Money supply and monetary base

Because inflation is a monetary phenomenon, we should see what is going on with the money supply in Japan. There are two measures of money to consider, monetary base and M2. Monetary base consists of cash in circulation plus current-account balances (excess reserves available to lend) on the BOJ’s books. M2 is cash, demand deposits, and certificates of deposit.

In another throwback to Economics 101, monetary base is the fuel with which the banking system can create new money and credit via fractional reserve lending (i.e., you have to keep a percent of your funds in reserve). Central banks rely on this mechanism to induce large changes in the money supply via their relatively small transactions in the purchase and sale of securities. However, what happens in an economy such as Japan’s, which endured the simultaneous bursting of its twin stock and real estate bubbles in 1990? If commercial banks find themselves awash in non-performing loans, they are unable to extend new credit, and if borrowers are faced with slack demand for their products and services, they are not borrowing. In short, the entire credit expansion mechanism freezes up and no addition to the monetary base can lead to an expansion of the money supply. Both low interest rates and excess money are ineffective at stimulating new borrowing in this situation, and deflation results.

As an aside, this mechanism, also called a “liquidity trap,” was described by John Hicks during the Great Depression, the study of which was Fed Chairman Benjamin Bernanke’s academic specialty. He feared this while a member of the Federal Open Market Committee (FOMC) in 2002-2003, and it was his advocacy of extraordinary measures to preserve the flow of credit that led the Federal Reserve to maintain a 1.00 percent federal funds rate into 2004.

The Federal Reserve studied the Japanese experience as well. The only criticism offered here is the American stock and real estate cycles are out of phase; stocks fell in 2001-2002, and real estate began its downturn in 2006. Thus the U.S. was never in danger of a Japanese-style deflationary epoch.

We can see the ineffectiveness of the BOJ’s policies by mapping both the year-over-year changes in the monetary base and M2 against the two CPI measures described above. M2 growth fell in the early 1990s after the bubbles burst and has yet to recover. The changes in the monetary base have been violent, both higher and lower. The BOJ concluded in 2001 that near-zero interest rates were insufficient to stimulate credit demand, so they embarked on a policy of “quantitative easing,” or the shoving of funds into their current account (green arrow). This had no impact on M2 or the price indices. When they decided to end this policy in 2006 (orange arrow), M2 growth declined slightly, but once again the impact on inflation was nil.

We can conclude the funds injected by the BOJ were borrowed elsewhere. Restated, the BOJ aimed at Japanese consumer prices and hit global asset prices instead.

Would it have been any different if the BOJ had been able to stimulate M2 growth? Quite possibly yes. If we map the year-over-year changes in M2 against those for the general CPI, we find M2 leads the CPI by 20 months on average. The r2, or percentage of variance explained, is 0.76.

A second factor in the Japanese experience has to be accounted for as well. The singleparty domination of the Liberal Democratic Party (LDP) has led to public works expenditures run amok, with the result that Japan’s national debt now stands in excess of 150 percent of GDP. The LDP chose to pay for their actions by raising the consumption tax in April 1997. This tax negated any incentive for the Japanese consumer to increase spending. The wholly predictable result was an immediate and pronounced downturn in the CPI.