As I write this post, the yen has broken below 100 to the U.S. dollar and the Nikkei has closed at a five-year high. So surely Abenomics is working, isn’t it? Well, it is certainly pushing up asset prices. Indeed, if I were still in my old job as a Japanese equity hedge fund manager I would have swung the bat as hard as I could after Bank of Japan Governor Kuroda’s original April 4 announcement. And I would plan to keep swinging the bat well into the future. Indeed, if my risk manager was not having a heart attack by now, I would feel I had not done my job properly.
Strange as it may seem, this is the logical path to follow given that Kuroda has based his analysis lock, stock and barrel on New Keynesian monetary theory. The two canonical papers that sit behind this are Paul Krugman’s “It’s Baaack! Japan’s Slump and the return of the Liquidity Trap” and Gauti Eggertsson and Michael Woodford’s “The Zero Bound on Interest Rates and Optimal Monetary Policy”. The Eggertsson and Woodford paper, which we can think of as Krugman 2.0, has become the intellectual bedrock for the Fed in fighting deflation and is much quoted by Fed Governor Ben Bernanke.
Both papers are difficult reads for the non-economist, but, as I mentioned in my previous post, the Richmond Fed has made available a “A Citizen’s Guide to Unconventional Monetary Policy” for non-specialists that contains the core policy prescription of the two academic papers referred to above. From A Citizen’s Guide, the critical passage is this:
In the Eggertsson and Woodford model, the com- mitment to making monetary policy “too easy” would only stimulate economic activity if the commitment is viewed by the public as highly credible. That is, markets must believe that the central bank will, in fact, hold rates “too low” in the future simply because it promised to in the past, despite the fact that at that point, it would wish to raise rates to avoid inflation.
Krugman, ever the wordsmith, put this more succinctly:
The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible…
Now we now that asset price inflation operates on a different time scale to consumer price inflation: indeed, Japan’s stock price indices are already up 50% from their December lows, while consumer price inflation has barely budged. Nonetheless, to whatever level asset prices go, Kuroda has to keep his mouth firmly shut to have any chance of the changing public perceptions of future inflation. He is not allowed to make Greenspan-type gnomic references to “irrational exuberance”, let alone pull back from Japanese government bond buying. He must drive Japan’s monetary policy as if he was in one of those defective Toyota cars that was recalled due to a faulty accelerator pedal that got stuck to the floor.
This, of course, is a bubble meister’s charter, since for Kuroda to succeed in changing consumer expectations he must keep the accelerator pedal depressed for years. It is also worth keeping in mind that the Bank of Japan’s newly minted 2% inflation target is only an intermediate goal. As I explained in my last post, what monetary policy is really trying to achieve here is the closure of an output gap, i.e., the difference between where the economy is currently operating and where it could be operating if labour and capital were fully employed.
Moreover, the problem is perceived as one of lack of demand, not supply. The idea is that households won’t spend today because they think goods will get cheaper tomorrow. In effect, even if they hold cash at the bank earning zero, deflation means that they are getting a comfortable real return. The policy goal a la Krugman, Woodford and Eggertsson is to make that real return negative. And the only way to create a negative real return when interest rates are zero is to have inflation. If you can persuade the populace that inflation is barrelling toward them in the future, then they will cut savings and increase consumption now—or so the theory goes.
In addition, if the economy is idling below potential with unused capital and labour, any sudden jump in demand will result in high productivity and economic growth. Growth, in turn, will lead to higher wages and greater government tax receipts. Thus—and this is where the magic of macroeconomics comes in—the act of spending more now results in higher wages and living standards in the future.
Surely, a classic win-win: more consumption and more growth. What’s not to like? Nonetheless, there are a number of problems. First, how smoothly this all works depends to a large degree on the extent of the output gap. An article by Gavyn Davies in The Financial Times takes a look at the difference between output gaps if we just extrapolate past growth and those if we take into account supply side phenomenon (click for larger image) for a number of countries.
He explains the graphs in more detail:
The graphs compare a simple extrapolation of the pre-2008 trend for GDP (red lines) with various estimates of potential GDP made by official bodies such as the IMF, OECD and the Congressional Budget Office in the US. The estimates of these official bodies are all made with similar “fundamental economic” methods, which attempt to allow for developments in labour supply, the capital stock, total factor productivity and the natural rate of unemployment, or the “Nairu”.
