Another kind of immaculate inflation doctrine


Mitsuo Shiota


September 11, 2021

Prof Sakuragawa’s policy proposals

Prof Masaya Sakuragawa at Keio university published an anticle titled “The Bank of Japan should abandon zero interest policy, and normalize monetary policy” (Japanese) in “Lecture on Economics” in Nikkei news paper on September 9, 2021.

His two main proposals are:

  1. The Bank of Japan should declare it will aim to raise interest rates to 1 percent, and promise it will never go back to zero interest rates except for emergencies.

  2. The Japan Government should make efforts to sell yen-denominated Japanese Government Bonds to foreign central banks by internationalizing the yen.

And he writes, “Once we reduce real interest rates to negative 1 percent, we can reach 2 percent inflation target.”

My intuition tells me his proposals are impractical, and even if they are practical, he is wrong.

As for practicality, interest rates that affect the economy are not overnight rates, but the long term rates, like 10 year government bond yields. The market will not believe the Bank of Japan will never go back to zero interest rates, so the long-term rates will not rise to 1 percent.

Now forget about practicality, and suppose the long-term rates will indeed rise to 1 percent. Then how is he wrong? It took me two days and brief reading of his books to find out his way of thinking and how he is wrong.

His thinking is based on the bubble theory by a French economist Jean Tirole, according to his book published in 2009 (Japanese). He writes, “A bubble exists when there is a difference between a market price and a fundamental value of the asset”, “Paper money is a bubble because it is evaluated in the market more than its fundamental value as of paper” and “Government bond is not a bubble as long as it will not roll over”. I am confused about the definition of “bubble.” So I would like to use my words, not his words, and avoid the word “bubble.”

Loanable funds market alone does not determine the real interest rate

Loanable funds market diagram’s x-axis is loan amounts and y-axis is real interest rates. Supply curve is upward slope to the right, and demand curve is downward slope as usual. The cross point, an equilibrium, determines the loan amount and the real interest rate.

In my understanding, he thinks his two proposals will shift supply curve to the right. His proposal #1 will induce savers to move their paper money holdings, which earn zero interests, to bank deposits, which earn some positive interests. His proposal #2 will allow banks to move their government bond holdings to loans. The supply curve will shift to the right, and the equilibrium will move to more loan amount and reduced real interest rate. He thinks that’s it.

Although I doubt his proposals’ effects on the supply curve, it is not the main problem. The main problem is that he thinks the real interest rate is determined in the loanable funds market alone.

No, it is not yet determined. Loanable funds market is not the end of the story, but only the start. One diagram of lonable funds market is drawn for a given real GDP level. When we draw diagrams for possible real GDP levels, we get many equilibrium sets of real interest rates and real GDP levels. When we draw IS-LM (investment-saving and liquidity demand-money supply) diagram, of which x-axis is real GDP level and y-axis is real interest rates, it becomes IS curve, which is downward slope. The real interest rate and real GDP level is determined at the cross point of IS curve and LM curve. If you are confused, refer to Paul Krugman’s article in May 2009.

For simplicity, I would like to use monetary policy based on Taylor rule to explain LM curve. Suppose inflation expectation is anchored at zero percent. The lower bound of nominal interest rates is now 1 percent, not zero, due to his proposal #1. Then the lower bound of real interest rates is 1 percent. Even if IS curve shifts a bit to the right thanks to his proposals, considering this upward shift of LM curve thanks to his proposal #1, and the position of the starting cross point which is far left of the kink of LM curve, the cross point will stay on the lower bound of LM curve. As a result, real interest rate will not decrease to negative 1 percent as he asserts, instead will increase to 1 percent.

Inflation comes not from Fischer equation, but from high pressure economy

In the above paragraph, I use Fischer equation to calculate real interest rates given nominal interest rates and inflation expectation. Prof Sakuragawa uses it to predict inflation from his (wrong) predictions of nominal and real interest rates.

Predicting inflation without explaining what changes people’s behavior is called “immaculate inflation”. One example is predicting inflation when the central bank increases monetary base (quantitative easing) in the liquidity trap, just based on the quantity theory of money. Paul Krugman, who coined the phrase “immaculate inflation” by mimicking “immaculate transfer” coined by John Williamson, pointed out another example in his article in March 2018.

When Prof Sakuragawa writes, “Once we reduce real interest rates to negative 1 percent, we can reach 2 percent inflation target”, it is another example of “immaculate inflation” by predicting inflation just based on Fishcer equation.

Prof Sakuragawa is trying to create custom-made economics for Japan

Prof Sakuragawa published a book titled “Japan can revive by internationalizing the yen” (Japanese) in 2011. In the afterword, he writes “Japan can never revive by believing and adopting economics imported from America. The idea of internationalizing the yen will never come from America. We have to create our own custom-made economics to revive Japan economy.”

He is trying to create custom-made economics for Japan economy. I admire him, as I am just a believer of economics imported from America. He may sometimes fall in some pit holes in the way. I hope he is courageous enough to admit his mistakes, and will go on.

P.S. He won the Nikkei / Economic Book Culture Award (Japanese) for his new book, “Economic Theory of bubbles” (Japanese) on November 3, 2021.