Japan’s Wrong Way Out

LONDON – Financial markets were surprised by the Bank of Japan’s recent introduction of negative interest rates on some commercial bank reserves. They shouldn’t have been. The BOJ clearly needed to take some new policy action to achieve its target of 2% inflation. But neither negative interest rates nor further expansion of the BOJ’s already huge program of quantitative easing (QE) will be sufficient to offset the strong deflationary forces that Japan now faces.

In 2013 the BOJ predicted that its QE operations would deliver 2% inflation within two years. But in 2015, core inflation (excluding volatile items such as food) was only 0.5%. With consumer spending and average earnings falling in December, the 2% target increasingly looks out of reach.

The unanticipated severity of China’s downturn is the latest factor upsetting the BOJ’s forecasts. But that slowdown is the predictable (and predicted) consequence of debt dynamics with roots going back to 2008.

Excessive private credit growth in the advanced economies before 2008 left many companies and households overleveraged, and their attempted deleveraging after the global financial crisis erupted that year threatened Chinese exports, employment, and growth. To offset that danger, China’s rulers unleashed an enormous credit-fueled investment boom, pushing the debt/GDP ratio from around 130% to more than 230%, and the investment rate from 41% of GDP to 47%. This in turn drove a global commodity boom, and strong demand for capital-goods imports from countries such as South Korea, Japan, and Germany.