The Sun May Set On The Land Of The Rising Sun

by: Kevin Wilson


Using the Japanese economy since 1990 as an analogy, we can infer that balance sheet recessions tend to nullify both conventional and unconventional efforts to boost demand.

Fiscal stimulus in Japan has failed to revive demand in the face of demographic challenges and rising taxes; monetary stimulus has boosted asset prices without improving exports or household incomes.

Japan could try a supply-side approach, and/or abandon the welfare state - so they are trapped, like mythological Greek mariners, between an economic Scylla and a political Charibdis.

Deflationary pressures on the global economy continue, placing the Federal Reserve and other central banks in a tough spot. Recessions in Russia, Brazil, possibly Japan, and potentially China, together with collapsing commodity prices, clear over-capacity in many industries, weak global aggregate demand, declining inflation or outright deflation, and slow GDP growth not only color the economic outlook for 2016, but are likely to alter the political situation in many countries. Federal Reserve Chair Janet Yellen and the FOMC have just raised interest rate policy for the first time in 10 years, hopefully marking with this decision the beginning of the end to the monetary experiment that was called quantitative easing, or QE. This involved the Fed buying huge quantities of US Treasury bonds and various Agency securities of longer maturities, raising the level of the Fed's balance sheet from $850 billion to about $4.5 trillion. The question for the markets now is, when will the Fed start to reduce its balance sheet holdings? The Fed's language in announcing the rate increase did not mention when the reduction in assets will begin. This means money will remain extremely cheap until the Fed decides to actually reduce their balance sheet. Meanwhile, a sharp policy divergence has arisen as Europe, China, Brazil, and Japan continue to aggressively ease monetary policy in the face of the global slowdown. Some version of QE is still on-going in Europe and Japan, but with mixed results. Fiscal stimulus in tandem with QE has not been prominent in the European or US recoveries, but has been very important in China and Japan.

The theory behind ZIRP has been that it would stimulate demand by cheapening credit, and also reduce each government's interest payments on their national debt. The expected rise in asset prices under each country's QE program, caused by yield-seeking investor behaviors, has been deemed beneficial, at least for the purpose of avoiding the expectation of continued deflation by consumers, which can become entrenched once allowed to get a foothold. Another, unspoken but critical goal has also been to devalue the local currency, which tends to make local exports more competitive and boost manufacturing and the growth of high-paying manufacturing sector jobs. Markets have reacted with joy to each new announcement of a QE program in a major economy. It is curious and a bit alarming that markets have in the process come to view bad news about the economy (i.e., the alleged necessity for additional QE) as good news for stocks and commodities. But the question arises, how big have the actual effects of QE likely been? Furthermore, is there any evidence that quantitative easing has actually worked to improve general economic conditions?

Some very important evidence on these questions has come to light as a result of Japan's Great Recession and the "Lost Decades" that the Japanese have experienced since 1989. A major source of analysis on the efficacy of QE has been provided by well-known economist Richard C. Koo, who was among the first to identify the implications of balance sheet recessions (The Holy Grail of Macro-Economics: Lessons from Japan's Great Recession, Revised & Updated Ed., 2009, John Wiley & Sons [Asia] Pte. Ltd., Singapore, 339p). His study of the Japanese government's response to their financial crisis examined all aspects of fiscal and central bank policy over the 20 year period after 1989, comparing them to the policies of the federal government during the Great Depression in the US. He has concluded that the QE applied by the Bank of Japan between 2001 and 2006 was completely ineffective, in spite of pumping liquidity equivalent to five times banks' required reserves ($30 billion) into the system. Money supply only increased marginally, lending activity stayed sluggish, and inflation stayed low, in spite of theoretical calculations that there should have been massive increases in all three of these parameters.

Richard Koo is not the only economist who has been concerned that QE programs in major economies may fail; Nobel Laureate Joseph Stiglitz has also been deeply concerned, pointing out that QE without accompanying stimulus spending (fiscal policy) was always highly likely to fail due to the depth of the recession in each country that tried QE. The US Federal Reserve's own internal models suggest that the effect of even massive amounts of QE has probably been very limited, perhaps 0.2% GDP growth/year for each $500 billion in QE. One of Richard Koo's major points is that it was fiscal stimulus in massive and repeated doses that saved Japan from a depression, not their failed attempt at QE. Instead of lamenting the so-called Lost Decades, Koo celebrated the successful avoidance of a depression, in spite of conditions that closely tracked those of the Great Depression in the US. This is a finding that I regard as most surprising, the opposite really, of the interpretation of Japan's Lost Decades presented by the Western news media. The implications for the US and Europe, if Koo is right, are profound. Although differences in the circumstances of these countries exist (e.g., Japan and Europe are net exporters, the US a net importer), the main idea is that the BOJ, ECB and the Fed's FOMC have been taking unnecessary risks, because the solution to declining aggregate demand is not to be found in monetary policy.

