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1 Mike Hall ECON 403b Prof.

Miller 5/10/13 Crises, Monetary Policy, and Reform The United States, the Eurozone, Japan. Three industrialized first world countries with advanced economies. Recently, these countries have dealt with their own crises; Japan in the 1990s, the United States in 2007, and the recent crisis in Europe. When discussing these respective crises, it is important to analyze the impact of monetary policy implementation, specifically through the United States Federal Reserve System (FED), the European Central Bank (ECB), and the Bank of Japan (BOJ). This topic has garnered much interest lately due to the impending nature of the ongoing global financial crisis. The United States remains a world power, and its relationship with China could be affected if Japan is able to reemerge from stagnant growth to compete in Asia. Furthermore, what happens in the Eurozone will have an impact in the United States as the US’s biggest exporter is in Europe. Finally, many are fearful of this continued stagnant growth in Japan and officials in the United States and Europe are taking measures to ensure the same problem does not befall their respective countries. In order to make an accurate comparison of the three economies, one must look at the institutional frameworks of the central banks, look at specific problems of each country, and analyze the effects of policy implementation in each country, both conventional and non-conventional measures. Although each country requires different responses due to different economic and political structures, the general

2 consensus is that the United States and the Eurozone are unlikely to travel down the same path as Japan, however its experience allows the United States and Europe to adjust accordingly. The BOJ did the poorest job of monetary policy implementation, followed by the ECB and the FED coming out on top. However, this is by no means a direct black and white comparison, and to be fair Japan was at a disadvantage comparatively speaking due to treading then unforeseen waters during the post war era. The United States and the euro area faced a less favorable external environment than Japan did with today’s many struggling economies (ECB Monthly Bulletin 100). While monetary policy can only go so far in terms of helping a country’s economy, the recent crises shed light on the institutional frameworks at hand, and ultimately the need for each country to make long term institutional reforms (such as in the financial sector) that are similar for developed countries but different in that they cater to the specific needs of each country in a global context. The buildup of the crises in Japan, the United States, and the Eurozone are somewhat similar while taking place in different areas of the economy. Japan experienced an enormous asset bubble during the 1980s, and currently, property prices have fallen close to 60 percent of their peak in 1990 (Ueda 179). After the asset bubble popped in Japan, there was a need for the corporate sector to rebalance due to excessive leverage. The United States experienced a housing bubble in the 2000s, however housing prices seem to have stabilized in the last couple of years. In Europe, there were not balance sheet problems at an aggregate level like there were in the US, but more so regional imbalances between Member States. The financial crisis froze the capital markets in 2007-2008, making it difficult for governments to

3 raise capital. Greece ran huge budget deficits starting in the 1980s. This fact coupled with lax tax collection measures led to corruption and a GDP to debt ratio of 130 percent (Nordin 14). Additionally, Portugal has faced debt woes due to an inefficient public sector, while Italy suffers from sluggish growth. Finally, Ireland had a realestate bubble similar to the United States, while Spain endured a property bubble while heading into a recession (Nordin 15). Before the bubble popped in Japan, the corporate sector had borrowed heavily from banks, using real estate for collateral. Once property prices sharply declined after the asset bubble popped, firms were forced to clean up their balance sheets. This process of reducing debt, or deleveraging, occurred through “an increase in corporate savings, a prolonged decline in private investment and a stagnation of firms’ profits throughout the 1990s” (ECB Monthly Bulletin 96). However, deleveraging can generate negative microeconomic externalities. Specifically in Japan, where “…a negative feedback loop developed among falling asset prices, financial instability, and stagnant economic activity” (Ueda 177). This term has been coined “Japanization.” The Japanese economy went through a much larger negative wealth shock than the United States and Europe, as both corporate and household sectors suffered great losses while households were mainly affected in the latter two countries. There was a greater impact on the Japanese economy, as the ratio of housing wealth to GDP in the U.S. was 234 percent at its peak, compared to 355 percent in Japan (ECB Monthly Bulletin 99). Thus, compared to the U.S. and Eurozone, Japan suffered “a larger pre-crisis bubble across several asset classes followed by a larger, more simultaneous and prolonged decline” (ECB Monthly

