Abenomics Contradictions

As our readers know, we have been very critical of most of the facets 'Abenomics' ever since it was instituted. You may wonder why we say 'most' and not 'all' facets. This is because the vaunted 'third arrow' of Shinzo Abe's economic policies, namely the long promised fundamental reforms of the labor market and other stultified features of Japan's economic system, would meet with our approval. The problem is of course that Abe seems to have mislaid the 'third arrow' somehow.

Similar to other would-be reformers that came before him, he is probably loath to confront Japan's vested interests. Consensus is regarded as very important in Japan. Challenging vested interests means however that one needs to veer off the path of consensus and risk confrontation. Still, let us keep an open mind about the 'third arrow' for now. Perhaps it will still materialize.

Unfortunately, we believe that Abe is much more concerned with his true non-economic agenda: namely implementing his nationalistic and militaristic dreams, which he inherited from his grandfather. Needless to say, nationalism and militarism don't mix well with the free market.


What prompts us to revisit the topic of 'Abenomics' is a recent article in the Japan Times that discusses the BoJ's inflationary policies. While conceding that a large portion  of the public appears to believe that the plan is 'working', it points out that many prominent and knowledgeable critics already consider it a failure. This should be no surprise, as the policy is riddled with contradictions, and harbors grave dangers to boot.


More than six months have passed. How has the BOJ’s strategy changed Japan’s financial markets and the real economy? Critics say Kuroda’s monetary easing scheme isn’t working, although most of the public apparently believes otherwise.

There are growing signs of inflation, but not the sort heralding the start of Abe’s much-advertised recovery and rising wages. Instead, imported fuel and other products have become more expensive because of the weak yen ushered in by Kuroda and Abe, and this bodes ill for the public’s living standards.

Meanwhile, Kuroda’s aggressive plan is allowing the debt-ridden government to issue fresh bonds continuously, further increasing the likelihood of a fiscal crisis, they said.

“People have been deceived by ‘Abenomics,’ ” Yukio Noguchi, a prominent economist and adviser to Waseda University’s Institute of Financial Studies, told The Japan Times in a recent interview. “Monetary easing is not working, and it’s going nowhere,” Noguchi said.


(emphasis added)

As we have always pointed out, Japan's aging consumers need inflation about as urgently as a hole in the head. An ever greater proportion of Japan's citizenry depends on fixed income, in the form of pensions and interest returns on savings. The living standards of this part of the population are certain to decline if Kuroda succeeds. However, the situation is not much better for wage earners. Wages are not increasing and hence fail to compensate for the rise in the cost of living. More on this particular point follows further below.

Secondly, the government that is already burdened with the greatest public debt of all industrialized nations, is getting a 'free pass' to continue with its fiscal profligacy. This is no longer merely a 'morality play' as Paul Krugman would say, who along with his fellow Keynesians has always supported more deficit spending and more inflation to get Japan out of its 'slump'. Following this advice has not only perpetuated the economic malaise, but has in the end saddled Japan with a debtberg that by now poses a major risk to the entire world. It should be clear that if and when a fiscal crisis strikes in Japan, it will leave no corner of the global economy untouched.


The BoJ's Activities

Next the otherwise praiseworthy article falls prey to what is a quite common error in both the financial and non-financial press regarding the workings of the modern-day central bank-directed fiat money system. It concerns just a technicality, but it is worth pointing it out, since journalists the world over tend to repeat this error with unwavering regularity.


“Since April, the BOJ has been gobbling up JGBs from banks and the open market. Its purchases amount to roughly 70 percent of the value of all new JGBs issued. But the banks are just stowing that money in their accounts at the BOJ because they can’t find any companies interested in borrowing it. “There is no demand for funds on the part of businesses. That’s why the monetary easing is not working,” Noguchi said.

Japan’s monetary base — the sum of cash in circulation plus banks’ current account balances at the BOJ — surged from 23.1 percent in April to 45.8 percent in October, thanks to the BOJ’s aggressive operations. But its money stock — the total amount of monetary assets available in an economy including credit created by bank loans, but excluding deposits held by financial institutions and the central government — only rose to 3.3 percent from 2.3 percent in the period.

This means banks are just depositing the massive funds provided by the BOJ in their own accounts at the central bank. The unloaned cash is thus having little effect on the real economy.”


