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Can the Japanese Economy End Deflation With These Steps?

Japan's newly elected Prime Minister Shinzo Abe is taking aggressive measures in an attempt to end the deflationary spiral that has plagued the Japanese economy for more than twenty years.

The return of Abe's Liberal Democratic Party (LDP) to power in a landslide election victory last month is seen as a mandate to do whatever it takes to revive the flagging Japanese economy.

One of the first policies likely to be put into place is the passage of a massive supplementary budget for fiscal 2012 (the year ending March 31, 2013). Depending upon how you count it, the budget ranges from 10 trillion yen ($112 billion) to 20 trillion yen ($224 billion).

Observers have expressed concern over the size of the stimulus and what impact it might have on Japan's sovereign credit rating and on the Japanese government bond (JGB) market, plus what it could do to the U.S. economy.

Let's take a look.

Arm Twisting the Bank of Japan

The supplementary budget is nothing but good, old-fashioned pork barrel spending; the kind of money politics the LDP was known for when they governed Japan for more than 50 years.

What is new and different about Prime Minister Abe's approach to reviving the Japanese economy is his strong arm tactics against the Bank of Japan (BoJ), Japan's central bank.

BoJ independence was enshrined in law only in 1999. Abe has run roughshod over the intent of the law by demanding that retiring BoJ Governor Masaaki Shirakawa sign a written document agreeing to do whatever is necessary-generally considered to be "unlimited easing"-to achieve an inflation target of 2% over the medium-term.

At its last Monetary Policy Committee (the equivalent of the Federal Reserve's Open Market Committee) meeting, which took place just after Abe's landslide election victory, the BoJ agreed to review its policy goals and come back in January with updated policy recommendations. The next Monetary Policy Committee meeting takes place over two days on Jan. 21 and 22.

Press reports indicate that the BoJ will roll over and do pretty much whatever Abe wants – and here's why.

There is little reason for the Bank of Japan to fight Abe at this point. The terms of both the governor and the vice-governor expire over the next few months and each will be replaced with candidates that agree with the Abe government's position on aggressive monetary policy in order to achieve the inflation target of 2%.

If the central bank doesn't go along peaceably, Abe has enough votes in the Diet to railroad through amendments to the Bank of Japan Act to eliminate the BoJ's independence under law.

What the BoJ Can Do for the Japanese Economy

The Bank of Japan already has a large asset-purchasing program in place to try to stimulate the economy. At its last meeting, the central bank pledged to increase the size of the asset purchasing program to a cumulative total of over 100 trillion yen ($1.1 trillion).

Currently, the BoJ will only purchase bonds with three years or less until maturity. It has been proposed that the bank move further out on the yield curve and purchase bonds with a duration of five years or more. This will ensure that the yield curve doesn't get too steep from the BoJ adding liquidity to the economy.

The BoJ also set out a program to allow private sector banks to fund the net increase in their lending for up to four years at the overnight call rate of 0.1%.

It has also been proposed that the Bank of Japan directly purchase foreign bonds. The central bank has balked at this, continuing the current system by calling for the Ministry of Finance to purchase overseas bonds using the BoJ as an agent. The Japanese government will continue to purchase foreign bonds, including U.S. Treasuries and European Stabilization Mechanism (ESM) bonds.

At the end of the day, the Bank of Japan is under enormous and growing pressure to boost liquidity in the economy and to weaken the yen to help Japanese manufacturers with their exports.

Will Japan Stop Buying Treasuries?

Some pundits, including Peter Schiff, have argued that Abe's stimulus policies are harmful to the United States. Schiff thinks that Japanese investors will stop buying JGBs in favor of other, higher-yielding assets.

The BoJ will have to buy more JGBs and that will leave them less money to purchase foreign bonds, and will force the U.S. Treasury to cover the shortfall.

"That means more money printing here …so we will have more domestic inflation," Schiff adds. "Eventually none of the foreign central banks will want to buy more dollars when they figure out the game that we're playing, continually creating money to buy products we can't afford."

We have heard this argument before, but here's how Japan's policy could work.

If the Bank of Japan is successful in weakening the yen, then it stands to make a lot of money by holding foreign bonds though the appreciation of overseas currencies against the yen.

If the weaker yen helps Japanese businesses boost earnings, it will increase employment and tax revenue and start to put a dent in Japan's national debt.

And it might even create a little inflation in the Japanese economy.

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