Richard Koo

EQUITY RESEARCH

April 16, 2013

Potential benefits and dangers of “quantitative and qualitative” easing
The Kuroda BOJ’s bold program of “quantitative and qualitative” easing shocked the financial world when it was announced two weeks ago. Attention also focused on the huge announcement effect of the policy as Japanese equity prices surged and European government bond yields slid. In this report I would like to discuss the potential benefits and dangers of the BOJ’s new policy, which has been labeled “easing of a different dimension” in Japan and which elsewhere has been described as a revolution in monetary policy. BOJ to double monetary base in two years The newly announced easing program, which seeks to double the monetary base in two years’ time, appears at first glance to be very aggressive. Japan already has a much larger monetary base (relative to GDP) than western economies, and it comes as little surprise that overseas analysts were shocked to hear it would be doubled again. However, the relationship between base money and GDP depends to a great extent on (1) the economy’s reliance on cash and (2) whether individuals and businesses prefer to place their savings in bank deposits or invest them in other financial assets, such as stocks, or real assets. Japan’s monetary base already larger than that of US or UK Japan’s monetary base already amounted to 12% of GDP in 2000, compared with figures of just 6.9% for the eurozone and 5.9% for the US. After Lehman Brothers collapsed and the global financial crisis took hold, the Fed expanded the monetary base by 250%, the ECB by 57%, and the BOE by 335%, but Japan, where the Shirakawa BOJ had already been increasing the supply of base money, still had a larger monetary base relative to GDP. Inasmuch as the quantitative easing programs undertaken by the US and the UK failed to bring the monetary bases in those countries to Japan-like levels when Masaaki Shirakawa was at the helm of the BOJ, Haruhiko Kuroda’s plan to increase the monetary base by another 100% naturally came as a surprise to observers outside the country.
To receive this publication, please contact your local Nomura representative. Richard Koo is chief economist at Nomura Research Institute. This is his personal view.

Richard Koo r-koo@nri.co.jp

Japanese version published on 15 April, 2013

See Appendix A-1 for important disclosures and the status of non-US analysts.

Nomura | JPN Richard Koo

April 16, 2013

Statutory reserve system links base money and money supply
Fig. 1: Kuroda BOJ seeks to overtake Fed and BOE
(x) 25

Bank reserves ÷ statutory reserves
20 BOJ BOJ: estimate FRB 15 ECB BOE

21.6x 18.7x 16.0x

10

9.7x

11.8x

5

4.8x 3.8x

0 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Notes: (1) The estimate is based on the assumption that required reserves will increase by 3% a year and bank reserves constitute 88.8% of financial institution's current deposit holdings with the BOJ. (2) The BOE has suspended reserve requirement in March 2009. The post-March 2009 figures are based on the assumption that the original reserve requirement is applicable. Source: Nomura, based on BOJ, FRB, ECB, EOB data

Simplistic comparisons should be avoided, however, since the size of the monetary base relative to GDP is greatly affected by people’s propensity to keep their savings in bank accounts. Perhaps more importantly, a distinction must be drawn between the monetary base and the money supply, which represents money actually available for use by the general public. Only when base money flows out into the real economy and becomes part of the money supply can it be spent, boosting economic activity and inflation. The statutory reserve requirement plays a key role in the transformation of base money into money supply. When the BOJ buys JGBs from private financial institutions, it deposits the money in their accounts at the BOJ, thereby expanding the monetary base. In Japan, the monetary base consists of currency and coins in circulation and current accounts at the BOJ, but as the latter also includes deposits from securities firms and money market dealers that are not required to hold reserves, the discussion below will focus only on reserve component of the deposits. Commercial banks seek to earn money by lending out those reserves, but they must keep a certain portion on deposit at the central bank in the form of statutory reserves. A statutory reserve ratio of 10%, for example, means banks can lend out 90% of their current account balances at the BOJ. When someone spends the money lent by a bank and the party receiving that money then deposits it somewhere else, the receiving institution can then lend out 90% of the new deposit to earn interest income (10% must be kept with the central bank as statutory reserves). This process comes to a halt only when all the base money supplied by the BOJ has been lent and spent to become statutory reserves. At that point in time, commercial banks have on their books deposits and loans equal to ten times the reserve deposits injected by the BOJ (this multiple is the reciprocal of the 10% statutory reserve ratio and is referred to as the money multiplier). Private-sector deposits at commercial banks represent money available for use by the private sector and are referred to as the money supply. The money supply also includes banknotes and coins, but in all modern economies bank deposits represent the lion’s share. Changes in the money supply have a major influence on economic activity and inflation.

