Spending and Production
We have long argued in these pages that the hoary inflationism propagated by Shinzo Abe's administration is host to very same contradictions that have bedeviled attempts to inflate nations to prosperity since time immemorial. In the modern age we can trace the fallacious idea that inflation can increase a nation's wealth to the Scottish gambler and monetary theorist John Law, who brought his theories to bear on an unsuspecting France after convincing the Duke of Orleans (the regent of France at the time), that his scheme would solve the government's debt problems as well as increase economic prosperity. All of this would be possible without any particular effort.
Law asserted that there was "not enough circulating medium" in the economy, and that his paper money scheme would alleviate this deficiency. The resulting spur to spending would then lead to economic recovery. Readers will immediately notice that the Fed and the BoJ both employ in essence the exact same reasoning: they argue that what the economy needs is "more spending", which in turn can be achieved by inflating the currency.
However, this is putting the cart before the horse. It is very easy to see why if one considers a barter economy for a moment (note that this merely serves as an illustration). Say that there is e.g. a tailor making coats and he wants to buy a pair of new shoes. What must he do so can he go about 'spending" in order to acquire shoes from the shoemaker? Obviously, before he can obtain a pair of shoes he will have to produce a coat – otherwise he will have nothing to offer in exchange for the shoes. The underlying principle demonstrated in this example isn't magically altered when money enters the equation. Money is merely a medium of exchange that facilitates exchanges by removing the "coincidence of wants" problem (in our example, the exchange could only take place if the shoemaker actually wanted a coat; in a monetary economy, the tailor can sell the coat for money to someone who wants a coat, and then can use the money proceeds to buy the shoes). Note here that credit does not alter anything either. The tailor may well borrow in order to buy the shoes. However, for there to be credit, something must first have been produced and saved – only thereafter is there something that can be lent.
What happens though when the supply of money is increased? What such an increase enables is consumption without preceding production. Essentially, the initial receivers of newly created money can engage in exchanges of nothing (new money) for something (real goods or services). The 'something" is then taken out from the economy's pool of real savings, but no offsetting contribution to the pool is made concurrently. It is however this pool of real savings that enables both the maintenance of existing production processes and an increase in production. It follows that whenever the pool of real savings is diminished by exchanges of nothing for something, the economy's ability to create wealth is weakened. Ultimately therefore, money printing achieves the exact opposite of what its supporters claim: it weakens the economy instead of strengthening it – scarce capital ends up being consumed.
The important point is that production must come before spending – production is what makes spending possible. Consumption that is not preceded by production harms the economy, it cannot possibly help it.
Rising Prices in Japan – The Last Thing Anyone Needs
It is widely held that the mild decline in consumer prices that has been observed in Japan in several short time periods in the post bubble era has stood in the way of "recovery". Keep in mind that in spite of the claims to the contrary, there has been no "deflation" in Japan: its money supply has grown very slowly, but it has grown every year since the bubble ended in late 1989. Since economic productivity hasn't stood still, we can assume that as a rule of thumb, there have been phases when productivity increased at a faster pace than the money supply, with the difference resulting in mild price declines (leaving aside the fact that there is actually no objective measure of the mythical "general price level"). To the extent that the decline in the prices of goods and services has exceeded concomitant declines in wages, Japan's consumers have become more prosperous.
Japan's unemployment rate stood at 4.2% when Shinzo Abe was elected. This is probably not too far from what the catallactic unemployment rate would be if Japan's economy were unhampered (admittedly this is just a guess: it may well be slightly lower). In any case, given its shrinking population, it can hardly be argued that Japan had an unemployment problem that required urgent tackling by government intervention, even if one were to believe such intervention to be beneficial (it isn't). The strength of Japan's currency, a result of the slow relative pace of Japanese monetary inflation, was anything but a problem. It made life for the export sector more difficult, but at the same time was an incentive for export oriented companies to become more efficient. By lowering the prices of imports and the cost of traveling abroad, the strong yen conferred tangible benefits to Japan's consumers. Moreover, Japan's demographic situation makes a strong currency all the more desirable, since an ever larger proportion of the population depends on fixed incomes.
