Monetary Policy

Bottom Line: Many experts hope that December snap elections will reenergize Japan’s structural-reform agenda, but the barriers to implementation remain high. Without progress on this “third arrow” of Abenomics, growth will remain almost fully dependent on easy money, intensifying global currency tensions in 2015. Most analysts are optimistic that this month’s elections in Japan could represent a turning point for the faltering Japanese economy. They argue a strong showing by Prime Minister Shinzo Abe’s Liberal Democratic Party (LDP) will provide a clear mandate to reinvigorate Abe’s structural-reform agenda. Indeed, the polls recently have moved in the LDP’s favor, and now suggest that the government could win well over three hundred seats in the lower house of parliament, nearly a two-thirds majority (the party currently holds 294 seats). Should Abe make economic reform a priority, he appears to have a mandate to make significant progress. Recall that structural reform was the ambitious third arrow of Abenomics, complementing monetary policy (the first arrow) and fiscal consolidation/reform (the second arrow). The government was committed to agricultural reform as part of a Trans-Pacific Partnership (TPP) agreement, as well as comprehensive labor and product market reforms. Many other governments, as well as market participants, linked their support for Abenomics to this third arrow in hopes of a supply-side effect that would allow a sustained increase in growth. To date, though, little has been accomplished. Given the continuing vested interests and political impediments to reform, my concern is that, though the government will “wave the flag” of structural reform in the coming months, the focus will quickly turn to domestic constitutional reform of the electoral system and regional defense concerns, sapping the energy behind economic reform. The fiscal arrow, in contrast, aimed to restore fiscal sustainability through upfront stimulus coupled with a multistage increase in the consumption tax. However, following weak growth numbers, the consumption tax has been delayed (though the government has committed to an increase in 2017). Although that makes a lot of sense on cyclical grounds, the government will still need to worry about fiscal credibility with government debt already in excess of 250 percent of gross domestic product (GDP). In that case, what is left to drive economic growth? Abenomics, which generated strong support based on its comprehensive three-arrow approach, would be reduced to a single arrow—aggressive monetary easing. A Sea Change for Monetary Policy Japan’s monetary policy is indeed extraordinary. At the end of October, by a five-to-four vote, the Bank of Japan (BOJ) surprised nearly everyone with a dramatic expansion of its unconventional monetary policy, citing renewed risks of deflation. If the program is fully implemented, bond holdings will be over 40 percent of GDP, adjusting for duration of the debt purchased, which is more than twice the size of the Federal Reserve’s three quantitative easing programs between 2008 and 2013. For a small, open economy such as Japan’s, easier money works in large part through the exchange rate. I would not argue that the central bank is aiming for exchange-rate depreciation, but at play is a central bank that—while motivated by domestic considerations—is taking advantage of the Fed’s turn toward normalization to make a dramatic move that ensures a substantial market impact by emphasizing the divergence of policy. As shown in Figure 1, the yen’s recent moves closely track movements in the Bank of Japan’s balance sheet. Japan has experienced sharp fluctuations in the past and there is reason to believe this time will be no different. Although some market commentators would argue that investors are already stretched, holding substantial investments that would do well in the case of a yen depreciation, from a fundamental perspective there is still some way for the yen to fall if the BOJ meets its asset-purchase targets. Still, Japan faces an uphill battle to reach its inflation target. A sharp and continuing decline in retail gasoline prices in yen, as well as the deflationary effect as the earlier consumption-tax hike wears off, has by some measures reduced underlying inflation to below 1 percent. Figure 1: The Dollar–Yen Exchange Rate and the Bank of Japan’s Balance Sheet Source: Bank of Japan; Oanda Exchange Rate Intervention In a coordinated announcement, the Japanese Government Pension Investment Fund (GPIF) announced a shift away from government bonds and toward equities, both domestic and foreign, doubling the share of equities to 50 percent. As a general rule it is not such a good idea to use government wealth funds as an instrument of monetary policy in this way: insurance and savings for future generations should be insulated from the short-term decisions that drive monetary policy. However, given that government policy has skewed previously toward support of the bond market, it can be argued that this is a good move from a longer-run perspective, and it does arguably strengthen the near-term wealth effects of quantitative easing. But it is worth highlighting that from an economic perspective, combining monetary easing with foreign asset purchases is the same as directly intervening in exchange markets, something the Group of Twenty (G20) has clearly opposed. In the context of weak global demand, it is unclear how Japan’s trading partners will respond to a sharp and continuing depreciation of the yen. To date, a number of Japan’s Asian trading partners have expressed concern, but we have not seen significant moves or the advent