A theory is put to the test

Nomura´s Richard Koo of ‘Balance Sheet’ Recession’ fame is desperate that his theory is being put to the test and is losing ‘face’. According to Ambrose Evans-Pritchard:

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.

He´s probably right with “beginning of the end for Japan´s economy”, if by that he means (which he doesn´t) that deflation will finally end and growth will pick up.

For too long monetary policy has been synonymous with interest rate policy. For example, at every round of QE Bernanke would say the objective was to drive down interest rates over the whole term structure. Curiously, the exact opposite happened as the chart illustrates.

Japan Reborn_1

The go-stop nature of QE reduces its effectiveness. The more recent ‘threshold contingent QE’ is a step in the right direction but, given the objects that make up the thresholds, has been causing ‘communication glitches’.

In Japan, given the more than two decades of low and sometimes even falling rates, the bond market took a little longer to ‘wise up. Yields fell for several months after Abe´s policy change announcement but for the past two weeks, following much better than expected growth news, they have soared as the market begins to realize that monetary stimulus designed to get rid of deflation has already managed to stimulate the economy.

As the charts show, the stock and foreign exchange markets were much quicker on ‘the draw’.

Japan Reborn_2

Japan Reborn_3

The big drop in the Nikkei on Thursday made headlines and some were quick to say “the end is near”.

Note, however, that after Abe´s election and up to May 22 (the day before the big drop), the volatility of stock prices had increased significantly. That usually happens during ‘state transitions’. Sometimes, doubts about the permanence of changes overwhelm market participants. It’s up to the PM and the BoJ to ‘stay the course’.

Japan Reborn_4

They could improve the situation enourmously if instead of having a 2% inflation target they announced an NGDP level target, as the following chart indicates.

Japan Reborn_5

 

Update: David Glasner explains the hightened sensitivity of markets in Japan:

[But] let’s just suppose that the Japanese, having experienced the positive effects of monetary expansion and an increased inflation target over the past six months, woke up on Black Thursday to news of Bernanke’s incoherent testimony to Congress suggesting that the Fed is looking for an excuse to withdraw from its own half-hearted attempts at monetary expansion. And perhaps — just perhaps — the Japanese were afraid that a reduced rate of monetary expansion in the US would make it more difficult for the Japan to continue its own program of monetary expansion, because a reduced rate of US monetary expansion, with no change in the rate of Japanese monetary expansion, would lead to US pressure on Japan to prevent further depreciation of the yen against the dollar, or even pressure to reverse the yen depreciation of the last six months. Well, if that’s the case, I would guess that the Japanese would view their ability to engage in monetary expansion as being constrained by the willingness of the US to tolerate yen depreciation, a willingness that in turn would depend on the stance of US monetary policy.

The highlighted segment in the paragraph above has correspondence to what happened in the early 1980s when the ‘US would not allow’ the yen to depreciate. And is also consistent with David Beckworths view of US supermonetary power status.

5 thoughts on “A theory is put to the test

  1. I finally went to the trouble of reading one of Koo’s papers recently just to see what all of the fuss was about and I’m almost sorry that I did. Koo’s paper is here:

    http://snbchf.com/wp-content/uploads/2013/04/Koo-Ineffectiveness-Monetary-Expansion.pdf

    The passage I take the most issue with is on pages 11-12:

    “The post-1990 Japan managed to maintain its money supply (Exhibit 7) and GDP (Exhibit 4) from shrinking because the government was borrowing the deleveraged and newly saved funds from the private sector (Exhibit 9) Unfortunately there was a period in economics profession, from late 1980s to early 2000s, where many noted academics tried to re-write the history by arguing that it was monetary and not fiscal policy that allowed the US economy to recover from the Great Depression. They made this argument based on the fact that the US money supply increased significantly from 1933 to 1936. However, none of these academics bothered to look at what was on the asset side of banks’ balance sheets.

