Getting more from Monetary Policy

Japan has made lots of mistakes and it is time that Europe learnt from them

We can all learn from watching others make mistakes and the experiences of Japan continue to provide valuable lessons.  Japan has stumbled into another recession following a hike in taxes to fix the government’s finances.  The other key policy doing the rounds in Japan, using expansive monetary policy to put an end to deflation, also seems to be flagging.  It is Europe that has most to learn from the unfortunate trials and tribulations in Japan since many of the same problems are shared by both.  What should Europe do to avoid making the same mistakes and decades of stagnation?

Following in the same footsteps

Japan has been hit first with many of the same problems that are increasingly expected to plague Europe and other Western countries.  For starters, new-borns in Japan are increasingly outnumbered by pensioners which have pushed the population into decline in recent years with an aversion to immigration further accentuating this trend.  This translates to fewer workers to provide the taxes needed for the rising costs involved with taking care of old people.  The situation is made worse by government debt which is already more than double GDP due to years of inefficient government spending.

Japanese consumer prices have been falling for years as a reflection of the weak demand.  There are few opportunities to profit from in Japan due to the falling population and even Japanese firms are looking elsewhere to invest.  Weak global demand means that even one of Japan’s strengths, exporting, offers only limited respite even with a weaker yen due to its loose monetary policy.  All of this means that the Japanese economy itself is like a tottery pensioner - even a small rise of sales tax from 5% to 8% was enough to push Japan back into recession.  This does not bode well for Europe where the economy is sputtering along due to many of the same problems while the governments there are also trying to get a grip on their finances.

Trying different directions

Having been stuck with these problems for longer, policy makers in Japan are increasingly more aggressive in coming up with solutions.  The current prime minister, Shinzo Abe, launched a raft of new measures dominated by a massive expansion of the money supply to target falling prices.  This new aggressive approach to monetary policy was facilitated by the government installing a new governor to the Bank of Japan who was willing to give up its independence and toe the line.

This is the complete opposite to the situation in Europe.  The head of the European Central Bank is eager to do more with monetary policy but is prevented from doing so by the German government.  German politicians want to reforms to come first due to an expectation that their neighbours will not implement the necessary policies. Whereas, in Japan, the aim was to use the loose monetary policy to help build momentum that will allow the government to implement reforms. 

Yet, the Abe government has been disappointing in its reform efforts (as Your Neighbourhood Economist predicted) and this will bolster the stance taken by Germany.  With the Bank of Japan finding it tough to generate sufficient inflation despite a rapidly expanding money supply through quantitative easing, many will question about the reasons behind using a similar policy in Europe.  Central banks are struggling to have much influence in a world that is already awash with surplus cash.  

Time for Plan C

It seems like the key lesson from Japan is that monetary policy cannot do much by itself.  Japan still languishes despite the best efforts of the central bank as the Abe government shirks the much needed measures to free up the economy.  Yet, bullying countries in Europe to reform by withholding the full extent of monetary policy is not helpful either.  A grand bargain marrying reforms with looser monetary policy, as was supposed to be the case in Japan, seems the obvious solution. 

This takes more political willpower when the many countries of Europe are involved but is not something beyond the realms of possibility.  Ironically, the chances for such a deal may be improving as deflation becomes more of a concerns and the economic stagnation in Europe also spreads to Germany.  Japan has already paid the price for years of economic mismanagement – there is no reason for Europe to do the same.

Question – where next for Japan

An inquiry from a reader prompts Your Neighbourhood Economist to look into the prospects for Japan

There has been another knock at the door of Your Neighbourhood Economist, with a reader what I thought Japan should be doing in the short and medium term?  The question arrived just days before another big policy development in Japan with the central bank ramping up its monetary policy.  This is the latest attempt by policy makers in Japan to resurrect an economy that has been languishing for decades.  To get an idea of what Japan should be doing, we need to start with what went wrong and why Japan has not made much progress.

What is not going right?

Japan got itself into trouble in the 1980s with the spectacular collapse of a financial bubble from which it has never recovered.  Property prices have fallen almost every year for two decades while prices for consumer goods have been inching lower for almost as long.  Japan has repeatedly tried to use fiscal stimulus but higher government spending has been unable to mask deeper problems with the economy.  Along with numerous roads and bridges which are hardly used, the main result of these rescue attempts has been a ballooning amount of government debt which only adds to Japan’s woes.

Monetary policy has been adopted recently as the potential saviour in the fight against what has been deemed as the main problem – deflation.  Falling prices were seen as prompting consumers to hold off spending and preventing companies from investing.  With this in mind, the central bank in Japan announced plans to double the money supply in early 2013.  But the policy of pumping more money into the economy was based on the false logic that deflation was a problem rather than just the symptom of a weak economy.  Instead, it is likely the case that deflation persists because prices rises had gotten out of hand in the past and need to fall back to appropriate levels.

