Re: Is Bernanke Behind The Rallies? Query to Barkley

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Michael Perelman wrote:
> Henry, could you elaborate on this?  Thanks.

Deflation wreaks havoc with business balance sheets; it discourages
investment; it leads consumers and corporations to postpone spending.
With the consumer price index falling at about one percent per year, and
the broader GDP deflator falling at about 2 percent per year, deflation
has become persistent in Japan in recent years, as Japan continues to
enjoy a substantial trade surplus in foreign currencies, mostly dollars.

Aside from a temporary increase in 1997 when the consumption tax was
raised, prices have been falling in Japan for the past decade.
Deflation is damaging to the operation of the banking system, and this
is one of the key links between monetary policy and banking policy in a
central banking regime.  With deflation, interest rates are forced to
become very low -- close to zero.  Yet near-zero interest rates only
postpone, but not eliminate, the need for banks to deal with problem
loans, because, notwithstanding Milton Friedman’s famous pronouncement
that inflation is everywhere and anywhere a monetary phenomenon,
deflation, the reverse of inflation, is not everywhere and anywhere just
a monetary phenomenon.  Deflation is a problem that cannot be cured with
monetary measures alone, as Japan has found out and as the US is about to.

With near zero interest rates, borrowers find it easier to meet their
interest payments to the banks, and loans remain performing even if the
borrowing firms are structurally unprofitable.  And deflation makes it
harder for borrowers to repay loan principal.  With negative real
interest rates (after inflation adjustment), banks are actually paying
their borrowers.  A zero interest rate can be a high real rate in a
deflationary environment. Under a national banking regime, banks are
performing their duty as long as they support the national purpose.  In
Japan’s case, the banks’ role was to support export.  Even if the banks
did not make a profit or their corporate borrowers could not meet debt
service temporarily with current cash flow, the banks were serving the
national purpose as long as the borrowing corporations were gaining
market share in the global market.

Post-war Japan was prepared to export the national wealth created by its
people in exchange for gold or gold-backed dollars.  This mercantilist
national purpose for a war-torn economy worked until 1971 when the US
took the dollar off its gold standard.  Yet it took another three
decades, before the full impact of exporting for a foreign fiat currency
took its toll on the Japanese economy.  This adverse impact was finally
brought home by the globalization of financial markets after the end of
the Cold War, and exacerbated by the Tokyo Big Bank on April 1 1998 and
the adoption of the Central Bank Law on the same day.  The end of the
Cold War robbed Japan of its geopolitical guarantee for a huge market in
the US; the Tokyo Big Bank subjected the Japanese financial system to
international market pressures and the Japan Central Bank Law forced the
Japanese banks to be profit centers rather than service institutions.

With a central banking regime in a neo-liberal globalized market
economy, firms and banks are separated from any national purpose, except
as affected by domestic tax policies or by national security
restrictions.  Banks and firms exist mainly to make profit for their
shareholders of any nationality.  Loan default decisions would surface
at a more timely stage if interest rates, both nominal and real, stay
steady and appropriately low for sustainable expansion of the economy
and its money supply, which generally requires between a 1-3% inflation
rate.  As a result of delays in confronting de facto default due to near
zero interest rates, business failure, liquidation, and loss of jobs
when they finally occur can be much more severe than if the finance
restructuring were made earlier.  Near zero interest rates dulls the
sensitivity of interest payments as a barometer of business robustness.

In March of 2001, the BoJ, then a three-year-old central bank, made an
important change in monetary policy.  It announced that it would provide
ample liquidity until the inflation rate was equal to or greater than
zero; that is, until deflation is ended.  That policy is essentially one
of inflation targeting.

The BoJ conducts monetary policy and its business operations under the
new Bank of Japan Law of April 1 1998, which has been established on the
principles of "independence" and "transparency."   The BoJ implements
monetary policy by adjusting the supply of funds in line with demand for
them in the money market through market operations.  Since February
1999, the then barely one-year-old central bank has kept the
uncollateralized overnight call rate, the operating target, at virtually
zero percent.  This is known as the zero interest rate policy.  This
means that the BoJ will inject funds into the money market without limit
whenever necessary.  In fact, the BoJ has been supplying funds in such
large volume that excess funds continue to remain in the banks, but the
funds have not found their way into the market.

