FOREIGN POLICY



 

The Japanese economy has been living in a fantasy world for decades, and the U.S. economy could soon be joining it there.

Nobody has ever mistaken U.S. President Donald Trump for an academic economist, but when it comes to monetary policy his views are consistent: The United States should have the lowest interest rates in the world. This would be a boon to manufacturers and especially to U.S. exporters, because lower rates would put downward pressure on the dollar, making American goods less expensive abroad. But it would also spark a race to the bottom as the United States tries to compete with negative rates in Europe and Japan.

The idea has also put the president on a collision course with the Federal Reserve. The U.S. central bank has cut its target policy rate three times this year to a range of between 1.5 percent and 1.75 percent, but it has signaled that this is as far as it wants to go, barring any major economic downturn.

Trump renewed his attack on the Fed in a speech Tuesday. “We are actively competing with nations who openly cut interest rates so that now many are actually getting paid when they pay off their loan, known as negative interest,” he said. “Give me some of that money. I want some of that money,” he added, demonstrating his penchant for viewing complex economic issues through the lens of his own potential profit.

Trump may get his wish: Former Treasury Secretary Larry Summers warned in a recent CNBC interview that the U.S. economy is perhaps “one recession” away from a turn to negative rates. “It’s a very different world when everyone’s stuck at zero interest rates,” he said. That very different world, with its strange new economic risks and its own inexorable force of gravity, has long been evident in Japan, where negative rates have become the norm. Japan offers the clearest preview of the economic fantasy world that the West may soon enter, whether it wants to or not.

Japan’s slide into negative rates has come as the government and central bank tried to fight a persistent slump that took hold after the collapse of a vast real estate and stock market bubble in 1990. Lower interest rates were meant to encourage investment by companies and also tend to push up inflation, two goals the country wanted amid persistently falling prices and wages. The government, meanwhile, launched successive waves of spending programs, pushing its own debt to record levels. The effect of each set of actions was dampened by Japan’s shrinking population; the only apparent solution was to do even more.

Japan became the first major economy to ever move to a zero interest rate policy in 1999 as the Bank of Japan sought to stop a slide into deflation by making money available at virtually no cost. The hope was that banks would in turn lend to worthy companies that would in turn invest, with the resulting increase in the money supply leading to inflation. It didn’t work as planned, and the economy continued to suffer from a liquidity trap in which investors facing near-zero returns park their money in bank accounts where, in practical terms, it was taken out of the economy.

Resorting to such extreme measures to jolt a persistently stalled economy used to be seen as a “Japan problem” reflecting the unique nature of that country’s economy and national character. Today, however, it appears that Japan may be the forerunner for the rest of the world, not the outlier.

Japan’s stimulus policy became much more aggressive in 2013 under new Bank of Japan Governor Haruhiko Kuroda, who vowed to undertake even stronger measures than the quantitative easing policy the U.S. Federal Reserve initiated during the global financial crisis in 2008. Dubbing it a “Quantitative and Qualitative Monetary Easing,” he has gone on a buying spree unparalleled in central banking.

Kuroda’s goal was to pump in enough money to break Japan from its deflationary mindset. His initial target was to create 2 percent inflation in two years, a target he now readily admits was too optimistic. There has indeed been some progress. Instead of declining at a rate of 0.5 percent to 1.0 percent, he has produced a fairly steady inflation rate hovering just below 1 percent.

To achieve this, the central bank targets short-term interest rates at minus 0.1 percent, and even the benchmark 10-year bond yields nothing to investors. But this has come at a huge risk.

The Bank of Japan now purchases up to 80 trillion yen ($735 billion) worth of Japanese government bonds every year. It is also active in the stock market, buying into exchange-traded funds and real estate investment trusts.

The danger in all this is that it has extended the bank’s balance sheet to potentially dangerous levels. Its assets and liabilities are 2.5 times larger than when Kuroda came into office and are larger than the entire Japanese economy. In traditional economic theory, such a monetary expansion should fuel runaway inflation that would effectively bankrupt a country, such as in prewar Germany. In addition, the Bank of Japan’s bond-buying has allowed the government to continue to deficit spend, without the risk of higher interest rates that could further dampen growth. While the central bank strongly disputes the idea that it has monetized the government debt, it today owns about 45 percent of all Japanese government bonds.

It is not just Japan, of course. The European Central Bank, after taking a stab at negative rates in 2014, has now aggressively gone back to the policy, deciding in September to lower its deposit rate to minus 0.5 percent, although it did take steps to protect some deposits against this new low rate. Globally, negative yielding debt hit a record of $17 trillion in August, according to the Bloomberg Barclays Global Negative Yielding Debt Index.

