Johannes Guttenberg’s printing
press was instrumental in the cultural, intellectual, and economic changes that
transformed Europe from a medieval to a modern society. It played an integral
part in the Renaissance, the Protestant Reformation, and the rise of the Age of
Reason. Through the printing of newspapers, it helped educate the masses. It supported
the growth of science and democracy. In short, without it, the world as we know
it would scarcely exist.
Sadly, the impact of the metaphorical
printing press of the world’s central banks is likely to be far less
distinguished. Despite much hype, there is little if any evidence that central
bank money printing is a reasonable basis for organic economic growth. It
certainly does nothing to address the long-term structural problems faced by
many of the world’s developed economies. For more than four years now, the
Federal Reserve’s main policy rate has been below the rate of inflation. For
much of that time, our central bank has conducted quantitative easing, buying
assets from banks to inject money into the financial system. In turn, banks
have re-deposited most of this money with the central bank. From January 1959
through September 2008, excess reserves of financial institutions as a
percentage of the US money supply averaged 5.49%. From October 2008 through
February of 2013 it has averaged 64.24%. In short, a great deal of the money
being created by the Fed is being held on reserve at the Fed. It’s not entering
the US economy. As such, quantitative easing is having little, if any, impact on
the demand for goods and services and virtually no impact on inflation. About
the only thing it seems to be inflating are stock prices.
Similarly, in Japan, stock prices
are up approximately 45% since mid-November on anticipation that the Bank of
Japan would massively increase its quantitative easing program. Today, the bank
did just that, doubling its asset purchase program in an attempt to stamp out deflation. This brings the bank’s monthly purchase program
to roughly 90% of that of the Federal Reserve despite the fact that the
nation’s economy is about a third the size of that of the US. After suffering
through years of deflationary pressures, it is highly unlikely that the Bank of
Japan can reach its stated goal of increasing the rate of inflation to 2% within
the next two years. The fact is that money printing alone will not cause
inflation. What is truly needed is for demand to outstrip supply (see GMO’s James
Montier: Hyperinflations, Hysteria, and
False Memories).
The Bank of Japan’s money printing, much like the Fed’s, is likely to result in
a massive increase in bank reserves on deposit with the central bank rather
than a massive increase in demand that outstrips supply. Note that despite the
Fed’s massive printing of money over the last four years, US inflation has
remained subdued. Only in 2011, when the Arab Spring drove energy prices higher,
did headline inflation exceed 2.07%. Despite its challenges, the US economy is
in far better shape than the Japanese economy and it doesn’t face the
deflationary pressures of Japan. As such, it’s unlikely that inflation in Japan
will rise to 2% over the next five years, let alone in the next two.
Not only does it appear unlikely
that the Bank of Japan will reach its inflation target, but one must ask whether
the nation will truly be better off if it does. The promise of quantitative
easing has already significantly weakened the Yen, which is supportive of Japanese
exports. Yet the nation has little in the way of natural resources, the
importation of which becomes more expensive as the Yen weakens. The shuttering
of nuclear plants in the aftermath of the 2011 earthquake has resulted in trade
deficits in each of the last two years in a nation that has long run surpluses.
Trade deficits require external funding, something Japan, with its
exceptionally low rates can ill afford. Approximately 94% of Japanese
government debt is owned by the Japanese, who have been willing buyers as a
lack of inflation resulted in a real returns despite absurdly low nominal rates.
The need to finance externally would pose an enormous problem because foreign
investors subject to even modest inflation would suffer a negative real rate of
return given the 0.45% yield on 10-year Japanese government debt.
What will happen to Japanese savers
if the central bank reaches its 2% inflation target? Given current yields, a
population with a median age of 45.5 years, a slightly negative population
growth rate, and a debt-to-GDP ratio north of 200%, success would create its
own set of challenges. If the Bank of Japan managed to create inflation while
maintaining negative real interest rates, it would place enormous pressure on
the nation’s large population of retirees and near-retirees, likely curtailing
their consumption of goods and services. If, on the other hand, yields rose to
continue to accommodate the current level of real return, the government’s cost
of servicing the nation’s massive debt would
significantly increase. Additionally, the price of currently existing bonds
would decline significantly, forcing a significant capital loss on any saver
needing to liquidate bond positions. A victory in the nation’s war on deflation
might well prove pyric given its structural issues.
In short, turning on the central
bank’s printing press won’t fix the structural problems Japan faces. In fact,
it might exacerbate some of them. Despite that fact, having witnessed the Fed’s
ability to levitate US equities on a rising tide of printed money, investors,
expecting the same from Japan, have driven the nation’s equity market dramatically higher over the last four and half months. While quantitative easing may
well push markets higher still, it won’t fix the ills of the developed world.
What is worse, when that becomes painfully clear, equity prices are likely to fall
significantly, having been lifted by monetary largesse rather than
fundamentals. Sadly, global central bankers have decided that the best method
to deal with collapsing bubbles is to provide enough liquidity to create
another one. We think that makes about as much sense as providing an alcoholic in
detox with large quantities of booze to cope with withdrawal symptoms.