The BoJ, at its Monetary Policy Meetings (MPMs), decides the guideline
for market operations that covers the inter-meeting period of about half
a month or a month ahead.  Market participants, on the other hand, often
engage in funds transactions that become due in three or six months.
This requires them to forecast movements in the overnight call rate
during the period between the next MPM and the maturity date of their
transactions.  Consequently, when the outlook for interest rates is
uncertain, market forces will set interest rates on term instruments,
such as three- or six-month instruments, substantially higher than the
prevailing overnight rate.

To avoid such an outcome, the BoJ has announced its intention of
maintaining the zero interest policy "until deflationary concern has
been dispelled," suggesting possible continuation of the policy beyond
subsequent MPMs.  This announcement aims at ensuring that the effects of
the zero interest rate policy permeate the economy.  As a result, money
market rates, including those on three- to six-month instruments, have
stayed around zero percent.

This is an application of Nobel economist (1995) Robert E. Lucas’ theory
of "rational expectations".  The theory postulates that expectations
about the future can influence the economic decisions independently made
by individuals, households and companies. Using mathematical models,
Lucas showed statistically that the average individual would anticipate
- and thus could easily neutralize - the impact of a government's
economic policy.  Rational expectation theory was embraced by the Reagan
White House during its first term, but the theory worked against
Reagan’s  “voodoo economics” instead of with it.

When the BoJ first adopted the zero interest rate policy in February
1999, the economy and the financial markets interacted in a downward
spiral.  Sluggish economic activity had made market participants
increasingly worried about the stability of the financial system.  Had
extreme pessimism spread in the financial markets, Japan's economy could
have plunged into a catastrophic crisis.  This situation could create an
abrupt freeze on economic activities, such as business investment and
household spending.

The zero interest rate policy effectively stopped the toxic interaction
between economic activity and the financial markets by removing concerns
among market participants that they might face difficulties in funding
due to a liquidity shortage in the market.  In the meantime, the
Financial Function Early Strengthening Law and other legislation enacted
in the autumn of 1998 provided the framework for the stabilization of
the financial system.  In March 1999, approximately one month after the
adoption of the zero interest rate policy, major banks were
re-capitalized by injection of public funds.  Moreover, fiscal spending
was increased significantly to support economic activity.   But the yen
money supply did not expand due to a recurring trade surplus denominated
in dollars.  The zero interest rate policy masked the symptoms, but it
did not address the disease.

Japan's economy has shown no signs of a self-sustained recovery in
private demand despite the zero interest rate policy.  Under these
circumstances, the timing of a policy change and the meaning of "until
deflationary concern has been dispelled" which is generally regarded as
the criterion for terminating the current policy, have again become the
focus of attention.

The BoJ describes the condition: "until deflationary concern has been
dispelled" as meaning "until a self-sustained recovery of the economy
driven by private demand could be forecasted with a certain degree of
probability." A fall in prices of goods is not necessarily deflation,
for it may be the effect of a rise in productivity from the same cost
base.  When computer prices fall, it is not deflation.  Generally,
deflation is defined as a spiral of declining prices, particularly in
asset prices in addition to prices of goods, accompanied by contraction
in economic activity.  An overall decline in the level of prices brings
about a fall in corporate profits and wages; and this fall leads in turn
to a contraction in economic activity, resulting in another price
decline. This indicates that the economic momentum behind price
developments is an important criterion in identifying the risk of prices
declining further.

While interest rate policy can be stimulant or depressant in an
inflationary environment, a zero interest rate policy can have
unintended adverse effects in a deflationary environment.  Since cost of
money is near zero, there is no compelling reason for banks to lend
money out, except for earning fees to refinance loans made earlier at
higher interest rates.  This creates problems for banks down the road by
reducing future interest income for the same loan amount.  The narrow
spread in interest will also force banks to raise credit thresholds,
shrinking the pool of qualified borrowers.  It can also cause a
distortion in income distribution in the household sector by denying
interest income it would have otherwise earned by savers.  It can create
problem for pension funds and insurance companies.  Structural reform
can be delayed by too much easing of the necessary cash flow pain.
Market participants' risk perception can be dulled.  Institutional
investors, such as life insurance companies and pension funds, can then
face difficulty in finding good investment opportunities to pay for long
term commitments made at high interest rates.