The implication of these estimates for potential GDP is that about two-thirds of the shortfall in GDP relative to the linear trendline in the G4 countries has been due to supply side phenomena, notably the low level of capital investment, the fall in underlying productivity growth as the IT revolution has waned, and a rise in the Nairu. For the US, real GDP at present is 13 per cent below the linear trendline, but only 4.2 per cent below the average of the three “fundamental economic” estimates shown for potential GDP.
This is the exactly the argument I have been making in my previous posts. Japan’s growth decline is principally a supply-side issue—the direct result of an ageing workforce and slower productivity gains from technology. If, therefore, Japan’s output gap is relatively small, gluing Kuroda’s accelerator pedal to the floor has a number of downsides.
To try to get an understanding of the potential dangers of unconventional monetary policy, I think it necessary to look at some individual actors within Japan’s economy and guess how they will react.
We can get some more detail by looking at the table below from Japan’s Institute for Population and Social Security Research. From the table (click for larger image), we find that 33.7% of Japanese households are headed by someone of the age of 65, 26.2% with a head between 50 and 64 and 40.1% below the age of 50. In other words, 60% of the population is in either in retirement or, for those in their 50s, likely to be making retirement planning a key factor in all their savings and spending decisions.
Next, we can take a look at where consumption actually goes in Japan (taken from the Family Income and Expenditure Survey here, click for larger image):
From the table, we can broadly package three of these categories as ‘necessities’: food, utilities and medical expenses. Even faced with negative interest rates, consumption of these items will not be brought forward. Indeed, for those in or near retirement, I would suggest that the prospect of inflation raising the price of future necessities is likely to prompt more savings not less. Moreover, food and utilities have a high import component, and so their prices will rise the fastest of any consumption goods following the rapid depreciation of the yen in the wake of Abenomics. And the elasticity of necessities is, by definition, low. People have to consume these goods by necessity and will substitute out of other non-necessitities to do so if necessary.
For the non-necessities, the marginal propensity to consume generally declines with age. That doesn’t mean that the elderly save more as they get older; they in fact dissave due to falling income as they retire. But they are unlikely to dissave more faced with a negative real interest compared to younger households.
I am not saying that Abenomics will have no economic impact. We can, for example, see from the March consumption numbers that housing expenditures have jumped. This is likely to be the response of the Japanese baby boom echo generation (the 4o something children of the baby-boomers) jumping into the housing market due to the prospect of asset inflation. In other words, the impact is coming through asset prices not general prices. But this is likely to be a short-lived phenomenon. Over 60s will not be rushing out to buy new homes and behind the baby boom echo generation the population cohorts slump.
So who is the overall beneficiary here? Obviously, those who have risk assets.
It is difficult to find up-to-date wealth distribution statistics for Japan, but the OECD shows the top 10% of Japanese households owning 40% of total wealth as of 1999; as in the rest of the world, I expect the concentration of wealth to have increased since then. In addition, overall wealth in Japan is split pretty evenly between net financial wealth and non-financial assets (principally property). For the numbers, see a recent paper by Charles Horioka comparing Japan with six other advanced nations. Further, from the Bank of Japan’s Flow of Funds publication, we have an understanding of what financial assets Japanese households hold (click for larger image).
Such assets are mostly cash in banks plus illiquid private insurance and pension holdings. Stocks are only a very small part of net financial wealth. Kuroda’s inflation guidance is a direct assault on the bank deposits as he is attempting to create a negative interest rate via inflation. In response, households have four choices: 1) move the yen deposits into some kind of foreign currency-denominated asset, 2) buy Japanese equities to try to secure an equity premium that overcomes the negative interest rate, 3) buy property or 4) bring forward consumption of non-necessities. Accordingly, it can easily be seen that two of the four possible responses will not directly increase demand and close the output gap, and a third, buying property, will only work in the unlikely event that the property price surge prompts a new building spree—inflating prices in the secondary property market will do little to close the output gap.
