Scott McGlashan: The cautionary tale of quantitative easing in Japan

Quantitative easing, introduced in Japan in the spring of 2001, was the culmination of a series of policies begun a decade earlier including fiscal stimulus, interest rate cuts, bank recapitalisations, and in some cases, nationalisations.

But the cumulative impact of these previous policies failed to lift Japan out of recession. Bank lending and consumer prices continued to decline.

Nonetheless, the Bank of Japan (BoJ), a long-standing sceptic of the efficacy of any monetary targeting, was reluctant to introduce quantitative easing.

Remembering the terrible post-war inflation that effectively destroyed the yen, it resisted printing money until political pressures became too great.

Over the next four years, money base to GDP doubled as bank deposits at the BoJ increased and the amount of notes in circulation rose. While current proponents of the policy in the UK and US criticise with hindsight the pace and extent of Japanese easing –  witness the speed, in contrast, of the recent expansion of the US money base – the reality is that the BoJ could not have done much more.

From time to time, interest rates turned negative so that short-term money market deposits were debited – not credited – with interest. Once rates became negative, it became temporarily impossible to expand the stock of money.

Even accepting the caveat that outcomes might have been better had there been a way to ease more, the impact of quantitative easing in Japan was disappointing.

Deflation persisted, bank lending continued to decline, and after an initial period of weakness, the yen exchange rate firmed and the range traded.

Increasing the money supply did nothing to increase the price of goods as velocity plummeted, since additional money was not wanted for domestic consumption or investment.

So if a rapid increase in the supply of money failed in many respects, what did it do? It funded the carry trade as both domestic and foreign investors borrowed near limitless amounts of yen at almost no cost to fund the purchase of foreign securities and property.

It is probably no accident that world equity markets bottomed – and the increase in property prices in many countries accelerated – about a year after quantitative easing commenced, and that the global property and securities bubbles began to deflate a year after the policy was abandoned.

Today, the BoJ is refusing to consider re-adopting quantitative easing. It now views the 2001-2006 period as an experiment in monetary policy that failed. With hindsight, it is difficult to see any beneficial consequences of this experiment and the downside risk, the potential to add to the inflation of asset bubbles, is obvious.