8 min read 20 Feb 17
Summary: Why is the Bank of Japan (BoJ) trying to raise the rate of inflation? Taking account of its demographic profile, Japan’s economic performance has been impressive by developed world standards, as <<link>Anne Richards at Bond Vigilantes recently points out, and the economy appears to be at close to full employment.
The economic rationale for raising the inflation rate of an economy usually has two dimensions: to reduce real interest rates to encourage higher consumption and investment spending, and to erode real wages stuck at levels which are “too high” for the labour market to clear. Another reason to raise inflation rates is to deal with “excess” leverage.
To the extent that it provides a coherent rationale at all, the BoJ seems to use a different set of arguments, at least in public. Policy makers talk about a “deflationary mindset” and a tendency to defer consumption in anticipation of lower prices. In private, Japanese policy makers seem to worry most about the stock of public sector debt.
So what is really going on? The conventional case for raising inflation can be dismissed. The BoJ is clearly not trying to reduce real wages to allow the labour market to clear. The idea that Japan needs a lower real interest rate structure to raise consumption and investment also looks irrelevant. First, the theory is weak, particularly given Japan’s demography and per capita income. Second, if the economy is at full employment, there is no need for stimulus. It is plausible that there is a case for raising animal spirits – that demand will create its own supply and capacity will emerge if demand accelerates because there is lots of innovation that has not been exploited due to some kind of collective pessimism. Policy-makers may view this hypothesis as worth testing – the output gap (for want of a better framework), may be a lot bigger than measured and assumed.
But either way, lower real interest rates should not be expected to raise demand. The equity risk premium and observed levels of demand influence corporate spending far more than real interest rates, and the consumer suffers from the doughnut dilemma. If Japan wants to raise spending to revive broad confidence, some form of helicopter drop makes far more sense than desperate attempts to raise inflation expectations.
I don’t know if ‘deflationary mindset’ is a catch-all description for bad things. But the idea that consumption is being postponed due to expectations of lower prices seems odd. And this seems to be Governor Kuroda’s main objection to Japan’s relatively mild cumulative deflation. But relative price variance in Japan – like everywhere else – is far higher than aggregate price variance. In other words, the price declines of individual goods (say computers), which are falling due to productivity gains, and the price rises of goods in scarce supply (such as healthcare), are more significant than change in broad CPI measures – so relative price changes are likely to dominate consumption decision-making. The idea than an expectation of lower prices is depressing spending seems ad hoc and spurious.
What about the balance sheet arguments? This seems to be the real motivation of many Japanese policy-makers. Whenever a Japanese official gets handed the finance ministry brief, they look through the numbers and hit the sake. No one worries about private sector debt levels or asset prices in Japan at the moment. The collective policy-making obsession is with Japan’s public sector debt.
Japan’s public sector debt problem is an illusion, and the next finance minister should be briefed to throw away the drinks cabinet, and taken through some straightforward accounting.
Firstly, net debt, not gross debt matters for solvency. Secondly, the correctly measured net debt of Japan (net of public sector financial assets and bonds held by the BoJ) is around 65% of GDP and falling. Japan has no public sector debt problem.
In a world of QE, or Japan’s QQE, public sector debt accounting is dreadfully misleading. The Bank of Japan is in the process of owning most of the outstanding government debt of Japan (it currently owns around 40%).
BoJ holdings are part of the consolidated government balance sheet. So its holdings are in fact the accounting equivalent of a debt cancellation. If I buy back my own mortgage, I don’t have a mortgage.
So why does anyone think Japan has a public sector debt problem? Largely due to spurious accounting and confused analysis. Unthinking members of the economics profession haven’t helped. Remember, that the Bank of Japan buys government bonds by creating bank reserves. We don’t need to rehearse the arguments why bank reserves are not genuine liabilities of the Bank. Put simply, it’s obvious to most people that notes and coins are not ‘liabilities’ or debts of the state in any meaningful sense. Bank reserves are simply the electronic equivalent. Simon Wren-Lewis provides a clear and rigorous explanation.
The crux of the issue with central banks’ balance sheets and reserve creation is what to do if there are too many reserves. What would indicate too many reserves? Either chronic lack of profitability in the banking sector or rapid, inflationary, credit growth. Neither is the case.
Some years ago, I outlined a mental exercise where the Bank of Japan simply bought all the outstanding stock of public sector debt, and asked what would change. Most Japanese government bonds are held by the public – intermediated by the insurance and banking sectors. So the private sector would lose an interest-bearing asset and receive a zero interest asset (let’s just assume the BoJ pays zero on reserves). So the net interest income of the private sector declines and the public sector’s debt shrinks. There’s no drama – a minor negative for the private sector. Broadly, that’s what’s happened – which also explains the backlash against negative rates.
So is there any logic to what the BoJ is doing – other than illustrating that given prevailing economic conditions in Japan the government can elect to have no debt? There may be. Analysis of public sector debt often ignores the fact that the debt is an asset to the private sector. In Japan’s case the high gross debt in fact reveals a very high private sector financial asset to GDP ratio. To my knowledge there is no good recent data on the distribution of the ownership of financial assets in Japan – but they are highly likely to be concentrated in a relatively small cohort of elderly rich people. The absence of inflation is Japan could be interpreted as revealing that the asset to income ratio is too low to generate enough demand, or the distribution is too skewed.
Why does this matter? Well, the BoJ may in fact have stumbled upon a solution to the ‘Piketty Problem’. Japan is likely to have high intra- and inter-generational inequality. If the BoJ does indeed succeed in sustaining, say, 1.5% inflation over 15 years, and the average yield on the stock of bonds held by the private sector is 20bps, the real value of those assets declines by 20%. The BoJ is redistributing wealth, and targeting – to borrow from Piketty – a level of r that sits below g, at least for bonds. This is a novel take on the euthanasia of the rentier, a theme wisely revived recently by Duncan Weldon.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.