Fix-up job not working

The result of this monetary policy has been as Your Neighbourhood Economist might have expected with just a brief and temporary boost to inflation.  Prices for consumer goods cannot rise consistently if consumers themselves do not get a similar rise in pay.  Higher wages in Japan seem unlikely as a declining population hurts aggregate demand and Japanese firms invest more overseas than domestically.  Yet, rather than change tact, Japan’s central bank has opted for more of the same. 

This involves the Bank of Japan aiming for an even larger boost to the money supply in Japan with annual purchases of 80 trillion yen (US$720 billion or £450 billion) in government bonds.  The timing of the new policy comes as the Japanese economy is faltering under the added weight of a tax hike designed to fix the government’s finances.  Japan has gotten itself deeper and deeper into trouble and seems likely to be an example of what not to do in terms of fiscal and monetary policy.   

Where to from here

The best option left to the Japanese government is to reform the economy so as to increase competition and improve efficiency.  There is substantial domestic opposition to reforms even within the current government headed by Prime Minister Shinzo Abe who included reforms as one of his key policies.  An easy way to sidestep domestic politics would be to jump on-board to plans for the Trans-Pacific Partnership (TPP).  This is a free trade agreement with the United States, Australia, Mexico, Chile, and other countries around the Pacific Rim.

Left to themselves, Japan will probably continue to stagnated due to the stifling effects of its consensus style of politics which make it tough to come up with reforms that keep everyone happy.  As such, Japan has a history of positive change only coming when imposed from the outside and this free trade agreement looks likely to follow this trend.  Greater competition from foreigners will help lower costs of business and create impetus for freeing up businesses in Japan from a host of restricting rules.  Facing up to the outside world looks like the best way to inject life back into a Japanese economy that has been slowly decaying for years.

Deflation – déjà vu with a twist

Signs of deflation I have seen before start showing up in my neighbourhood but falling prices have been with us for a long time

Your Neighbourhood Economist has been getting a sense of déjà vu recently – to do with deflation.  My past experiences of falling prices come from years spent living in Japan and I am seeing the same things again in my neighbourhood in London.  Japan and deflation make for a scary combination considering that Japan is a byword for prolonged economic stagnation and poor policy choices.  But deflation may have already been lurking around unnoticed for a while. 

This looks familiar

The symptoms of déjà vu started with the fast food chains such as McDonald’s and KFC offering cheaper menu options.  This first started in London a few years back but it was a sign that consumers did not have much cash to spend.  It is a sorry state of affairs when even the least expensive places to eat out need to provide food with even lower prices to attract customers.  But it is the same tact that similar companies had adopted in Japan around a decade ago in the face of increasing price conscious consumers.

The other memory of deflation in Japan was from buying groceries at the supermarket.  The most notable place was shopping at my local 100 yen store (which is like a pound shop or a dollar shop).  While the prices of the products on the shelves did not change (obviously), there was a noticeable increase in the range of goods that could be brought for 100 yen.  The same trend is becoming more obvious in the UK in the success of discount supermarkets such as Lidl and Aldi.  To keep up, the mainstream supermarkets have been slashing prices but shoppers are still switching to their cheaper rivals. 

The only areas in the economy where prices are still rising are sectors where the pressures of price competition are less fierce.  UK companies such as energy providers or train operators function in imperfect markets where consumers have less choice and few other options.  Spending on energy or transport often cannot be avoided so companies do not have to try hard to sell their products.  As such, it is large energy bills and higher transport costs that are increasingly responsible for inflation.  With nowhere else to go, consumers have increasingly turned to the government to prove an answer despite there being little that politicians can do.

We live in deflationary times

Yet, for good or bad, this may be the new world that we live in now rather than just a temporary blip amid a slow economic recovery.  In a new global era, firms and consumers can scourge the world for the cheapest places to buy whatever they want.  This impacts what we buy off the shelves at our local store as well as what we can purchase off the internet.  Technology further aids this trend by providing information on what is on offer outside of our neighbourhoods and for what price.  And we are increasingly consuming services through the internet at cheaper rates than ever before.

This is great for us as consumers but the flipside is that companies in our local economies face growing pressures and will not be able to provide the same level of employment opportunities or pay the same wages as before.  This is a problem for governments who want their national economies to prosper.  Jobs are seen as the primary gauge of the health of the economy but boosting employment is tricky when competing on a global scale.