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Figure 1 illustrates how much money supply can grow from the present level for leading economies based on the size of monetary base relative to statutory reserves. In other words, it shows how much money supply can grow if the money multiplier reaches its maximum value. Massive supply of reserve deposits has not sparked inflation Before Mr. Kuroda was appointed BOJ governor, base money supplied by the Fed under quantitative easing amounted to 16.0x statutory reserves (Figure 1). The corresponding multiples for other central banks were 9.7x for the BOE, 4.8x for the BOJ, and 3.8x for the ECB. If the money multiplier were functioning properly, the money supply would therefore be 16 times larger than it currently is in the US, 9.7 times larger in the UK, 4.8 times larger in Japan, and 3.8 times larger in the eurozone. If such an expansion in money supply actually took place in a short time, it would normally entail a similar increase in prices, leading to unprecedented inflation rates of 1,600% in the US, 970% in the UK, and 480% in Japan. The reason why this has not happened will be discussed in detail below. In short, however, businesses and households in these economies have stopped borrowing money even though interest rates have fallen to zero. And with no one borrowing money and many actually paying down debt, the money multiplier has turned negative at the margin. BOJ plan not significantly more aggressive than Fed’s QE Using this concept of the statutory reserve deposit multiple, the BOJ’s new policy would lift potential growth in the money supply—and therefore inflation—from 4.8x to 18.7x. The latter number is much higher than the corresponding figures of 9.7x for the UK or 3.8x for the eurozone, but is roughly equal to the US multiple of 16.0x and somewhat less than the 21.6x peak there. In that sense, the BOJ’s easing program can be viewed as an attempt to catch up with (and overtake) the Fed on the easing front. Estimates based on the quantitative easing schedule provided by the BOJ suggest that Japan’s monetary base (as a multiple of statutory reserves) will overtake the UK sometime this autumn and pass the US next summer. QE did not lead to economic recoveries in US or UK The next question is what Japan will accomplish once its monetary base reaches the levels of the US or the UK. Inflation in both of these economies is around 2% and real interest rates are heavily negative, which is what Mr. Kuroda seeks. Yet the unemployment rate remains at 7.8% in the UK and 7.6% in the US. The UK is in the midst of a triple-dip recession, and recent US consumption and jobs data have not been particularly encouraging. Japan, meanwhile, has an unemployment rate of 4.3%, far below the 6.5% level at which the Fed says it will discontinue its zero interest rate policy. That suggests Japan’s economy may not necessarily enjoy a resurgence even if the BOJ succeeds in lifting inflation rate to 2%. Deflation took root in Japan when economy fell off fiscal cliff in 1997 Central bank officials in the US and the UK claim quantitative easing has been a success because it prevented a Japan-like deflation. But as I noted in my last report (2 April 2013), the rate of Japanese wage growth four to five years after the bubble collapsed was roughly equal to the levels now being observed in the US. Deflation took root in Japan only after 1997, when the nation fell off the fiscal cliff following the Hashimoto administration’s illfated experiment with fiscal consolidation. That was seven to eight years after the bubble burst. It therefore makes no sense to compare conditions in the US and UK, which are only five years into the post-bubble era, to those in Japan, where more than 20 years have passed since the bubble collapsed. Money supply cannot expand without growth in private credit Common to all of these countries is the fact that businesses and households are saving in spite of zero interest rates. They are doing so because of the severe damage caused to balance sheets when the bubble collapse drove asset prices lower while leaving debts intact. Private savings are running at 8.8% of GDP in Japan, while the corresponding figures are 7.0% for the US, 3.3% for the UK, 8.1% for Spain, 8.6% for Ireland, 7.0% for Portugal, and 4.4% for Italy. The fact that businesses and households in these economies are responding to zero interest rates by saving money rather than borrowing and spending aggressively clearly suggests that lending—and hence the money supply—will not expand no matter how much base money the central bank supplies. Growth in private credit has been severely depressed, as noted here on numerous occasions. Even in the US, where conditions are said to be relatively healthy, private credit has yet to recover to pre-Lehman levels. Quantitative easing—whether in Japan, the US, or the UK—cannot directly stimulate the economy or raise the rate of inflation so long as businesses and households refuse to borrow money and spend it.