In short, Japan's leaders had no obvious reason to embark on what is known as "Abenomics". Certainly there were a great many reasons for instituting economic reform, but there was no reason to inflate and lower the exchange rate of the yen. The negative effects of this policy are now becoming increasingly manifest, as we can see from the following anecdote recently reported by Bloomberg:
“When Shigeo Aiba is worried about the survival of his company, it’s time to pay attention. Aiba is president of Togo Seisakusyo Corp., a Japanese maker of industrial springs that traces its roots back more than 150 years to when Jyouuemon Aiba began repairing farm equipment among the rice fields of Chita peninsula 270 kilometers (170 miles) southwest of Tokyo.
The business, which survived the effects of the Great Kanto Earthquake, defeat in World War II, destruction by a typhoon and the collapse of the asset bubble in the 1980s, is now struggling to survive Abenomics.
“The cost of wages will go up while Abenomics, which is seeking to boost inflation, will raise the price of everything, adding to our costs,” said Aiba in an interview at Togo’s factory in Aichi. “We will be buried without a new source of revenue.”
Togo represents the cost of Prime Minister Shinzo Abe’s effort to end 15 years of deflation by increasing fiscal and monetary stimulus and promoting wage growth and spending. While Japan’s big exporters such as Toyota Motor Corp., Aiba’s biggest customer, are benefiting from a weaker yen, many domestic producers like Togo Seisakusyo with fewer than a thousand staff are struggling. Companies about the same size or smaller than Togo employ two thirds of Japan’s workforce.”
So exporters have been given a temporary shot in the arm (it is temporary because domestic prices will adjust to the lower exchange rate and all the alleged benefits of the devaluation will then be history), at the expense of consumers as well as companies that employ two thirds of the country's workforce. In other words, Mr. Abe's policy of "raising wages and spending by increasing monetary and fiscal stimulus" is an all around failure that clearly threatens the economic well-being of Japan. Note that the rise in nominal stock prices on the Tokyo stock exchange is irrelevant to the 80% of Japan's population that doesn't own stocks. So the great bulk of Japan's inhabitants does not even have the consolation of having garnered speculative profits in the stock market (and those who have made such profits need to cash out to realize them, which would lead to losses for those who have bought at the now higher prices). More from Bloomberg:
“ Large manufacturers’ confidence rose in September to the highest level since 2007, an Oct. 1 central bank report showed. Consumer confidence fell for three of the past four months through September, while rising energy prices pushed up consumer prices excluding fresh food in August at the fastest pace since November 2008.
“Small companies in this area will remain cautious for a while,” said Nobuhiko Hayashi, executive director of the local branch of the Japan Academy of Small Business Studies. “It’s in their DNA after going through economic hardships. We don’t yet know if Abenomics will succeed.”
Demand for loans by small manufacturers fell to 1 from 2 in October compared with three months ago, while the level of borrowing at large producers rose to 5 from 2, according to a Bank of Japan index that gauges responses from a survey of senior loan offices at the nation’s top 50 lenders.
The "large manufacturers" referred to above are of course precisely the export oriented companies that currently enjoy a temporary surge in profits in yen terms due to the currency's decline. However, the first signs that these profits will be eroded by the adjustment in domestic prices can already be seen in the major factor contributing to the sharp decline in consumer confidence, namely rising energy prices. Note that Togo is a company that has survived untold upheaval, from war to natural catastrophes to the post-war hyperinflation. And yet, it may not manage to survive "Abenomics".
The "Kuroda Put'
Another potentially dangerous development related to the BoJ's quantitative easing policy has come to our attention. As we have pointed out previously, market participants apparently don't believe that the BoJ's attempt to inflate will actually succeed. If they were to believe it, they would have to sell JGBs, as it makes no sense to own 10 year bonds yielding 60 basis points if the rate of consumer price increases is expected to reach the BoJ's target of 2 percent p.a. The JGB market should normally discount rising inflation expectations well in advance, but has so far failed to do so:
JGB, continuous contract prices, weekly: 10 year JGBs are yielding just 0.6% at present – via BarCharts.
This is perhaps not too surprising, as money supply growth in Japan remains anemic. Whatever additions to the money supply the BoJ's buying of various securities creates has for some time effectively countered by continuing declines in private sector credit outstanding (that may actually be changing now). The BoJ's "QE" policy mainly adds to bank reserves, but it has failed to spur inflationary lending. Still, domestic prices are now increasing due to the decline in the yen's exchange rate (i.e., productivity no longer offsets the increase in the money supply sufficiently to keep consumer prices in check).
So why are investors still bidding up JGBs? It turns out that Japan's banks have adopted a strong belief that their JGB holdings will be protected by a "Kuroda put":
“Japan’s largest lenders are shifting their debt portfolios to longer-maturity sovereign notes, seeking to squeeze out higher returns and betting that central bank buying will shield them from potential losses.
