Consolidated balance sheet approach gains traction as BOJ considers QE

The Bank of Japan is now considering whether to move to balance sheet expansion in its bid to lift the Japanese economy out of deflation. Japanese policy, which will then further tighten the nexus between fiscal and monetary policy, is now the furthest along the path toward the consolidated fiscal and monetary approach that is occurring nearly everywhere in the crisis currency zones.

According to Reuters, the latest considerations are something that Japanese central bankers are discussing ahead of the shift in leadership that sees Haruhiko Juroda take over the helm.

“The BOJ’s current policy is still about controlling interest rates. Shifting that focus to balance sheet expansion will open up a lot of possibilities in terms of policy options,” said one of the sources.

The difference between the two approaches is a subtle one in that the central bank’s current policy tool – a 101 trillion yen $1 trillion (664.58 billion pounds) programme of asset buying and lending – also expands the BOJ’s balance sheet, which at a third of GDP is a bigger proportion of the economy compared with those of the U.S. and European Union’s central banks.

But proponents suggest measuring the central bank’s actions by the expansion of the balance sheet has a better chance of finally shaking Japanese out the psychology of deflation that has become entrenched during the past two decades.

It will be easier to convince the public of the central bank’s efforts to reinflate the world’s third-biggest economy if they can easily measure jumps in the size of the BOJ’s balance sheet, supporters of the idea say.
On the other hand, trying to push down interest rates that are already low has limited potential, they say.

We can look at this as a hallmark of Abenomics as the economic policy of Japan’s Prime Minister is called. The approach is to go guns blazing on both the fiscal and monetary side in support of increased economic activity, rather than letting monetary policy do the heavy lifting alone. A lot of commentators have pointed to the new Japanese economic policy as a renewed salvo in the long-running currency wars. To wit, the Japanese yen has depreciated in value along with this policy’s denouement. However, the goal is to reflate the domestic economy by any means possible with the currency depreciation as an integral part of that goal.

The effectiveness of monetary policy alone has been poor during this economic crisis. And so, governments are increasingly looking at other ways to reflate their economies. The approach we are seeing most is what I have labelled the consolidated balance sheet approach because it represents the end of full central bank independence as the government’s agent in setting monetary policy on the government’s behalf and the beginning of central bank working in concert with fiscal policy. Japan is furthest along in this policy paradigm shift because it is furthest along into debt deflation. However, I believe this is where all of the crisis currency zones are now headed.

Let’s be clear here. Most economists believe that too much fiscal consolidation is bad irrespective of whether they believe in the government budget constraint and longer-term consolidation. The question for economists go to how much consolidation if any to do in the short-term and which levers to pull, fiscal or monetary. Ever since the inflationary period of the 1970s, there has been a pull away from fiscal policy as an economic lever. The Robert Samuelson post on Kennedy and inflation from the Washington Post that I linked to recently is a very good example of this.

The prevailing dogma in the economics world right now is that monetary policy is superior to fiscal policy in managing economic turns. This is very much in line with the more laissez-faire way of thinking in which government is as minimally interventionist as possible. The thinking here is that the central bank can and will adjust policy rates in order to steer the economy. Automatic stabilizers will kick in to fill out the government’s social safety net role and then all will be well.

 But, unfortunately this view is flawed. What we saw during the last 30 years was a secular decline in interest rates throughout the developed world that led to a large increase in private sector debt and a huge build-up in leverage at financial institutions. In the US, much of this was a direct result of monetary policy skewed toward post-economic trough reflation. See my 2009 post “A brief look at the Asset-Based Economy at economic turns” for an analysis showing how leverage was never unwound during recession. So, with rates now at zero percent, interest rate cuts have hit the wall and policy makers are at pains to deliver a monetary policy-centric reflationary program that actually works. That’s where quantitative easing and permanent zero come from. Supporters of these policies will tell you that they work. But they are largely untested and have not been effective. They are second-choice monetary tools at best and Ben Bernanke has said so explicitly.

QE and zero rates will not work except via asset prices – creating a dangerous misallocation of resources due to private portfolio preference shifts. We can see this in the UK where just today, we learned that despite the Bank of England’s efforts to reflate the economy, UK banks have actually reduced lending and not increased it. If you understand how quantitative easing really works and that loans create deposits, you will also understand that this outcome is not unexpected.

But that leaves us in a quandary. How do we reflate this economy that is still in crisis if we have run out of monetary bullets? Enter the consolidated balance sheet approach. This brings us back to fiscal stimulus and the fiscal and monetary agents working hand in hand. And that’s where Japan is now – and where other currency areas are heading as we speak.

Back to the current situation. The United States is closest to Japan in conducting a more consolidated balance sheet approach to policy. For example, if you look at quantitative easing in the United States, it was decried vociferously by China and Brazil. Many emerging markets saw the US policy as tantamount to currency manipulation in an effort to gain a one-up on the competition. But, the situation is more complicated than this. Clearly, the Fed has been very much focused on the US domestic economy, especially since trade is a much lower percentage of the economy for the US than it is for export-oriented economies like Germany. Fed Chairman Ben Bernanke, for one, has vociferously defended QE as being about domestic policy.

