By Anthony Harrington
On 12 June Japan's Nikkei index fell 6.25% to 12,445, it rallied a touch the next day, but that drop was sharp enough to send shock waves through the Japanese political establishment and to put chills into the heart of the global investment community. Just a few weeks earlier, on 22 May, the Nikkei peaked a few points short of 16000 under the influence of bold statements from the Japanese Prime Minister and the Governor of the country's central bank, who said, more or less, that they intended to run the printing presses flat out to get rid of the deflation that has plagued the country for two decades, and to restore a "healthy" rate of inflation, somewhere around 2%.
After the peak comes the down slope. The day after the peak, the index crashed 6.9%, its biggest one day fall since the market reaction to the Japanese earthquake, tsunami and subsequent nuclear disaster at Fukushima on 11 March 2011. Since then, volatility has been the name of the game, with the index yo-yoing up and down, but generally headed down. The market is now off 11% from that 22 May high. Of course, giving back 11% of a 40% gain is not, of itself, a disaster. A correction of that order would be expected from most markets after such an extraordinary gain, so one needs to take the inevitable hysteria that follows that kind of correction with a pinch of salt. But it does refocus attention on the fact that Japan is now in its 24 year of non-recovery and has the highest debt to GDP ratio of any country on the planet.
In a recent edition of his News from the Frontline newsletter John Mauldin cites Milton Friedman’s famous dictum that deflation can always be beaten if you are prepared to print enough money. While that is self evidently true, Mauldin points out that no sane central bank is going to take this literally and totally trash its currency by throwing the doors open to a Weimar Republic or Zimbabwe style hyper-inflation of the 1 euro of yesterday equals 1 billion euros today variety. Yet as Mauldin notes, “sensible” money printing is highly unlikely to get the job done for Japan. The reason lies in Japan’s demographic disaster.
With more than 60% of the population headed towards the over-60s category, there are just too many retired persons. People spend less in retirement. This means that domestic demand is set to shrink faster than productivity, though productivity too is going to shrink, causing the economy to contract. Inflation does not live well in a contracting economy – that’s deflation territory. And with demand shrinking faster than productivity, prices have to fall if producers are going to shift their goods off the shelves. Falling prices equals deflation, not inflation. Printing more money doesn’t do a whole lot for this cycle. The money has to go into circulation for it to have an impact. Otherwise it sits in the banks and does nothing except improve bank capital ratios to absurd proportions. Firms won’t want to invest in new projects and new production in the face of falling demand.
None of this is easy to fix. Japan could turn this around by running an “open doors” immigration policy, but in terms of race, Japanese society is one of the most conservative societies on the planet. If you are not Japanese, they really don’t want you setting up home there. So no hoards of youthful foreigners are going to be welcomed to the shores of Japan any time soon. Their demographic problem is there to stay.
So that leaves monetary policy as the weapon of choice. The problem the Bank of Japan has, however, is that it has a twenty year history of starting the printing presses rolling amid much promising that it is going to print until inflation reappears, only to slam the brakes on just when it seems that the policy might be about to work. This time, it seems, is likely to be no different, despite the bold pronouncements of Prime Minister Abe and Central Bank governor Haruhiko Kuroda. Bond yields of Japanese Government Bonds (JGBs) are gyrating in a similar fashion to the country’s stock market as investors worry about jitters hitting the central bank. Kuroda is buying JGB’s by the boatload to keep the yield down and demand high, but storm clouds are gathering. Japan desperately needs monetary policy to be backed by the second of Prime Minister Abe’s “three arrows” strategy, namely, structural reforms of a kind that would make Japanese companies more responsive to shareholders and thus more efficient.
Current policy is also trapped in a logical contradiction. Bond yields have to stay low for the “loose for longer”, U.S.-Fed style monetary policy to work, but investors in JGBs are not going to sit quietly by while inflation ramps up to 2% and puts them into severe negative yield territory. They are already bidding up yields which is why the BoJ is having to intervene again and again. Then there is the fact that Japan is already having to allocate a considerable portion of government revenues to meeting the interest on its huge public debt. If it was successful in reflating the economy, to the point where rates had to go up to (unbelievable thought) cool off rising inflation, the interest costs would kill it. If rates started to spiral upwards Japan would really have to invest in a lot more printing presses and you could kiss the yen good-bye. More shocks ahead for the global economy, it seems ...