Friday, May 04, 2007

Thoughts on Raising Japanese Interest Rates

This week's Economist has an interesting piece about the possibility that higher interest rates could cause consumer spending to rise. At least in Japan.
Saving grace

EVERY economics student learns that higher interest rates depress growth by curbing borrowing and spending. That, according to the conventional wisdom, is why the Bank of Japan (BoJ) must continue to hold interest rates at historically low levels; a rise in rates would risk tipping the economy back into recession and deflation. Yet a few brave economists believe, to the contrary, that higher interest rates would actually encourage households to spend more, not less.

...The problem is that ultra-low interest rates risk creating economic distortions, such as the excessively weak yen, asset-price bubbles, or inefficient investment. Worse, low interest rates may themselves be discouraging consumers from opening up their wallets. Debtors gain from low interest rates but savers lose, and Japanese households have the biggest stash of savings (relative to their income) among developed economies. Their net financial assets, excluding equities, amount to 3.2 times personal disposable income, compared with a ratio of only 1.9 in America and 1.1 in Germany (see left-hand chart).

...[I]n recent years, savers have earned peanuts on their assets, whereas debtors have gained relatively little from low rates, because most of their debts are at fixed rates (see right-hand chart). Tadashi Nakamae, a Japanese economist, estimates that, using 1992 as a benchmark (when interest rates were over 5%), households have suffered a cumulative net loss of interest income of over ¥200 trillion ($1.8 trillion) as a result of near-zero interest rates, equal to fully 65% of annual income. It is hardly surprising that household spending has been depressed.
There's no single, correct theoretical answer to the question of whether higher interest rates cause consumers to spend more or less; theory tells us either outcome could happen. So it really is an empirical question. And empirically, there's lots of evidence - at least for the US - to suggest that higher interest rates typically cause consumers to spend less.

But Japan is indeed a very special case, so it's worth considering the possibility that the typical empirical results might not hold there. As the Economist piece acknowledges, however, there's little chance that the BoJ will actually raise interest rates to test out this theory, if for no other reason than (thanks to the size-unknown "carry trade") it could have sharp and hard-to-predict effects on the yen/dollar exchange rate. And sudden, uncertain movements in the dollar are not something that any Asian government wants to risk right now.

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