The existing (and ongoing) massive expansion of base money into the banking systems of the US, England, and Japan is without precedent. As Nomura’s Richard Koo notes, at 16x statutory reserves, the liquidity ‘should’ have led to unprecedented inflation rates of 1,600% in the US, 970% in the UK, and 480% in Japan.
However, it has not, yet. In short, Koo continues, businesses and households in these economies have stopped borrowing money even though interest rates have fallen to zero. And with no one borrowing money and many actually paying down debt, the money multiplier has turned negative at the margin – because of the severe damage caused to balance sheets when the bubble collapse drove asset prices lower while leaving debts intact (so-called balance-sheet-recession).
This suggests that there is little physical or mechanical reason for the BOJ’s easing program to work. But the program could also have a psychological impact – and Japanese media is on an ‘inflation’ full-court press currently. The risk here is that not only borrowers but also lenders will start to believe the lies. No financial institutions anticipating inflation could ever lend money at current interest rates. No actual damage will be done as long as the easing program remains ineffective. But once it starts to affect psychology, the BOJ needs to quickly reverse the policy and bring the monetary base back to ‘normal’. If the policy reversal is delayed, the Japanese economy (and inflation) could spiral out of control.
Via Richard Koo, Nomura,
The Money Multiplier… and inflation…
Before Mr. Kuroda was appointed BOJ governor, base money supplied by the Fed under quantitative easing amounted to 16.0x statutory reserves. The corresponding multiples for other central banks were 9.7x for the BOE, 4.8x for the BOJ, and 3.8x for the ECB. If the money multiplier were functioning properly, the money supply would therefore be 16 times larger than it currently is in the US, 9.7 times larger in the UK, 4.8 times larger in Japan, and 3.8 times larger in the eurozone.
If such an expansion in money supply actually took place in a short time, it would normally entail a similar increase in prices, leading to unprecedented inflation rates of 1,600% in the US, 970% in the UK, and 480% in Japan. The reason why this has not happened will be discussed in detail below.
In short, however, businesses and households in these economies have stopped borrowing money even though interest rates have fallen to zero. And with no one borrowing money and many actually paying down debt, the money multiplier has turned negative at the margin.
US and UK have ‘not’ been a success…
Central bank officials in the US and the UK claim quantitative easing has been a success because it prevented a Japan-like deflation. But, the rate of Japanese wage growth four to five years after the bubble collapsed was roughly equal to the levels now being observed in the US.
Common to all of these countries is the fact that businesses and households are saving in spite of zero interest rates. They are doing so because of the severe damage caused to balance sheets when the bubble collapse drove asset prices lower while leaving debts intact. Private savings are running at 8.8% of GDP in Japan, while the corresponding figures are 7.0% for the US, 3.3% for the UK, 8.1% for Spain, 8.6% for Ireland, 7.0% for Portugal, and 4.4% for Italy.
The fact that businesses and households in these economies are responding to zero interest rates by saving money rather than borrowing and spending aggressively clearly suggests that lending – and hence the money supply – will not expand no matter how much base money the central bank supplies.
Growth in private credit has been severely depressed. Even in the US, where conditions are said to be relatively healthy, private credit has yet to recover to pre-Lehman levels.
Quantitative easing – whether in Japan, the US, or the UK – cannot directly stimulate the economy or raise the rate of inflation so long as businesses and households refuse to borrow money and spend it.
But still the central bankers try…
Mr. Kuroda and other reflationists would probably argue that the newly announced easing program differs fundamentally from the incremental approach taken thus far because it marks a “new dimension” in aggressiveness. This is correct in one respect and wrong in another. Although Mr. Kuroda argues that the announcement of the current program has had a much greater impact than past announcements, this hypothesis has already been tested overseas, and the medium and long-term results do not support his conclusion.
Ignoring the reality that…
Clearly, the issue is not how aggressively or quickly the central bank eases, but rather the extent of the damage to private sector balance sheets caused by the bubble collapse. These experiences also underline the fact that a great deal of time is needed for businesses and households to repair their balance sheets.
and the empirical proof that…
The limited impact of the bold monetary actions undertaken by the Fed and the BOE suggests we should not expect much from the BOJ’s plan in the medium term in spite of its aggressiveness.
Perhaps more important was why Japan’s interest rates were so low.
Essentially, the private sector had stopped borrowing money because of balance sheet problems, the subsequent debt trauma, and a shortage of domestic investment opportunities.
With no private-sector borrowers, Japanese banks selling JGBs yielding 0.6% to the BOJ may find themselves forced to reinvest the proceeds in JGBs given the lack of alternatives. If the replacement bond is likely to yield only 0.4%, the correct option is to continue holding the bond yielding 0.6%.
In that sense, quantitative easing in Japan has already reached its limits.
