consider their country to be suffering from a too-strong currency that makes it hard to export and thus depresses manufacturing.
Conversely, a disaster like this might cause Japanese households and businesses, especially insurance companies, to sell investments held in other countries because they need the cash back home. Some households and businesses need to rebuild, and property insurers will face claims totaling tens of billions of dollars. This happened after the 1995 earthquake in Kobe.
Such repatriation of Japan’s investment abroad would increase the demand for yen, making it more valuable relative to foreign currencies. This would make Japan’s exports more expensive to foreigners and imports cheaper. That is precisely what the country does not need if it wants to follow its usual export manufacturing-led growth strategy.
What the Bank of Japan did this week, creating many more yen, was an effort to counteract appreciation of the yen. It had little success by itself, as the yen hit a new strength of only 76 to the dollar, but with the G7’s announcement on Thursday that it also would intervene and yen selling on Friday by the Fed and other G7 central banks, the yen dropped back to around 80 per dollar.
Japanese manufacturing has been a source of strength for many years, but it has an Achilles heel. Just-in-time manufacturing depends on a smooth flow of intermediate components from many different plants to final assembly. Even though the four prefectures sustaining most of the earthquake and tsunami damage produce only 6 percent of Japan’s gross domestic product, they have enough different plants that the disruption to final assembly plants downstream is considerable. And these plants generally don’t have sufficient stocks of components to tide them over the supply interruptions.
The nuclear power plant crisis has to play out before the world can know where Japan stands in terms of damage and economic prospects. It will take even longer to judge whether its central bank has been prudent or foolhardy in this dramatic intervention.
St. Paul economist and writer Edward Lotterman can
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.