Market Overview

Bank of Japan Unfairly in Political Crosshairs

Bank of Japan Unfairly in Political Crosshairs

Parents in Japan scare their children by telling them that they will one day grow up to head the Bank of Japan (BoJ).

Current BoJ governor, Masaaki Shirakawa, has been under intense political pressure to do more to end Japan's deflationary spiral. He has been accused of being too timid or too afraid of inflation to go all out to rescue Japan from more than two decades of stagnation.

Personally, I think this criticism is most unfair. Of course, it is easier for politicians to criticize the central bank than it is for them to take the politically difficult steps that might actually improve the situation. I think that there is a way out for Japan but it runs completely counter to the calls for “unlimited stimulus," inflation targeting, negative interest rates and massive bond purchases that are now being called for.

Politicians simply will not acknowledge that there are limits to what a central bank can do. Japan is awash in money.

The BoJ has printed so much money it would make Fed chairman “Helicopter Ben” Bernanke blush.

The Bank of Japan buys trillions of yen worth of Japanese government bonds (JGBs) from the secondary market every month.

The central bank has bought Japanese real estate investment trust (JREITs), Japanese stock market index ETFs and has directly purchased corporate debt yet the Japanese economy continues to be caught in a vicious cycle of sluggish growth, hampered by a strong yen and declining prices.

For all of the money that has been created by the Bank of Japan, the central bank has still not convinced Japanese corporations, banks and consumers to spend.

This is illustrated by the velocity of money. For those of you who do not have Economics 101 textbook handy, this is nominal GDP/money supply (usually M2+CD). In theory, as a central bank creates money, it circulates in the economy as it is lent and spent, creating GDP. In the U.S., until recently, the velocity of money was around 1.4, which means that, for every $1 created by the Fed, the economy grew by $1.40.

In Japan, the velocity of money is about 0.55. So, for every 100 yen created by the Bank of Japan, the economy grows by 55 yen. This is what is called a liquidity trap. The money is out there. It just isn't being used.

In this case, it seems to be counterproductive to continually print more and more money if it isn't going to show up in the economy anywhere. It just puts more of a strain on the Bank of Japan's balance sheet without doing anything to spur economic growth. This is the fallacy of quantitative easing in a zero interest rate environment.

In the early 2000s, the Bank of Japan embarked on a policy of quantitative easing—ostensibly to boost the economy—but it didn't really help because banks were not lending and consumers were not borrowing. However, the Japanese banking crisis was at its peak at that time and there was a genuine concern that some of Japan's biggest banks might fail.

What quantitative easing did—and very successfully I might add—was to provide a liquidity cushion in the event that a major bank went under. With so much liquidity in the money market, a single bank failure, no matter how large, would not end up being a system-wide crisis because the BoJ had ensured that there would be more than enough liquidity in the system to prevent one bank failure from becoming a string of bank failures because of a lack of liquidity.

Once the banking crisis was over, the central bank ended quantitative easing and withdrew the surplus liquidity from the market. Adding liquidity to the money market did not increase economic activity and taking it away did not decrease economic activity.

A central bank can change interest rates and adjust the amount of money in the system. It can't make people save or spend.

Japan's politicians seem to think that, even though there is way too much money in the Japanese economy now, if only there were a little bit more, people would stop saving and start spending.

Theoretically, if it costs nothing to borrow, which is the case at zero interest rates, then there should be infinite demand for money.

But that is only looking at one side of the equation. In a deflationary environment, the best thing you can do with your cash is to hang onto it. The value of cash rises when there is deflation. It costs nothing to hold onto cash and, unless there is a fire or a tsunami that wipes out your hiding place or your kids find it, there is no risk to holding cash either.

If interest rates are at zero, there is no reward for investing so you keep your money in your pocket.

The only proposal from the politicians that makes any sense at all is to charge negative interest rates on cash balances. If people have to pay to keep money in the bank, then they might choose to spend it instead. Or they might choose to take it out of the bank and put it in a drawer.

In my opinion, the only way out of the current situation is for Japan to raise overnight interest rates to say 1.5% or 2% and let the rest of the yield curve follow. By raising rates, you create a reward for investment and a penalty for not investing. All of the cash that has been hoarded in dresser drawers and hollowed out walls will come pouring out, looking for a return.

Of course, no politician will ever agree to raise rates in the midst of deflation so the status quo will continue. The BoJ will print more money and purchase more assets, deflation will persist and the yen will strengthen.

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