At the same time, we need to look at what happens to younger households who own few assets and rely on income to build wealth or poorer aged households with few assets. In their case, Abenomics will immediately result in a jump in the price of necessities via the depreciating yen. They cannot hedge any of this by shifting bank deposits abroad or buying property or shares since they don’t have large savings. Accordingly, unless the new monetary policy feeds through to higher incomes quickly, they are worse off. Indeed, there is a direct transfer of wealth: monetary policy is boosting the price of risk assets (stocks and shares) but reducing the value of yen earnings due to the currency’s fall. The wealthy, who have risk assets, should be happy; the people of modest means, who don’t have risk assets, should be hurting.
If you wanted to close the output gap in a more efficient manner, then the Bank of Japan should have distributed currency evenly to all households and promised to keep doing so until 2% inflation had been reached. That would have been a much more equitable and efficient way of increasing demand without going through asset markets—but perhaps is an unconventional step too far.
So what is the worst that could happen pursing this path? Easy. Those with financial assets made up of mostly cash will flee into hedges: assets that are unlikely to suffer negative real interest rates. Such assets include foreign denominated assets, shares and perhaps property. This will all lead to a sharp fall in the yen and the creation of an asset bubble, but with only a minor closure of any output gap (if one should exist).
The sharply falling yen, in turn, creates cost-push inflation via imports causing real wages to fall. Japanese firms will see increased profits but are very unlikely to return these to employees. Japan has been part of a global structural trend seeing firms taking an ever larger share of national income over the years (profits) and employees taking a smaller share (wages). Why would this change?
Critically, whether the economy is strong or weak, Kuroda still isn’t allowed to tap his foot on the brake (the monetary theory he has signed up to requires total commitment going out years). In other words, the government bond buying must continue regardless of yen depreciation, asset bubble formation or economic performance in general. Only when general inflation is etched into expectations can any change be made.
Nonetheless, the initial exhilaration over the stock market rally will soon wear off, as most households (who are non-risk asset holders) will see their standard of living fall. Before long, Prime Minister Abe’s popularity rating will also likely head lower. At some particular tipping point, Kuroda will lose political cover from the ruling Liberal Democratic Party and the financial markets will start to sense that the central bank might blink after all.
As with all asset bubbles, the winner is he or she who times the exit best. A wise market sage once told me “if you are going to panic, panic first’. But once one or two jump on a hunch that Kuroda is losing his nerve, the market will go into an epic rout, devastating consumer confidence among households rich and poor.
By now, however, the Japanese government bond market will also been compromised since its natural buyers will have been forced into other assets purposefully by Kuroda, leaving the Bank of Japan as the sole bidder in times of stress.
Indeed, should markets and the economy swoon, the Bank of Japan will come to own the Japanese government bond market. And this will be at the very time when central government revenues are collapsing (along with the asset bubble) and bond issuance is shooting up again to plug the yawning fiscal deficit. Amidst the growing pandemonium in all markets—stock, bond and foreign currency—those who are early to extract themselves from yen-denominated risk assets have only one place to go: abroad. The yen, therefore, will take another sharp movement down, leading to further cost-push inflation (and perhaps capital controls).
Who is going to benefit most from all this? That’s easy. The hedge fund community. Kuroda’s commitment to be credibly irresponsible is much better than the ‘Bernanke put’. You can short the yen or buy the Nikkei knowing that every time the trade loses steam, Kuroda will be forced to pump it up again to maintain credibility. Then you wait until Abe’s political capital is so drained that he is unable to give Kuroda cover. At that point, you short the hell out of the Nikkei. The government will be handing you money on both sides of this trade: it is better than the breaking of the British pound by George Soros back in 1992.
Of course, this monetary experiment will have a cost in terms of a lower standard of living for the Japanese people through the collapse in the yen and general financial market instability. We should also keep in mind that Japan was doing just fine before all this started (in total contradiction to the media contrived public perception) as former Governor Shirakawa favourite chart shows (click for larger image):
Finally, it was, of course, Keynes himself who talked about the baleful influence that academic economists could occasionally exert:
But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
Paul Krugman reproduced this quote approvingly in a blog post in 2011. But irony upon irony (and generally I am a huge admirer of Krugman’s work), I think it is Krugman himself who, in Japan’s case, is the academic scribbler providing distilled frenzy for the madmen in authority: Abe and Kuroda. And in so doing he is setting up the hedge fund trade of the century. Is a strange old world.