Japan's Reckless Deflation Battle

The end of deflation is unlikely to be a smooth and controllable affair...

THE MARKET has been focused on the Bank of Japan's capitulation to the Abe government's threats to pack its governing council with Yes men and to rewrite the law defining its powers if it did not throw its weight behind the latest attempt to deprive the archipelago's many pensioners – as well as its other purchasers of imported stuffs – of a living income, writes Sean Corrigan for the Cobden Centre.

Not that this is how the matter is being presented, of course, as the dark forces of global Keynesianism exult at the prospect of yet another New Deal being launched somewhere in the world. After all, it must be about time that one of them actually 'did what it said on the tin' and restored prosperity by means of a clod-hopping bout of fiscal-monetary intervention to a people from whom it was taken by an earlier series of similarly ill-judged interventions from on high.

Given the already heated political situation in the region, the timing could be better, particularly with regard to a yen whose 10-week decline has only been exceeded (benignly) in the reversal of safe haven flows once the Lehman crisis began to abate and (less happily) during the Sakakibara episode in 1995 which arguably set the stage for the global instability of 1997-98. Already, Japan's neighbours and export competitors – the equally growth-scarce Korea and Taiwan – have begun to make noises about the policy implications, while the Bundesbank's Jens Weidmann has also expressed hopes that this does not mean a return to the dark days of competitive devaluation.

But, more fundamental than this is the very question of what the Bank and the LDP think they can achieve. Does the country really need any further, grandiose, state-financed spending programs even if it could apparently bear to spend Y200 trillion (sic) on disaster-'toughening' schemes, according to Abe advisor Satoshi Fujii? Can the country really be languishing so badly under the crushing burden of nominal interest rates which have barely inched above the giddy heights of 1% at the short end and 2.5% at the long these past fifteen years? Is the fall off in exports really either attributable to – or curable by – developments in the level of a real exchange rate which at its most unfavorable lay only 0.5 sigmas above its stationary, three-decade mean?

For now, the system has held together, with JGBs rallying under the same old QE rationale that has kept US yields from backing up in the face of yawning deficits. Given the presence of a non-price-sensitive buyer, wielding an inexhaustible check book, one would have to be truly foolhardy to short the bonds in one's own currency though it is quite another matter if you come at them from abroad and later hope to spend the returns in your own, foreign domain.

It would not, however, be too wise for the authorities to flout the wishes of their long-suffering citizens, especially not when they have such a deep, vested interest in seeing neither their money, nor the banks and government debt which provide its backstop undermined. At a massive 115% of GDP, M1 money plays a bigger role in the economy than it does in most other developed nations (c.f., the ~50% in the Eurozone, or the ~20% which prevails in the US). As such, it makes up 55% of household financial assets and over 70% of financial net worth, with another 25% of the total exposed directly or otherwise to government debt.

For their part, banks hold over Y400 trillion in JGBs to back up their customers' deposits, a total which is perhaps eight times larger than their equity capital  (meaning a 180bp back up in 10-year yields would effectively wipe them out, if properly marked to market), while other financial institutions hold as much again. This is clearly not a country where one should knowingly tinker with people's faith in either of these instruments – cash or bonds – in the pursuit of a serially failed and oft-vitiated nostrum.

Perhaps that is why the BOJ seems to have both postponed the onset of its Fed-like QEternity program to 2014 and to have hedged about the wider terms of its abasement with a number of caveats. 

Even though it has committed to covering not just the deficit twice over this year, but actually the entirety of government outlays, its outgoing governor did publicize the valid objections of board members Kiuchi and Sato, while reserving to the Bank the right to 'ascertain whether there is any significant risk to the sustainability of economic growth, including from the accumulation of financial imbalances' and to attempt to hold the government to its pledge to 'flexibly manage macroeconomic policy but also [to] formulate measures for strengthening competitiveness and [the] growth potential of Japan's economy' while ensuring it will 'steadily promote measures aimed at establishing a sustainable fiscal structure with a view  to ensuring the credibility of fiscal management'.

Good luck with that, we would be tempted to say, but the more fundamental point is not whether we gaijin think that all this must soon break apart, but rather when Japanese banks, Japanese insurers and pension providers and, above all, Japanese individuals lose faith in their own money.

Here, we might note that they have been quiet net sellers of JGBs for a few quarters now, their actions only being offset by the increased absorption of the BOJ itself. One thing is for sure; the 'end to deflation' will not be a gentle or controllable affair, if and when it comes, nor will its impact be limited to Japan alone.

Time to Buy Gold?...