And I believe the Fed does see QE as being more about reflating the US domestic economy by putting a floor under asset prices, reducing mortgage interest costs, and stopping household deleveraging. The Fed chairman has said time and again that the Fed’s dual mandate compels it to act aggressively. And he has implied that fiscal agents are actually working to dampen the economy, making it more imperative that the Fed act aggressively.

Fed Vice-Chair Janet Yellen does the same in a speech today on the challenges confronting monetary policy. Her speech is entirely geared toward supporting domestic demand and employment given the Fed’s dual mandate, cognizant of the risks. She says the following:

“The large shortfall of employment relative to its maximum level has imposed huge burdens on all too many American households and represents a substantial social cost. In addition, prolonged economic weakness could harm the economy’s productive potential for years to come. The long-term unemployed can see their skills erode, making these workers less attractive to employers. If these jobless workers were to become less employable, the natural rate of unemployment might rise or, to the extent that they leave the labor force, we could see a persistently lower rate of labor force participation. In addition, the slow recovery has depressed the pace of capital accumulation, and it may also have hindered new business formation and innovation, developments that would have an adverse effect on structural productivity.

In contrast to the large gap between actual and maximum employment, inflation, apart from fluctuations due to energy and other commodity prices, has been running for some time now a little below the rate of 2 percent per year that the Committee judges to be consistent with the Federal Reserve’s dual mandate. The Committee anticipates that inflation will continue to run at or below 2 percent over the medium term. Moreover, expectations for inflation over the next 5 to 10 years remain well anchored, according to surveys of households and professional forecasters.

With employment so far from its maximum level and with inflation running below the Committee’s 2 percent objective, I believe it’s appropriate for progress in the labor market to take center stage in the conduct of monetary policy. Let me therefore turn to the FOMC’s recent actions and describe how I see them promoting this important goal.”

 She then goes on to show how domestic policy is being supported. However, Yellen has a long section about “reaching for yield”. And as always I like her frankness on these matters because she acknowledges that there is some of that going on:

Of course, risk-taking can go too far, thereby threatening future economic performance, and a low interest rate environment has the potential to induce investors to take on too much leverage and reach too aggressively for yield. At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.

That’s pretty explicit. Yellen simply believes the benefits of accommodative policy outweigh the risks, whereas people like myself do not.

The UK is certainly on the road to this kind of policy as well. Bank of England head Mervyn King wants more QE and he is likely to get it now. And in the euro zone, it is clear that the OMT program is a back door way of financing budget deficits until fiscal consolidation can be achieved. The ECB is clearly working on behalf of the euro zone sovereign governments because it must. Without explicit ECB support, the euro would have collapsed last year with the crisis in Spain and Italy.

All of this is a means of reflating the domestic economy or giving the crisis economies room to undergo fiscal consolidation. It is not principally about the exchange rate. That said, there is a large element of currency manipulation here. The Japanese do know their policies are likely to weaken the yen. They want the yen to weaken because the strong yen was killing their exporters. But the currency war rhetoric has become a bit overwrought since that is a secondary track in the reflation effort. Bloomberg had a good post today on this highlighting how Brazil which started the currency war rhetoric is moving away from the currency as a driver of policy.

The currency wars declared by Brazilian Finance Minister Guido Mantega are proving more a battle to salvage economic growth than a spiral of competitive devaluations.

While the yen and pound slide on the prospect central banks will intensify stimulus and South Korea’s won and Chile’s peso strengthen, volatility in the currency market is below its average of the past decade and global stocks have gained $2.15 trillion since the start of 2013. Policy makers reduced intervention over the past 12 months as foreign reserves grew at the slowest pace in four years, data compiled by Bloomberg show.

Even Mantega, who used war terminology in 2010 to criticize industrialized nations for policies that weakened their exchange rates, says he is abandoning efforts to push down the real. Federal Reserve Chairman Ben S. Bernanke and other policy makers signaled last week that currencies are a corollary, not a cornerstone, of policies to boost growth from unacceptably low levels, paving the way for what Morgan Stanley calls a third round of “Great Monetary Easing.”

“Central banks are going to throw the kitchen sink at reviving growth and spurring inflation because the alternative to that is deflation,” Neil Williams, head of economic research at London-based Hermes Fund Managers, which oversees about $42 billion, said in a phone interview on Feb. 27. “The countries that have overall loosened their policies most have had the weakest currencies. It’s not a blatant attempt to out-grow others, it’s just a case of all countries trying to do the same thing at the same time.”

My expectation is that, as this crisis drags on, policy makers will come to understand that monetary policy is tapped out, that the new monetary policy tools are only effective in concert with expansionary fiscal policy. The United States was the last holdout on austerity and is now succumbing as well. I expect this to mark the peak of the global economic cycle, with another global economic downturn making plain how ineffective the monetary tools are. And then the consolidated balance sheet approach will ratchet up everywhere as countries desperately look for ways out of the economic malaise. Japan is the first on that path.