(originally posted Oct 31)
This week the Federal Reserve put an end to their fourth round of Quantitative Easing, having exploded their balance sheet from $800 billion at the start of QE, to over $3 trillion today. Everyone thought that the financial markets would now have to live without the monetary dope that has been fueling euphoria in stock markets in the U.S. and elsewhere. Everyone was wrong. In a completely unexpected move, the Bank of Japan announced it was expanding its Quantitative Easing program from 70 trillion yen to 80 trillion yen, bringing its monetary base to the equivalent of $750 billion. The purpose of all this liquidity? The Bank of Japan is desperately trying to achieve its target of 2% price inflation.
Everyone reading this can remember 2% inflation. It’s what the world experienced prior to 2008, when the bankers blew up the global financial system and unleashed a wave of deflation that resulted from massive defaults in the mortgage bond markets. The exception to this experience was Japan, which had been suffering outright deflation for twenty years, represented by falling wages and outright declines in consumer prices.
To combat deflation, during those twenty years Japan embarked on a massive fiscal stimulus program. The government went into borrowing overdrive, rebuilding railroads, airports, bridges, and ports. The effort was for naught. Deflation marched steadily on, and the only thing Japan had to show for their anti-deflation campaign was a government deficit that now exceeds 200% of its GDP, one of the highest deficit exposures in the world.
To cope with a deficit of that magnitude, the Bank of Japan pushed interest rates to zero percent, where they have remained for years. Any higher interest rates, and the government interest cost on its debt would drown out any other deficit spending, causing a severe economic recession. Japan, in other words, is now chronically dependent upon government spending as a prop to its economy, and the government is chronically dependent upon zero interest rates to avoid paying any interest whatever on its mountain of debt.
This is why the Bank of Japan found Ben Bernanke’s idea of Quantitative Easing so beguiling. It allowed the government to continue deficit spending on a massive scale, and to do so (apparently) cost free. The Bank of Japan would keep interest rates at zero in perpetuity (until some magical date when the government got its finances in order), and the BOJ would become an active buyer of this government debt, replacing the public investors who were increasingly reluctant to buy Japanese government paper that offered no yield. And why should a private investor buy such paper, when the government itself says it wants inflation at 2%, but it also wants to issue paper at 0%, which does not compensate the investor for the risks of inflation as small as even 2%?
And so this morning, the Bank of Japan surprised the markets with a dramatic expansion of its QE program, to the point that the Bank of Japan will now buy up every single bond issued by the government of Japan. This is 100% monetization of the government debt. The market has abandoned Abenomics to describe what is going on in Japan, and is calling this “Banzainomics,” since it is so reminiscent of the phrase uttered by the Kamikaze pilots of World War II as they hurled their planes to complete destruction. It’s a tactic that ultimately did not stop the Allied advance, and Banzainomics will not stop deflation.
Why? Because the world is an integrated place, and Japan cannot act in isolation. The very first thing that happened in other markets when the Bank of Japan made its announcement is that the Nikkei and most Asian stock markets jumped higher. QE is good news for equities. This has become completely apparent in the US, where the S&P 500 has followed an upward trajectory step by step with the expansion of the Fed’s balance sheet through QE. The correlation is both fascinating to look at and frightening at the same time, because the asset inflation brought about by QE is one of the principal causes of the maldistribution of American income and wealth that even the Fed now professes to be worried about.
It should also be noted that the Bank of Japan today announced something called Qualitative Easing, wherein the pension fund of the government will now be used to buy Japanese equities. The intention of the central bank to goose up asset values and other risk assets cannot be more evident, and it is getting harder and harder for central banks to avoid the charge that they are siding exclusively with the wealthy against everyone else.
This is also evident in the fact that price inflation has moved modestly, up to 1% annually. This is just enough to pinch hard the spending power of consumers, especially of retired people who comprise such a large demographic in Japan. They have few investments left, and what is left earns zero percent interest, so every jump in inflation hurts them. The political consequences of this pain are starting to appear in Japan, and since the government is facing elections in 2015, today’s actions seem like a last-ditch effort of the government to jump-start the economy, so that economic growth will finally kick in and feed some wealth down to the average family or individual.
But the second result has shown up in the foreign exchange markets. The yen, which had traded at 102 to the dollar just a few months ago, fell sharply this morning and is now at 112 to the dollar, on its way most likely to 120, a level last seen nearly ten years ago. A weaker yen is “just what the doctor ordered” if you are an exporter in Japan, but it is devastating for the Japanese consumer, because the cost of imports will rise, leading to even higher domestic inflation.
Isn’t this what the Bank of Japan wants? 2% inflation? Yes, and no. Yes, if the economy overall grows at that rate, and everyone benefits. No, if Japanese wages continue to stagnate, and the central bank finds it impossible to raise interest rates, and reward savers. This would just put more political pressure on the government. It is this latter result, however, which has been the inevitable consequence of QE so far, and it seems to be the only likely outcome of this last-ditch attempt at economic stimulation.
The final evidence that the world is economically integrated, and no one can ignore what happened today in Japan, is apparent in the U.S. this morning. The stock markets in America exploded upwards on this news, the Dow setting a new historic high. Add to that, the fact that two Fed governors stated this morning that the Fed should have continued with QE, or at the very least tied its continuance to reaching its inflation targets, and you can see that there are those who believe that what the Bank of Japan is doing is essential and the only real option available to fighting deflation and reigniting inflation.
