How to stimulate the economy after a zero interest rate
(source of information : "Japan: reflation without reform equals disaster," BusinessWeek, March 26, 2001
Bank interest plays a very important role in stimulating a nation's economy. The lower the interest rate is, the more money Japan lent to its trade partners to purchase goods from Japan. In recent years, many of Japan's trade partners, especially developing nations, were not able to pay. If borrowing by businesses and consumers becomes cheaper, more investment and consumer purchase of durable goods will be forthcoming. This, in turn, will increase demand for employment and raw materials (i.e., higher derived demand.) Any investments with potential rates of return higher than the interest rate are worth undertaking by borrowing money from banks.
In addition, a bank's interest rate represents a cost of investing in the stock market (i.e., bank interest is an opportunity cost of stock investment). The lower the interest rate is, the more attractive the investment in stock becomes, and prices of the stock go up. This, in turn, increases the equity of a firm as well as the wealth of households, and encourages further investment and consumption. This chain reaction is called a multiplier effect. The bank's interest rate is often artificially adjusted by a central bank of a country to take the maximum advantage of its stimulating effect upon the economy.
In recent years, Japan, once one of the most dynamic economies in the world, has experienced a serious recession. Collectively, Japanese banks now hold $250 billion in defaulted loans due to the recession. To provide a big boost to its economy, the Central Bank of Japan lowered its interest rate to an annual rate of .15%, almost zero percent. This means that money is almost free to borrow, and practically any investments are worth undertaking. Yet, even with this historically unprecedented low interest rate, there is no visible economic recovery for Japan on the horizon, and some economists now suggest a drastic measure for its recovery. The new policy is known as "reflation," a term which describes the attempt to deliberately encourage inflationary pressure by printing more paper money. Inflation is the major curse of many developing economies, and no country advocates inflation as a remedy for economic recovery, unless it is the last resort. Inflationary pressure encourages borrowing because inflation depreciates the value of money, and future payment of a loan has a lower value than its initial value. For example, assume that inflation is 10% and rate of interest is 2% per year. If a person borrows $100 for one year, and pays back $102 at the end of year, the following occurs: due to 10% inflation, the value of $102 is actually $92, and the borrower directly benefits from about $7 in real income (i.e., 90% of $8) by simply borrowing. Borrowing will be especially active for long term investments and consumption, such as new construction or residential housing that typically carries a 20-year mortgage. The new investment increases employment and demand for raw materials, which, in turn, increases national income through a multiplier effect, i.e., the final income is much larger than the initial investment.
However, critics of the reflation policy point to serious caveats and argue that applied to Japan without other economic remedies, the policy may cause exactly the opposite effect. First, Japanese banks with serious loan defaults are extremely reluctant to issue new loans and content with putting their surplus cash in government bonds or investing in safer overseas stocks, especially in the United States. Therefore, any new monies printed by the Japanese government may simply return to the government vault in exchange for long-term government bonds. The government cannot directly participate in the investment of private sector of the economy, and therefore the cash in the vault totally negates the intended purpose of printing more money in the first place.
Second, a more likely scenario is that the banks will invest additional cash in overseas stock markets. To purchase U.S. stocks and bonds, the banks need dollars by selling yen, Japanese currency, and the price of yen will be devalued. Devalued yen encourages exports from Japan but discourages imports to Japan. For example, if the yen devalues from 100 yen to 200 yen per $1, then a Japanese exporter earning $1 in the U.S. market earns 200 yen instead of 100 yen as before. On the contrary, a Japanese importer has to pay now 200 yen instead of 100 yen to import a good selling at $1 in the U.S. Japan is already a net exporter in the world trade and enjoys a very strong positive balance of payment with practically all of its trade partners. In many cases, Japanese banks back their past accumulated debts. Therefore, if the yen is devalued and Japanese exports stimulated further, the danger of escalating loan defaults may ensue.
Third, on the consumer side, inflationary pressure from the reflation policy may not encourage borrowing and increased spending. Japanese consumers are known for their frugality even during an economic boom. A higher rate of inflation will lower the true value of their savings, especially savings for retirement. In order to compensate for the reduced value of their savings through inflation, Japanese consumers will simply save more, rather than spend more, of their additional monies.
Therefore, an appropriate policy to bring Japan out of its current recession is to treat the defaulted bank loans as sunk costs which cannot not be recovered, and the government can forgive all these loans and start the economy anew. Yet this policy sets a precedent to reward the bad economic judgment of a bank.