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Is BOJ’s easing plan different from what preceded it? Mr. Kuroda and other reflationists would probably argue that the newly announced easing program differs fundamentally from the incremental approach taken thus far because it marks a “new dimension” in aggressiveness. This is correct in one respect and wrong in another. Although Mr. Kuroda argues that the announcement of the current program has had a much greater impact than past announcements, this hypothesis has already been tested overseas, and the medium and long-term results do not support his conclusion. Economists and analysts in the US and the UK have long argued that the BOJ blundered after the bubble collapsed by waiting seven or eight years to take interest rates to zero. If the Bank had only acted more quickly, they say, monetary accommodation would have been more effective. In contrast, the Fed lowered interest rates from 5.25% to zero in only a year, setting a new record for speed, and the BOE cut rates from 5.75% to 0.5% in just over a year. Both the US and the UK implemented massive quantitative easing programs and expected the announcement of these programs to have a major impact. Fed Chairman Ben Bernanke estimated the global financial crisis would lower US GDP by about 0.5% and predicted conditions would return to normal in about a year. The BOE singled out the “failure” of the BOJ’s incremental approach and declared that, unlike Japan, it would increase the money supply immediately with a bold program of quantitative easing designed to drive a recovery. No sense in trying to mimic bold US and UK approaches But the subsequent events in the US and the UK have demonstrated that this criticism of the BOJ and the insistence that “speed is everything” were entirely off the mark. Mr. Bernanke now says the Fed will not lift interest rates until 2015, eight years after it began cutting rates in 2007. That means the US economy will have been in a downturn for eight years. And the UK has entered a triple-dip recession. Clearly, the issue is not how aggressively or quickly the central bank eases, but rather the extent of the damage to privatesector balance sheets caused by the bubble collapse. These experiences also underline the fact that a great deal of time is needed for businesses and households to repair their balance sheets. The limited impact of the bold monetary actions undertaken by the Fed and the BOE suggests we should not expect much from the BOJ’s plan in the medium term in spite of its aggressiveness. Quantitative easing running up against a wall in Japan Mr. Kuroda also says the BOJ will support the economic recovery by lowering long-term interest rates with the purchase of longand superlong-term government bonds. But the 10-year JGB yield has not fallen since the BOJ began buying these bonds in quantity, with yields around the 5-year sector actually rising. The reason is that interest rates in Japan were already at extraordinarily low levels before Mr. Kuroda took the helm, which is very different from the situation in the US or the UK when Lehman failed. Perhaps more important was why Japan’s interest rates were so low. Essentially, the private sector had stopped borrowing money because of balance sheet problems, the subsequent debt trauma, and a shortage of domestic investment opportunities. With no private-sector borrowers, Japanese banks selling JGBs yielding 0.6% to the BOJ may find themselves forced to reinvest the proceeds in JGBs given the lack of alternatives. If the replacement bond is likely to yield only 0.4%, the correct option is to continue holding the bond yielding 0.6%. In that sense, quantitative easing in Japan has already reached its limits. Impact of lower long-term rates in US and UK may be fading In the US and the UK, the central banks began buying government debt when long-term interest rates were still quite high, and the resulting drop in long-term rates provided a meaningful boost to the economy via lower mortgage rates. But the fact that businesses and households in both countries are now refusing to borrow in spite of zero interest rates suggests the impact of lower long-term rates may have spent itself, in which case the recession could continue despite ultra-low interest rates, as it has in Japan. In the early 1990s, soon after Japan’s bubble burst, falling interest rates prompted businesses and households with relatively healthy balance sheets to take advantage of the lower rates to invest and consume based on expectations of an economic recovery. But such demand dried up and eventually disappeared entirely, resulting in long-term rates falling below 2% and then 1%. Meaningless to increase lending in a world without borrowers The underlying cause of a balance sheet recession is a decline in—and ultimate disappearance of—private demand for funds due to a critical shortage of borrowers.