(emphasis added)

The error is contained in the sentences highlighted above. It is not the case that 'banks are just stowing away their cash at the central bank and not lending it out'. This would imply that the excess bank reserves that are piling up on the liabilities side of the BoJ's balance sheet can themselves somehow be lent to the public. This is not the case.

Banks can use excess reserves in only two ways: for interbank lending (whereby banks holding cash assets in excess of reserve requirements lend reserves to banks that are short of required reserves), and to pay out cash currency to customers who wish to draw down their demand deposits in the form of cash. In the former case, reserves just move to and fro within the banking system, but remain deposited with the BoJ (only their temporary ownership changes). In the latter case, excess reserves held at the BoJ will be drawn down, but currency in circulation will increase to exactly the same extent, once again leaving the liabilities on the central bank's balance sheet unchanged (the central bank's liabilities consist mainly of its capital, currency in circulation and bank reserves). The money supply would be left unchanged as well, as people would merely be transforming money substitutes (deposit money) into currency.

However, it is of course true that in spite of the BoJ's monetary pumping and swapping of interest bearing assets for bank reserves (the main goal of which is to suppress long term interest rates), bank lending remains anemic in Japan. It is actually regressing. Commercial banks continue to decrease the total amount of credit and fiduciary media outstanding. They are in fact doing so at an accelerating pace. The only reason why Japan's money supply is growing at all is that the BoJ also occasionally buys assets from non-banks, which creates both new bank reserves and new deposit money (since bank reserves and deposit money are created in tandem on such occasions, the new money  consists of covered money substitutes).

This is what the situation looks like at present:



BoJ credit

Total BoJ credit outstanding and its 12 month rate of change (currently at 38.9%) – click to enlarge.



Japan TMS, components

Japan's money supply TMS and its components. As can be seen, the biggest growth is in covered money substitutes, which are created by the BoJ directly. However, fiduciary media – deposit money that is theoretically available on demand but for which no reserves actually exist – still constitute the bulk of the money supply – click to enlarge.



Japan TMS component growth ratesAnd lastly, the year-on-year growth rates of Japan's true money supply components. Covered money substitutes grew by 116.3% year-on-year, currency outstanding grew by 2.5% and uncovered money substitutes declined by 5.6% (the decline has recently accelerated to 13.9% annualized in the past quarter and 15% annualized last month). In combination, total year-on-year growth of money TMS is currently at 4.6% – click to enlarge.



Actually, the recent true money supply growth rate of 4.6% year-on-year is close to the upper end of the range seen in Japan since the bursting of the bubble in late 1989.

If banks cannot lend out their reserves directly, what can they do? In the fiat money system as it is presently constituted, banks can create new deposits ex nihilo at anytime they wish. In other words, they can create new money literally out of thin air, simply by crediting accounts. This happens in the course of credit expansion.

As an example, say that e.g. Hiroshi deposits 10,000 yen with Mizuho Bank in a demand deposit. Assuming a 10% required reserve ratio, Mizuho Bank can then lend 90% of this deposit, or 9,000 yen, to Kaito, who has applied for a loan. These 9,000 yen are then credited to Kaito's current account, however, the demand deposit due to Hiroshi is not decreased. Instead, both assets and liabilities on Mizuho's balamnce sheet have increased by 9,000 yen (a loan of 9,000 yen to Kaito has been added to the asset side, and a new deposit liability to Kaito on the liabilities side).  So it appears that Hiroshi's original deposit now has two owners, since Kaito can dispose of the 9,000 yen, while Hiroshi continues to have command over his 10,000 yen deposit as well. Or putting it differently: 9,000 new yen have been created out of thin air. The money supply has increased by 9,000 yen in new, uncovered money substitutes (a.k.a. fiduciary media). This is the privilege of fractional reserve banking in a nutshell.

What the BoJ wants to achieve with its machinations is to increase credit demand by suppressing interest rates, and so incite credit expansion and the creation of additional fiduciary media. In this endeavor it is failing so far.


The 'Limits of Monetary Policy', the Yen's Decline and CPI

The article in the Japan Times continues:


“Meanwhile, the long-term interest rate, which theoretically factors in an expected rate of inflation, has fallen and is dwindling at an ultra-low level of around 0.6 percent. This signals that the market does not yet seriously believe that inflation in Japan will reach Kuroda’s 2 percent goal, said Kazuhito Ikeo, an economics professor at Keio University.