It has since pulled back from that peak but still represents an estimated 15 to 25 percent of the entire global bond market.
“Central banks basically tumbled into negative rates, but it finally sank in that they are in this for much longer than they had previously thought,” said Martin Schulz, a senior research fellow at the Fujitsu Research Institute in Tokyo. “The BOJ was spot on in this trend.”

The concept of negative interest rates in itself runs counter to common sense. Why give someone your money only to get less back at a later date? When Japan’s financial futures market started altering their trading software systems in 2001 so money market traders could input negative numbers, there was widespread skepticism.

It turns out that within the financial system, there are some reasons for investors to buy at least short-term debt at a negative rate. One is the issue of convenience—highly liquid securities such as U.S. Treasury bills are an easy way for banks to manage their cash holdings and meet regulations on their levels of capital. In addition, there is the perversely logical reason to buy negative yielding debt: an expectation that rates will go even further negative in the future, which will make the current bonds more valuable.

One of the major strains in a negative-yield world is within the financial system. The first casualty in this has been banks that trade in the Japanese government bond market. With almost no price fluctuation and only one buyer of any significance in the market, liquidity has, not surprisingly, dried up.

More broadly, ultralow interest rates make it difficult for banks to earn a profit through the traditional spread between deposit interest rates and lending rates. There are few sales prospects among Japanese corporate clients, which themselves are now sitting on cash of 500 trillion yen ($4.6 trillion), and even home mortgage loan rates are now around 0.8 percent, a return that makes it difficult to justify the costs in writing and servicing the loans.

With such low margins, banks have largely ignored the central bank and government’s exhortations to go out and lend more, especially to small start-ups that are seen as vital to the long-term health of the economy. For these entrepreneurs, the idea of cheap loans is a mirage, because banks have largely decided to avoid the risks involved at any price.

So why does Trump want to enter this strange world? At the most basic level, he has shown a concern bordering on an obsession with the value of the dollar, which he believes is too high. There are some legitimate concerns. While the Japanese government likes to point out that the current rate against the dollar is roughly unchanged from 20 years ago, in real terms, when adjusted for inflation, the yen is near its lowest levels since the 1970s.

There is another potential reason for the U.S. president’s interest. With low interest rates backed by increased bond-buying by the central bank, the cost of servicing U.S. debt falls sharply, no small factor in the federal budget as deficits near the $1 trillion level on an annual basis. Debt service costs totaled $376 billion for the 2019 fiscal year, making it one of the largest line items in the federal budget.

While Republicans have traditionally warned of the risks of high levels of government, under Trump they have thrown this caution to the wind. In this, they are actually on the same side as some liberal Democrats who point to the developing theory that governments can carry much larger levels of debt than previously thought without igniting inflation.

Supporters of this concept, known as Modern Monetary Theory, point to Japan as the perfect case study. Despite a national debt now around 230 percent of GDP and an oversized central bank balance sheet, runaway inflation seems a faraway risk.

Japanese officials, however, are having none of it. Even as the government continues to run up red ink and the central bank absorbs the new debt, both the Ministry of Finance and the Bank of Japan insist that Japan must get back to what are considered normal conditions and work down these balances over time.

The government recently went ahead with an increase in the national consumption tax to 10 percent from 8 percent as part of its program to make at least some progress on the debt mountain and to help finance the social spending that will be needed as the nation ages.

Asked about the idea of Modern Monetary Theory in May, Kuroda told a parliamentary committee that “Japan’s fiscal condition it totally different from what MMT assumes.” Finance Minister Taro Aso has said that the theory is “an extreme idea and dangerous, as it would weaken fiscal discipline,” a rather ironic concern given the free-spending ways of the Japanese government.

As the 2008 financial crisis has shown, liquidity can disappear overnight. A return to rates at historical levels would mean massive paper losses for bondholders and would threaten defaults that could again swamp the financial system. Common sense would suggest that central banks can’t continue like this. But that’s what they have been saying about Japan’s perilous government finances for nearly 30 years.

“The central banks have shown that they are willing to bail out anyone and everyone, so the risks of a crash are low, at least for now,” said Fujitsu’s Schulz.

The question for many is what happens in the longer term. Among those sounding the alarm is Ray Dalio, the founder of Bridgewater Associates, the world’s largest hedge fund firm. He recently posted a column on LinkedIn headlined “The World Has Gone Mad and the System Is Broken” in which he warns of the dangers of too much money now chasing too few opportunities.

He writes that a surplus in capital is being pushed into increasingly questionable investments, both in bonds and stocks. At the same time, central banks will not be able to keep buying the debt forever and may need to pull back just as the economy slows, sending interest rates suddenly higher and stocks and bonds lower.

“This set of circumstances is unsustainable and certainly can no longer be pushed as it has been pushed since 2008,” he concluded. That analysis, however, is unlikely to sway Trump.