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Yet the quantitative easing policies adopted by central banks in the major economies are all designed to increase the number of lenders. When the problem stems from the lack of willing borrowers, the central bank’s emergence as a new lender is hardly going to improve the situation. If anything, new lending by the central bank will further weaken private sector financial institutions already hurt by excessive competition. An objective analysis of the BOJ’s easing program in light of other countries’ experiences with quantitative easing suggests investors would be wise to rein in their expectations. There is no reason why the money multiplier should turn positive when private demand for funds is nonexistent despite zero interest rates. But bold accommodation may have psychological impact… The discussion above suggests that there is little physical or mechanical reason for the BOJ’s easing program to work. But the program could also have a psychological impact. One notorious minister of propaganda is reported to have said that “people will believe a lie if it is repeated often enough.” In today’s Japan the media—and especially the omnipresent variety shows on TV—cannot stop talking about inflation. These commentators are completely unaware that the money multiplier in Japan is negative at the margin even though rates have fallen to zero. They are simply repeating the simplistic view that aggressive easing by the BOJ will eventually generate inflation. Hearing this from morning to night will cause some people to start worrying about inflation even though there is no way the BOJ’s policies can directly create inflation. If they start to anticipate higher prices and modify their behavior accordingly, inflation could become a reality. Moreover, the Japanese media has a tendency to move all at once and in the same direction, causing the lie to be repeated even more frequently. It would therefore not come as a surprise if many people changed their behavior in expectation of future inflation. And could help private sector overcome debt trauma One definitive difference between Japan and the West is that 20 years of deleveraging have enabled Japan’s private sector to complete its balance sheet repairs. Fully half of Japan’s listed companies are now effectively debt-free. Even with clean balance sheets and record-low interest rates, however, these businesses still refuse to borrow money because they remain traumatized by their earlier experience with debt, with wounds that are more psychological than physical. Psychological tactics—such as repeating the inflation lie often enough—might just help businesses and households overcome their aversion to debt since it is debtors who will come out on top during a period of inflation. There is no way such a strategy could have worked in Japan until the last few years, and there is no way it would work in the West today. This is because businesses and households with impaired balance sheets cannot take on more debt until they finish repairing their finances, no matter how often the inflation lie is repeated. Nor is there any reason why financial institutions would lend to technically insolvent businesses and households. Even if they wanted to, the authorities would prevent them from doing so. Japanese businesses and households have finished repairing their balance sheets, and only psychological scars and a shortage of attractive investment opportunities are keeping them from borrowing money. In this environment, Mr. Kuroda’s bold methods may go some way towards relieving the psychological trauma and providing a shot in the arm to the economy given all the media talk about inflation. A resumption of private-sector borrowing and spending could remove what has been the largest obstacle to a Japanese economic recovery. Inflation expectations and BOJ exit strategy will push interest rates higher The risk here is that not only borrowers but also lenders will start to believe the lies. No financial institutions anticipating inflation could ever lend money at current interest rates. A financial institution that suddenly saw inflation on the horizon could not continue holding 10-year government bonds that yield 0.6%. The resulting rush to sell could trigger a crash in the JGB market, inflicting heavy damage on domestic financial institutions. The question is how the Kuroda BOJ would respond to such a crash. If it began buying more JGBs, the monetary base would expand, stoking inflation concerns at a time when private demand for funds was already recovering and the money multiplier had turned positive at the margin. But if the BOJ sold its JGB holdings in an attempt to quell inflation concerns, bonds would drop further, blowing a large hole in the balance sheets of financial institutions and the government.