“When the policy interest rate has effectively fallen to zero, monetary policy won’t work much any more,” Ikeo said in a recent interview. Ikeo believes the economy is stuck in a rut because its potential for economic growth has declined and monetary measures alone can’t solve the problem, he said. “I think it has become clearer that there is a limit to what monetary policy can do,” Ikeo said.”


(emphasis added)

We would tend to formulate it even more drastically: not only does monetary policy have 'limits', it actively harms the economy. For one thing, it leads to an unmerited redistribution of existing wealth to early receivers of newly created money from later receivers, by enabling the former to use 'nothing' (new money from thin air) to bid for 'something' (real assets/resources) before prices have been altered. Secondly, it distorts interest rates pushing them below their natural level and thereby alters relative prices. This sends a false signal about the economy's pool of real savings (making it appear larger than it is) as well as present and future consumer demand to entrepreneurs. Malinvestment of scarce capital is the inevitable result. In the end, capital will be consumed rather than accumulated. A business cycle, i.e., a boom-bust cycle will be set into motion. Lastly, it should be obvious that increasing the  money supply cannot possibly increase society's wealth (only the few who are profiting from the redistributive effect mentioned above will benefit). It merely dilutes the purchasing power of the monetary unit. Assume for argument's sake that the money supply were doubled overnight, ceteris paribus. Would we be twice as rich as before? Obviously not, since money is merely a medium of exchange. The goods money can buy would not have magically multiplied concurrently. There is no point whatsoever in increasing the money supply.

The conclusion is that with regard to smooth, harmonious economic development, an agency manipulating interest rates and the money supply is not only superfluous, it is positively harmful.

The Japan Times continues:


“Much of the public believes the drastic easing measures adopted by Abe and Kuroda helped weaken the yen and benefited exporters. The yen-dollar rate has fallen from around 78 to about 100 over the past 14 months. This helped send the Nikkei stock index soaring from December, one of the main reasons Abenomics has public support. But the yen started depreciating last fall, long before Kuroda’s widely proposed takeover at the BOJ officially took place in April, Noguchi said.

Abe was just “lucky” to see the yen fall, Noguchi claimed, crediting the easing of the eurozone debt crisis last fall rather than clear signs that Abe’s Liberal Democratic Party was getting ready to boot the unpopular Democratic Party of Japan from power.

In September, Japan’s consumer price index rose 0.7 percent from the same month last year to log its fourth consecutive rise, hinting at inflation. The uptick, however, was misleading. It was largely caused by the costly rise in energy imports, exacerbated by a weaker yen. This, of course, is not a sign of economic recovery, both Noguchi and Ikeo said.

Workers’ real wages fell 2 percent in August compared with the same month the previous year, logging two drops in a row. Inflation without wage hikes will only erode people’s living standards. “It is wages that matter. If prices go up without a rise in wages, the real income of the people just goes down,” Noguchi said.”


(emphasis added)

There is always an initial 'feel-good' effect from monetary debasement, as it pushes up asset prices and helps some groups in society at the expense of others – in Japan's case, an ephemeral benefit for exporters and the owners of stocks has been created to everybody else's detriment.

We agree by the way that the yen's decline owes far more to perceptions about the euro crisis (the 'safe haven premium' went out of the currency) than the BoJ's or Abe's policies (especially given that money supply growth remains very subdued on a relative basis). Regarding 'CPI', it should be noted that in the long run, the currency's purchasing power will tend to decrease or increase roughly by the difference between money supply growth and the gains achieved by increasing economic productivity (leaving aside fluctuations in the demand for money, which are usually tied to the business cycle). Note that if e.g. energy prices rise for some reason while the money supply remains unchanged, then some other prices in the economy must perforce decline. Given the mathematical and logical impossibility of measuring and calculating the mythical 'general price level', CPI data should in any case always be taken with a grain of salt.


Shinzo Abe's Inner Hoover

Regarding the fact that living standards are increasingly endangered by the decline in the yen's purchasing power, Shinzo Abe is apparently trying to deal with the problem by invoking his inner Hoover. This prompts a dry remark by Mr. Noguchi:


“Abe apparently is well aware of this risk and has repeatedly urged top business leaders in Keidanren, the nation’s largest business lobby, to push for wage hikes to generate “a virtuous cycle” of raises and economic expansion.

Noguchi calls Abe’s approach “sheer nonsense” because Japan is not a planned economy and the government thus cannot force businesses to raise wages against their will.


