Japan Needs Paul Volcker to Escape `The Matrix'

Commentary by William Pesek

March 24 (Bloomberg) -- Japan's political establishment has turned even more inward than usual as it battles over who will run the central bank. It may be better off looking outside the system.

In such a seniority-based business culture, it comes as no surprise candidates for Bank of Japan governor have been around a long time. The first casualty of politicians' bickering was Toshiro Muto, who began at the Ministry of Finance in 1966.

Koji Tanami, also rejected by lawmakers last week, arrived at the Finance Ministry in 1964. Masaaki Shirakawa, who was named acting BOJ chief, has 34 years of central bank experience. In Japanese economic circles, that makes Shirakawa a relative newcomer.

Now the search is on for a full-time replacement for Toshihiko Fukui, whose term expired on March 19. With the global economy in turmoil, lawmakers hopefully realize how bad it looks to have the top of the BOJ in a state of flux, if not farce.

The real problem may be that Japan is looking for a BOJ chief among the usual candidates, and that just won't do. Economists who've spent decades at the central bank or the Finance Ministry tend to get homogenized intellectually. Fresh thinking is rewarded less than the number of years spent in the system.

What's needed is someone from outside, well, ``The Matrix,'' or at least Japan's financial version of it. The premise of the science fiction film trilogy -- humans living in a simulated reality created by machines to pacify and subdue the human population -- always stuck some observers as a bit Japan-like.

Japan's Matrix

No, Japan's 127 million don't live in The Matrix, though policy-making often seems to. Where else can a central bank that effectively has zero interest rates claim it's independent? Where else can politicians build up the world's biggest public debt and avoid the consequences?

All this is possible because of Japan's wealth and the sophistication of its financial model. Yet here's the rub. If a nation's responsibility to create a high standard of living, offer top-notch services and decent air quality, Japan is a remarkable success. As an investment destination? Not so much.

As the world slides toward recession, speculation is growing that the BOJ will soon lower its benchmark lending rate from 0.5 percent. Given how aggressively the Federal Reserve is cutting U.S. rates, it will be very difficult for Shirakawa to resist political pressure to ease.

Looking ahead, though, Japan needs a policy maker to help break the economy out of The Matrix. Someone like Paul Volcker, perhaps.

Volcker's Example

Volcker faced 14 percent inflation and 15 percent bond yields when he was named Federal Reserve chairman in 1979. Using some unconventional policies -- essentially targeting money supply -- Volcker brought consumer prices down to 4 percent by the time he left the Fed in 1987.

Japan's challenge is quite different: Moving rates away from zero without killing the economy. Yet the independence Volcker exercised in the face of extreme pressure from politicians and the unusual tactics he employed remain a fascination for economists to this day.

Volcker wasn't exactly an outsider. He had worked for either the Fed or the U.S. Treasury on and off for 27 years. In 1965, he left the Treasury for a job at Chase Manhattan Bank. Volcker returned to the Treasury in 1969 and in 1975 became president of the Fed Bank of New York.

As Volcker told me a few years back, those four years back in the private sector gave him a fresh perspective on how policy makers should stabilize economies.

BOJ Tussle

The Finance Ministry and the BOJ boast many smart officials. Yet it's hard not to wonder if Japan should look for a less doctrinaire central banker. Japan needs someone with an independent streak, the intellectual constitution to weather criticism and fresh ideas.

There's growing angst over Prime Minister Yasuo Fukuda's failure to replace Fukui and opposition lawmakers playing politics with the BOJ. The bigger question is when Japan will allow the BOJ to do its job.

Fukui failed because he tried to do the impossible: simultaneously end deflation and normalize interest rates. He should have picked one of those goals and pursued it.

The 800-pound gorilla in the room complicating the BOJ's job is debt. Japan's debt is at least 150 percent of gross domestic product, which explains why politicians go ballistic when the BOJ tries to move rates away from zero.

Normalcy Needed

The BOJ enables the government in its highly-indebted state, and that's the way politicians want it. There's no serious discussion of reducing debt because, with 10-year bond yields at 1.3 percent, it seems manageable for now. Every BOJ rate hike makes the debt less manageable, something politicians remind the central banker of daily.

Japan won't grow at its potential until normalcy returns to its monetary and fiscal policies. With no protests in the street, politicians have little reason to change their ways.

Giving its rapidly aging population, few issues are more critical than reducing debt. If the BOJ had a maverick at the helm, politicians would find it harder to borrow. And Japan would have a better chance of breaking out of The Matrix.