Kudos to Kyle Bass at Hayman Advisers for warning that the Bank of Japan would lose control of its 70 trillion bond buying blitz. The spike in the 10-year yield to 1pc on Thursday was certainly shocking to behold.
His point is that the BoJ faces a “rational investor paradox”. The authorities are trying to drive up the inflation to 2pc and therefore to devalue Japanese government bonds (JGBs), so why on earth would you want to own them?
“If JGB investors begin to believe that Abenomics will be successful, they will ‘rationally’ sell JGBs to buy foreign bonds or equities,” he told Bloomberg
He says the scramble to sell has “overwhelmed” buying by the BoJ. Governor Kuroda will now have double down with a huge increase in the scale of QE.
The argument is similar to warnings by Nomura’s Richard Koo, Japan’s most famous economist and an arch-Keynesian. The two men reach the same conclusion coming from diametrically opposed theoretical starting points.
As I reported last night, Mr Koo thinks the Abenomics plan of monetary reflation is madness. “Once inflation concerns start to emerge the BoJ will be unable to restrain a rise in yields no matter how many bonds it buys.” This could lead a “loss of faith in the Japanese government” and the “beginning of the end” for Japan’s economy.
Mr Koo said the BoJ faces a “time inconsistency problem”, a variant of Mr Bass’s paradox. Markets react more quickly to events than the economy. “The Japanese authorities are trying to generate inflation first and then hope for recovery, which means debt service costs will increase before tax revenues do.”
This will worsen the debt trajectory, set to reach 245pc of GDP this year (IMF), roughly where Britain ended the Napoleonic Wars. But then Britain produced half the world’s manufactured goods in the early 19th century, so it may be tougher for Japan.
Mr Koo says “long-term rates may rise before the real economy”. If so lenders will respond to these signals more quickly that borrowers, choking credit.
He says Kuroda has “altered the market structure of the last two decades” and undermined a fragile equilibrium, inviting a speculative attack on the JGB market by foreign hedge funds.
So that then is the critique. I don’t agree that it is game over for Abenomics. My view is that the Keynesian doctrines of endless fiscal stimulus without monetary support advocated by Mr Koo over the years is the cause of Japan’s desperate crisis (though he says the economy could have achieved escape velocity long ago if they had done more of it, which is not as absurd as it sounds).
Au contraire. Monetary policy should take the strain, pursuing a nominal GDP target of 3pc and later 4pc to turn the vicious circle of the “denominator effect” (ie a rising debt load on a shrinking nominal base) into a virtuous circle.
This is what Takahashi Korekiyo achieved with such brilliance in the early 1930s, setting off a boom and falling debt ratios. Though he also forced the BoJ to finance fiscal spending too to kickstart recovery. I am not against that either if it works. In fact in it is a rather good idea (for Japan, not the UK obviously).
Mr Koo’s argument that balance sheet recessions require radical action by governments is correct, but I refute his claims that QE was tried and failed in Japan. It was never tried.
The BoJ meddled on the margins with pinprick purchases of short-term debt, buying from the banking system, and merely pushing up the monetary base. Of course it failed. Who cares about the monetary base. It is irrelevant.
What they should have done is to conduct old-fashioned open-market operations, la Friedman, Fisher, Hawtrey, Cassel, or Keynes himself, buying long bonds from non-banks to force up the M3 money supply. That works, as Ben Bernanke discovered when he finally alighted upon the policy by accident late in the Fed’s QE efforts.
True, the ructions in Japan over the last few days have been extraordinary. Governor Kuroda was forced to reassure the nation on Friday that the BoJ has the instruments to restore order to the bond markets
Premier Shinzo Abe was very blunt in parliament, warning that “sharp increases in long-term interest rates could have a grave impact on the economy and the government’s fiscal conditions. We expect the BOJ to respond appropriately,” he said.
Mr Abe is not pleased, I would surmise, and quite understandably so since the BoJ seems to have cocked up badly. My guess is that JGB market will settle down once they work out how to execute the task.
I stick with my view that the BoJ has the means to crush all resistance, and should do so. This may require financial repression. Rutaro Kono and Makoto Watanabe from BNP Paribas have an excellent note out this morning arguing that Kuroda will have to copy the “pegging operations” of the Fed in the 1940s.
In effect, the Fed became part of the Treasury’s debt management team as the budget deficit hit 25pc of GDP in WW2. It capped one-year notes at 0.875pc and 30-year bonds at 2.5pc. The markets knew that all necessary means would be used to hold the line (as the Swiss did in 2011 to hold the franc at 1.20 to the euro).
It certainly worked. It allowed the US to whittle away its wartime debt through inflation and negative real rates. The creditors paid the price. It was an “inflation tax”, or covert debt restructuring.
That is what lies in store for Japan, and it will be horrible for pensioners, savers, and those expecting an annuity. Whether the authorities can pull it off it without capital controls is an interesting question. My guess is that controls will be part of the mix in the end, and much else besides. Tough. Leaders don’t run countries for the benefit of markets.
But all this is clearly “doable”, and if the alternative is a spiral into mayhem and debt default, you can hardly blame Mr Abe for wanting to try. There was always a “Hail Mary” element to this massive reflation experiment, a last-ditch effort to avert a debt compound spiral.
The critics are right to say it may fail. But are they suggesting that the previous status quo was tenable? If Mr Bass happens to read this blog, I would like to know what he would do if he were prime minister of Japan.
As for the countless readers demanding an apology from me for backing QE, Abenomics, and all the sins of monetarism: I defy you all.
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