Should the European Union Emulate Japan's Inflationary Monetary Policy?—Posner

For many years now Japan has been plagued by deflation, which has retarded its economic growth; since 1981 the average annual growth of Japanese GDP has been only 2.1 percent. Deflation implies that the value of money relative to goods and services is rising, which reduces consumption (and hence production) by inducing people to postpone purchases in the expectation that prices will be lower in the future. Recently the Japanese central bank at the behest of Prime Minister Abe increased the volume of Japanese money in order to increase the ratio of money to goods and services, and thus change deflation to inflation. Inflation can induce a temporary spurt in consumption, but not a permanent increase; although Japan has announced a goal of 2 percent annual inflation, I assume the major goal of the increase in the money supply is to increase exports and reduce imports, thereby stimulating domestic production (both of exported goods, but also of domestic substitutes for imports made more costly by the devaluation since their prices in yen rise) and so consumption, employment, and economic growth, as well as ending deflation. In addition, an increased supply of money should reduce interest rates, thereby stimulating borrowing and so further stimulating consumption. 

Keynes urged devaluation of the pound against the dollar in the 1920s in order to stimulate the stagnant British economy, but the British Treasury refused because of Britain’s very substantial foreign investments, which would be worth less if the pound were weaker. Apparently no similar obstacle was interposed to the Japanese devaluation. 

It is not yet clear how effective Japan’s devaluation will be either in reducing deflation or in stimulating production and employment. The reason is that Japan has many very inefficient labor regulations, along with a very aged population (the Japanese people have the greatest longevity of any nation’s population), a combination that, by making for sluggish production and cautious consumers, depresses economic growth. The depressive effect may greatly limit the efficacy of the new policy. Abe wants to remove inefficient regulation, but the political obstacles may be formidable. 

Europe is suffering from protracted economic stagnation too, so the question arises whether it might benefit from emulating Japanese devaluation. The obvious objection is that the major European countries (except Britain) have the same currency, the euro, so that devaluation would not alter relative prices among the euro countries—and they are major trading partners of one another. Then too for such a large part of the world’s economy (roughly 20 percent) to devalue could well, depending on the size of the devaluation, induce retaliatory devaluation. 

For devaluation to stimulate economic growth without provoking retaliation from outside the euro bloc might require that the economically weakest European countries, primarily Spain, Portugal, Italy, Greece, and Cyprus, abandon the euro and then devalue the local currencies that would replace it. But for a nation to abandon the euro would be very difficult, because as soon as the abandonment was realized to be imminent, euros would flow out of the country to avoid the devaluation that would ensue from the replacement of the euro by a local currency, and because all sorts of legal and financial tangles would ensue from the fact that contracts in euro countries are denominated in euros. 

A devaluation of the euro, as distinct from abandonment of the euro by the economically weak European nations, would not involve these problems. And if it were a modest devaluation (modest enough to avoid retaliation by the United  States, China, or other leading non-EU nations), it would increase the weak EU countries’ exports outside the EU and reduce their imports from outside the EU, and thus strengthen the economies of the EU nations. The resulting spur to economic growth would reduce the rates at which the weak EU countries borrow, by reducing the risk of default, and so would reduce their fiscal deficits. 

Devaluation is no silver bullet, however. To minimize the risk of retaliation, it cannot be too great. if it is small, it is unlikely to overcome the drag on economic growth that anticompetitive labor and other regulations, heavy taxes, inefficient state companies, corruption, and waste impose on an  economy.

Comments

[Gertrud Fremling]

Macroeconomic policy can only do so much. Japan has a major problem of fewer and fewer people in the young cohorts. See http://www.nationmaster.com/country/ja/Age_distribution

With a shrinking number of workers and consumers, who would want to invest?

[Thomas Rekdal]

I could not agree with Gertrud Fremling's comment more. The demographic changes and welfare policies in both Japan and Europe are beyond effective control by macroeconomic policy makers--perhaps even in the sense of producing the least worst outcome. Investors can only hang on to the gunwales and hope for the best.

[Gordon Longhouse]

"Keynes urged devaluation of the pound against the dollar in the 1920s in order to stimulate the stagnant British economy, but the British Treasury refused because of Britain’s very substantial foreign investments, which would be worth less if the pound were weaker."

How is that again?
If the pound is less valuable relative to other currencies how can it be that overseas investments (presumably not denominated in pounds) would be worth less because of a devaluation of the pound? Surely they would be worth more to an English investor.
The investments that foreigners have made in England would be worth less by reason of a de-valuation.
It hardly seems likely that the British treasury made a mistake of this nature.