4 Bulletin 100). The main issue in Europe has been an increasing divergence between two groups: the “external surplus group” and the “external deficit group.” The external surplus group includes countries that have run external current account surpluses over a period of five years starting in 2007, while the external deficit group includes countries that have run external current account deficits (ECB Monthly Bulletin 102). “In the external deficit group, the recession following the crisis…led to strong deleveraging by the private sector” (ECB Monthly Bulletin 103). Household lending increased while finances of non-financial corporations returned to pre-crisis expansionary levels. But in order to account for this, budget balances deteriorated in the public sector, and government debt dramatically increased, though not uniformly across countries. In the United States, everyone has heard the story of the property and credit market bubble that burst in 2007 due to serious financial instability and ultimately led to bank recapitalization (i.e. bailouts). There have been much larger spreads in lending and borrowing rates for banks in the U.S. compared to Japanese banks, which is one reason why deleveraging pressures are less severe in the United States in 2012 compared to Japan during the late 1990s and early 2000s, which is a ten year span for Japan but only five for the U.S. (Ueda 184). These balance sheet issues lead us to policy implementation of central banks. And as we will see, “…a rapid response by a central bank in a situation of financial crisis and economic stagnation can be a better choice than allowing a process of Japanization to drag on for years” (Ueda 178). In dealing with these crises, Japan responded slowly in terms of monetary policy, as nobody anticipated a protracted slowdown of the economy.

5 Conventionally, monetary policy includes manipulating interest rates and increasing/decreasing the money supply. While the U.S. has the federal funds rate, the BOJ targets the “call rate”. The BOJ started to lower the call rate in 1991, which dropped to less than 0.5 percent by 1995, amounting to total cuts of more than 800 basis points over the four year period (Ueda 189): The behavior of the real interest rate suggests that the Bank of Japan was cutting the nominal rate faster than the speed with which inflation fell, and thus was providing stimulus to the economy. The decline in the real interest rate, however, came to a halt and started to move upward in the late 1990s as the deflationary trend set in (Ueda 190). This caused the liquidity trap in Japan, and the call rate has been in the zero to 0.5 percent range since the 1990s. Conversely, the FED reacted much more rapidly in 2007-2008 than the BOJ did. The fed funds rate was brought down to near-zero within 18 months of the crisis (Ueda 190). This is one of the reasons that the United States has escaped deflation while Japan has not, however the U.S. has suffered from an extremely weak labor market. The ECB also decided to cut rates, from 4.25 percent to 1 percent (Kikuta 14). One lesson to draw here is while these aggressive policy measures helped wear off pains of the crisis, low growth due to balance sheet repair remains. Thus, central banks should put emphasis on restraining a buildup of a bubble instead of cleaning it up after it bursts (Shirakawa 377). Because of the liquidity traps that existed and exist in these countries, the central banks decided to resort to nonconventional monetary policy, starting with Japan in the late 1990s. And As Krugman notes: “textbook economics tells us that to

6 adhere to conventional monetary rules in the face of a liquidity trap is not prudent; it is irresponsible.” Generally, these types of policy measures include “quantitative easing” and “forward guidance of interest rates”. Quantitative easing consists of large-scale asset purchases in distressed markets. This is when central banks are concerned with what types of assets they purchase, as opposed to “pure quantitative easing” where central banks are solely concerned with the size of their balance sheets. But at a zero interest rate, the market is already drenched with liquidity, so many put more emphasis on what types of assets are being purchased as opposed to the size of balance sheet increases. Thus, the effectiveness of pure quantitative easing is up in the air (Ueda 191). The other type of monetary easing, forward guidance, provides assurance to the market that the policy interest rate (i.e. the fed funds rate) will be lower than currently expected in the future. In the early years of the crisis, Japan channeled funds into the banking sector, while the U.S. channeled funds into a variety of agents, such as money market mutual funds and broker-dealers. This reflects the nature of the U.S. financial system being more market based than Japan (Ueda 192). Currently the FED has undergone two rounds of quantitative easing, coined QE1 and QE2. The ECB does not purchase bonds from the market like the FED does, but instead enters into a repo (repurchase) agreement. They did so using Main Refinancing Operations (MRO), Long-Term Refinancing Operations (LTRO), and Dollar Line Swaps. In a dollar line swap the FED lends dollars to the ECB for Euros for a specified period at a very low rate. This gives the ECB access to emergency funds while the FED earns interest risk free as it is lending to a central bank and thus avoids the financial instability in the