of a “currency war.” Credit is due to the Chinese government, which has held fire so far. But, amid softening domestic demand (the Chinese government this week lowered its growth target to 7 percent, despite substantial stimulus), any move by China to moderate the pace of renminbi appreciation against the dollar or other currencies as a response to the yen’s move would likely trigger a chain reaction in the region. Europe also will be watching the yen’s move closely. Although there are good reasons close to home for the European Central Bank to ease monetary policy, on the margin the Japanese move contributes to deflationary pressures in Europe. The United States is in a different position. Trade is a relatively small share of its economy, and so even a material appreciation is unlikely to undermine the strong growth outlook and continued strengthening of the labor market. So why worry? Indeed, U.S. policymakers appear broadly supportive of Japanese monetary policy, and see stronger growth in Japan, however achieved, as a positive contribution to the global outlook. The problem is as much political as economic. A sharp appreciation of the U.S. dollar against its major trading partners, driven by expectations that the Federal Reserve will begin to normalize policy while others ease, is bound to be contentious. There could be particular ramifications for trade. Congress is likely to produce a bill granting the president trade promotion authority (TPA), which is essential for any meaningful agreements on TPP or other trade negotiations underway. This case for bipartisanship on this issue is based on the historical Republican support for free trade, and recognition that Democrats have been the primary hurdle to passage of free trade agreements to date. Perhaps optimism is justified, but do not underestimate the risk that negotiations could go off track. In the past, both parties have pressed for tough language requiring any trade deal to address exchange-rate misalignments, and that pressure is likely to mount if dollar strength is seen as a risk for the economy. Such exchange-rate language could be a dealbreaker, as it is hard to see Japan or other U.S. trading partners making the tough concessions needed to agree to these conditions. There is much to commend the Bank of Japan for as it reverses decades of orthodox policy in order to jump-start growth with aggressive monetary easing. But relying on only one arrow presents both economic and political risks at home and abroad. Let us hope that optimism about the structural arrow proves correct. Looking Ahead: Kahn's take on the news on the horizon Draghi needs to start acting European Central Bank (ECB) President Mario Draghi has been promising to do whatever it takes to restore growth and achieve price stability, and needs to deliver now, beginning with the ECB’s December meeting. Greek elections loom Snap elections highlight Greece’s continuing economic challenges and could reinvigorate a debate over the adequacy of Europe’s crisis response. Cheap oil burns holes in government budgets Falling oil prices are putting significant pressure on a number of exporters’ government finances, including Russia, Venezuela, and Nigeria.

Bottom Line: The European Central Bank's (ECB) recent asset-quality review (AQR) and stress test of eurozone banks was an important step. But restarting growth requires stronger macro policies if Europe is to avoid a Japan-style lost decade. That includes a more concerted effort to deal with the sovereign debt overhang that is a threat to consumption, investment, and growth. In my recent Policy Innovation Memorandum (PIM), I argue that the overhang of debt is a critical constraint on growth, and call for debt relief for Europe's periphery. Why now? Partly, I expect debt issues will return to the fore over the coming years as growth stalls, adjustment fatigue increases, and spreads on periphery sovereign debt rise again. In addition, many of the critical policy debates in Europe were sidelined while awaiting the ECB-led AQR and stress test of the major European banks, which was released at the end of October. Supporters hoped that a credible stress test, and the positive market reaction that resulted, would represent a turning point in the crisis and "jump-start" the European economy. "I definitely think the banking crisis is behind us," said Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem after the release of the report. Such optimism is misguided and dangerous. The AQR and stress test constitute a serious effort to address the capital shortfall and restore confidence in the financial system, but they do not address all concerns. The review sets the stage for the ECB to emerge as the single supervisor and regulator for Europe's major banks, an important—if incomplete—step toward banking union. This effort, however, will not jump-start lending or get Europe growing again. Without growth, how confident can we really be that the crisis is over? Absent more supportive policies, the banking sector cannot regain its health, capital will remain inadequate, and a year from now the stress test may well look unconvincing. In that regard, I agree with Gavyn Davies: the exercise is a "necessary, but far from sufficient, step to fix the low-growth, low-inflation condition that has become the norm in the European economy." Europe's Three Arrows: The Japanification of Europe Concerns about European growth are a growing weight on markets. At the recent International Monetary Fund (IMF) and World Bank annual meetings, there was widespread talk of the risk of "Japanification" of the European economy, meaning a prolonged period of underperforming growth