Ja­pan’s ex­per­i­ment with rates of less than zero

The Pak Banker - - OPINION - Noah Smith

BY now, fi­nan­cial mar­kets have ab­sorbed the news that the Bank of Ja­pan has de­cided to im­ple­ment neg­a­tive in­ter­est rates. In do­ing so, the BOJ fol­lows Europe, which sent rates slightly below zero in 2014. Pre­sum­ably, the new tar­get of -0.1 per­cent will be achieved through more pur­chases of as­sets such as ex­change traded funds and real es­tate in­vest­ment trusts, as well as the usual govern­ment bonds.

There are two in­ter­est­ing and im­por­tant ques­tions here. The first is "Why is Ja­pan do­ing this?" The se­cond is "How low can rates go?" Let's talk about the se­cond ques­tion first. There's real un­cer­tainty about how far below zero a cen­tral bank can push nom­i­nal in­ter­est rates us­ing stan­dard tech­niques like as­set pur­chases. If hold­ing your money in a bank ac­count or govern­ment bond causes its value to steadily shrink, you can just with­draw your money and put it in cash, hide it un­der your pil­low or bury it in the back yard. I can al­most guar­an­tee you that some­where in Ja­pan, some- one is do­ing this right now.

One so­lu­tion is sim­ply to put a tax on pa­per cash. This is the so­lu­tion be­ing pro­moted by Univer­sity of Michi­gan econ­o­mist Miles Kim­ball, who has been go­ing around the world evan­ge­liz­ing for elec­tronic money for years now. The Univer­sity of Chicago's John Cochrane is skep- tical, point­ing out other ways that savers could avoid los­ing money to neg­a­tive rates. But most of th­ese tech­niques rely on pre­pay­ing bills, which could be pe­nal­ized more un­der an elec­tronic money sys­tem.

Now it's true that -0.1 per­cent isn't very much below zero, so there won't be a huge flight to cash just yet. But if the BOJ de­cides to send rates deeper into neg­a­tive ter­ri­tory, ex­pect to see some­thing like Kim­ball's elec­tronic money sys­tem.

Let's think about why the BOJ made this move right now. One rea­son might be that since the spring of 2015, Ja­pan's core in­fla­tion rate has tum­bled back to about zero. If the BOJ takes its of­fi­cial 2 per­cent in­fla­tion tar­get se­ri­ously, it might be im­ple­ment­ing neg­a­tive rates in or­der to hit the tar­get. But if this were the main mo­ti­va­tion, it's com­ing a bit late, since in­fla­tion col­lapsed al­most a year ago.

A more likely ex­pla­na­tion is that the BOJ is try­ing to can­cel out some neg­a­tive de­mand shocks. One big such shock is the China slow­down, which is al­ready hurt­ing Ja­pan's trade in a big way.

A se­cond hit to de­mand will come if the govern­ment de­cides to raise taxes again. A higher tax on con­sump­tion im­posed in 2014 raised rev­enues and put Ja­pan on a sounder long-term fis­cal foot­ing, though it prob­a­bly hurt the econ­omy tem­po­rar­ily. One or two more sim­i­lar tax hikes might put Ja­pan on the path to longterm fis­cal sus­tain­abil­ity. So adopt­ing neg­a­tive rates might be how the BOJ hopes to can­cel out the hit to de­mand from th­ese fu­ture taxes in­creases.

A third rea­son for neg­a­tive in­ter­est rates also in­volves fis­cal is­sues. The lower rates go, the more cheaply the govern­ment can re­fi­nance its debt. Once all debt is re­fi­nanced at neg­a­tive rates, the govern­ment's in­ter­est pay­ments van­ish, al­low­ing it to ap­ply more taxes to­ward its spend­ing com­mit­ments to the el­derly. If the govern­ment can ex­er­cise fis­cal re­straint and re­sist the urge to splurge, then neg­a­tive rates will act as a stealthy form of debt monetization.

All of th­ese chal­lenges might even­tu­ally call for very neg­a­tive rates. So it makes sense for the BOJ to test the wa­ters now, by send­ing rates a lit­tle bit below zero. This will give the cen­tral bank an idea of how easy it is to push rates below zero with stan­dard tech­niques, which will help in­form it about when it might need to im­ple­ment a Kim­ball-style elec­tronic money sys­tem. In part, neg­a­tive rates are an ex­per­i­ment.

So what are the risks of neg­a­tive rates? The ob­vi­ous one is that at some point Ja­panese savers -- most of which are cor­po­ra­tions at this point, since house­hold sav­ings have col­lapsed -- might start mov­ing their money out of the coun­try.

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