7 EU (Nordin 16). These policies in the EU have been deemed “credit easing”. QE has been questioned constantly, however remains successful in the U.S. Effects were not effective when Japan implemented them to fight deflation and were thus abandoned. “The general view in the US is that though QE has done little to spur consumption, it has been extremely effective in improving market confidence (Klyuev, 2009), and therefore preventing it from entering a deeper recession” (Nordin 11). In Europe, credit easing does not solve the underlying problem in the Eurozone, but does help to buy time by reducing pressures on markets while political reform is taking place. Now that we have looked at different monetary policy responses to the crises, it is important to look at the institutional and historical reasons for why each country chose the policy that it did, and why the FED acted more aggressively. The first issue involves mandates. The FED has a dual mandate, which includes “Stable prices, moderate long term interest rates and maximum employment” (Federal Reserve, 2000), while the ECB has a single mandate that includes “Maintaining price stability over the medium term” (European Central Bank). The BOJ’s mission states that "currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy” (Bank of Japan). So while the FED maintains a dual mandate, the ECB and BOJ are closer to single mandates. The FED based this current aggressive monetary policy on what happened during the Great Depression. A key highlight included the Fed’s indecisive actions during the 1930s (Nordin 18). Thus, when the crisis occurred in 2008, the Fed chose not to repeat inaction and instead bailed out financial institutions. On the other hand, the ECB drew its monetary outlook

8 experience from hyperinflation in Germany from 1921-1924. After World War I, the cost of the war amounted to $31.4 billion ($442 billion in 2012 rates) (Nordin 19). But instead of taxing its citizens, Germany chose to finance its debt through borrowing, and when they were unable to do so they resorted to printing money, which led to a rapid devaluation in the German Mark. In fact, the Mark halved in value every 3.7 days (Nordin 19). This has caused the ECB to focus heavily on price stability targeting. The BOJ has been around since 1882, but has focused its policy on events of World War II, in which the Act of 1942 was implemented to reflect the wartime situation. This Act was amended several times, including the establishment of the Policy Board as the highest decision-making body of the Bank in 1949 (Bank of Japan). This Policy Board takes its decisions by a majority vote (Mongelli 3). Finally, the Act was revised completely in 1997 under two pillars of “independence” and “transparency”, which reflected the events of the lost decade. The market-based nature of the U.S. financial system meant the need for more government action, as opposed to Japan where its financial sector is more intertwined with government and less subject to market pressures (Ueda 178). Additionally, it is easiest for the FED to implement monetary policy. The Board of Governors and FOMC get together and make decisions based on recommendations from banks and advisory committees, whilst in the ECB policy recommendations are subject to parliamentary approval from all 17 Euro member states (Nordin 20). This reason has the FED and BOJ as much better off than the ECB in terms of policy implementation. The ECB acts as a single currency, but maintains 17 politically diverse countries with different fiscal policies. Also, the EU Treaty makes it illegal for the ECB to provide direct

9 financial aid to distraught governments (Nordin 16), which leads to much more rigidity in policy. On a general level, the monetary policies of the FED, ECB, and BOJ seem to not have been effective, or have not done enough to stimulate the economy. They have failed to stop deflation in Japan and economic stagnation in the United States and Europe. This could be due to the sheer size of negative shocks to the economy. Deleveraging causes huge problems for respective economies, and in order to account for this, central banks are forced to enact loose monetary policy to stimulate the economy. Once a liquidity trap occurs, banks then must enact nonconventional policy, in order to increase aggregate demand that was lost from deleveraging. But after a while, nonconventional monetary policy such as quantitative easing and credit easing loses its effectiveness when the action is repeated (Ueda 198). Part of the reason why the U.S. remains better off than the Eurozone and Japan is the FED has more power and flexibility than either the ECB or the BOJ, and thus has more tools in its monetary toolkit and more influence on the economy. For example, markets for mortgage backed-securities (MBS) and corporate bonds are similar in size to government bond markets. Fannie Mae and Freddie Mac’s debt and MBS exceeded 50 percent of the FED’s total assets in 2010 (Ueda 197). Compare this to Japan, where nonfinancial corporate bonds make up only 10 percent of GDP but the market for long-term government bonds exceeds 130 percent of GDP (Ueda 197). And capital market debt and stocks are only 4.1 percent of BOJ’s assets (Ueda 197). Thus, while the BOJ can lend to financial institutions to ease funding pressure, the FED has more ability to affect private capital markets through asset purchases.