And QE may have run its course…
But the fact that businesses and households in both countries are now refusing to borrow in spite of zero interest rates suggests the impact of lower long-term rates may have spent itself
The underlying cause of a balance sheet recession is a decline in – and ultimate disappearance of – private demand for funds due to a critical shortage of borrowers.
Yet the quantitative easing policies adopted by central banks in the major economies are all designed to increase the number of lenders…
When the problem stems from the lack of willing borrowers, the central bank’s emergence as a new lender is hardly going to improve the situation.
If anything, new lending by the central bank will further weaken private sector financial institutions already hurt by excessive competition.
An objective analysis of the BOJ’s easing program in light of other countries’ experiences with quantitative easing suggests investors would be wise to rein in their expectations. There is no reason why the money multiplier should turn positive when private demand for funds is nonexistent despite zero interest rates.
The discussion above suggests that there is little physical or mechanical reason for the BOJ’s easing program to work. But the program could also have a psychological impact…
One notorious minister of propaganda is reported to have said that “people will believe a lie if it is repeated often enough.”
In today’s Japan the media—and especially the omnipresent variety shows on TV—cannot stop talking about inflation. These commentators are completely unaware that the money multiplier in Japan is negative at the margin even though rates have fallen to zero. They are simply repeating the simplistic view that aggressive easing by the BOJ will eventually generate inflation.
Hearing this from morning to night will cause some people to start worrying about inflation even though there is no way the BOJ’s policies can directly create inflation. If they start to anticipate higher prices and modify their behavior accordingly, inflation could become a reality.
Moreover, the Japanese media has a tendency to move all at once and in the same direction, causing the lie to be repeated even more frequently. It would therefore not come as a surprise if many people changed their behavior in expectation of future inflation.
The problem is – what if the people start to believe…
The risk here is that not only borrowers but also lenders will start to believe the lies. No financial institutions anticipating inflation could ever lend money at current interest rates. A financial institution that suddenly saw inflation on the horizon could not continue holding 10-year government bonds that yield 0.6%. The resulting rush to sell could trigger a crash in the JGB market, inflicting heavy damage on domestic financial institutions.
The question is how the Kuroda BOJ would respond to such a crash. If it began buying more JGBs, the monetary base would expand, stoking inflation concerns at a time when private demand for funds was already recovering and the money multiplier had turned positive at the margin.
But if the BOJ sold its JGB holdings in an attempt to quell inflation concerns, bonds would drop further, blowing a large hole in the balance sheets of financial institutions and the government.
By that time the monetary base could easily have grown to, say, 15 times statutory reserves. In that case the money supply would continue growing, causing inflation to spiral out of control, unless the central bank reduced the monetary base to about 1/15th of its current level.
I suspect that the BOJ would employ all the tools at its disposal to achieve this, including a sizable increase in the statutory reserve ratio, but all of those measures would serve to push rates higher, resulting in large losses for the BOJ and other JGBs investors.
Which could rapidly lead to…
If the government bond market crashed, losses on the BOJ’s JGB portfolio would be subtracted from the money it transferred to the national treasury, adding to the fiscal deficit. And if the portfolio was large enough at the time of the crash, it could even raise doubts about the viability of the Bank’s balance sheet.
The inflation fears and the talk of large losses at the central bank could then undermine confidence in the Japanese currency. Japan’s national debt now stands at 240% of GDP, domestic industry is being hollowed out, the population is aging and shrinking amid falling birthrates, and even the trade balance has fallen into deficit.
The chief reason why people continue to use the yen in spite of these bleak fundamentals is that the BOJ has earned their trust with its anti-inflationary actions.
If the BOJ recklessly stokes inflation, triggering a crash in the JGB market and heavy losses on the Bank’s bond portfolio, public confidence in both the currency and the central bank could evaporate overnight.
And don’t rely on 80 year old ‘proof’ since it is different this time…
Mr. Kuroda’s methods have frequently been compared to those of the 1930s-era finance minister Korekiyo Takahashi, who championed a successful policy of BOJ underwriting of government debt issues. But Japanese people in those days could not move money freely overseas. The authorities today need to be especially careful inasmuch as almost anyone can move funds abroad with a telephone call or a few clicks on a computer screen.
Be careful what you wish for…
No actual damage will be done as long as the easing program remains ineffective. But once it starts to affect psychology, the BOJ needs to quickly reverse the policy and bring the monetary base back to a level more in line with the value of statutory reserves.
If the policy reversal is delayed, the Japanese economy could spiral out of control at a time when base money equal to many times statutory reserves is sloshing around in the market.
Moreover, the act of scaling back the monetary base must be carefully calibrated so as to minimize damage to the JGB market. The BOJ, Ministry of Finance, and Financial Services Agency should also have contingency plans in place in the event that easing triggers a crash in the yen or the bond market.
Full article below…