(emphasis added)

Contrary to Abe, Hoover was actually successful in getting businesses to keep wage rates too high, which resulted in soaring unemployment in the early 1930s. Japan actually has no unemployment problem though (not least due to demographics: the labor force is constantly shrinking), which makes the whole 'Abenomics' experiment even more curious. What exactly was it that Abe wanted to 'fix'? Anyway, he cannot force businesses to raise wages as Mr. Noguchi points out, short of threatening or enacting legislation to that effect.

The most dangerous aspect of the 'reflation' policy remains however that it allows the government to continue to postpone dealing with its debtberg:


“Probably the biggest risk with Abenomics, however, is a potential crash in JGB prices that would cause long-term interest rates to spike and gut the debt-laden government. Ikeo pointed out that the BOJ’s massive bond purchases are in fact helping the debt-ridden government finance itself, even if the central bank claims this is not its intention. If the BOJ keeps up this charade, confidence in JGBs might crash, Ikeo said.

“Soon or later, concerns over fiscal sustainability will emerge. You can’t rule out the possibility of a surge in the (long-term) interest rate at a critical point,” he said.

The resulting surge in debt-serving costs would devastate the government, which has already racked up a public debt totaling almost 200 percent of gross domestic product — the highest of all developed countries. Nearly half of Japan’s ¥92.6 trillion general account for fiscal 2013 is barely being financed by fresh JGB issues.

According to Noguchi’s simulation, if the average JGB yield jumps to 4 percent in fiscal 2014, debt-serving costs will leap to a staggering ¥50 trillion in fiscal 2025 alone, which is more than half the size of the fiscal 2013 budget.

“This is nothing but fiscal bankruptcy,” Noguchi warned.”


(emphasis added)

The article goes on to point out that JGB doomsayers have always been proved wrong in the past and speculators betting on a crisis have been repeatedly burned (shorting JGBs is widely known as the 'widow-maker trade'). However, Japan's trade surplus has turned into a deficit lately and its current account surplus is consequently declining, so the dangers to the JGB market are increasing. Should Japan require foreign financing for its public debt (currently the bulk of its debt is held by domestic investors) it is doubtful that current low interest rates could be maintained.

Noguchi in addition points out that if domestic investors should become convinced that the yen will no longer strengthen, they will be tempted to ditch JGBs in favor of foreign bonds, which would have a similar effect on interest rates.

In essence one could say that Japan's government is just one market panic away from bankruptcy. In that sense the 'help' the BoJ provides to the government's finances with its 'QE' program is really a poisoned chalice. By enabling even more seemingly painless deficit spending, it makes an eventual crisis more rather than less likely.



The situation is sooner or later bound to get 'interesting' (in the Chinese curse sense). Stay tuned.



Charts by: Michael Pollaro




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2 Responses to “A Useless and Dangerous Mountain of Money”

  • SavvyGuy:

    When the ratio of outstanding Treasury debt to GDP gets too high, deliberate inflation is a way to reduce that ratio. It has been done before in the US in the 1940s as well, after gold was confiscated in the 1930s.

    Furthermore, one has to differentiate between the coupon yield on JGBs versus their market yield. Once JGBs have been sold to unsuspecting buyers at par value, the Japanese treasury is only responsible for making coupon yield payments, regardless of what the market price for JGBs may be in the future. Debt-servicing costs for issued JGBs will remain unchanged, and it is fallacious for Noguchi-san to presume that they will increase if JGBs crash.

    As inflation rises, so do GDP and income tax revenues. Existing JGBs will tank, and their original buyers will become bag holders. However, new JGB issuance may be somewhat reduced in the future due to rising tax revenues, creating a “scarcity effect” and thus providing at least some semblance of support to JGB prices.

    I do not condone “Abenomics”, but it does seem possible that it might actually work, by the simple expedient of stealing the wealth of existing JGB holders.

    • I don’t think Noguchi didn’t consider the fact that the coupon payments at issuance are what counts. Japan has huge debt rollovers coming over the next several years, so if market rates were to rise, so would its refinancing costs. Note what he says: ‘if rates rise to 4% in 2014, debt service costs would be X in 2025’ – so he is definitely considering the range of maturities out there that will require refinancing.
      By the way, I do think Japan could still alter its debt dynamics if it really tried. But the inflation strategy strikes me as very risky – especially if they decide to become even more ‘creative’.

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