10 Similarly in the euro area, where “the sovereign debt crisis has impeded the passthrough of lower policy rates to the private sector in some euro area countries, partly because of the strong correlation between the cost of market funding for sovereigns and banks” (ECB Monthly Bulletin 110). The reason that this is happening in Europe is due to the lack of flexibility of the ECB and the political and fiscal diversity of the Eurozone. This leaves us with the question of, what do we do currently? With all three economies currently struggling, the two main issues are structural reform and how each country should move back to prosperity. First we start with Japan. While its economy grew at an annual per capita rate of 3.3 percent from 1974-1990, it was probably due for a slowdown as this growth rate was unlikely to be sustained after hitting the technological frontier (Ueda 198). Also, Japan’s workforce started shrinking in the late 1990s, while its population started declining in 2005. This could have contributed to deflation, which was difficult for the BOJ to combat with conventional and nonconventional monetary policy due to expectations of lowgrowth and low-inflation, coupled with the previous discussion of being a less market-oriented economy than the U.S. Japan would have benefited from bank recapitalization in the mid 1990s, but instead took a regulatory forbearance approach due to it not recognizing a negative correlation between financial factors and the real economy until Q4 1993 (Ueda 187). The financial crisis of 1997-98 in Asia (the equivalent of the Lehman collapse in the U.S.) set off signals for the government to start a recapitalization process. This helped trigger deflation, which was already difficult to combat due to the liquidity trap that Japan was and still is in

11 today. Obviously Japan needs to fight deflation, but the question is how this is to go about. Two main camps exist—growth and austerity. Growth advocates support increased government spending in a crisis, while austerians vouch for spending cuts and tax increases. In Japan, a hike in the consumption tax rate in 1997 was one of the main triggers for the occurring crisis (Ueda 184). In order to fix this slump, Japan needs some expected inflation coupled with deficit spending. As Krugman notes: Deficit spending has put part, but only part, of the excess desired private saving to work; this has mitigated the slump, but not produced a booming economy, except perhaps briefly circa 2007. And the Bank of Japan has always pulled back on monetary policy when the economy looks better, instead of doing what it should, which is to keep the pedal to the metal until the inflation rate is solidly into positive territory (Krugman 2013). With the new governor Haruhiko Kuroda taking office, and backed by Prime Minister Shinzo Abe, the BOJ is targeting a 2% inflation rate, which is the second part of combining “temporary fiscal stimulus with a real effort to move inflation up” (Krugman 2013). This policy has been deemed Abenomics. Thus, an austerity measure will not work because there is a lack of aggregate demand, so money needs to be pumped into the economy, not taken out. Pumping out cash by the central bank will create a weaker yen, which will boost exports and trigger higher wages and increased investments (Dvorak 4). They could benefit and should implement more aggressive fiscal and monetary policy.

12 In Europe, we saw that the main issue is the big financial differences between external surplus groups and external deficit groups. Europe would also benefit from growth over austerity measures. The single mandate of the ECB has the Eurozone obsessed over stable prices while rejecting other measures such as growth and full employment. At first this made sense when the euro was first formed as the idea was to create a single currency while maintaining financial independence of member states. While austerity measures trimmed the deficit in Greece, output continued to fall. The process of deleveraging is ongoing in some euro countries, and this reduction in private and government debt will limit growth as these balance sheet adjustments affect firms’ investment expenditures and households’ consumption (ECB Monthly Bulletin 104). Further, demand fell and unemployment rose as spending was crowded out of the economy—the exact opposite of the policy that needs to be implemented during a recession. First, more government spending is needed. “A public investment program could modernize infrastructure of the southern Eurozone economies and boost the productivity of their workforce by improving workers’ health and education” (Miller & Sciacchitano 24). This would help increase the aggregate demand that is weakening in the area. The other reform that needs to take place is to the structure of the euro. The EU would greatly benefit from being able to directly buy sovereign debt to help the balance sheet adjustments that will be necessary in countries such as Ireland, Spain, Cyprus, and Portugal, countries that all face high levels of debt and are in deficit (ECB Monthly Bulletin 103). The Eurozone also needs to move towards stronger political integration and flexibility in monetary policy. Because the ECB requires approval from all 17