and low inflation. Though there was no consensus, I came away convinced that Europe needs its own version of Japan's Abenomics—its own "three arrows": Monetary policy. ECB sources have been quoted as suggesting that bolder action, including the purchase of government bonds (quantitative easing, or QE), could come before the end of 2014 or at the January 2015 meeting. A narrow majority (Germany is not alone in its opposition) now seems to recognize that current policies are inadequate, but it appears unlikely that the ECB will be proactive or clearly articulate its commitment to QE unless growth and inflation numbers get significantly worse. Forward guidance on policy, as much as the purchases themselves, will provide the real boost in the European case. Fiscal policy. Europe needs a more countercyclical fiscal policy, with greater spending by the surplus countries providing the demand that is missing as the periphery countries continue to consolidate, but it is hard to imagine such coordination on fiscal policy any time soon. The IMF expects European fiscal policy to be broadly neutral in 2015–2016. Structural policies. Although Spain is credited with some significant reforms, the regional reform agenda—including labor-market, spending, and product-market reforms—lags elsewhere in Europe. A comprehensive supply-side reform is needed to raise potential growth, though it should be acknowledged that structural reform often is disruptive politically and economically in the short run. There are two problems here. First, these remedies are well understood by European leaders—the problem is not imagination, but leadership. Europe remains stuck, and it seems that only a crisis can spur the needed response. Second, the downside of the analogy to Japan and the three arrows of Abenomics is that Europe should also address a fourth arrow—the debt overhang—which exerts a continuing drag on investment and confidence. With the stress test complete, now is the time to address this problem as part of a comprehensive pro-growth package. Debt Policy: The Missing Fourth Arrow Across Europe, sovereign debt is higher than it was immediately following the financial crisis. Last year, gross government debt was 175 percent of gross domestic product (GDP) in Greece and 133 percent in Italy; Portugal and Ireland's governments both hold debt stocks over 120 percent of GDP. Meanwhile, household and corporate debt remains high and continues to threaten bank balance sheets. Low interest rates make these debt burdens manageable for now, and have allowed countries such as Greece and Portugal to reenter markets. But with growth through 2015 projected at an anemic 1 percent, this is a problem deferred, not solved. Continued uncertainty over debt will condemn Europe to years of low growth and its attendant ills. Growth projections for the short- and medium-term are far too low to relieve problems like extreme unemployment—in excess of 35 percent for youths in Spain, Greece, Portugal, and Italy—and the social and political instability it can ignite. Continued weak economic performance will only further reduce confidence and investment, possibly widening the premium on periphery sovereign debt. The way out of the growth doldrums resides in forcefully tackling the debt problem. Europe's leaders need to find the political will to launch a structured debt-relief program. In my PIM, I argue that one place to begin is by looking to the Paris Club, an informal group of official creditors that convenes to address debt problems in low- and middle-income countries. Though my European friends hate my analogy to a forum that supports developing countries, clear lessons can be drawn. Specifically, Europe should implement four of the Paris Club's principles. First, rules should be adopted on a case-by-case basis to tailor restructuring programs to a country's income and debt level. Second, predictable debt relief should be conditional on policy performance, including structural reforms, continued progress toward fiscal balance, and programs to address the burden of corporate-sector debt. Third, countries should receive a cutoff date that would delimit the debt eligible for restructuring. In all cases, only debt accrued before that date would be eligible. This makes the country receiving relief fully responsible for any future debt accumulated. Finally, comparability of treatment for other creditors should not be ruled out as needed. The Paris Club framework is particularly important in the case of Europe, where much of the debt is owed to creditors in the official sector. This is particularly true in the case of Greece. At the end of last year, Greece had received a total of nearly 215 billion euros from "the Troika"—a group made up of the European Commission, the ECB (through the European Financial Stability Facility, or EFSF), and the IMF. This amount was equivalent to 108 percent of Greece's 2013 GDP and 62 percent of its total debt stock (see Figure 1). As a result of the 2012 private restructuring, the vast majority of Greece's debt is now owed to official creditors. Resolving disputes among these official creditors will be much easier if a set of rules is in place. In addition, consideration could be given to reducing debt held by the European Central Bank as part of rescue efforts. Citigroup Chief Economist Willem Buiter has an innovative proposal to cancel ECB debt holdings purchased to fund a temporary fiscal stimulus package. The principle also applies to the bonds the ECB has acquired as part of rescue efforts in the periphery. Figure 1: Greece's Troika and Non-Troika Debt, Year-End 2013 Source: European Commission Criticisms of proposals like these