“When future historians look back on our way of curing inflation, they’ll probably compare it to bloodletting in the Middle Ages.” – Lee Iacocca
Japan, the U.S., and Quantiative Easing…
For those of you who aren’t familiar with quantitative easing: it is the important-sounding way central banks manage the economy through monetary policy. The most common way is by manipulating the rate at which they loan to other banks; when the economy is running too hot, the central bank will raise the rate at which it loans money — thereby discouraging borrowing and capital investment. Likewise, if the economy is in the tank a central bank can lower the rate at which it lends to other banks, thereby encouraging borrowing and capital investment in the economy.
Central banks have other tools at their disposal to encourage or discourage economic activity — like raising and lowering interest rate requirements, or adding or reducing liquidity by buying or selling government bonds. These tools also contribute to the umbrella of quantitative easing. For the most part, however, central banks have relied on interest rates — until recently.
In the late 1980s and early 1990s, Japan hit an economic brick wall. Its central bank lowered rates repeatedly until it finally came to a point where its monetary authorities instituted something called Zero Interest Rate Policy — or ZIRP. This essentially meant the Japanese central bank would hold interest rates at or just above zero long enough to stimulate the economy and get things rolling again. It didn’t work.
In the early part of this decade, the Bank of Japan took its next stab at quantitative easing. It printed a lot of money, and subsequently did everything it could to get that money into the economy so people and businesses would start spending again. The Japanese central bank used the new excess cash it was creating to buy its own bonds — especially the long-end of the yield curve. In other words, the government was printing money and lending it to itself. The theory was that by purchasing its own bonds, it would inject money into the system at the same time it held those longer-term rates down — thus inspiring domestic investment.
Again, it didn’t work. Japan has had very little economic growth for twenty years. It is commonly referred to as the “lost decade,” but it’s really two lost decades. And it’s tragic.
It is important to understand what has been going on behind the scenes. Japan is a creditor nation with a tremendous amount of personal savings. This means the government borrows a lot domestically — from citizens who have a propensity to save, not spend. Still, printing money is inflationary — it is an immutable law of economics. When a government prints money, prices and rates should rise. And when Japan drove rates down by printing money and buying binds, prices and rates did rise: everywhere else in the world. And herein lies the crux of this story.
You’ve heard a lot of talk about the irresponsible policies initiated by Alan Greenspan and Ben Bernanke — lowering interest rates, creating massive mal-investment, and driving asset prices much higher than the market can sustain. These are the foundations of our housing bubble’s expansion, along with its subsequent implosion.
What you probably aren’t hearing a lot about is the role Japan played in this catastrophe. Because Japan has kept its interest rates low for so long, people could borrow from them at extremely favorable rates. These borrowers could then take this capital abroad, where seemingly “safe” investments were returning far more than the rate of interest owed on the Japanese debt. So all that money Japan was printing was inflationary; the goods and services being purchased abroad by this cheap Japanese capital stimulated demand all over the globe. And, of course, that excess demand caused rising prices and rising rates everywhere but Japan. This was a huge part of the mal-investment that caused so many bubbles — and ultimately the global economic crisis.
The difference between Japan’s attempt at quantitative easing and recent U.S. monetary policy changes should be obvious:
1. As Japanese interest rates hovered near zero, the global economy was exploding. There was no shortage of people eager to take advantage of low-cost funds in Japan and invest them around the world. Today, the opposite is true; while U.S. rates might be at historic lows, there is nowhere near as much demand to borrow in the U.S. and invest elsewhere. The global economic crunch has ensured that.
2. The U.S. is a debtor nation. In fact, the Chinese and the Japanese are the two biggest holders of our debt. If they — or any of several other major foreign players — decide to stop loaning money to the U.S., rates will go much higher. Further, with U.S. long-term bond prices at historic highs (inverse to their low yields), there may be some incentive for foreign holders of those Treasuries to liquidate in order to spur their own domestic growth. And that brings me to the next point.
3. Japan and China are huge exporters to the United States. But the U.S. economy has buckled, and that means we will be importing much less. And that, in turn, probably means that countries like China will have far less cash to buy our Treasuries. On top of all that, countries like China are slowing domestically along with everyone else. They will have to tighten their budgets just like everyone else.
4. Finally, I think Japan has been given a giant reprieve over the last two decades. They implemented ZIRP and quantitative easing at a time when they would be effectively sheltered from the damaging inflationary effects of copiously printing currency. But that party is over, and I believe Japan will suffer the consequences of their irresponsible policies — probably more than the rest of the world.
No matter how you look at it, higher interest rates and prices are coming. But most people who agree with me are focusing on the United States and Europe. In my view, however, the problem is going to be much, much worse. I think Japan is in a lot of trouble.