Here today and here tomorrow

Deflation is often seen as a problem in itself.  The standard economic theory goes that, if prices are falling, consumers will wait to spend as goods will be cheaper tomorrow.  Yet, globalization and technology are not something new and we have had downward pressure on prices for a long time.  Inflation has been low for the past few decades suggesting that deflation may have not been that far away.  It is perhaps only the voracious appetite for raw materials in China and elsewhere that pushed up global commodity prices and stopped deflation setting in sooner.    

If it has been around for so long, deflation by itself may not be so bad after all.  Yet, an overreaction by policy makers might be.  The European Central Bank seems set to ramp up its measures to fight off threats of deflation (and a morbid economy in Europe).  The central bank in Japan has launched a renewed onslaught against falling prices but to little avail.  Yet, the forces of globalization and technology cannot be reversed using just monetary policy.  Falling prices are something that may be with us for a while so it is better to get used to living with the potential for deflation and focus our efforts on other economic evils.

Free Trade – Missed by Many

Free trade is a route to greater prosperity and better government but its biggest advocate has retreated from its crucial role

US foreign policy was something that people loved to hate.  America was portrayed as a global bully who pushed everyone else into playing by its rules.  The Iraq War is perhaps the most obvious example of this but the conflict also marked a turning point when the US started to withdraw from its dealings with other countries.  While this might appear to be cause for rejoicing, the retreat of the US from international affairs has left a gap that has yet to be filled.  A lack of impetus in the promotion of free trade is one key area where the world is missing the US in a way that is not yet widely understood.

More than just buying and selling across borders

Free trade is something that many people would be glad to see the end of.  It allows for greater globalization which has been vilified as costing jobs and hurting our economy.  Although a source of pain for some in the West, globalization has been a boon for most of us, providing a range of cheaper goods for everything from bananas to iPhones.  At the same time, export industries in less developed countries have pulled millions out of poverty.

Openness to free trade with the rest of the world involves more than just exporting and importing.  It is part of a bigger package that includes less overall regulation and more economic freedom.  This may not seem like much to those in countries that already have this in place, but to places under the rule of an autocratic government, it is something worth fighting for.  Such a battle has dominated the news so far this year as it plays out in Ukraine.

The protests that overthrew the oppressive regime in Ukraine were triggered by the government stepping back from an EU trade agreement and instead opting for a closer relationship with Russia.  This was taken to have the broader meaning that the Ukrainian government was choosing the autocratic style of government characterised by Russia rather than the democratic freedoms of the EU.  Yet, the unrest in Ukraine shows the preference of its citizens and how opening up to trade (and expansion of the EU) can spur on hearts and minds when seen as part of a bigger picture. 

Free trade can have a positive influence in other ways as in Japan.  Political lobbyists such as farmers have tended to block greater access for imports into Japan.  Japanese politicians are apt to side with such vested interests instead of with voters in general who would benefit from cheaper imports.  In the past, it has only been pressure from outside the country - typically from its main ally, the US – that has helped open Japan up to free trade.  Delayed but critical reforms needed to fire up the Japanese economy could be pushed through if a deal were to be done on the Trans-Pacific Partnership which is a free trade zone encompassing countries on the Pacific Rim.

China can only offer so much

The fight for free trade typically needs a champion.  This is because the negative impact of greater trade is concentrated in a few sectors which are proactive in their opposition.  The gains from more open borders are, on the other hand, spread out amongst us all, resulting in only weak support.  Thus, despite the substantial advantages of free trade, progress has been halting.  The problem is exacerbated by each country having its own boisterous domestic forces against free trade so that getting a large number of governments to sign up is a tricky proposition. 

The US government had been the driving force behind free trade, using access to its own lucrative domestic economy as a bargaining piece.  Rather than being a bully, the US spread economic freedoms through trade like a benevolent power.  But, the US no longer has the ability or willingness to play this role.  A rebalancing of the global economy means that the lure of the US economy pales in comparison with other countries such as China.  The weakening of its relative economic strength also means that the US is less generous in its bargaining with other countries.  This is reflected in the stalling of what was supposed to be the next big round of global trade talks which started in Doha in 2001.

The lure of Western ideals as embodied in free trade still remains.  Countries clamber to join the European Union despite its recent troubles.  Economic power may be shifting away from the US and Europe but their democratic style of government is still sought after by many (although politicians have not been showing themselves in a good light).  Free trade in itself is not the answer but it will help push many countries in the right direction. 

Tax Hike in Japan to test fight against Deflation

The Japanese government has been proactive in its battle with deflation but higher consumption taxes will show how much progress has actually been made

There is a big test coming up for the Prime Minister of Japan, Shinzo Abe, and his own brand of economic policies which have been labelled “Abenomics”.  Abe has launched a range of aggressive measures to end deflation and get the Japanese economy moving again.  However, a rise in the consumption tax from 5% to 8% in April will provide a thorough examination of the economic recovery in Japan.  The results will matter not only for the long-suffering Japanese citizens but may also provide crucial lessons on how to combat the growing threat of deflation.