often start with a call for realism. It is highly unlikely that Germany and the other creditor countries would agree to commit to debt relief, even if highly conditional on policy reform, because such a commitment would make explicit the costs of sustaining the European Monetary Union with an incomplete set of economic policies. These creditors are concerned by the precedent a major debt-relief effort might set and by the issue of moral hazard (i.e., that easy relief would encourage recipient countries to relax their reform efforts and return to their bad old ways). But making explicit the cost of saving the eurozone with all its current members is simply good governance, as compared to hiding the costs by presuming they will be repaid in full. Further, the moral hazard problem, though a real concern, can be addressed by making relief conditional on performance. Finally, over the longer term, Germany does not benefit from killing its export markets in the periphery. These factors together make a compelling case for a structured program of debt relief. A Lost Decade Now is the time to embark on a comprehensive effort to restart growth in Europe, including a fourth arrow aimed at debt reduction. Low interest rates, the relief provided by earlier maturity extensions, and the confidence that could be achieved from the stress test combine to create a window for action on the debt. A year from now, if growth has not returned, indebted governments will be called on to rescue or shore up weak banks, uncertainty will return, and confidence and investment will be much harder to achieve. Europe needs a rules-based approach to debt relief. The Paris Club is one place to look for guidance to begin setting these rules. The sooner they are established, the sooner Europe will see a return to growth. Otherwise, a lost decade looms. Looking Ahead: Kahn's take on the news on the horizon Lame Outlook for the Lame Duck The U.S. Congress faces a long to-do list for the lame-duck session but is likely to achieve little; the international agenda—e.g., IMF reform and trade promotion authority— is likely to be deferred. More Economic Woes for Ukraine and Russia In Ukraine, the IMF team heads out. A large financing gap looms, calling the IMF program into question. Meanwhile, the Russian economy slips into recession. A Global Slowdown October saw analysts marking down their global growth forecasts, a trend likely to continue in November.

Bottom Line: The use of financial and economic sanctions against Russia demonstrates their power to penalize countries with globally integrated markets. We now need a strategy for convincing other countries (and markets) that this new weapon will be reserved for combating serious violations of international norms and not used as leverage in conventional commercial disputes. A code of best practice or principles could help guide the use of sanctions. In debating the consequences of Western sanctions on Russia,some observers voice concerns that sanctions are becoming an easy option for the United States and its allies when conflicts emerge. In a war-weary world, sanctions are an attractive alternative to military action, and, as I have argued elsewhere, the Russia experience has demonstrated the power of financial sanctions to impose costs on large, globally integrated economies. By imposing sanctions, Western powers wanted to send a strong signal to Russia (and to other countries contemplating similar actions) that there was a price to be paid for its violation of Ukrainian sovereignty and continued destabilization of the region. The United States and Europe may also have wanted to send a broader message: governments should adhere to basic international norms if they wish to participate in global markets. But concerns have now risen regarding which norms will be defended and how. What constitutes an egregious violation of international rules? I have been an advocate of comprehensive sanctions in order to impose substantial up-front costs on Russia. I have also argued that there is inevitable momentum for an extension of sanctions in this case, both as a response to Russia's actions in Ukraine and to its evasion of sanctions announced earlier. I still see this expansion as appropriate, although I recognize the costs to U.S. and European interests. However, it is also important that sanctions advocates address the risks of extension, including the concern that certain measures to increase sanctions could disrupt global markets to a greater extent than previously witnessed. Already there are reports of market makers pulling back on risk positions over concerns of a broader lack of liquidity should sanctions be extended to current payments. Such concerns can act as a brake on international cooperation and encourage countries to limit their integration in global markets as an insurance policy against future sanctions. More broadly, such considerations may increase efforts to create new international institutions, such as the Asian Investment Infrastructure Bank (AIIB), which risk fragmenting the framework for global economic governance if not properly coordinated with existing international financial institutions, such as the World Bank and Asian Development Bank. These concerns about the future overuse of financial sanctions fall into three basic categories: Are financial sanctions too easy to implement? Sanctions could become an easy option that is too readily applied in future cases. Although sanctions have not brought about peace in Ukraine, I would argue that the effects on Russia are significant and the costs will rise over time as capital outflows continue, investment in Russia is discouraged, and lost