Official announcements often have hidden meanings that escape the commentariat, leaving citizens unaware that an important page in their governments' policies has just been turned. So it was with the Bank of Japan's Sept. 21 press release, which held so many revelations that observers struggled to digest and explain them all. Much of the discourse that followed focused on familiar topics, such as the end of quantitative easing or additional interest rate drops. Others registered surprise at and approval of the bank's new inflation target, which makes room for officials to overshoot their targets.
But what has received far less attention is that, for the first time since World War II, the Bank of Japan's bond purchases will now be directly linked to the government's issuance of debt. In many ways, this could be the biggest economic development Japan has seen since the 1985 Plaza Accord, which set the country on a path toward a bubble-ridden economy and the two "Lost Decades" of stagnation that followed.
The Road to Fiscal Dominance
When a government spends more money than it brings in with taxes, it typically issues bonds to make up the shortfall. The market and central bank then buy those bonds since they are, in theory, the safest asset available. From there, the bonds serve as the basis for any number of transactions. The more a government issues, the higher the risk that it will be unable to pay them off — and, as a result, the higher the interest rate the market demands. If functioning properly, this system acts as a natural check on government spending, since skyrocketing interest payments and deteriorating public finances would threaten the government's ouster.
There is, however, a way to skirt the consequences of piling on more debt. A government could persuade the central bank to buy its debt, printing new currency to do so. This situation is known as fiscal dominance, in which the amount of money a central bank issues — in other words, the state's monetary policy — is decided by the government's spending needs rather than the economy's.
The reason this deal sounds too good to be true is because it is. The costs of the government's mounting debts haven't been erased; they are simply borne by the country's currency, which becomes less valuable abroad. Imports get more expensive and inflation starts to rise as the government, freed of its interest-rate shackles, spends well beyond its means. Zimbabwe, Argentina, Brazil and Italy have each fallen into the trap of fiscal dominance and, once in its grasp, have found it notoriously difficult to escape. As the chief of Italy's central bank put it in 1973:
"We have asked ourselves whether the Banca d'Italia could have refused to finance public deficits ... Such an action would place the government in the impossibility of [not being able to pay] salaries to public servants ... and pensions to people. While this action would have the appearance of a monetary policy initiative, in practice it could be construed as an act of subversion, for it would bring about a paralysis in the institutions."
A Path Well Traveled
Japan's first brush with fiscal dominance came in 1932, when the Japanese economy was growing as sluggishly as it is today. The boom years of exporting materiel to Europe during World War I had subsided, giving way to a decade of inflation as a strong yen ate away at the competitiveness of Japanese products. The weak global demand seen during the Great Depression dragged the Japanese economy down further still, as did Tokyo's decision to rejoin the gold standard in 1930 — a choice a contemporary industrialist likened to "opening a window in the middle of a typhoon."
In response to the mounting deflationary pressure on the yen, newly installed Finance Minister Korekiyo Takahashi abandoned the gold standard in December 1931. The value of Japanese currency against the U.S. dollar fell by 60 percent over the next year, and government spending began to rise. Tokyo tried to jump-start the economy with funds that were underwritten by the Bank of Japan, freeing the government from fears of soaring interest rates. The money was largely funneled toward social and infrastructure projects, though Tokyo also set aside some to finance its budding military aspirations in Manchuria. The central bank, meanwhile, slashed interest rates in an effort to encourage borrowing. In concert, all of these measures saw great success. The Japanese economy roared back to life, inflation rose and the country entered into one of the strongest periods of growth it would see in the 20th century.
But all good things must come to an end, and fiscal dominance — as is so often the case — proved to be a tap that could not easily be turned off. By 1936, it had become clear that inflationary pressure was building and prices were on the verge of spinning out of control. Takahashi tried issuing fewer bonds, but his efforts forced deep cuts to military spending, which created friction between the government and an increasingly powerful army. In February 1936, a group of military officers assassinated the finance minister, and the armed forces gradually assumed control of the country, subordinating Japan's economy and institutions to the military's objectives as the world moved closer to World War II.
Stumbling Through Uncharted Territory
The end of the war brought an end to fiscal dominance in Japan. It also triggered a brief period of hyperinflation as the Japanese economy struggled to recover its productive capacity, much of which had been destroyed in the final stages of the conflict. Even so, the damage also created significant opportunities for growth. When Japan joined the Bretton Woods system of fixed exchange rates in 1950 with a weakly valued currency, that initiated two decades of record-breaking economic expansion. The collapse of the Bretton Woods system in the early 1970s gave Japan a free hand to shape its monetary policy once more. Then, when government interference led to loose policies and exorbitant inflation during the global oil crisis of 1973-74, the Bank of Japan began to assert its independence in monetary policy, eventually enshrining it in the 1997 Bank of Japan Act.
The Japanese economy continued to grow, albeit at a slower pace, throughout the 1980s — that is, until the United States decided that the dollar was overvalued and the 1985 Plaza Accord rapidly strengthened the yen. Japan's monetary policy remained loose as officials strove to avoid economic slowdown, but in doing so they inflated speculative bubbles in real estate and other sectors. Those bubbles popped in 1991, plunging the Japanese economy into a low-growth slump from which it has yet to recover.