So-called city banks including the Bank of Tokyo-Mitsubishi UFJ Ltd. and Mizuho Bank Ltd. boosted holdings of Japanese government bonds maturing in 10 years for a record fifth-straight month in September, while selling notes due in two to five years, data released yesterday from the Japan Securities Dealers Association showed. Five-year JGBs yielded 0.205 percent today, while the 10-year rate was 0.62 percent, versus 2.61 percent for U.S. Treasuries due in 2023.
Longer-term JGBs have outperformed shorter notes since May, a month after Bank of Japan Governor Haruhiko Kuroda more than doubled the average maturity of debt the central bank buys as part of its stimulus. Bank of America Corp. said the BOJ stands ready to increase stimulus should the economic recovery falter, a backstop it and other banks have called the Kuroda Put.
“JGB investors feel the urge to stay in the market as the BOJ stuffs its face with bonds,” said Makoto Noji, a Tokyo-based senior debt strategist at SMBC Nikko Securities Inc., one of the 23 primary dealers obliged to bid at government debt sales.
Not only are banks taking an enormous risk in view of the growing likelihood that consumer prices will actually rise more strongly in Japan, there is also a growing risk due to the fiscal incontinence of Japan's government. A fiscal crisis is probably unavoidable in the long term (even though various mitigating factors have so far kept it at bay). It has already been decided that a planned increase in the sales tax – allegedly designed to "lower the deficit" – will be countered by more inflationary measures as well as an increase in government spending. The latter makes no sense whatsoever. What point is there in raising taxes to increase revenues when at the same time spending is increased to "offset the effects" of the tax increase? It seems the main motive for the sales tax hike is to induce the BoJ to boost its "QE" program even further.
Note the dangerous assumptions people make regarding the support enjoyed by the JGB market, even as CPI is already exceeding the yield on the 10 year JGB:
“Government data will probably show on Oct. 25 that nationwide consumer prices excluding fresh food rose 0.7 percent last month from a year earlier, according to the median forecast of economists surveyed by Bloomberg News. The rate, the BOJ’s favored measure of inflation, advanced to 0.8 percent in August, the fastest pace since November 2008.
“We have to take into account the possibility of faster inflation over the long term,” said Tadashi Matsukawa, the head of fixed-income investment in Tokyo at PineBridge Investments Japan Co., which manages about $1.1 billion in bonds.
More than 70 percent of economists in a Bloomberg poll forecast that Kuroda will add to stimulus in the first half of next year. Meanwhile, Prime Minister Shinzo Abe’s administration will compile a 5 trillion yen economic package in December to offset damage from an increase in the sales tax in April to 8 percent from 5 percent. The consumption levy is scheduled to increase further to 10 percent in 2015.
“The Bank of Japan has already made a commitment to take action should the fears of the tax hike’s damage to the economy be borne out,” Bank of America Merrill Lynch strategists Shogo Fujita and Shuichi Ohsaki wrote in a report this month. “It seems safe to assume that such action would be along the lines of the ‘Kuroda put.’”
“Since there is limited scope for growth in lending, banks have no other choice but to buy JGBs, even if yields are low,” said Toru Yamamoto, the chief strategist at Daiwa Securities Co., a primary dealer. “Banks have to go up the yield curve in search for higher returns.”
The final paragraph is highlighting what we referred to as a dangerous assumption above: namely that Japan's banks have "no choice" but to buy more JGBs and that by implication, JGB prices will "never" fall. And even if they do fall, it is assumed that the "Kuroda put" will provide a floor under prices – which has of course been the experience of market participants up to this point.
Whenever people assert sotto voce that certain outcomes are simply not "possible", it is safe to assume that these so-called "impossible" events are highly likely to eventually happen. If so, Japan's banks will be in the unfortunate situation of being up to their gills in JGBs at exactly the wrong time, which could rip uncomfortably large holes into their balance sheets. A fiscal crisis would inevitably be accompanied by a major banking crisis as well.
In view of Japan's dire fiscal situation, the "Abenomics" experiment is truly playing with fire. The government would not be able to bail out the country's banks if a fiscal and currency crisis were to erupt – and given the interconnectedness of the global financial system, this would have rather noticeable knock-on effects on the rest of the world.
The clock keeps ticking on "Abenomics".