13 member states, Germany is able to block lower interest rates and a devaluing of currency, even though that is the policy Greece would benefit from. Herein the problem lies where the external surplus and external deficit groups essentially act as separate entities and need separate monetary policy even though they share a single currency. Greater political unity would allow every country to be on board for the benefit of the euro, not its own individual country. Finally, Europe would greatly benefit from a unitary fiscal policy, similar to how Washington acts in the U.S. This would allow the Eurozone to add more tools to its macroeconomic toolkit to work alongside monetary policy and would definitely help prevent further financial instability. That leaves us with the U.S., which is at the root of the problem. Essentially the collapse in 2007-2008 rippled across the globe and had a domino effect on other countries. By learning from Japan’s woes, the FED acted swiftly and implemented aggressive monetary policy to keep core inflation in positive territory. While the U.S. sits in a liquidity trap, it is much better off than Japan due to previously mentioned reasons and the fact that the workforce is not shrinking. “The Federal Reserve has said interest rates will remain near zero until US unemployment falls to at least 6.5 percent” (Steen 1). Currently the economy is at 7.5 percent unemployment, but the FED projects a low fed funds rate to continue through late 2014 (Ueda 193), while unemployment is expected to be around 7 percent at the end of 2013 (Krugman 2 2011). In order to help out these near zero rates of the FED, more quantitative easing should take place, as it has been effective to spur consumer confidence. However, Mr. Bernanke declared that “further expansion might lead to higher

14 inflation” (Krugman 2, 2011). The argument here is that he feels pressured from those who are worried about inflation. There are some politics involved with the FED where they have to report to Congress and sometimes enact policy in a way that pleases them. However, inflation is projected to remain low, so the FED should not be so concerned about that matter. Part of the reason may be due to pressure from the wealthy. The main problem we see in the United States is financial instability, specifically inequality, which led to the problem in the first place. Austerians, and members of the 1 percent, are typically worried about budget deficits as opposed to growth through government spending. As Krugman notes: “the years since we turned to austerity have been dismal for workers but not at all bad for the wealthy, who have benefited from surging profits and stock prices even as long-term unemployment festers” (Krugman 2013). Thus, the power of the elite and wealthy in the U.S. may be leading to continued pressure on the FED. The solution has been previously discussed in class and in my last editorial. The United States needs to decrease inequality through universal social programs and government spending to spur real wage growth, which would also benefit from stronger labor unions. Additionally, the financial sector needs to be more regulated to ensure that banks do not become “too big to fail” and that the country will have to resort to deleveraging. Overall, the three currencies seem to have enacted similar monetary policy during crises, though the U.S. and Europe had the advantage of learning from Japan’s mistakes. It is better to lean against an asset bubble by enacting strong monetary policy instead of trying to clean it up after a recession has ensued, otherwise

15 countries my be forced to undergo a process of deleveraging. Further, nonconventional measures such as quantitative easy and bank recapitilization are important when a country faces a liquidity trap. The United States is better off than Japan and the Eurozone due to having a dual mandate and the most flexibility in terms of policy. Japan is moving in the right direction, but could face a hindrance if its working force continues to shrink. And while the euro is nice in theory, it has faced fundamental flaws due to political differences and a single mandate. The U.S. needs to reverse the effects of increased inequality and lopsided power that have gradually occurred. While monetary policy can be somewhat effective, it is only part of the solution. Monetary works well in conjunction with fiscal policy, but the main theme that has occurred includes real institutional reform taking place. If permanent measures are not enacted to shrink inequality and regulate the economy, the global economy is going to continue to face problems. I have faith that these recent crises have been truly eye opening to lawmakers and policy makers who realize that the utmost significance is placed on heading in a new direction. Japan demands it. The Eurozone demands it. The United States demands it. The future of the global economy demands it.