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By that time the monetary base could easily have grown to, say, 15 times statutory reserves. In that case the money supply would continue growing, causing inflation to spiral out of control, unless the central bank reduced the monetary base to about 1/15th of its current level. I suspect that the BOJ would employ all the tools at its disposal to achieve this, including a sizable increase in the statutory reserve ratio, but all of those measures would serve to push rates higher, resulting in large losses for the BOJ and other JGBs investors. Lending would also be expanding, enabling banks to offset at least some of those capital losses with interest income, but initially I suspect capital losses would substantially exceed the increase in interest income. Mounting inflation expectations will also hurt BOJ This is also likely to pose problems for the BOJ, which by then will probably hold a massive portfolio of JGBs. If the government bond market crashed, losses on the BOJ’s JGB portfolio would be subtracted from the money it transferred to the national treasury, adding to the fiscal deficit. And if the portfolio was large enough at the time of the crash, it could even raise doubts about the viability of the Bank’s balance sheet. Koichi Hamada, professor emeritus of economics at Yale and economic adviser to the prime minister, was asked in an interview with the Nikkei on 21 March whether sustained JGB purchases would not increase the risk of problems on the BOJ’s balance sheet. He responded that such concerns were nonsense since the Bank can always print more money. But in fact no country allows the central bank to do that. For the BOJ to print more money to cover losses on its bond portfolio—particularly at a time when it is desperately trying to keep inflationary pressures under control—would simply be out of the question. Confidence in yen could also be undermined The inflation fears and the talk of large losses at the central bank could then undermine confidence in the Japanese currency. Japan’s national debt now stands at 240% of GDP, domestic industry is being hollowed out, the population is aging and shrinking amid falling birthrates, and even the trade balance has fallen into deficit. The chief reason why people continue to use the yen in spite of these bleak fundamentals is that the BOJ has earned their trust with its anti-inflationary actions. If the BOJ recklessly stokes inflation, triggering a crash in the JGB market and heavy losses on the Bank’s bond portfolio, public confidence in both the currency and the central bank could evaporate overnight. Mr. Kuroda’s methods have frequently been compared to those of the 1930s-era finance minister Korekiyo Takahashi, who championed a successful policy of BOJ underwriting of government debt issues. But Japanese people in those days could not move money freely overseas. The authorities today need to be especially careful inasmuch as almost anyone can move funds abroad with a telephone call or a few clicks on a computer screen. Soros’ warning In a CNBC interview on 5 April, investor George Soros warned that the new easing program was a dangerous policy that could potentially trigger a crash in the yen. He was concerned about just the sort of scenario discussed above. Fortunately, Japan’s large foreign currency reserves ($1.25trn as of end-March 2013) will give it the ammunition it needs to defend against foreign attacks on the yen. But even those reserves may not be sufficient if Japanese investors start to desert the currency. Policy should be reversed as soon as psychological impact of easing is felt No actual damage will be done as long as the easing program remains ineffective. But once it starts to affect psychology, the BOJ needs to quickly reverse the policy and bring the monetary base back to a level more in line with the value of statutory reserves. If the policy reversal is delayed, the Japanese economy could spiral out of control at a time when base money equal to many times statutory reserves is sloshing around in the market. Moreover, the act of scaling back the monetary base must be carefully calibrated so as to minimize damage to the JGB market. The BOJ, Ministry of Finance, and Financial Services Agency should also have contingency plans in place in the event that easing triggers a crash in the yen or the bond market. Second and third pillars of Abenomics could address weak demand for funds The correct way to address the anemic private demand for funds that is at the bottom of Japan’s prolonged economic slump is to undertake fiscal stimulus and structural reforms—the second and third components of Abenomics. Fiscal stimulus in particular would be able to raise the money multiplier and create demand by having the government borrow and spend unborrowed private savings. The only reason the money supply in Japan has not shrunk despite extensive privatesector deleveraging is that the government has successfully served as borrower of last resort.

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Other options for the “second pillar” that are being discussed include policies to encourage business investment, such as investment tax breaks or accelerated depreciation schemes. If such measures succeeded in ending the private sector’s aversion to debt, I think everything would start moving in the right direction at a time when interest rates were low and banks willing to lend. Policies needed to increase supply of cheaper, more roomy housing The third pillar of Abenomics—structural reforms and deregulation—needs to provide the kinds of attractive investment opportunities that tend to be in short supply in a mature economy like Japan’s. Oft-mentioned candidates for reform and deregulation include energy, environmental businesses, and agriculture. I think policies aimed at achieving more effective use of urban land, enabling residents to live in larger homes for less money, would create significant new domestic investment opportunities. There are few city dwellers in Japan who do not want to live in larger homes. This issue was first broached in the Structural Impediments Initiative talks between Japan and the US some 22 years ago, but unfortunately little progress has been made since then. Abe administration has yet to unveil second and third pillars One concern is the fact that while the first pillar of Abenomics—monetary accommodation—is already being implemented, the second and third have been slow in coming. I think the base money supplied by the BOJ would come to life if the government announced an accelerated depreciation scheme for capital investment or a bold plan for deregulation of the energy sector. An economic stimulus that is entirely reliant on monetary easing will not only distract and confuse the public with unwarranted inflation concerns but also could result in a shortened and qualitatively inferior economic “recovery” because of the lack of reforms for the future. The Abe administration therefore needs to present concrete proposals for the second and third pillars of its economic strategy as soon as possible. Trade deficits will continue to weigh on yen Recent equity gains driven by expectations of a weak yen and higher corporate earnings are likely to persist. I think yen depreciation resulting from the fundamental shift from trade surplus nation to trade deficit nation is unlikely to be reversed barring major new developments in the West. Inflation rate will pick up as a result of a weak yen as well. Former Governor Masaaki Shirakawa described the approach of trying to maximize the psychological impact of a monetary policy unlikely to have any direct impact on prices or the economy as “chanting-a-spell monetary policy.” For now all we can do is hope and pray the BOJ’s new efforts are successful. Meanwhile, the Abe government and BOJ need to be ready to normalize policy as soon as the psychological impact of the easing measures starts to manifest itself.

Richard Koo’s next article is scheduled for release on 8 May 2013.

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