Economic Policy - could do better

A report card for Japan's Prime Minister might see him get an “A” for effort but a “C” for execution.  Abe has had a busy first year in power and has attracted plaudits for his three arrows of economic policy encompassing fiscal stimulus, monetary easing, and structural reforms.  This has translated into 10.3 trillion yen (or around US$100 billion) in extra government spending and the Japanese central bank aiming to double the money supply over a two year period.

Hopes were buoyed as the Japanese economy perked up in early 2013 while the stock market in Japan was one of the best performers last year.  Unfortunately, Abenomics did not live up to the hype with economic growth slowing and many investors selling their Japanese shares in 2014.  The shortfall against expectations has been due to an unwillingness to push through the reforms which are key to getting the economy moving again.

Your Neighbourhood Economist had always been sceptical about the outlook for the reforms as Abe is a conservative in a political party which is known as a bastion of old-school traditions in Japan.  The Japanese government is not alone in using expansionary monetary policy as a shortcut to improving the economy.  Yet, two decades of stagnation show that there is no easy route to scoring good marks where the economy in Japan is concerned.

Economic recovery put to the test

The hike in the consumption tax (which has been on the cards for decades) is a move to sort out the government finances but threatens the goal of defeating deflation.  Consumer prices have begun to edge upwards but this depends on the central bank in Japan continuing to print a torrent of new yen notes.  Rising prices are a novelty in Japan after decades of deflation with the higher consumption tax set to bump prices up a further notch.

It is not clear whether Japan is ready for this real-life lesson on the effects of inflation.  Many companies in Japan are not yet convinced that inflation has taken hold with some even lowering prices to absorb the higher taxes.  As a result, wage gains have been timid despite the government's efforts to bully Japanese firms into paying their workers more.  Inflation without higher wages is even worse than deflation as consumers increasingly feel the pinch.  The increase in consumption tax could exacerbate this trend and depress spending.

Little to learn

A poor showing in economic policy in Japan will seldom make the news elsewhere but it does not bode well as other places look set to face a similar set of problems.  The causes of deflation in Japan are becoming more prevalent in Europe – high government debts, an ageing population, a stagnating economy, and companies struggling amid globalization.

Lessons learnt in Japan could be applied elsewhere.  Yet, successes have been few and far between.  Japan does not make a good case study for fiscal stimulus (more due to problems within Japan rather than problems with the idea of a stimulus).  Neither has monetary policy had much impact with an increase in the supply of money only having a limited effect on inflation (due to the link between money supply and inflation being weaker than assumed).  Europe is instead contemplating negative interest rates which is something that Japan has not tried.

Too much inflation will drag down the grades of central banks but deflation could earn them a fail.  Part of the reason is that deflation has been seen as a cause of the malaise of the Japanese economy (even though deflation is more likely just a symptom).  If the Japanese economy could return to being the star pupil it was in the 1980s, deflation would no longer come with such a bad reputation.

What Europe has to teach Japan

As the Japanese government mulls a higher sales tax to improve its finances, what do the experiences of Europe over the past few years suggest?

When thinking about the problems with the economy in Europe – feeble economic growth, high levels of debt, and banks shackled with bad debts – Japan has been seen as a lesson of what not to do.  Europe had the luxury of learning from Japan’s mistakes – Japan tried to ride out the problems while Europe has been more proactive in sorting out the mess following the global financial crisis.  It could be argued that Europe has come further in a few years than Japan has come over the past two decades, and with Japan considering a move to improve its dire finances through higher sales tax, it seems a good time to see whether Japan has anything it can learn from the experiences of Europe.

Talk of crisis in Europe is significantly more muted these days with the worst of the Eurozone debt troubles having been left behind in 2012 (for more, refer to Both good news and bad news for Europe).  Recent data showed that the economy in Europe grew marginally in the second quarter of this year giving rise to hopes that a brighter future awaits.  A key element of Europe’s gradual return to health has been its austerity.  Japan has been saved from the forced cut backs imposed by some governments in Europe as domestic savers in Japan are reliable buyers of government bonds there.  But the absence of any pressure to rein in spending has a downside as well in the form of more and more debt.  

Normally, gradual and mild rises in interest rates act as a warning signal as in Europe when buyers of bonds shun the debt of any country that seems likely to default.  So even without any signs of trouble being on its way, debt in Japan could all of a sudden reach a point where a large chunk of the holders of its debt decide to jump ship resulting in financial meltdown.  The lack of urgency has meant that austerity has never taken off in the same way that it has been embraced by leaders in Europe. 