16 Works Cited Dvorak, Phred, and Eleanor Warnock. "Stagnant Japan Rolls Dice on New Era of Easy Money." Wall Street Journal. N.p., 21 Mar. 2013. Web. 9 Apr. 2013. <http://online.wsj.com/article/SB10001424127887323639604578368143 556112754.html>. Krugman, Paul. "The 1 Percent's Solution." The New York Times. N.p., 25 Apr. 2013. Web. 09 May 2013. <http://www.nytimes.com/2013/04/26/opinion/krugman-the-onepercents-solution.html?pagewanted=all>. Krugman, Paul. "The Intimidated Fed." The New York Times. N.p., 28 Apr. 2011. Web. 09 Apr. 2013. <http://www.nytimes.com/2011/04/29/opinion/29krugman.html?_r=0>. Krugman, Paul. "The Japan Story." Web log post. The New York Times. N.p., 5 Feb. 2013. Web. 9 Apr. 2013. <http://krugman.blogs.nytimes.com/2013/02/05/the-japan-story/>. Krugman, Paul. "Reckonings; The Japan Syndrome." Weblog post. The New York Times. N.p., 09 Feb. 2000. Web. 09 Apr. 2013. <http://www.nytimes.com/2000/02/09/opinion/reckonings-the-japansyndrome.html>. Miller, John A., and Katherine Sciacchitano. "Why the United States Is Not Greece." Dollars and Sense: Real World Economics. N.p., Jan.-Feb. 2012. Web. 09 Apr. 2013. <http://dollarsandsense.org/archives/2012/0112millersciacchitano.html>.

17 Mongelli, Francesco P., Dieter Gerdesmeier, and Barbara Roffia. "The Fed, the Eurosystem, and the Bank of Japan: More Similarities or Differences?" Vox EU. Center for Economic Policy Research (CEPR), 7 Feb. 2009. Web. 09 Apr. 2013. <http://www.voxeu.org/article/fed-eurosystem-and-bank-japansimilarities-and-differences>. Monthly Bulletin. Publication. ECB, May 2012. Web. 9 Apr. 2013. <http://www.ecb.europa.eu/pub/pdf/other/art2_mb201205en_pp95112en.pdf>. Nordin, Afiq, Aqib Durani, Bujar Berisha, Lujja Sulaiman, Mirza Zia, and Mohammad Usman. "The Federal Reserve and the ECB - A Comparison of Central Bank Monetary Policy in Post-crisis U.S. and EU." Scribd. N.p., n.d. Web. 09 Apr. 2013. <http://www.scribd.com/doc/129671104/The-Federal-Reserve-andthe-ECB-A-comparison-of-central-bank-monetary-policy-in-post-crisis-U-Sand-EU>. Shirakawa, Masaaki. Central Banking: Before, During, and After the Crisis. Publication. Bank of Japan, 2013. Web. 9 Apr. 2013. <http://www.ijcb.org/journal/ijcb13q0a18.pdf>. Steen, Michael. "ECB Sticks to Its Monetary Guns." Financial Times. N.p., 7 Mar. 2013. Web. 09 Apr. 2013. <http://www.ft.com/intl/cms/s/0/3dad09ea-871a11e2-bde6-00144feabdc0.html>. Ueda, Kazuo. "Deleveraging and Monetary Policy: Japan Since the 1990s and the United States Since 2007."

18 The Journal of Economic Perspectives Summer 26.3 (2012): 177-201. JSTOR. Web. 6 Mar. 2013. <http://0-www.jstor.org.helin.uri.edu/stable/41581137>. The United States and Japan have had similar economic experiences after Japan experienced its recession in the 1990s and the U.S. just recently recovering from the financial letdown in 2007. The U.S. has been more aggressive since 2007 than the Japanese were in the 1990s. This article helps present a modern, up-to-date perspective about the these respective economies and their monetary policy implementations. 1990s. This article helps present a modern, up-to-date perspective about the these respective economies and their monetary policy implementations.