Conventional
thinking and reporting has it that Japan is conducting a larger version of the
same monetary experiment they’ve been running for about 15 years. The
implication here is that we can safely analyze what Japan is up to through the
same monetary lens, as always, but with a slightly wider aperture.
By now,
we are all familiar with the details. Japan has initiated a program of
monetary expansion that goes by the shorthand of 2-2-2. In two years,
the Bank of Japan (BoJ) will fully double the monetary base as
it seeks a minimum of 2% inflation.
In the
aftermath of this announcement, the yen weakened by a whopping 8% against the
dollar, the Nikkei stock average vaulted up by roughly 10%, and the $10
trillion Japanese government bond market had to be frozen twice because of
intense volatility.
In
truth, what Japan is running is as much a massive social experiment as it is a
monetary experiment. It has such enormous implications to everyone, but
especially the Japanese people, that we should all be paying very close
attention.
Creating Inflation
The
basic formula for creating inflation involves more money and credit chasing too
few goods. Whether this is more goods (just not enough to match the
growth in money and credit), the same amount of goods, or even fewer goods is
not important. What matters is that there is more money and credit than
goods.
On this
front, so far, so good. Japan is going to fully double (!) the monetary
base in just two years. In any tidy, mathematical world where economics
is governed by linear, rational processes, this doubling of the monetary base
would result in inflation.
Unfortunately,
the real world is not very tidy.
The
monetary base is really an abstraction that refers to the amount of money that
the banking system has available to pyramid into a greater number of
loans. As I am sure you have figured out by now, simply having more money
in the system will not automatically result in more money chasing goods.
In fact,
without a good reason to borrow and then spend that money, those new funds may
well just sit in the banking system chasing nothing related to real goods and
services in the real economy. Instead, that money will simply chase
financial assets such as stocks and bonds.
The BoJ
knows this, and yet their plan revolves around the idea that they can create
inflation by simply doubling the monetary base. Does this mean they are
confident that there is pent-up consumer demand that was stymied by a lack of
cheap funds from the banking system?
The very
short answer is ‘no.’ The BoJ knows perfectly well that
more base money will do nothing to stimulate additional inflation via consumer
demand, and they know this because Japan has had rock-bottom borrowing costs
for a very long time.
The Real Target – Trust
So if
the BoJ already knows that more base money will not lead to the buying of more
goods and services, then what is their plan for stoking inflation?
The
answer is both simple and somewhat upsetting: They are targeting people’s trust
in the yen. The idea is simple to understand, as inflation requires that
people prefer to hold ‘things’ instead of money. That is, the preference
for money is diminished and the preference for real things, perhaps anything
other than money, is elevated.
If
enough people decide that holding money is a losing proposition, they will
favor consumption instead. The way to get people to favor things instead
of money is to debase their confidence in money. So people’s trust in
money has to be targeted, and this is, indeed, the BoJ’s target.
The sad
part of this story is that the BoJ is seeking a 2% (minimum) inflation target
under the theory that higher inflation will be good for the economy and
therefore Japanese businesses and therefore Japan.
The
problem is that there are multiple reasons that prices might rise. Some
of them are beneficial to these inflationary aims, and some of them are
destructive. For example, if prices rise because people lose confidence
in the yen, and prices rise because imports cost more, then this simply hurts
consumers at the benefit of exporters.
In
short, there is no net societal gain. The accounting identity in play
here is that one entity’s loss is another entity’s gain. If consumers and
importers have to pay more for imported goods simply because the yen has fallen
in value, then all we have to work out is who gains. Exporters gain, by
and large, as do other sectors.
That’s
just the way these things work – it is not possible to engineer a gain where
everybody benefits because one sector’s deficit automatically becomes another
sector’s gain. It is simply Newtonian physics. For every force,
there is an equal and opposing force – only the forces are economic and involve
gains and losses.
The form
of inflation that Japan hopes to stoke involves the kind where money currently
stored in Japanese bank accounts comes roaring out into the Japanese
economy. The BoJ is willing to harness the import/export losses as a
useful means of convincing the local businesses and populace that the yen is
just not a safe store of value.
So the
basic plan that the BoJ has put into motion is to ruin local faith in the
yen. It is actively targeting trust, a necessary component of any
fiat-based currency, under the twin theories that it knows what it is doing and
will know when to stop.
The
problems are that I am pretty sure they will succeed beyond their wildest hopes
and that nobody at the BoJ has any experience in massive social engineering
experiments.
Conclusion
The BoJ
is not just running the largest monetary experiment in their history, but also
the largest social engineering experiment.
Trust is
an essential component in every economy and for every currency. The BoJ
has just upped the ante by explicitly and specifically targeting trust in the
yen. Perhaps they know what they are doing, and we certainly hope so, but I
happen to think it is playing with fire.
There
really aren’t any guidebooks for it to follow, and even if there were, it is
doubtful that the economists in charge would have been required to study them
during their academic training and political careers.
If the
notion of your pilots flying blind bothers you, then you are probably not very
happy or confident with the BoJ’s actions here. Were I a Japanese
citizen, I would immediately convert my yen holdings to something, anything,
else. Swiss francs, gold, dollars – anything (!) would be preferable to
me here.
Once
your central bank declares war on its own currency, this is just the prudent
thing to do.
For
everyone else, Japan is now the largest economic Petri dish on the planet and
is well worth studying for what happens next. The early results, with a
manic pulse in the Nikkei coincident with arrhythmic gyrations in the Japanese
government bond market, suggest that something has been shaken loose in Japan.
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