Japan is trying a different tack as a means to sort out its finances – a higher sales tax.  This option has long been thrown around as a possibility in Japanese politics and has dominated headlines in Japan with the Abe government considering a two stage rise in sales tax from 5% to 10% by October 2015.  The two different approaches – to cut spending or raise revenues – are both plausible solutions but it seems strange that Japan and Europe have chosen different routes to solve similar problems.  Europe has had more success with its way of doing things but that may be a sign of great resolve instilled through higher interest rates.  Some countries in Europe have adopted measures to increase their income but it begs the question – why has the Japanese government not made more of an effort to rein in its spending?

Government spending in Japan was 15% higher in 2012 compared with 2007 before the global financial crisis but government revenues have fallen by over 8% over the same period.  One of the key reasons behind Japanese politicians’ aversion to cutting spending is its patronage style of government.  Political leader divvy up the resources that come with the levers of power in the same way that traditional community bonds would dictate.  Support of those in power comes through rewarding your followers, and even though this old-style source of power is on the wane, it is where the current ruling party has a reliable support base in rural districts which are overrepresented in the Japanese parliament.  So the reasoning behind the approach of the Japanese government would be that higher taxes will spread the pain whereas cuts to spending will hurt your supporters.

The Abe government in Japan has been trying lots of other tricks including even greater increases in spending in 2013 through a fiscal stimulus package (see When Keynesian policies won't work for why this is not likely to work) along with expansionary monetary policy (which is unlikely to do much good either – see Don't hold your breath).  Yet, spending seems to have passed being useful considering the countryside in Japan is already covered with roads and bridges that see little traffic as well as a multitude of small plots of land farmed by the elderly with government support.  This seems even more incongruous considering that the population in Japanese is declining which will see further falls in revenue and higher spending on pensions and medical bills for the elderly.  This means that the reforms proposed by the Abe government are even more crucial in order to make the falling number of workers even more productive.  Or else, Japan might have to resort to another policy option used in Europe – default…

Japan – Don’t hold your breath

Hopes are high that Japan might be set for an economic reboot but a deeper look at the new policies and politicians involved suggests otherwise.

Your Neighbourhood Economist was once an optimist regarding the prospects for the economy in Japan after having lived there for nine years.  A nascent recovery in the seemingly morbid Japanese economy always seemed to be just around the corner.  It seems as if the economy in Japan is at another possible turning point with a string of new policies that could just do the trick.  The newish Prime Minister has taken on board some bold policies and optimism abounds, but after having been disappointed in the past, Your Neighbourhood Economist is not getting carried away and thinks that another let-down is the more likely outcome.

The despairing state of the Japanese economy is so bad that it makes the Eurozone crisis look like a day out at the beach (where many Europeans will be in August).  Not only is the government debt equal to around 230% of GDP (which makes Greece seem not so bad) but close to half of what the government spends each year is made up from borrowing.  Japan is still dealing with the consequences of perhaps the largest property bubble in history which burst in the late 1980s, but prices for property are still falling over two decades later and share prices are still only around a third of their peak in 1990.  To make things worse, Japan is also in the grip of deflation (falling prices) which typically stops consumers from spending and firms from investing.

Any optimism may seem surprising faced with such problems but the election of a new LDP government headed by Shinzo Abe has sparked hopes of a turnaround.  Abe has prompted a raft of new policies (referred to as the three arrows) encompassing monetary and fiscal policy combined with reforms.  The first two of the arrows have already been unleashed – a 10.3 trillion yen (US$116 billion) stimulus package (fiscal policy) and plans to double the money supply over two years (monetary policy).  The third arrow involves key reforms necessary to revive the economy but only piecemeal policies have been released so far leaving Your Neighbourhood Economist worried that the first two arrows won’t amount to much while the critical reforms will be stifled.

The best policy response to a temporary drop in demand is typically an increase in government spending to make up for the shortfall and keep the economy ticking over.  But this prescription for a fiscal stimulus has been tried over and over in Japan with little avail as the problems are beyond being fixed in this way (for more, see When Keynesian Policies won't work).  Neither does the doubling of the money supply hold much promise.  As shown in other countries with loose monetary policy, companies and consumers have shown that they would much rather pay back debt or hoard extra cash rather than spend or invest it.  So the extra funds from the central bank will only probably show up in the bank accounts and only a small portion of it will likely feed through to the real economy (see Why is the economy still stuck? for more on the poor track record of monetary policy).  An expansive monetary policy tends to be a favoured policy option for governments that are looking for a way to avoid unpopular but crucial measures to shore up the economy (for more detail, see Perils of doing too much).

