What Japan can learn from Switzerland

The Swiss National Bank does a much better job in explaining and executing its exchange rate policy than the new leadership of the Bank of Japan. A column by Barry Eichengreen.

Barry Eichengreen
«The simplicity of the policy aids communication. And the SNB has done a good job of conveying the message.»

The government of Shinzo Abe has been subjected to a firestorm of criticism for proposing that the Bank of Japan should actively push down the yen exchange rate in order to jumpstart the Japanese economy and put an end to years of deflation.  Yet, all the while, the Swiss National Bank has intervened in the foreign exchange market to prevent the franc from rising and Swiss industry from suffering additional damage.  Haruhiko Kuroda, widely anticipated to be Prime Minister Abe’s pick to head the BOJ, is seen as a currency warrior likely to manipulate the exchange rate to his country’s advantage.  Yet Thomas Jordan, despite the SNB’s extensive intervention in the foreign exchange market, has succeeded in dodging similar criticism.  Why the difference?

The obvious answer is that Japan is a much larger economy – fourteen times larger.  Its monetary and exchange rate policies have a much larger impact on its neighbors.  Switzerland, to its good fortune, is small enough to fly under the radar.

But this is not the entire story.  Switzerland may be a small country, but it punches above its weight in financial markets.  The SNB’s policy also sets an important precedent.  Policy makers in other countries concerned about exchange rate manipulation presumably care if the SNB is setting a bad example, even if the impact of its policies on the rest of the world is limited.

Rather, other factors explain why the SNB’s policy has not attracted more criticism from abroad.  First, the SNB, unlike the BOJ, has done a good job of communicating its intentions.  It has explained that its policy is not designed to depress the franc from current levels.  It is not designed to steal demand from Switzerland’s neighbors.  The commitment is simply to prevent the currency from rising further.  The simplicity of the policy aids communication.  And the SNB has done a good job of conveying the message.

Puzzling signals from Tokyo

The same cannot be said of Japan.  The first step in the new policy, doubling the BOJ’s inflation target from one to two per cent, sent an admirably clear signal.  But there was then less clarity on how the new government and central bank board would go about pursuing that target.  In a limp policy statement following its meeting on 21-22 January, the policy board suggested that if 2 per cent inflation to fail to materialize it would consider ramping up its asset purchases in 2014.  Some readers initially dismissed the “4” in 2014 as a misprint.  Why the central bank wouldn’t wish to emphasize its commitment to 2 per cent inflation by ramping up asset purchases already this year is a mystery.  Why it is not prepared to do more given its forecast of core inflation for 2014 of only 0.9 per cent is similarly mysterious.  The failure of the BOJ to convincingly answer these questions is a failure of communication.

Moreover, Prime Minister Abe and his finance minister Taro Aso both suggested that the BOJ should consider buying foreign assets to push down the yen, while failing to explain why this was a desirable approach.  It is not as if there is a shortage of Japanese government bonds to buy.  Some economists would argue that pushing down the exchange rate is the best way for a central bank to signal that higher prices are coming.  But if this was the strategy, it was not adequately described or justified.

And where the SNB explained that it was intervening because the franc was continuing to rise, the BOJ has not explained how it is factoring into its calculations the fact that the yen has fallen by 30 per cent against the euro and 20 per cent against the dollar since it first appeared in October that Mr. Abe would emerge victorious from the election.  Back in October it was possible to argue that a Swiss-style ceiling on the yen was justified.  But now, with the yen having fallen by 25 per cent, the case is harder to make.  And, again, the BOJ has failed to make it convincingly.

Worst of all, members of the Abe Government have suggested tampering with the central bank law.  The government might seek to limit the independence of the BOJ to ensure that monetary policy was more aggressive and in line with the wishes of the politicians.   Such a move, while guaranteed to produce a more inflationary monetary stance in the short run, would not inspire confidence in central bank policy.  To the contrary, it could raise fears that policy might change as soon as the cabinet changed.  The SNB has come in for plenty of criticism at home for its policy.  But Swiss politicians have been careful not to question the central bank’s independence.  The recklessness of Japanese officials in doing so has raised unnecessary questions about the conduct of policy.

Finally, the markets have figured out that what is in the SNB’s interest is also in the interest of the rest of the world.  To prevent the franc from rising against the euro, the SNB has been buying the bonds of Eurozone countries.  This is helpful to the Eurozone, given weak demand for the bonds of the Eurozone periphery and the reluctance of the ECB to match the Fed and Bank of England in quantitative easing.  The SNB’s additional demand raises bond prices, puts downward pressure on long-term interest rates, and gives the Eurozone at least a modest fillip of pro-growth stimulus.

Some commentators have objected that the SNB is buying bonds mainly from Germany and other countries with high credit ratings.  In doing so it is widening spreads between bunds and the bonds of the crisis countries.  But for this criticism to make sense, investors must be silly enough to care only about headline spreads and not about underlying economic and financial conditions.  If the SNB is, in fact, buying mainly bunds, this means lower interest rates for Germany but no change in interest rates for other countries.  In a Europe where interest rates are too high on average, this can only be a good thing.

What’s good for Japan might be good for the world at large

If the SNB’s self-interested policy is, in fact, good for the rest of the world, the same could be true in principle of the BOJ.  If that new policy succeeds in pushing down long-term interest rates and lifting inflation expectations, it will encourage funds to flow from Japan to other countries, lubricating financial conditions abroad.  The world will be better off with a Japanese economy that is growing than with one that continues to shrink.  It will be better off with a Japan that finally sheds the curse of deflation.  The fact that foreign officials and commentators haven’t figured this out can again be chalked up to the Bank’s flawed communications policy.

A final lesson for Japan concerns what can be achieved.  When the SNB first announced its new policy of capping the exchange rate, there was widespread skepticism that it would succeed.  But by committing fully and unconditionally to the policy – by indicating that the central bank would do whatever it took to make it work – Mr. Jordan and his colleagues proved the skeptics wrong.

Observers are similarly skeptical that the Bank of Japan will succeed in hitting its 2 per cent inflation target.  Previous BOJ governors encouraged this skepticism by arguing that success at ending deflation rests not just on the actions of the central bank but on the decisions of other entities, meaning firms and households.  This is tantamount to suggesting that it is not within the capacity of the central bank to end deflation.

The SNB could have said the same about the franc exchange rate.  It could have left itself an out by arguing that the franc’s value would depend not just on its action but also on those of Swiss firms and households.  Instead, it signaled that it would do whatever it took to hit its exchange rate target.  Its commitment was unconditional, and it made clear that if early steps did not suffice it stood ready to do more.  The new BOJ leadership should follow this example.  If it does, the goal of ending deflation will be within reach.