What's Wrong With Japan?


Japan’s monetary policies of negative rates and aggressive quantitative easing have produced current results of essentially 0% GDP growth and negative inflation.

The damage to profitability in the financial sector and to savers is large, and the country’s aging demographics (a constituent that needs to save) represent an additional headwind.

Helicopter money, or dispensing money to each eligible adult while tying these funds to spending incentives, works through a more direct channel than the financial markets.

Either way, Japan needs to engage in easing measures that will fundamentally devalue the country’s currency.

The US may be able to undergo a slight tightening process, which makes going long the USD/JPY a viable, though likely low-return, trade.

Developed economies have had little success in stimulating economic growth through monetary policy over the past eight years. The economic malaise in Japan has been worse than in the EU and US and has been an issue plaguing the country since it fell into a deep recession in 1989. The country's inflation rate has not been able to hold even 2% since the early-1990's. The inflation seen in the past couple years were a temporary result of a VAT hike that went into effect in April 2014.

(Source: Ministry of International Affairs & Communications; modeled by tradingeconomics.com)

Abenomics has been in effect since Shinzo Abe's December 2012 re-election and is primarily characterized by a mix of negative interest rates, aggressive quantitative easing implemented by the BOJ, a 2% inflation target, avoidance of excess yen appreciation, and an expansion of fiscal spending. Yet no policy has had a beneficial solution. Since the financial crisis, Japan has officially had three additional recessions, defined by periods of negative GDP growth in two or more consecutive quarters.

(Source: Cabinet Office of Japan; modeled by tradingeconomics.com)

Unfortunately, the BOJ is likely to do more of the same to limited effect. Inflation had a run to at or above 2% from early-2014 to early-to-mid 2015, but has since declined and been negative for six consecutive months. The danger in deflation, of course, is that consumers lack the incentive to consume when their money is likely to be worth more in the future. Considering that a majority of GDP is comprised of consumption in developed economies, deflation can be a very undesirable thing.

(Source: Ministry of International Affairs & Communications; modeled by tradingeconomics.com)

If we look at the last ten years, the policies pursued have had virtually no effect on inflation outside of the April 2014 VAT increase, which does not represent true demand-driven inflation.

(Source: Ministry of International Affairs & Communications; modeled by tradingeconomics.com)

The BOJ's quantitative easing strategy has undergone the standard practice of purchasing domestic sovereign debt, and additionally reached into corporate debt (similar to the ECB) and gone even further by purchasing exchange-traded funds made up of equities and Japanese real estate investment trusts ("J-REITs"). These policies are designed to bid up asset prices, create more wealth, and thereby encourage consumption and pull forward future growth into the present.

I believe negative interest rates and quantitative easing to this level of aggressiveness don't really work. Once interest rates are negative, you can technically compress discount rates further. This will have the effect of decreasing the rate at which cash flows are discounted and thereby increase asset prices as a whole. Moreover, it will aggressively push investors into riskier assets as bond yields and savings rates are squeezed. But the issue is that it is highly damaging to bank profitability and severely punishes those with a degree of risk aversion. Coercing people to spend by making saving unattractive as possible only works to a point.

No matter how bad central banks make it for savers, it doesn't alter the reality that people still need to save some portion of their income to remain comfortable financially. This is particularly true among those who may have limited time horizons and are therefore disinclined to having higher amounts of risky asset exposure. Demographics are also not on Japan's side, as it's the world's oldest population. For this reason, going below 0% won't tangibly incentivize more consumption. In fact, poor savings yields may actually encourage the opposite effect by encouraging these individuals to save more (and therefore consume less) to compensate for the lack of returns. Accordingly, the strategy of negative rates and more aggressive easing not only offers diminishing returns, but is categorically counterproductive.

As the argument goes, doing the same thing over and over again and expecting different results isn't a wise decision. In another article I described how a different form of loose monetary policy that works outside of the conduit of the financial markets, known as "helicopter money," may be more beneficial. In that post I described how QE is largely a policy by which the wealthiest people in the economy benefit (i.e., those who can buy assets like stocks and real estate) but lacks the direct means by which this extra purchasing power at the top can be effectively deployed down to classes with higher consumption propensities. Some will say that redistributive fiscal policy measures can cover this aspect. Maybe this can be somewhat true, but this only enhances the indirectness of the channel by which economic improvement might be enabled. On top of this, QE doesn't guarantee indefinite, consistent asset price appreciation. Obviously many other influences outside of central banks impact financial market performance as well. The results in Japan have still been objectively very disappointing with virtually no growth and no inflation.

Japan needs something more ambitious and closer to a monetary fiscal expansion, or essentially what has come to be Milton Friedman's original idea of helicopter money. The BOJ would print money and equitably dole it out directly to each eligible adult rather than relying on financial market engineering. Given that Japan is in a deflationary state, which incentivizes hoarding, this program would likely be less effective than it might be if it were employed in the US or EU, which are running along at slightly over 1% inflation. Therefore, these funds would need to be directly linked to spending incentives, such as vouchers and coupon programs, in order to push it out to its intended purpose (consumption).

One thing going for Japan currently is that its currency has appreciated versus the US dollar since early-2016 and is trading around 2-3 year highs.

(Source: investing.com)

This policy would depreciate the yen in accordance with its magnitude. The most obvious trade in such a scenario would be to go long the USD/JPY (or short the FXY if ETFs are the preferred instrument). The current sentiment on the USD/JPY is a bit bullish as it stands. The BOJ obviously isn't tightening its monetary policy anytime soon and will very likely expand its easing programs, while the US may tighten to a marginal extent.

With that said, helicopter money (even in the alternative definition of monetizing fiscal deficits) is currently illegal in Japan. As a consequence, the BOJ is largely shackled to monetary policy measures that haven't worked and I don't believe will engineer Japan back to prosperity anytime soon. Consumption cannot be pulled forward indefinitely and negative rates undermine the profitability of the banking system by which monetary policy is transmitted in the first place.

Final Thoughts

In my view, continuing on with monetary policies that have not worked and are therefore unlikely to work ahead is senseless and damaging. Growth and inflation are still virtually non-existent. And the country has officially been in three recessions since the beginning of 2011. Negative aggregate growth ensued over the final three quarters of 2015; though given Q3 2015 was slightly positive, a fourth recession did not technically occur.

Changing the narrative on Japan's no growth, deflationary economy isn't going to occur with continually loosening monetary policy that derives much of its influence through the financial markets. Though currently beyond the legal constraints of the BOJ, instituting a form of fiscal expansion -- initiated by the central bank -- that places money in the hands of consumers while tying these funds to spending incentives has the opportunity to work more directly. The BOJ would devalue the yen and would have the additional benefit of working not directly through the government's fiscal budget. There is no guarantee that helicopter money will work, but between tried and failed alternatives, it's the last remaining realistic option.

Either way, with persistent easing and devaluation procedures likely continuing and what I believe will be very slight tightening by the US Federal Reserve, a long USD/JPY position is probably a fairly safe trade.

Disclosure: I am/we are long USD/JPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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