Over the past 25 years, different administrations have tried different economic "cures," many of which were lifted from Takahashi's playbook. Most tried some form of increased government spending: The 2016 fiscal stimulus package was the 26th to be implemented since 1990. At the same time, the country's monetary policy has grown more experimental and extreme. In the late 1990s, the Bank of Japan became the first central bank to push interest rates down to zero, and in the early 2000s it became the first to enact quantitative easing policies. Since taking office in 2012, Prime Minister Shinzo Abe has loosened the reins on the Bank of Japan even more, allowing it to buy bonds at an unprecedented rate and to institute negative interest rates.
But by and large, these attempts to kick-start the Japanese economy have been thwarted by global economic weakness. The 1997 Asian financial crisis struck just as the business cycle promised to pull Japan out of its doldrums. The timing of the 2008 financial crisis was even worse, hitting just as Japan began to show signs of a recovery driven by quantitative easing. Meanwhile, as Japanese companies have been forced to look abroad amid stagnation at home, the country has become one of the world's biggest creditors. Japan's foreign investments have become an impressive platform of national wealth, and international traders have grown accustomed to converting their money into yen at any sign of trouble, putting upward pressure on the currency and undermining Tokyo's efforts to weaken it and encourage inflation. Japan's aging population, moreover, is more inclined than younger age groups to save and invest cautiously, foiling the government's attempts to spur consumption, growth and inflation.
Reaching the End of the Road
Twisted and warped by more than two decades of experiments, Japan's economy has become a misshapen mess. Furthermore, the tools that Tokyo once used to reshape it are nearing the end of their usefulness. Quantitative easing — Abe's signature policy approach — has left the Bank of Japan with 38 percent of the country's government bonds, a figure expected to rise to a whopping 63 percent by 2019 if the bank continues to buy bonds at its current rate. Because the economy must retain some access to government bonds to continue operating, there seems to be little room for the bank to lean on quantitative easing more than it already has.
Meanwhile, Japanese interest rates have been pushed to negative 0.1 percent. Theoretically, they could drop even lower — Switzerland's interest rate, for instance, is at negative 0.75 — but the ramifications of negative interest rates still aren't well understood, and bank Gov. Haruhiko Kuroda has publicly expressed fears that Japan's banking system has already been hurt by the decline. Considering that financial institutions often rely on interest rate differentials to make their profits, negative-yield long-term bonds could create headaches for banks and insurance companies alike.
Many observers have suggested that the Bank of Japan return to the age-old remedy of fiscal stimulus. But at 229 percent of gross domestic product, Japan's debt is one of the largest in the world; if it continues to pump money into the economy, its ever-expanding debt could eventually shift the market's perception of Japan from haven to sinking ship, flinging interest rates upward and setting off an instant crisis.
By all accounts, Japan seems to be reaching the end of its experimental period, a fact to which the position of the yen can attest. As a matter of instinct, Japanese policymakers consistently try to push the currency's value down. Abe has been no exception, and initially the prime minister's economic reforms arrested and reversed the strengthening of the yen. Since January, however, the currency has climbed once again, and it appears that Japan has few choices but to hope for a miracle, throw in the towel or chart a new course.
Blazing a New Trail
Hoping for miracles as a means of governance went out of fashion a long time ago, and throwing in the towel is no real option at all. Instead, the Japanese government must find a new way forward, and on Sept. 21 it did just that. In its press release, the Bank of Japan revealed that it plans to keep the interest rate of 10-year government bonds at zero. The bank's stated purpose of this policy adjustment was to manage the bond yield curve, keeping the yields of longer-dated bonds higher than their shorter-dated peers to help the country's financial institutions. But in reality it has far more important implications.
For the first time since 1945, the Japanese government has the central bank's explicit commitment to keep interest rates at a predictable level, no matter what. Should the market lose faith in Japanese bonds and start to sell them, the central bank would now be obliged to step in and buy them in order to reach its own interest rate targets. The final plank of Takahashi's 1932 rescue platform has been nailed into place.
If it chooses to, the Japanese government can increase spending without worrying about the consequences, knowing that it would be underwritten by the Bank of Japan. The bank, meanwhile, would find one of its own problems — a shortage of bonds — solved by the government's issuance of more debt. With literally unlimited fiscal capacity at its disposal, Tokyo would be able to drive up economic growth and inflation. But as was true of Takahashi's policies, the costs of temporary success would take time to make themselves known, likely only emerging when attempts to shut off the funding taps reveal that reversing fiscal dominance is easier said than done.
Of course, none of these dire predictions are preordained. A miracle may yet happen, reviving inflation and economic growth by other means and allowing Japan to avoid making full use of its new policy. Or, even if fiscal dominance does take hold, Japan could prove to be an exception to the rule, finding a way to turn off the tap without suffering the consequences of its spending spree. (The country is far less militarized than it was in 1932, making a retread of the 1936 coup extremely unlikely.) At this point, the only thing that can be said for certain is that the Japanese government has used the central bank to free itself of any spending constraints. But how the administration will choose to make use of its newfound freedom remains to be seen.