Money-Pumping Myths, Japan Edition

Due to the unprecedented amount of assets purchased as part of the Bank of Japan’s various “QE” programs over the last two decades, it is widely believed that the BOJ has been engaged in a relentless money-printing campaign aimed at igniting inflation during the current post-crisis era. However, given the fact that these so-called money-pumping policies have had so few real-world inflationary consequences to-date, most analysts have come to believe that the increase in the money supply has failed to deliver inflation since it has been largely cancelled out by natural offsetting deflationary forces. These natural deflationary forces, it is argued, have essentially rendered the BOJ impotent and laid bare the real-world limitations of monetary policy as a means of escaping an intractable deflationary spiral, as the BOJ is only now figuring out.

Unfortunately, this explanation ignores the fact that while BOJ asset purchases may have indeed increased reserve balances within the banking system, it has not substantially increased the type of money that really matters in determining inflation – namely, it has not directly increased money actually spent on goods and services by the general public. In the modern monetary system in which we operate today there are in fact two flavors of QE, each with varying impacts on both the money supply and inflation. One method increases the overall supply of money in circulation within the broad economy, and the other simply increases the balances held by commercial banks in their reserve accounts at the BOJ.

The QE process that is used by the BOJ involves purchasing assets from the private banking sector, and paying for these assets by crediting the reserve accounts that these banks hold at the BOJ. This increase in reserves adds to what is known as Base Money, but Base Money is money used solely within the banking system and for the most part does not escape into the hands of the general public. It is commonly asserted that an increase in the reserves of commercial banks stimulates the creation of money since banks are able to lend new money into existence through the mythical “money multiplier”. However, this ignores the fact that in a modern economy the money multiplier is no longer actually used and commercial banks are never reserve-constrained when it comes to their lending activities. What restrains bank money-creation is capital requirements and the credit-worthiness of would-be borrowers, not the quantity of reserves held by commercial banks at the BOJ. If the banks don’t want to lend and customers don’t want to borrow, no amount of additional reserves will solve this problem.

The second type of QE, which has been used by central banks such as the Federal Reserve and the Bank of England, involves purchasing assets from non-bank entities. When the Fed, for example, purchases assets through QE, it writes a check to the non-bank seller who then deposits this check into their commercial bank account and receives a corresponding deposit. The commercial bank then takes this check to the Federal Reserve, who then credits the reserve account that the commercial bank holds at the Fed. The key distinction is that under this scenario, the seller of the original asset receives newly created deposit money and, in addition, the seller’s bank is credited with newly-created reserves. In the type of QE practiced by the BOJ, on the other hand, reserves are created in exchange for the purchased assets, but no new deposit money is created for the general public to spend.

In what is perhaps one of the longest-running policy mistakes in central banking history, the BOJ has repeatedly failed to create inflation precisely because of the mechanism which they are using to purchase assets via QE. In comparison, the method used by the Federal Reserve has been effective at warding off a post-2008 deflationary spiral precisely because they have managed to expand the money supply through the creation of additional deposit money in the hands of the general public.

Given this article’s claim that QE in Japan has not served to significantly expand the money supply, exactly how does the theory match up with realty? Quite well, actually. Since 2005, Japan’s money supply (as measured by the True Money Supply metric) has increased by an average of only 3.8% per year. If we assume that real economic growth averaged approximately 2% per year over this same period, then this would imply that inflation would have clocked-in at about 1.8% per year, which fits more or less in line with the low inflation reality of post-crisis Japan.

Anyone who understands the mechanics of QE, the link between inflation and the money supply, and the difference between base money and broad money, would not have been surprised in the slightest by the complete failure of the BOJ to generate significant inflation for the better part of two decades. The fact that so many people believe that current BOJ QE measures are inherently inflationary is a testament to either their complete confusion over the mechanics of QE or a much larger misunderstanding of the way monetary policy transmits higher prices through to the overall economy.