Why is Japan toying with helicopter money?

There are many ways of defining helicopter money, but the essential feature is that it involves an increase in the budget deficit which is financed by a permanent increase in the central bank’s monetary base, not by the issuance of government debt. Although this does not literally involve dropping banknotes from the sky, its economic effects are similar.

…Why is Japan even considering such extreme measures? The key here is that this policy is mainly about inflation expectations and real interest rates, not about output and unemployment. There is general agreement that the output gap in Japan is very small, at about 1-1.5 per cent of GDP, and that the labour market is operating close to full employment. So this is not a case of using government stimulus to correct a serious recession.

Instead, the Japanese problem is that inflation expectations have plummeted since the failure of Governor Haruhiko Kuroda’s attempt to ease monetary policy by introducing negative interest rates in January. With nominal interest rates now at the zero lower bound right across the yield curve, the fall in inflation expectations has left real yields above the equilibrium or natural rate of interest. This leaves Japan extremely vulnerable to any new deflationary shock, from China for example.

If helicopter money could restore inflation expectations to the 2 per cent target, the drop in real interest rates would suddenly makes the gross government debt ratio, at 240 per cent of GDP, look more sustainable. Furthermore, the government could boost aggregate demand by announcing a fiscal expansion that would promise a rise in nominal GDP, and (unlike under QE) that would not result in any increase in public debt held by the private sector.

…There is little doubt that this would “work” if pursued with sufficient determination. A government that promises to increase its direct public expenditure, while permanently monetising all of that debt, can surely generate inflation.

…In Japan, bad memories of helicopter money in the 1930s under Finance Minister Takahashi still loom large. Then, the episode ended with the assassination of Takahashi when he tried to withdraw the stimulus, and inflation rose markedly.

Because of these bad memories, Japan still seems some way from a formal arrangement in which some of its public debt is permanently monetised by the BoJ, and where the Ministry of Finance adjusts its fiscal objectives accordingly. Prime Minister Abe clearly needs pursuading that this degree of macro-economic unorthodoxy is “respectable”, which is probably the reason that Ben Bernanke was wheeled in to meet him.

The likely outcome is a fudge, in which the government expands fiscal policy “temporarily”, while officially aiming for a primary budget balance by 2020. Meanwhile the BoJ would “independently” choose to finance the “temporary” fiscal stimulus by increasing its asset purchases yet again.

Whether this strategy of helicopter money in disguise would be powerful enough to shock inflation expectations upwards seems very doubtful. But if it fails, Japan may remain stuck in its deflationary trap indefinitely.

By Houses and Holes in Featured Article, Global Macro
at 11:05 am on July 19, 2016