Thursday, April 4, 2013

The Printing Press Won’t Save Japan

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.