Of course, “reigniting inflation” always means, to a central bankers, getting back to the warm and cozy days of 2% consumer price inflation. It never means getting to the 20% inflation of the 1970s, or the 2 million percent inflation of Weimar Germany, or more recently, Zimbabwe. That could never happen, could it? Central bankers, after all, view themselves as a type of Master of the Universe, able to pull levers to move the economy where they want it. They all say, for example, that they can at any time withdraw all this stimulus, even though the record shows that Japan is terrified of selling any of its bonds into the market, and the Fed can’t seem to come up with any time frame when it would start liquidating its $3 trillion horde of Treasury securities and mortgage-backed bonds.
It can’t do that, because that would cause a recession, and the Fed would never want to be blamed for bringing about a recession. It is quite happy, however, to accept the credit for bringing about a recovery or preventing a recession, which the Fed is constantly reminding us is just what it did in 2008. The Fed wants the world working in one way only – growing ever upward with the gentle help of 2% inflation.
This means that the only way a recession could ever occur is through some non-Fed, extraneous “black swan” event. How about this for a black swan event? The yen continues to depreciate, other Asian currencies follow, but the Chinese yuan, which is locked into an automatic appreciation by virtue of its own policies to prevent imported inflation (especially on pork and rice), will drag China into a collapse of its exports, and a depression, not a recession. China is already poised on the brink of a recession, as its housing market is showing severe strain. Any more foreign exchange stress and the engine which has been at the center of the Chinese miracle for 30 years – namely, exports – will be crushed, and the economy will be crushed with it.
In a sense, though, Japan is a black swan of its own. The market pays it little attention, other than to play the “carry trade” game by borrowing very cheap yen and investing them in dollar instruments earning a “magnificent” 1.5%, which is an extravagant interest rate these days. But Japan deserves attention. Its economy is larger than that of France and Germany combined. It is the perfect example of an export-oriented economy that has seen its manufacturing industries hollowed out and sent to China or elsewhere. It has nothing to sell to the world anymore, other than its government bonds used to finance the well-being of an increasingly aging population. As its once vaunted and feared trade surplus has fallen in recent quarters to a deficit, it lives off debt, which no one wants to buy. It is therefore trapped in a situation that ultimately can only be resolved in a drastic collapse in living standards, forcing the Japanese to learn to live on one third of their income, putting their per capita living standards on a par with the Chinese.
This is the fate of almost all of the industrialized West, most especially the United States, which lacks the benefit of savings generated by a trade surplus. The US has no savings to speak of; every sector of the economy lives off debt, most especially its corporations, which have ballooned their debt in recent years, gorging on zero interest rates and plying the money into the stock market, buying up their own stock. Very much like the Japanese central bank is now doing, buying up its own government’s debt. The difference is, when a corporation does a stock buyback, most of the benefits go to the corporation’s executives, whose stock options motivate them first, foremost, and always to jack up the price of their stock.
What we’ve been witnessing for the past six years are central banks buying up their own government’s debt to keep the debt machine going and free money flowing into their economy. At the same time, corporations are borrowing heavily, distorting their balance sheet in the process, to buy up their own stock and keep the option payouts going. This is financial manipulation on an epic scale, and masks the fact that organic economic growth has virtually disappeared from the industrialized economies.
The result is an evisceration of the middle class in country after country, as wages continue on their forty year path of stagnation, which is the principal means by which deflation spreads. The central banks try to counteract this, thinking that flooding the economy with “liquidity” will reignite inflation. Unfortunately, it ignites only asset inflation, while wage deflation condemns Western countries to ever-lower living standards. We all are, in that sense, Chinese, which is proud of the 20% of its population of middle-class able to earn a wage of $15,000 a year, which is interestingly becoming the normal wage in the U.S. retail and fast food industries, and now spreading to white collar jobs.
In other words, globalization marches on, and either you stuff billions of Chinese, Indian and Brazilian workers back into a state of poverty, or you continue to impoverish a billion or so Europeans, Americans, and other non-wealthy workers in industrialized economies. This first option is not going to happen, so what the central banks are fighting is the alternative of a diminishing middle class. What the central banks refuse to recognize is that their monetary policy tools are unequal to a problem that is structural to the global economy, and not related to the normal business cycle.
Prior to the introduction of Quantitative Easing, the West faced the ultimate consequences of globalization: a calamitous decline in living standards, with attendant social unrest, but for the most part manageable with intelligent and honest political leadership (a contradiction in terms?), which would recognize that the West now needed a permanent set of welfare entitlements to provide a very basic standard of living for millions of workers who had fallen into poverty.
What happened, instead, is that the central banks have enabled their governments to add $10 trillion of debt to the global economy, to stimulate consumption and give the illusion that everything is normal. But it is not. The debt cannot be repaid, because if it could the central banks would be able to find investors in the market willing to buy it. Once the bond markets realize the debt is no longer serviceable (and that process may already be underway – interest rates have recently jumped as prices of government debt have fallen), rising interest rates will push all economies into a worsening recession. Exchange rate realignments will exacerbate the pain of what will be a global depression, not a recession.
Things will be so bad, that even those in the US who voted for Mitt Romney will recognize that the 47% of “moochers” living off the wealth of others will have doubled in size, and that they themselves are part of that number. But then it will be too late, because the central banks will have squandered the borrowing capacity of their governments. It will now it be impossible for these governments to do what could have been done six years ago – establish basic living entitlements for millions of people falling into dire poverty.
The consequences will be financially, socially, politically, and culturally – what? Disastrous, calamitous, horrendous? Pick your adjective, but just bear in mind the reality will almost certainly be worse.
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