Europe Should Take Lessons from Japan

Efforts to talk down the exchange rate accompanied by actual balance-sheet expansion by the central bank are likely to be good for the rest of the world. A column by Barry Eichengreen.

Barry Eichengreen
«If the ECB limits itself to verbal interventions, Japan has every right to criticize Europe as hypocritical. »

Informed sources tell us that Japanese government officials are furious with their European counterparts.  From the Wall Street Journal’s «Real Time Economics Blog» on down, we hear that Japanese leaders have blown a gasket over the efforts of the European Central Bank and European government officials to talk down the euro exchange rate.   They sense a double standard, and they are abandoning customary diplomatic niceties in making an issue of it. 

The Japanese recall how in 2013 European leaders expressed serious reservations about Abenomics, and in particular about its so-called «first arrow,» which involves a radical expansion of the Bank of Japan’s balance sheet, when it became evident that this implied a significantly weaker yen exchange rate and, by implication, a stronger euro.  They recall how Japanese delegates were subjected to pressure at the G20 meeting of finance ministers in Australia in February of this year to refrain from policies that would lead to a weaker yen.

A weaker yen is, of course, precisely what Japan needs in order to escape its deflationary trap.A weaker yen means higher import prices, which will feed through into higher prices of domestic goods and services.With domestic prices no longer falling, Japanese households will have less reason to defer their spending. With Japanese goods more competitive on international markets, there will be more spending on Japanese exports as well, encouraging Japanese companies to invest in capacity expansion.  For a Japan that has been mired in deflation for more than a decade, a weaker exchange rate is a winning strategy.

What will the ECB do?

Unfortunately, it is not obviously a winner for a Eurozone that is itself at risk of deflation.  The euro exchange rate is already over-strong, and the yen’s depreciation only makes it stronger.

European officials have belatedly acknowledged their exchange rate problem, and they are attempting to talk the euro down.  At the beginning of this month, Mario Draghi flagged the high euro exchange rate as a «serious concern» that will «have to be addressed.»  ECB vice president Vitor Constancio warned a week later that the strong euro was having a «material impact» on the European economy, where «material» was another way of saying «significantly negative.»  Jean-Claude Juncker, as part of his campaign for the presidency of the European Commission, proposed the adoption of «general guidelines» for action in the event that the euro exchange rate becomes too strong. 

So far, European officials have limited themselves to verbal intervention, but it is widely expected that in June the ECB will follow up with actual policy measures.Whether these will be mainly cosmetic, like a cut in the institution’s deposit rate, or involve more meaningful steps, such as undertaking a long-term financing operation (LTRO) targeted at small and medium-sized enterprises or, more radically, U.S.-style quantitative easing is yet to be determined.

Expanding the balance-sheet is crucial

It is easy to understand European policy makers’ concern.Eurozone inflation is running below 1 per cent, closer to negative territory than to the ECB’s 2 per cent target.  The surprisingly weak 2014 Q1 figure for economic growth, which at 0.2 per cent was barely half that forecast, only adds urgency to the matter. 

At the same time, it is easy to understand Japanese policy makers’ anger.They see Europe pursuing the very same policies for which they are so ferociously criticized.  They wonder, as the British would say, why sauce for the goose is not also sauce for the gander.

Those Japanese officials have a point.But, ironically, they have failed to make a key distinction that works in their favor.  That distinction is as follows: while efforts to talk down the exchange rate accompanied by actual balance-sheet expansion by the central bank are likely to be good for the rest of the world, a policy of verbal intervention that is not coupled with aggressive balance-sheet expansion will have negative repercussions abroad. 

Bank of Japan’s policy is helpful for Europe too

In Japan, not only are the BOJ’s large-scale asset purchases pushing down the yen exchange rate, but they are also depressing yields on fixed income securities and encouraging Japanese investors to search for yield abroad.  Foreign investment from Japan is one reason why yields on the bonds of peripheral Eurozone countries have fallen so precipitously in recent months.

While Europe doesn’t benefit from a weaker yen, it benefits from lower government borrowing costs.  If capital outflows from Japan pick up further, as they should once Abenomics takes hold, the effect of those lower bond yields will dominate.  The BOJ’s policy will remain a positive for Japan, but it will also be positive for Europe.

Now contrast the case of the ECB, where efforts have focused on talking down the euro, perhaps to be accompanied in June by some cosmetic policy action.  If that verbal intervention succeeds in weakening the euro, this will be good for European exporters but bad for their Japanese rivals.  Absent significant balance sheet expansion by the ECB, there will be no impact on capital flows, and no offsetting benefit for the Japanese economy. 

Readers with a historical sensibility will appreciate that we have been here before.  Countries engaged in competitive currency depreciations in response to the Great Depression and Great Deflation of the 1930s.  These so-called «beggar-thy-neighbor policies» were the subject of much recrimination.  They are popularly believed to have fanned the tensions that culminated in World War II. 

Remember the 1930s

But the reality was more complex.  Starting in 1931, some central banks opportunistically pushed their exchange rates down while doing little to expand their balance sheets and money supplies.  Their weaker exchange rates ratcheted up the pressure on their trading partners.  With domestic credit conditions remaining tight, these countries attracted capital rather than sending it abroad.  Their policies beggared their neighbors.

But there were a few prominent exceptions.  And the most prominent was none other than Japan.  Under its proto-Keynesian finance minister Korekiyo Takahashi, Japan not only aggressively pushed down the yen exchange rate but also aggressively expanded supplies of money and credit.  Unlike other countries devaluing their currencies, Japan was not a magnet for capital inflows.  Thus, its policies did not have the same beggar-thy-neighbor effects on the rest of the world.  Not incidentally, those policies also succeeded in ending deflation and jumpstarting the Japanese economy’s recovery from the Great Depression.

The implications for the current debate are clear.If the ECB limits itself to verbal interventions, Japan has every right to criticize Europe as hypocritical.Efforts to talk down the euro exchange rate as a way of boosting European growth will impact other countries negatively, unlike Japan’s own policies, which are unlikely to have this effect.  If, on the other hand, the ECB takes steps to aggressively expand its balance sheet in June, placing further downward pressure on European bond yields, it will be less attractive for Japanese investors to search for yield in Europe.  Instead, more Japanese money will stay at home, boosting investment there.In this case, Japanese observers should absolve the ECB of blame.

The ECB already has multiple reasons for acting aggressively.  Verbal intervention alone is becoming less effective.  The threat of deflation is growing more severe.  If diplomatic tensions with Japan and other Asia countries provide yet another reason for it to act aggressively, all the better.