Crossing the Rubicon – II

While a new, apparently perpetual, monetary stimulus gives equity markets a semblance of the health they manifestly lack, Japan tries to regain the lead as the world’s most distorted capitalist economy. Bear in mind that this was a place they rightfully owned for much of the 1990s. Back when Americans scornfully though this whole idea of not letting companies sink was oh so Japanese, all those fancy ideas about samurai honour. It could never happen in the US where, of course, no company was too big to fail.

In Japan, Prime Minister Abe said his country will pursue a “bold” monetary policy to set inflation rate up at 2% YoY. It made me wonder what have the Japanese been trying to do since 1991? It seems they had just been aiming at 1% and, since the 1% target inflation didn’t do much good, they seem to think 2% is a lot better, twice as better I suppose. But how exactly does Mr. Abe expect to succeed by doing exactly what is predecessors did escapes me. I expect him to use ever growing deficits to provide for larger quantities of money to run amok in the Japanese economy. Or is he ready to take the next step? Namely to just go ahead and print money without the implicit promise that he will pay back what, at least formally, could be considered a debt?

I don’t think the Japanese are that desperate but the question is, no matter what he does, if he succeeds in bringing inflation up (I mean inflation as measured by consumer prices index, actually a consequence, not a cause of inflation, but never mind), he is declaring that Japan is defaulting on his previous, massively-pilled-up-over-the-years, government debt and would make the prices on those bonds collapse (I mean 0.7% 10 year yield vs 2% year inflation, expectations for the future, worldwide, have to be pretty grim). I know he said he was only aiming at raising mid-term inflation as if inflation was something one could keep in a jar at home. Ironically, if he was to succeed, he would most likely fail to take equity prices significantly higher, in real terms, as equity does not over-perform in inflationary environments unless heavily tortured data is used to corroborate that conclusion. The reason is, quite logically, because inflation prevents entrepreneurs from making right economic calculations as price changes are too much and too varied for market prices to successfully be used for those calculations. It would be very hard to tell what consumers are demanding to satisfy their needs and how capital could or should be employed to satisfy them. There is also the problem of new money coming into the system not being neutral, benefiting the first holders of currency at the expense of the latter and, no matter how rational one’s expectations are, there is nothing one could do about it if one does not hold the right tools to face it. And most likely regulations will prevent the use of those tools, but I don’t want to bring more complexity into the matter.

Needless be said, that this is not what the Japanese government wants. They, like most of the Western economies, are betting these measures bring about a spike in the equity markets without questioning the price of government bonds, something that, like most of his predecessors, Mr. Abe is actually getting: a little short-lived spike on the Nikkei with little or any change in government bond yields (nobody said he would be getting it perfectly).

This brings us to the old debate where the US, the UK and now Japan are doing great because they have their own currencies while Europe, namely the Southern parts of it, are doing poorly because they cannot let themselves go from that straightjacket. I’m afraid it does not work like that.

The reason why increasing deficits apparently are not lagging those economies is simply because they are not being paid, so population at large is yet to suffer the cost of their government. When the Gold Standard was around, a country running a deficit would see their gold possessions reduced as, above the cost of shipping gold, creditors would demand the real stuff being delivered. If, banks were not working on fractional margin, the shipment of gold had no further consequences since gold was just like any other commodity and, if people freely exchanged it for something else, it was because they believed they would be better off with that exchange. So Mercantilist attempts to increase the quantity of gold by prohibiting its export would end in prices of commodities and wages rising. But, in the 19th Century, for industrial nations with sophisticated banking systems, gold was the basis of a credit pyramid, meaning that when gold was exported in significant amounts, the banking system had to reduce the amount of credit accordingly and a contraction of the economy through deleveraging took place. And yet, the threat of gold shipments kept the system in check, preventing governments from running large deficits or, if they did, making them pay the penalty by having to leave the gold standard, like it happened in Portugal in 1891. This system was so powerful that it allowed the international division of labour which, in turn, increased the wealth of people in ways not seen before in the history of mankind in the countries that kept to the Gold Standard rules. Not only that, it also worked an element of international appeasement. Its abolition at the very beginning of WWI was what made this war the mother of all wars seen until then. Paper money allowed governments to divert virtually unlimited resources into the conflict.

After the war, and then again after WWII, the Gold Standard was reinstated but with a fundamental flaw. Only one (or two) currency(ies) could be converted to gold. As foreign holdings of convertible currencies mostly stayed at the countries of origin never to be changed into gold (it seemed a lot better if they accrued interest from local government bonds) this meant the these countries (namely the US after WWII) could run deficits without ever having to pay them or, and this is the interesting part, having to deleverage the credit pyramid. That is of course until other nations began to demand their gold, like it happened in 1931 and then 1971.

The world of fiat-currency is, in a strange way, more democratic. Every single country has the theoretical possibility of running deficits without having to pay them or reduce leverage. Governments just have to make sure people are willing to accept the debt they issue, that is, promises for future goods and services they will exact from taxpayers. And investors are free to choose (with notourious exceptions, like social security pension funds). But I bet the countries of Southern Europe would not particularly appeal to international creditors were they to run their own currencies. And let’s face it, neither will the US, Japan or the UK if and when their importance is reduced in the international scene. They get away because they are rich, but with increasing taxation, regulation, and resources being diverted to non-productive uses, that day will surely come. And to believe the money spent by the state, any state, to trigger economic booms is the path for economic growth is delusional. Meanwhile, capital is being destroyed.


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