JAPAN DISCOVERS QE HAS RISKS / THE WALL STREET JOURNAL REVIEW & OUTLOOK

REVIEW & OUTLOOK

May 19, 2013, 12:47 p.m. ET

Japan Discovers QE Has Risks

A debate breaks out over the 'bubbly' stock market.

Well, that was fast. Japanese Prime Minister Shinzo Abe's aggressive pro-inflation policy is only a few months old and a fight has erupted over its early effects. And this while there is no economy-wide inflation.

On Wednesday, the Nikkei 225 closed above 15000 for the first time since 2007. Former Vice Finance Minister Eisuke Sakakibara—known as "Mr. Yen" from his stint managing foreign-exchange policy—took to the airwaves to call the market "bubbly" and warn that "there will be some corrections . . . probably by the summer." Bank of Japan Governor Haruhiko Kuroda contested this bubble theory in parliamentary testimony, arguing that fundamentals support the market moves.

Then there's real bubble trouble in the market for Japanese government debt. Years of exceptionally loose monetary policy encouraged markets to value Japanese government bonds (JGBs) far above what one might expect for a highly leveraged government sitting atop an anemic economy with a shrinking population. Last week prices fell and yields for 10-year bonds rose to 0.92% on Wednesday from 0.6% the previous week, before the central bank stepped in to reduce yields slightly.

That yield is only a three-month high, but the speed of the move was surprising, and the warning is clear. If investors start to believe the pledges by Messrs. Abe and Kuroda to deliver inflation of 2%, they will demand higher returns on their investments. In a Japanese twist, looser money could lead to higher nominal interest rates.

This would have potentially serious consequences for the balance sheets of Japanese banks, insurers, pension funds and households that are the main holders of government debt that totals more than 200% of GDP. It also raises the sobering prospect that a rotation out of JGBs could come long before other parts of Abenomics have begun and a durable economic expansion that lifts revenues has taken hold.

Meanwhile, commentators are engaged in an esoteric debate about what sort of inflation Japan may develop. A growing chorus of observers suggests the economy is headed for "cost-push inflation," the kind that happens when a weaker yen causes import prices to rise and consumers bear the burden when their incomes don't increase proportionately.

Mr. Abe and his supporters are hoping for "demand-pull" inflation, in which companies would increase wages to boost purchasing power. Since a weak yen is increasing operating costs and the economy remains sluggish, there's little sign this is happening. Wage growth is still negligible.

Yet since inflation is by definition a rise in the general price level, not one set of prices, it's never as orderly as proponents of inflationary policies like to claim. It's hard for a central banker or anyone else to predict who will win or lose more. Meanwhile, investors are pouring into assets in search of a return for their loose cash, which takes us back to the rising stock market.

What ties all of this together is the desperate need for growth in the real economy, and not simply in the money supply. Growth will boost corporate earnings in ways that give stocks a sustainable reason to rise, make the government's debt burden repayable, and stimulate wage growth and consumer confidence.

Japanese are discovering that although their politicians often equate a return to inflation with a return to growth, the two are different. Mr. Abe has set his sights on inflation, and perhaps he's going to get some. But he'll regret that choice unless the other policy reforms he is promising succeed. As he announces his plans in the coming weeks, the stakes are high.

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