I was just quick reading this interesting paper from Daniel Leigh of IMF. As it is quite technical, I just read the english bit. A paper on Bank of Japan and lost decade is just too tempting.
Bank of Japan has been hugely criticised for making a Japanese recession a prolonged slump or what is called as Japan’s lost decade.
This paper seeks to shed light on the topic by focusing on the experience of Japan, a country that entered a liquidity trap in the mid-1990s, and experienced a “Lost Decade” (Hiyashi and Prescott, 2002) of slow growth, deflation, and output persistently below potential (Figure 1). 3 Japan’s experience has stimulated a lively debate about what went wrong. As Blanchard (2000) notes “this may not be a bad time to assess the lessons from the Japanese full experiment” (Blanchard, 2000, p. 185). A number of authors attribute much of the economy’s disapointing performance to “exceptionally poor monetary policymaking” (Bernanke, 2000, p. 150). In addition, Kuttner and Posen (2002) find that “Japanese fiscal policy was contractionary over much of the 1990s,” and attribute part of the protracted downturn to insufficient fiscal stimulus. However, this paper focuses on the contribution of monetary policy.
What policy was the Bank of Japan following, what “exceptional mistakes” did it make, and what, if anything, could it have done to help avoid the “Lost Decade?” This paper addresses these questions by first investigating whether the Bank of Japan’s interest-rate policy is well described by a standard Taylor-type monetary policy reaction function.
Secondly, the paper conducts counterfactual simulations based on the estimated structural model to investigate whether alternative interest-rate policy approaches proposed in the literature could have improved macroeconomic performance.
In the counterfactual analyses, I try the following alternative interest-rate policy rules to see whether they could have helped Japan avoid the deflationary slump: (i) a policy rule with a higher inflation target, as originally suggested by Krugman (1998); (ii) a policy rule with a strong response to the output gap; (iii) a policy rule that combines a higher inflation target with a strong response to the output gap; and (iv) a price-level targeting rule along the lines of Eggertsson and Woodford (2003). The paper builds on existing research by investigating the effectiveness of these policy rules based on the historical series of estimated shocks for Japan during the 1990s and a structural model that displays plausible macroeconomic dynamics.
And what are the findings?
My analysis suggests that the Bank of Japan’s interest rate policy fits a forward-looking reaction function with an inflation target that declined over time, reaching about 1 percent in the early 1990s. These results suggest that there was nothing unorthodox about Japanese interest-rate policy. Next, using an estimated structural model, I identify a number of adverse shocks occurring over the 1990s. It thus follows that monetary policy was not solely responsible for the economy’s poor performance. However, the Bank’s policy rule had an Achilles’ heel.
Aiming for a low inflation level and responding to the economy according to a conventional policy rule provided insufficient insurance against the contractionary shocks that occurred over the 1990s. The counterfactual simulations based on the series of estimated shocks that occurred over the 1990s suggest that a rule that combined (i) a higher inflation target of about 4 percent per year and (ii) a more vigorous response to the output gap would have substantially improved the economy’s performance and would have avoided the zero bound on nominal interest rates. Importantly, rules that had only (i) or (ii) would have provided only partial protection against the large deflationary shocks. I also find that a price-level target would have delivered superior stabilization results.
Hmmm. Policy rules with a focus on both inflation and output would have worked.
Lessons for today’s central banks??
So what lessons does Japan’s experience offer for the rest of the world? Following the most severe financial crisis since the Great Depression, and the deepest recession since the Second World War, how can monetary policy help to avoid a new “Lost Decade?” A number of central banks still regard an interest-rate policy that aims for very low inflation, such as 0–2 percent, with all other macroeconomic objectives being secondary. Some of these central
banks operate in economies that have similar structures to the Japanese economy and have, during the recent crisis, been subject to similar shocks. The results in this paper suggest that such economies may need to take out greater insurance against such shocks by raising their inflation targets and increasing their efforts to stabilize output, or by adopting a form of price-level targeting.
Hmm….. Raising inflation targets…. Janet Yellen also said the same but she suggested increasing it from 1.5% to 2%. Leigh suggests a higher target.