On Japan, Stimulus, Currency Depreciation and Inflation

I have heard a lot of doomsday predictions regarding Japan over the last twenty years. None of them have panned out as yet. This year, we are hearing a lot more as a result of the Japanese Central Bank’s intention of ‘monetizing’ the government’s debt and because of the government’s high level of debt relative to Japan’s GDP. Is any of this stuff sensible investment advice?

The short answer here is no, it is not good investment advice . And the reason the doomsday scenarios are wrong is because they hinge on a faulty model of the monetary system and its implications for inflation.

The standard view is that Japan has increased its government debt so much that the country has no other option than to pursue an inflationary monetary policy to devalue the value of the Yen and precipitate a wave of inflation to also devalue the real value of the government’s debts. Hedge Fund investor Kyle Bass believes 2013 will be the year that the Japanese accomplish this and he is betting against Japan’s currency and/or bonds in order to profit from his view. The right question to ask regarding whether this scenario will pan out is “how exactly will the Japanese Central Bank stoke inflation and what impact will this inflation have?” My view is that the central bank’s desire to buy JGBs will have no discernible medium-term impact on the value of the Japanese Yen because it has little or no impact on Japan’s real economy.

When the Japanese central bank expands its balance sheet and creates bank reserves by buying Japanese government bonds, it must first change its balance sheet by creating two entries on either side of its balance sheet to satisfy double-entry bookkeeping accounting. It records the ‘money’ creation as an asset an simultaneously records a corresponding liability that increases the size of the BoJ’s balance sheet but does not alter its net capital position. Everything else is the same. Then the BoJ uses the money asset to buy JGBs from a financial institution. The net result of the transactions, therefore, is an increase in the bank reserve liabilities of the BoJ offset by an equal increase in assets in the form of the JGBs the central bank now owns.  For the financial institution with which the BoJ transacted the JGBs and reserves and the Japanese private sector as a whole, there has been a net decrease in JGB assets that is exactly offset by bank reserve assets. No other changes have occurred. So the transaction is an asset swap of government paper for reserves, both liabilities of the consolidated government balance sheet comprising the central bank and the central government. 

We have seen this before. The Japanese have done it many times and the Americans have also done it too. The asset swap can indirectly affect the real economy via changes in private portfolio preferences, inflation expectations and so on. However, the only way for this asset swap to have any direct effect on the real economy is via credit creation – and only to the degree that the net addition of reserves creates the kindling for more bank credit. Unfortunately for Mr. Bass and his theory about Japan, reserves are not kindling for credit creation because banks are not reserve-constrained. Credit increases only when banks grant it due to the demand for credit by customers the banks deem creditworthy subject to the banks’ capital requirements and not to reserve requirements. If an individual bank wants to lend, it simply borrows the reserves in the inter-bank market or pays the overnight rate for borrowing reserves directly to the central bank. And to the degree this put the banking system at the reserve limit, the central bank is forced to add reserves to the system in order to hit its fixed overnight interest rate target. None of this is a factor now anyway, since the Japanese banking system is flush with excess reserves as the overnight rate for money is essentially zero.

The point here is that it’s irrelevant whether the central bank buys JGBs. This will not affect the real economy or exchange rates.

On the other hand, the policy Japanese Prime Minister Abe is advocating can have an impact. As I outlined on Christmas Eve, Mr. Abe has threatened to unify fiscal and monetary policy in order to allow the Japanese government to continue to deficit spend under a monetary regime that is sufficiently loose to allow the Japanese to escape their deflationary episode.

Bloomberg reports:

The Japanese government will announce around 12 trillion yen ($136 billion) in fiscal stimulus measures to boost the nation’s shrinking economy, Japanese media reported today.

The Yomiuri newspaper and Kyodo News both reported the figure for extra spending in the fiscal year through March, with the Yomiuri saying that 5-6 trillion yen will be directed to public works projects, without citing anyone. Prime Minister Shinzo Abe told business leaders today that he hopes to compile the measures this week.

The spending may help to accelerate a recovery from recession as Abe pledges to boost growth and end deflation in the world’s third-largest economy. While Japan’s public debt is more than twice gross domestic product, Finance Minister Taro Aso said last week that the government doesn’t need to adhere to a 44 trillion-yen cap on new bond issuance in this fiscal year.

As I wrote in my last report on Japan, “The approach that Keynesians want Japan to take is that of increasing deficit spending until consumer demand causes the economy to reach full capacity and inflation takes hold. While Abe claims that he wants to use a two-pronged approach of reflationary fiscal policy supported by accommodative monetary policy, it is not clear how much latitude he would have to try this approach. Nor is it clear that Abe actually wants to lean toward fiscal policy as his reflationary tool of choice.”

It IS now clear that Abe wants to go full bore on fiscal and monetary stimulus. As an investor, you have to see that as bullish because it means that the Japanese government is prepared to add net financial assets to the private sector in order to meaningfully boost employment and growth such that private spending can start to fill in the gap and push the economy out of deflation. This supports growth and given the negatve impact on real interest rates of reflation, it is bearish for the yen. What Mr. Abe wants is for his policy to spark private sector spending and credit growth, causing Japanese real interest rates to decline from decreased deflation or outright inflation. And this is the only way he’s going to get it. Because the Bank of Japan controls interest rates, there will be no affect on nominal rates and corporate rates could fall if the policy is successful in reflating the economy.

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