However, I would also point out, as I have discussed elsewhere, that Keynesian fiscal stimulus like that favored by Koo has not worked anywhere else where it has been tried, except perhaps in China after 2008. It "worked" in China because funds available under the huge Chinese stimulus program were spent directly on infrastructure and similar projects. Although these projects weren't needed on a demand basis, and therefore represented mal-investment in non-productive assets in many cases, at least they provided strong support to the labor component of the economy, boosting wages and consumption in the short run. In the long run, the mal-investment in China can now be seen to have created huge overcapacity that now haunts the Chinese economy, so it is not a given that it actually was the correct approach. Stimulus packages passed in the U.S. and elsewhere were mostly spent on transfers of wealth rather than productive infrastructure, and were relatively small to boot. In any case, the viability of Keynesian stimulus has been seriously questioned by the research of Nobel Laureate Robert Barro, who studied the negative impact on GDP of World War II government spending.

Skeptics have also argued that the BOJ didn't execute QE properly, claiming that if only the BOJ had used $120 billion instead of $30 billion, or some such multiple, things might have worked out better. But many economists ignore what really drives the private sector's response to a balance sheet recession: deleveraging. In the recoveries from the 2008 Global Financial Crisis, Japan's 1990 Great Recession, and the 1929 Great Depression, the private sector has in each case relentlessly paid down debt, creating a "fallacy of composition" problem, i.e. the prudent actions of many, when taken collectively, are in aggregate destructive to economic activity. The fact is that as long as deleveraging is going on, there is no private sector interest in having more credit available during a balance sheet recession, i.e. there is low credit demand. Thus, lending activity stays low even when interest rates reach zero. This is exactly what happened in Japan. It has happened to a lesser extent in Europe and the US. The money multiplier must also stay low under these circumstances because there is such reduced lending activity, which means output growth is doomed to remain weak. Money supply also stays relatively low because increasing the central bank's balance sheet technically does not increase money supply at all, and banks continue to convert their excess reserves to government debt rather than lending, since credit demand is weak. Thus there is little or no inflation pressure, and deflationary trends and expectations persist in spite of all monetary policy efforts.

It may be relevant to point out though, that Japan has never really recovered fully, and is even now sliding back into recession and deflation again, its fifth dip in the last seven years. It seems likely that all those years of fiscal deficits have weakened the private sector semi-permanently by displacing its activities over time. Sharply declining household income in the face of slowly rising prices over the last three years, in spite of massive doses of QQE, seem to confirm this. Demographic changes have also helped drive the decline, and may represent a really substantial hurdle for the economy. This general deterioration led in 2012 (a few years after Koo published his book) to the newest experiment, that of "Abenomics." Under this approach, named after Japan's current Prime Minister, a set of radical policy changes (the "Three Arrows") were proposed in order to turn things around.

The first Arrow involved massive new QE - called Qualitative and Quantitative Easing, or QQE, by the BOJ - designed to devalue the yen openly, thus forcing money to move out of hoarding and back into the economy. The Second Arrow involved fiscal stimulus, and the Third Arrow involved labor market and tax reforms. Although QQE has been applied with great vigor, with the BOJ's balance sheet rising almost vertically (now at a $655 billion annual rate) over the past three years, and with the yen depreciating significantly in response, there has been no big surge in exports, a completely unexpected outcome. Abe's government did commit to massive fiscal stimulus (the Second Arrow), and the budget deficit has reached about $850 billion in 2015. But this spending has been offset by a massive increase in sales taxes that hit consumers hard over the last two years. And there have been serious issues with the Third Arrow of "Abenomics." Reforms have not really gotten the traction needed yet, and as a result PM Abe recently proposed a reboot, or "Abenomics 2.0" as a means for making a mid-course correction.

If I may make a suggestion about how to interpret all of this, it may seem that the problem is demand-driven, but the solution could likely be a supply-side approach. The demand problem may have started with the bubble collapse and balance sheet recession in 1990, but Japan's demographic challenges have kept demand weak and are now very important issues for policymakers in attempting to change the economic outcome going forward. It is not clear how Abenomics as proposed can really address the demographic problem for growth. Just as we have seen in global central bank monetary policy failures, efforts to stoke demand artificially have not worked in most countries. So what are the Japanese, or we ourselves to do? It would seem based on empirical analysis that since monetary policy in this situation has been manifestly ineffective, and since the massive fiscal stimulus needed is politically untenable over the long term (and laden with the seeds of economic destruction, since it would require big deficits), we must perhaps look elsewhere for permanent solutions.

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The alternative? Economist John Hussman once pointed to what the Austrian School economist Ludwig von Mises noted many years ago: that massive central bank easing such as the BOJ has done and continues to support is "invariably a form of [denial] that attempts to avoid the need to restructure debt or correct fiscal deficits, [deferring] wiser but more difficult choices by instead destroying the value of the currency." Japan still needs to restructure their remaining bad debt, however painful that may be. Japan also needs to eventually cut the budget deficit, however painful that may be. Supply-side economic policies would then need to follow, including things like promoting capex by corporations, limiting regulatory impacts, and lowering tax rates instead of raising them. How can all of this happen? The welfare state would have to take a back seat in favor of economic growth. It is arguable however, as analyst George Friedman has discussed, that Japanese society finds the new normal of high debt and low growth perfectly acceptable. However, I would still question whether it is ultimately sustainable given the huge and growing debt load carried by the Japanese economy. I believe that Japan's profligate government spending practices over the past 25 years have landed them in the same relative position as the mariners of Greek mythology, trapped between the economic monster Scylla and the political monster Charibdis.

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