The best hope for the Japanese economy is the reforms in the third arrow such as joining in on the new Pacific free trade agreement which would open up the economy to more competition from overseas.  The reforms are needed to cut through regulation in many areas which stifle innovation to the benefit of vested interests who resist any changes to this harmful regulation.  This is the nature of politics everywhere but the problem is more pervasive in Japan due to a culture that prizes consensus where making changes in the face of opposition is frowned upon.  The extent to which the Prime Minister is willing to go up against the vested interests is as yet unclear.  The reforms announced in June which were supposed to provide initial targets of the third arrow were disappointing.  While the announcement came at a crucial time ahead of elections (which the ruling LDP party won a sweeping victory), the signs are not good. 

The LDP gets the bulk of its support from the vested interests who oppose reforms and has little impetus to rebel against its support base considering that the main opposition party is in disarray.  The LDP has pushed ahead with reforms in the past – most notably under the leadership of Junichiro Koizumi who was Prime Minister between 2001 and 2006.  But Koizumi was a maverick from outside of the party mainstream while Abe is a party stalwart who has already had an unimpressive spell as Prime Minister.  Abe does not seem to be a true believer in the need for reforms as Koizumi was and Abe’s main focus instead seems to be changing the constitution to increase the military might of Japan.  So while it is high time for a turnaround in the fortunes, it does not look like any amount of arrows will slay the beasts sucking the life out of the Japanese economy.

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

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.

Currency Wars – Japan’s Central Bank Strikes Back

Japan ups the ante with policy makers eyeing monetary policy as a means to weaken their currency but where will it end…

Currency wars is not exactly the stuff of the latest blockbuster showing at the cinema but the issue is making headlines and setting pulses racing.  And it is the normal staid world of monetary policy that is the cause of the tensions.  In the face of weak economic growth, most central banks in developed countries tend to set interest rates close to zero and have had to resort to the unconventional tactic of quantitative easing or the buying of bonds to increase the money supply.  Creating more money in this way has an added effect of also reducing the value of the currency (see Where is all the money going? for more on quantitative easing) and a lower currency is helpful for exporters trying to sell their goods overseas.  With more quantitative easing acting to prompt more exporting, it is an easy way to help out businesses who may be suffering from sluggish demand in their domestic market.  So with quantitative easing all the rage, are central banks set to battle it out to see who can print the most money?

Central banks are not typically caught up in efforts to stimulate the economy.  Their role typically involves maintaining inflation near a target level.  However, the persistent stagnation in the global economy combined with high levels of debt in many countries has taken away governments’ abilities to revive the economy through increased spending or lower taxes.  As such, central banks have been enlisted to combat the worst economic slump since the Great Depression.  Quantitative easing was initially called into service as a boost to the economy but its effects on the currency markets have not gone unnoticed.

The latest salvo which has ramped up tensions was the Bank of Japan (the central bank in Japan) raising its inflation target from 1% to 2% following political pressure from the newly elected government in Japan.  It is not the action of the Japanese central bank that is causing concerns but that the Bank of Japan acted under a barrage of pressure from the government.  It is seen as crucial that central banks are allowed to operate for the good of the economy free from outside influences.  This independence from political pressure is the crux of the argument for central banks being entrusted with monetary policy (see More Power to Economists for more on why this is the case).

The flip side of the coin is that Japan has fallen victim to peculiarities of the currency markets following the onset of the global financial crisis in 2008.  Normally, the value of a currency would fall when the economy is doing poorly but the opposite has happened to the yen which surged in strength from above Y120 per US$ in 2007 to below Y80 per US$ in 2012.  So, as well as a recession in their home market and a drop in global demand for exports, Japanese business were under fire due to a strong currency resulting in the prices of goods exported from Japan becoming more expensive in foreign markets (for more detail, refer to Yen as Weathervane).  As a result, Japan posted its largest ever trade deficit in 2012 which is a sharp turnaround for a country known for its exporting prowess.

The new stance by the central bank in Japan had the desired effect with the yen dropping back above Y90 per $US but the plunge in the yen is based on market expectations of what could happen as the Bank of Japan has yet to do anything.  Furthermore, it is even unclear on what Japan’s central bank will do to work toward a “medium to long-term” goal of 2% inflation.  The Bank of Japan has not had any luck in lifting the country out of deflation and reaching its prior target of 1% inflation so it remains to be seen whether the shift in stance will have any effect.  An immediate change is the further politicization of central banks who have gradually been given more responsibility for the economy than was part of their initial remit.  The use of monetary policy as means of manipulating the currency is now in the sights of policymakers across the globe.  This poses the question - do other countries dare follow Japan’s lead?  There might be a sequel: ‘Currency Wars - Return of the Printing Presses’?