The BOJ's zero interest policy, combined with asset deflation have
caught the Japanese insurance companies in a vise.  Both new loans rates
and asset values are insufficient to carry previous long-term yields
promised to customers.  Japan does not have a debtor friendly bankruptcy
law, as the US has.  At any rate, insurance companies, like banks,
cannot file bankruptcy. They are governed by an insurance commission,
which normally has a re-insurance fund to take care of insolvency.
The fund is nowhere near sufficient to handle systemic collapse.  The
same happened to the US FDIC (Federal Deposit Insurance Corporation) in
the 1980s.  The insurance sector in the US has the same problem which
will get worse as the Fed further lowers the Fed Funds Rate (FFR).
Several segments of the insurance sector, such as health insurance and
casualty insurance, have already collapsed for other reasons.

In the era of industrial capitalism, lower interest rate was stimulant.
 But in this era of finance capitalism, lowering rates creates complex
problems, especially when most big borrowers routinely hedge their
interest rate exposures.  For them, even when rates drop or rise, the
cost remains the same, the only difference is that they pay a different
party.

Central banks are still applying industrial capitalism monetary
economics to the new finance capitalism. That is the main cause of the
multi-wave financial crash that began in 1982 in Mexico and developed
with full force of contagion in 1997 in Asia.  In fact, in more than two
years since the zero interest policy announcement, the BoJ has
significantly expanded money as measured by the monetary base, which is
bank reserves plus currency in circulation.  The monetary base is up 34
percent since the Bank of Japan began its new policy.  However, broader
measures of liquidity that are more closely associated with general
price increases have not grown nearly as rapidly for reasons stated
above. The growth rate of broad money, which includes individual and
business deposits at banks, has hardly increased at all.  Moreover, bank
lending has not increased due to a liquidity trap.  As the Japanese
trade surplus adds to Japan’s dollar reserves, yen deposits and loans
remain stagnant.  Even after adjusting for loan write-offs, bank lending
was down 2.6 percent in 2002 and consumer prices continue to fall.

The reason the increase in the growth rate of the monetary base has not
resulted in higher growth of loans and deposits at banks, or a rise in
prices, is not, as some economists suggest, that the increase in the
monetary base has not been sustained for long enough.  Nor are more
increases needed in reserve balances banks hold at the BoJ, a key
component of the monetary base.  The anti-inflation bias of the central
banking regime has deprived policymakers of any historical guide in
overcoming persistent deflation.

The current round of global deflation is caused by weak demand resulting
from the effects of dollar hegemony as sustained by a global central
banking regime regulated by the Bank of International Settlement (BIS).
 The neo-liberal globalization of trade and finance prevents all
non-dollar economies from effectively increasing their local currency
money supply for domestic development.  To avoid speculative attacks on
their currencies, all increases in local currency money supply must be
channeled to fuel export for trade surplus in dollars.  This shrinks the
exporting economies’ own money supply while adding to the dollar money
supply to fuel the dollar economy at the expense of non-dollar
economies.  Consumers in non-dollar economies are robbed of purchasing
power because low wages are necessary to compete in the global export
market to accumulate trade surpluses in foreign currencies, mostly
dollars.  At the same time state credit cannot be used to finance
domestic development to raise income for fear of inducing speculative
attacks on the local currencies.


Henry C.K. Liu

> On Thu, Jun 19, 2003 at 09:01:20PM -0400, Henry C.K. Liu wrote:
>
> >  Japanese policy of keeping the yen’s exchange value lower than that
> > dictated by market pressure has now become an attempt to eliminate
> > domestic deflation.  But a below-market yen leads to a larger trade
> > surplus in dollars, causing a net shrinkage in the yen money supply,
> > thus shrinking the yen asset economy, leaving it with over-capacity and
> > making yen assets less valuable.  What Japan is doing is investing in
> > the dollar economy while dis-investing in the yen economy through its
> > trade surplus. This is the real cause of deflation in Japan.
> >
> > To restore strong economic growth in Japan, deflation must be stopped.
> > Under a central banking regime, the most straightforward way to stop
> > domestic deflation is to force the yen to depreciate in foreign exchange
> > value.  But this would go against market forces generated by Japan’s
> > trade surplus.  Yet if Japan keeps the exchange value of the yen low
> > merely to sustain its export prowess, it will continue to feed domestic
> > deflation.  This is because the rate of shrinkage of the yen economy
> > from a huge trade surplus denominated in foreign currencies, mostly
> > dollars, is greater than the rise in yen money supply released by a
> > reluctant central bank.