Crossing the Rubicon – X

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Alphaville

Big in Japan

(Things are easy when you’re big in Japan)

The case for Japan is a simple one or is it not? Stagnant for 20 years, the Japanese Government wants to believe their economy touched bottom. Now, all it needs is some stimulus to resume growth (is it a coincidence that the Spanish and Greek prime-ministers said exactly the same? And, at least, the Spanish premier, begs the ECB to do the same). If the Americans tried to stimulate their economy via QE – Quantitative Easing, the Europeans chose to keep their currency by performing QE – Qualitative Easing. The Japanese are going to try and be bolder and will go for QQE – Quantitative and Qualitative Easing, that is, doubling the size of their money offering while buying assets of less perceived quality. To be absolutely fair, the FED and the ECB also used both strategies. The FED did the twist while the ECB was never shy to increase the size of their balance sheet, before and after Draghi’s speech.

But the Japanese are ready to commit economic harakiri on the hope that economies can be steered from above. They can’t. To give you an idea of what this is about, the Japanese say they are trying to bring inflation into their price index to re-start the economy. But even they must know this idea is based in very shaky ground. If it was this easy, why wait 20 years to do it? No wait, they did not wait for 20 years, they have been doing it for the past 20 years. It is only that the target for inflation was 1% and now they are going for 2%. Are they thinking, if it did not kill the patient thus far, that it might cure to increase the dose? It could very well be that the medicine is what kept the patient from getting better all this time.

The idea that inflation is good for economic growth spurs mainly from the fact that economists are not entrepreneurs and thus, do not realize how economic growth can take place. This can be disguised by more or less complicated statistics to show otherwise, but the fact remains that, in their world of equilibrium, there is no room for economic improvement unless new money is created to allow for new investments. This was what Schumpeter thought and he is credited for explaining how capitalism produced growth by means of creative destruction, you can imagine the rest. The story goes more or less like this: if new money is created and prices rise, then workers will be lured to work for the same nominal “sticky” wage that they refused to agree to before. Investors fearing the depreciation of money look for capital goods, something in which to invest. This belief is allowed by the increase in money offer, which forces interest rates down (as if Japanese interest rates were not already ridiculously small) courtesy of the central bank using new money to outright purchases of interest rate related assets, or lending it against collateral of the same.

But there are too many assumptions on the way. Firstly that inflation is the rise in the prices of a group of selected goods and services, usually used for final consumption, and not the increase in the offer of money. For those goods and services to be representative of the increase in prices for the whole economy, money would have to reach every place simultaneously and homogeneously, and that never happens. The first holders of the new money will satisfy their own investment and consuming preferences at the expense of the last holders of currency. This, I believe, helps explaining the significant price surge in art masterpieces of lately. If someone thinks worldwide taste and appreciation for highbrow culture is increasing, they can think again. A Monet or a Picasso have the distinct advantage of remaining the property of the owner even when held in custody by someone else, while the quantity of them in circulation cannot be increased at will. Well they can be counterfeited but that involves hard work (so there is a cost to it) and nobody will dare say the new Picasso is worth the same as the original. They pay no interest, but, with interest rates this low, who cares? True they are not the most liquid assets around. But then again, the money used to buy them is not likely needed to pay for the groceries next week.

In all honesty, it must be said that the government of Japan is not really worried that the price index is not readily affected by the increase in money offer. In fact, they are probably hoping it will take a while and, in the meantime, investors look for capital goods to increase production of goods and services, that late arrivals to new money will then buy fearing depreciation. That is why the banking sector is primarily used, and money is not directly handed to the mob. But it could be anybody who owns the assets central banks are buying just as long as they are willing to sell these and buy into something riskier.

If they can’t find anything else then they will most likely buy whatever assets the central bank is buying because of liquidity fears: when things look ugly it is best to own something for which we know, or strongly believe, there is a buyer ready to give back what we paid for it. This could explain the rush into Japanese Government Bonds (JGB’s) after the announcement was made last week. And then, earlier this week when the JGB actually started to buy. That is, if it was ot front running. Either way it is distorting economy way beyond prudence.

Forever Young

(Hoping for the best but expecting the worst, are you going to drop the bomb or not?)

But can it last? The government believes it can. After all they plan to buy 70% of issuance and spread their purchases to the furthest away maturities. But this makes me wonder, is demand for JGB’s otherwise faltering? After being hit during the troubled 70’s, when the monetary system devised at Bretton Woods crumbled, we have seen Government Bond issuance gradually but surely increase to help finance the Welfare State. The success of this process is due not only to growing economies, that feed the expectation that increasing future responsibilities would be met, but also of lowering interest rates, courtesy of central banks, that gave portfolios the performance required to keep government bonds an attractive investment opportunity. But with economies shrinking, governments running deficits and interest rates this close to zero, where could this go next? Are the BoJ market actions the only thing standing between here and a JGB price collapse? Because if they are, from here we’ll go to quadrupling the size of the money offer. The only way to sustain prices is doing it exponentially, not without consequences though. How long until there isn’t a single price index that can disguise what is going on?

The worrying question is, with their population ageing (or more likely aged already) and the Yen devaluating due to this policy, who’ll buy JGB’s? In fact, shouldn’t the Japanese themselves look elsewhere for capital preservation? Maybe that helps explain the schizophrenia around JGB’s long bond which managed to print new year high and low in the same session.

As for the Nikkei, it should go up, but exposure to the Yen should be hedged. I’m not a great fan of directly extrapolating from the past. Yet, what else do we have to teach us but the past seen through the lenses our own experience? People flee from holding hard currency and fixed income investments as inflation creeps, going for equity to protect themselves, but this is only a partial protection, and it comes at higher risk. Bear in mind inflation is a tax under disguise. This means wealth is being transferred into the government (in a very destructive manner), so it is only natural that the majority of companies or business ventures (a set of capital goods ordered to satisfy human needs) also have to pay their toll.

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