When Keynesian Policies won’t work

Japan is set to try yet another fiscal stimulus but this is more about politics than following the ideas of Keynes.

Keynesian policies has made a dramatic return after been shunned as a viable policy option.  Firms and households have reined in their spending due to uncertainty over the future while banks cut back on lending after the global financial crisis.  The resulting slump in demand has opened up a role for governments to fill the gap in spending which is the core premise of Keynesian economics.  But this government action is only ever meant to be a stopgap to boost demand until normal economic conditions resume.

So a stimulus package after an economy has been stagnating for two decades is beyond what Keynes would proscribe.  But this is what the government in Japan is set to embark on.  As well as a likely waste of money, the extra government spending is also a worry considering the high level of public debt in Japan and previous stimulus policies which have resulted in a glut of public works being carried out leaving Japan with lots of roads and bridges which are hardly used.  But worst of all, it is used as an excuse to put off reforms needed to rejuvenate the economy and may doom Japan to another decade of missed opportunities for economic revival.     

The newly elected government, head by the new Prime Minister Shinzo Abe, released plans this month for a stimulus package worth 10.3 trillion yen (US$116 billion).  Abe has also bullied the Bank of Japan into lifting the target for inflation from 1% to 2% as part of a push toward more aggressive policy to get the country out of deflation.  But this is the same prescription that has been administered before in Japan and the outcome will probably be the same too – a short term boost bought with more debt.  To add to this, the Liberal Democratic Party (LDP) which Abe heads does not have the best track record.  Its previous numerous stimulus packages have been more notable for extending the LDP’s hold on power through building needless infrastructure in remote regions to secure votes.  The LDP maintained its stranglehold on Japan for over 50 years of almost uninterrupted rule and was only voted out of government in 2009 despite presiding over two decades of economic stagnation following the bursting of one of the largest ever asset bubbles at the end of the 1980s. 

The LDP is expert at looking as if it is doing something while not actually dealing with the core problems, but even more perversely, it is making things worse by adding to Japan’s mountain of debt.  Government debt in Japan which reached 237% of GDP in 2012 – the highest among developed countries.  Government debt is still increasing at a rapid rate with a budget deficit of 10% in 2012.  Japan’s only saving grace is that it is mostly Japanese banks buying government bonds and Japanese savers have tolerated the meagre returns which banks have been able to offer up as a result.  So Japan has been saved from a debt crisis like that which has plagued Europe but it has also allowed politicians to put off making the necessary changes and ballooning debt must eventually have consequences such as higher interest rates which may trigger bigger problems. 

The persistent sluggishness of the Japanese economy suggests that it is not a shortfall of demand that can be fixed by a fiscal shot in the arm but changes need to be made to help the economy work better.  For a country that relies heavily on exporting, it is relatively closed off to imports which reduces competition and results in higher costs for households and businesses.  Japan has many global firms but it is also a tough place to start a business.  Wages and prices also need to be able to move so the economy can adapt to new circumstances.  Change in Japan will not come from the policies enforced top-down but need to bubble up from below through the activities of individuals and start-ups and the government just need to put in place the reforms to make this happen.  Yet, there are few signs of this happening even after an economic slump lasting over two decades.  It is a scary look into the future for leaders in Europe.

The King is Dead - Long Live the King

Your Neighbourhood Economist fondly remembers his first Walkman.  It was red.  And it was a Sony.  Like the Walkman in question, Sony was the pick of the bunch at the time but its best days seem to be well behind it.  Like other Japanese electronics manufacturers, the qualities that propelled it to global dominance have also prompted Sony’s fall from the top.  Sony recently announced that it expects to post a bigger loss, a record net loss of 520 billion yen (US$6.4 billion), for the financial year than ended in March 2012.  And it is not just the one year - Sony has lost money in each of the past four years.

The immediate cause of Sony’s malaise is its television manufacturing division.  Numerous firms churning out flat screen TVs has resulted in a rapid decline in prices for TVs and Sony (and other Japanese firms) has been unable to cut costs faster enough (but we as consumers benefit from cheaper TVs).  Japanese firms such as Sony are suffering the same fate that they inflicted on their US rivals in the 1980s when the small upstarts with lower wage costs managed to snap up a growing proportion of the market.  Now it is the turn of the rise of South Korean and Chinese firms to rise to dominance. 

