Tuesday, 4 June 2013

All bets are ON

Both the government in Japan and many investors are betting on the power of monetary policy but it is not much more than a roll of the dice.

Japan has long suffered at the hands of the same problems that have hit Europe, and as a result, the central bank in Japan has also been a pioneer of the loose monetary policy which has since become the mainstream response to such problems.  The recently-elected Japanese government has upped the stakes with a further round of monetary policy which goes far beyond anything previously proposed.  Investors too have been putting their money on the line in the hope that the new measures will bring about a long awaited revival in the Japanese economy.  However, the limited effect of monetary policy so far in the aftermath of the global financial crisis suggests that this is nothing more than a gamble in order to avoid some tougher choices.

A massive financial bubble in Japan in the late 1980s has resulted in two decades of economic stagnation due to the now common culprits of the overpriced real estate market, overwhelming government debt, and a lack of sources of growth.  The interest rates have been set close to zero for more than a decade while the Bank of Japan has also pumped money into the economy.  Successive Japanese governments have held back from making the necessary reforms to help the economy unwind the imbalances built up during the boom years and instead amassed debt equal to 230% of GDP, rather than deal with the problems that the country is facing. 

The new wager on monetary policy involves a doubling of the money supply as part of measures to achieve inflation of around 2% in two years.  However, the new monetary measures will just be another stalling tactic if not combined with other policies which help to kick start business activities.  The immediate effect of printing more money is that the value of the yen has dropped from below Y80 to over Y100 against the US$.  A weaker yen is a boon for many of Japan’s manufacturing giants who have large exporting operations.  The boost to their profits along with hopes for a new beginning for the Japanese economy has prompted many investors to throw in their lot with the Japanese government and the stock market surging by almost 70% in 6 months until a recent setback.

Yet this is symptomatic of actions by governments and investors across the globe.  Booms and busts in any economy involve considerable transformation as businesses adjust to new realities and government can either try to facilitate this process of companies adapting, which helps the economy become more productive over the long term, or stand up against forces of inevitable change to ease the short term pain.  Prior faith in monetary policy has enabled governments to believe that central banks have the power to restart economic growth with less hardship.  But new engines of growth are not given the scope to expand and monetary policy is relied upon more and more to prop up the economy. And using monetary policy to weaken a currency and boost exports will only work as long as the country’s central bank is expanding their money supply faster than anywhere else (for more on this, see Currency Wars).

This complicates the process of selecting investments with a layer of politics being overlapped with normal considerations of business profits and economic performance.  And with monetary policy taking a more dominant role in the strength of the economy, investors find it necessary to track the actions of central banks rather than just corporate activities and economic indicators.  As such, investors are second guessing what the central banks will do while the central banks take their best shot at what they think will be good for the economy. 

It is questionable whether the current set of policies that are commonly employed by central banks have been of much use so it is a considerable punt by the Japanese government to put all its money on more of the same despite any consensus which suggests otherwise.  But it is a way of being seen to be proactive while actually avoiding backing more difficult choices which are more likely to pay off in the long term.  And with bets in the stock market following the government line, this will multiply the losers and add to the woes of those who actually try to sort out the mess in the future.

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