By Marshall Auerback, a portfolio strategist who writes for New Deal 2.0
Something is very wrong with Japan.
The Japanese economy has been much weaker than any other major economy for a while now: over the last business expansion, through the Great Recession, and in the recovery since the Great Recession trough. Japan’s business cycle has been led by its exports for well over a decade. It has been my guess that overinvestment in industrial tradeables by Japan’s Asian mercantilist competitors, especially China, along with yen strength has been seriously undermining the Japanese economy for some time. The recent all-time new highs in Chinese overinvestment and this year’s crazy yen strength would only accelerate this process and might well presage what lies ahead for the rest of the world, especially the US.
Throughout the past month, the data coming out of Japan has uniformly poor. This data — especially a METI forecast for a coming 3% decline in industrial production in the next two months — has been of a particularly gloomy and alarmist nature, especially from an organization such as METI, which has tended to be overly optimistic in its forecasts. But the data now says Japan may already be rolling over into a recession despite a growing global economy and a booming neighboring China. The markets right now with their yen “bid” seem as “out to lunch” regarding Japan as they were out to lunch regarding Europe last May/June, when the ECB contained an incipient currency/solvency crisis by backstopping the nations’ respective bond markets.
What to do about Japan? Both Federal Reserve Chairman Ben Bernanke and economist Paul Krugman recommended to the Bank of Japan over a decade ago that it adopt a significantly positive inflation target and conduct monetary policy with that objective. Bernanke suggested that the Bank of Japan do this by buying foreign exchange and issuing monetary base until that target was reached. Similarly, in the recent Democratic Party of Japan (DPJ) leadership election campaign, challenger Ichiro Ozawa argued for such an inflation target for the Bank of Japan.
Although Naoto Kan retained his leadership position (and, hence, remains the country’s Prime Minister), there are indications that he has begun to embrace much of the Ozawa platform. About a week ago, the Kan government moved to purchase significant quantities of foreign exchange through unsterilized issuance of yen in order to depreciate the yen. But it has not followed through after an initially promising start.
Unless the Bank of Japan follows Ozawa’s recommendation and conducts foreign exchange intervention on a scale consistent with ending deflation and reestablishing inflation, it will probably fall short of the policy actions needed to weaken the yen. This cannot be done through quantitative easing per se. I have argued before that QE in terms of targeting reserve balances is ineffective. It is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves, then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending. Right?
Wrong. Bank lending is not “reserve constrained”. Banks lend to any credit-worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves, then they borrow from each other in the interbank market. Or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves. But whereas a policy to target reserves might be in effective, this does not appear to be the objective right now in terms of what the Federal Reserve is currently doing in the US. In effect, it is trashing bonds as well as cash (getting bond yields lower through the promise of additional, but as yet undisclosed, measures) and inciting investors into risk assets, notably equities, on the premise that this will increase spending. In effect the Fed is targeting equity prices as a means of buttressing consumption.
Will it work? With the private non financial debt to GDP ratio still at 170% and only ten percentage points off its highs it appears that there are very high risks in the Fed’s approach. The markets may well call “Helicopter Ben’s” bluff and a failure to see some positive economic outcome from the embrace of outright QE could well cause a serious crisis of confidence in the US markets.
But let us take Japan; clearly, a very different situation pertains. For one thing, Japan can buy foreign exchange and sell yen forever and get the exchange rate down. The BOJ has done so in the past and these interventions have for the most part been successful. The exchange rate matters far more for Japan, whose ratios of exports to GDP and industry to GDP are far higher than in the US. Furthermore, if Japan manages to reverse deflationary expectations, there may be a real financial and real response. Japan has reduced its ratio of private non financial debt to GDP by FIFTY percentage points, not ten. There is more scope for loan demand. More important, in addition to less private debt, the liquid assets held by the private sector in Japan is just huge. The ratio of M3 to GDP has gone from 105% to 164% in twenty years. The public holds huge quantities of government bonds and, if the Japanese public thought they might not earn anymore the real return generated by deflation, the BOJ could well “chase” the public into a different category of risk assets, such as equities.
Japan has been experiencing a post-bubble adjustment for twenty years. The adjustment process in the US, by contrast, has been going on for a mere two years. It makes a difference. An aggressive intervention by way of forex purchases might really work for Japan.
But what is the alternative? We have just experienced a hint of that: the country’s largest consumer finance company, Takefuji, has just filed for bankruptcy. Deflationary pressures are intensifying again. There has generally been a high correlation between Japan’s ratio of fixed investment to GDP and its ratio of exports to GDP. Both went up in the 2000s into 2008 when the economy began to grow again. However, by 2008 the export growth was slowing. Economist Andrew Smithers blamed it on economic growth in Japan’s trading partners, which he argues was slowing.
Perhaps, but a more plausible thesis is that by that time China was starting to seriously compete with Japan’s export machine. Consider what happened to the Japanese economy in 2008: exports fell by almost forty percent, and of course fixed investment fell in turn. Even more striking is that Japan’s exports have recovered less than any other major economy post the Lehman induced catastrophe — likewise with its GDP. In spite of 20 years of largely subpar growth (with the notable exception of 2003-2007), the Japanese economy’s resilience in the face of ongoing external economic shocks has proven to be quite feeble, particularly in relation to its Asian competitors, especially China. It appears that a combination of Chinese technological advances and overinvestment, along with a super strong yen/dollar exchange rate has created the beginnings of a hollowing-out effect in Japan.
More economic data has come out in the latest Japanese tankan to confirm this abysmal picture. August industrial production fell -.3%. The consensus was looking for a rise of 1.1%. Industrial production is now below the level of January.
Worse yet is the METI forecast for industrial production in September and October. Companies who responded to the Meti survey expect a-0.1% decline in September and a -2.9% decline in October. These METI forecasts are often very wrong. So such a future decline is not set in stone. But my experience is when Japan’s industrial production is moving towards weakness these forecasts are too optimistic. Throughout this year, as industrial production has flattened and began to fall, the METI forecasts, which were consistently predicting significant rises in future months, have proven to be too optimistic. Other data appears to confirm the prevailing gloomy picture. Earlier last September, Japan recorded a large monthly fall in export volumes. Over the previous two months of July and August, the average level of exports at 3.8% is below the average of May and June. The Japan manufacturing PMI is also falling and is now below 50.
Tomorrow, I’ll examine the specific impact of China’s policies: how it has adversely impacted Japan and what it might portend for the US in the future.