Life at Sony was easy to begin with.  There was a clear goal – to copy and improve on the products of US firms.   It had a motivated and loyal workforce stemming from a consensus style of management and the group orientated nature of Japanese society.  Sony also benefitted from the government providing an environment which was good for exporters and with less of the rigours of competition which meant that Sony could apply itself to a different range of products.  So Sony pushed into a wide range of products and sacrificed profits while it built up a growing share of the market.  

But once Sony had risen to the top, it lost its way.  Japanese firms are good at playing follow the leader but struggle to innovate on their own.  This is because betting on new technologies at the cutting edge of electronics is difficult with a system of consensus management.  Its prior diversification proved to be a distraction to management who should have been focusing their and the firm’s efforts on core areas.  And discarding of unprofitable areas is not easy when you have amassed a large corporate family that had worked to the bone previously.  Sony still remains a scattered group of businesses with 6.4% of its 2011 sales coming from its music business, 8.3% from movies, and 11.1% from financial services. 

So Sony ended up losing its focus and has lost out to rivals in mobile phones and tablets (Apple and Samsung) and in game consoles (Nintendo – a much smaller firm which has shown that a few Japanese firms can innovate).  Further damage has been inflicted by a strong yen (which hurts Sony as an exporter from Japan) and weaker demand due to the global recession and the electronics giant is on the ropes.  A recent announcement by a new president that the firm would cut 10,000 or 6% of its global workforce will probably only help a bit considering the firm requires a major overhaul.

But as much as Your Neighbourhood Economist laments the decline of Sony, the rise and fall of different companies is a fundamental part of how the system of capitalism provides consumers with what they want.  Sony had its time as the favourite of consumers but firms like Samsung have managed to do a “Sony” on Sony and provide more attractive electronics at better prices.  And it means we can look forward with anticipation of what comes next after Apple and Samsung!

Yen as weathervane for global economy

Recent previous postings in this blog had looked at where investors move their money in the good times and the bad.  The choice is not limited to just stocks and bonds but also to what currency to invest in.  One currency more than all others has seen its fortunes dominated by the global flow of money, the Japanese yen, and has sometimes had to pay the price.

In economic text books back when Your Neighbourhood Economist was at university, currencies were determined based on trade flows.  If a country exported more goods and services than it imported (a positive balance of trade), its currency would rise.  The higher currency would mean that the price of exports increased and imports decreased so that the balance of trade would head back toward zero. 

However, globalization has meant that the flow of goods between countries has been overwhelmed by a flood of cash and so it is this that dictates the value of a currency.  Investors now move their money into countries that were growing and as a result had high interest rates.  Cash inflows into a country would lift the currency and raise the value of any investments in that country giving investors a boost to their returns. 

With money becoming increasingly easy to come by, investors came up with a new trick – borrow money in a country with a low interest rate and move it somewhere with a higher interest rate.  This is what is known as the carry trade and is where the yen comes in.

The Japanese economy has been in the doldrums after the bursting of a massive investment bubble in the late 1980s.  Its interest rates have been close to zero for a long time so investors could borrow in yen and invest in bonds in other countries with relatively low risk.  The carry trade also resulted in the yen being weaker than it normally would have been, because investors would sell the yen that they had borrowed, despite a large balance of trade and other factors that should have been driving the yen higher. 

The yen thus became a gauge of the world economy.  As long as interest rates elsewhere remained high on the back of a buoyant global economy, the yen would stay weak.  On the other hand, an economic downturn would lower interest rates globally and prompt investors to buy yen to repay their borrowing which caused the yen to rise.  So there was a link established whereby the yen was the currency to hold if an investor was pessimistic about the global economy.  That interest rates in Japan were close to zero didn’t matter as interest rates would be low everywhere during a global downturn.  Thus, the yen became a safe haven where investors would park their money when the economy turned bad.

The result of this is that, despite the onset of a recession both globally and in Japan, the yen was rising.  This was a major blow to Japanese manufacturers which export lots of TVs and cars and are the mainstay of the Japanese economy.  Perhaps, most perversely of all, the tsunami that devastated the Japanese northeast prompted a further rise in the yen.  This was because the havoc caused by the tsunami was seen as being bad for the global economy due to its effect on Japanese business in the region which supplied parts to many international firms.

The yen reached peak of above 120 yen to the US dollar in mid 2007 to almost 75 yen to the US dollar early in 2012.  So a jump in the yen to near 85 yen to the US dollar in March sparked interest that the direction of the market was about to change.  The upturn in the yen was triggered by an announcement of further easing by the central bank in Japan which comes at a time where other central banks are winding down their efforts to prop up their economies.  But little respite is expected for the Japanese economy until the interest rates else where such as in the US rise further.  For now, Japan looks stuck with a currency which is more of a weathervane for the global economy than a currency that reflects its domestic economic climate.