    The asset side of banks’ balance sheet clearly indicates that it was lending to the government that grew during this period (Exhibit 10). The lending to the private sector did not grow at all during this period because the sector was still repairing its balance sheets. And the government was borrowing because the Roosevelt Administration needed to finance its New Deal fiscal stimulus. In other words, it was Roosevelt’s fiscal stimulus that increased both the GDP and money supply after 1933.”

    There’s a reason why none of those academics attached much importance to the asset side of banks’ balance sheets.

    Koo acts like there’s a one-to-one correspondence between the banking sector’s assets and public and private sector liabilities, but that’s not at all true. For example, as Koo shows in Exhibit 9, banks held about 500 trillion yen and 250 trillion yen in private sector and public sector debt respectively in December 2007. But at the end of 2007 the total amount of non-financial private sector and public sector debt was about 850 trillion yen and 900 trillion yen respectively:

    Similarly in Exhibit 10 Koo shows that banks held about $16 billion in private and public sector debt each in June 1936. But in June 1936 the total amount of non-financial private sector debt and public sector debt was about $116 billion and $54 billion respectively (page 989:

    http://www2.census.gov/prod2/statcomp/documents/CT1970p2-11.pdf

    (Incidentally, why did Koo put the cutoff in 1936 instead of 1937? The recession didn’t start until 1937 after all. It’s probably because the asset side of the 1937 bank balance sheets are a lot less supportive of his already flimsy argument.)

    In both cases banks held only a fraction of each kind of outstanding debt. There is simply no clear relationship between debt and money supply. (Monetary policy is not credit policy.)

    More importantly, the period 1997-2007 includes the first Japanese QE (2001-2006) and the corresponding Koizumi Boom (2003-2007), which was also a period of pronounced fiscal tightening in Japan. Similarly, although the Federal Emergency Relief Work and public works projects funded by the New Deal were helpful in creating the swift recovery experienced from the Great Depression during 1933-37, as several academic studies have shown (e.g. Romer, Eichengreen, etc.) the recovery was primarily due to FDR’s ending of the gold standard and the subsequent devaluing of the US dollar.

  2. I was startled by the following passage that I found from a report Koo wrote in December:

    “But nightmare scenario awaits when private loan demand recovers. The problem is what happens when private loan demand recovers. Loan books could grow more than tenfold in the US and five fold in Japan and Europe if bank reserves remain at current levels, triggering inflation rates of 500% to over 1,000%.

    To avoid this outcome, central banks will have to mop up excessive reserves by raising the statutory reserve ratio, raising the interest rate paid on reserves, and selling government bonds. All of these measures will serve to lift interest rates, sending bond yields sharply higher and triggering a possible crash in the bond markets.

    A sharp increase in government bond yields could lead to fiscal collapse in countries with a large national debt. For Japan, where the national debt amounts to 240% of GDP, the results would be catastrophic.

    Expanding quantitative easing because it appears to be doing no harm is grievous error. Mr. Abe and his advisors may believe that all they have to do once their anti-deflationary policies succeed and JGB yields start to rise is have the BOJ buy more bonds. However, bank reserves under quantitative easing have risen to a level capable of fueling a 500% inflation rate, in which case the BOJ would have to sell, not buy, JGBs.

    Nomura | JPN”

    http://moslereconomics.com/2012/12/13/koo-on-reserves-time-bomd-500-inflation/

    Yes, you read that correctly. Koo is predicting that the current Japanese large scale asset purchases have the potential to create 500% to 1,000% rates of inflation, a crash in the bond market and a complete fiscal collapse.

    I think it’s high time that people realize that the Emperor Koo has no clothes.

  3. Pingback: Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman) | The Market Monetarist

  4. Mr. Koo? How has 20 years of fiscal stimulus worked out?

    Japan now carries too much debt, and never reduced that debt through inflation and robust growth.

    So the solution (according to Mr. Koo) is for more fiscal stimulus?

    You know, I used to think it was just the Theomonetarists, the ones who could not change their views, as their views were grounded in some sort of money worship.

    But here is a fiscalist, and he can’t change either.

    Economists make the Vatican look flexible.

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