confidence contributes to a low-growth, high-inflation outcome for the Russian economy. Historically, it was assumed that a strong international consensus was needed for sanctions to be effective. That may be less true now; the power of sanctions stems from a country's exclusion from financial markets, providing some scope for the United States to go it alone. Is the United States at risk? Other countries may find their inhibitions lowered on the use of sanctions, making the United States a possible future target. One could imagine that, for example, countries opposed to U.S. policy on Taiwan or the Middle East might impose sanctions citing the Russian example. How far is too far? Once sanctions have been imposed, the pressure to extend them could lead to excessive use. In the Russian context, this debate revolves around whether sanctions should be imposed on the payments system. To some, the payments system is a global public good that needs to be protected, which suggests that a higher standard should be set for sanctions in this area. Unlike a prohibition on oil drilling by foreign companies, for example, a restriction on Russia's access to the payments systems reduces the benefits to other users across the globe. The Policy Response The United States and its allies no doubt value their options in the current environment. Indeed, the ambiguity about what could come next creates an additional cost for those considering doing business in Russia, which constitutes an important element of the effectiveness of sanctions. But that same ambiguity is a source of concern and can contribute to a loss of legitimacy. Can this leverage be preserved while assuring the rest of the world that sanctions will be used judiciously and appropriately? The strategy for addressing these concerns may have relied on other governance reforms, such as International Monetary Fund (IMF) quota reform and market-strengthening initiatives—including a Doha Round agreement, the Trans-Pacific Partnership (TPP), and the Transatlantic Trade and Investment Partnership (TTIP)—to signal U.S. commitment to an open, thriving, and rules-based global marketplace. Unfortunately, all these initiatives appear to be in trouble, as does the global trade liberalization agenda more broadly. Better communication can also be part of the strategy. It was inevitable, given the complexity of the standoff in Ukraine and the need to build alliances with the Europeans, that policy would have to evolve in ways that were not always transparent to markets. Now that the United States and its European allies have more experience, there is an opportunity to distill lessons and explain the policy both to other countries and to the broader public. A conversation with allies about the principles behind sanctions comes at a useful time. Some European countries are experiencing fraying support for sanctions, perhaps associated with differential costs from the sanctions and concerns about an energy shortage if the dispute extends into winter. With sanctions at current levels, these tensions can be mitigated, but opposition could intensify should the U.S. government decide to extend sanctions. A more ambitious idea would be to explore the possibility of a global code of conduct, or rules of engagement, which specifies—in a more concrete fashion than has been done to date—the conditions that could lead to the imposition of sanctions by the United States and its allies. There are other examples of informal codes in the economic sphere that can provide inspiration. The Santiago Principles, for example, are a set of twenty-four voluntary guidelines for investments by sovereign wealth funds that were agreed to by a broad range of countries in 2008—both those with sovereign wealth funds and those receiving investments. The analogy is not direct, as the Santiago Principles focused on ensuring that states acted in a commercial manner and avoided destructive competition through commitments regarding disclosure, transparency, regulation, and governance. Nevertheless, there are some interesting parallels. First, the codes were voluntary and designed to respect the sovereignty and independence of the state-owned investment funds and the need to maintain control over investment choices. Second, the goal was to encourage better international standards and establish best practices to promote accountability and transparency. These principles have been successful in framing the investor behavior of these funds and also in clearing away some of the uncertainty and ambiguity surrounding these organizations. Any code of conduct would need to promote transparency regarding the decision to impose sanctions and their application, objectives, and conditions for removal. This code would discourage retaliatory measures and tit-for-tat responses that could prove destructive. It may be a bridge too far to seek agreement on a specific code. But even in this case, the effort to articulate goals and objectives could help stabilize markets and address the concerns of important U.S. allies. Looking Ahead: Kahn's take on the news on the horizon Infrastructure Matters The IMF and World Bank meetings called for more and better infrastructure spending, but can the Group of Twenty (G20) agree on meaningful initiatives ahead of November's Brisbane Summit? Exchange Rates in Focus Market commentary increasingly highlights divergent Group of Three (G3) monetary policy as a source of exchange-rate and broader-market volatility. Ukraine Elections Should we expect a populist backlash against austerity? With the IMF program failing, the new parliament that is elected on October 26 will have some tough decisions on the economy.