Deflation, Quantitative Easing and Hyperinflation in Japan: How Abenomics will Destroy a Proud and Successful Nation
by Andrew Alexander
The views represented in this article are solely those of the author and may not be construed as in any way representative of the views or policies of Oxford Royale Summer Schools.
Japan is a nation on the brink. It has been for almost thirty years. It has been a trend setter for longer still.
The industry of the Japanese people, and a sympathetic, and in many respects visionary, American occupation in the wake of the Second World War placed the nation at the white hot centre of the technological revolution, and the manner in which technology and real estate had come to be the twin preoccupation of Japanese society by the mid-1980s presaged the present day across the metaphorical West. And the nation leads still. Japan was the first country to undertake quantitative easing on a truly massive scale, and it will be the first to collapse as a result. A lot of people have lost a lot of money betting on Japan succumbing to gravity over the years, but I would wager that the next three to five years will see it become the first major domino to tumble in the brave new post-crisis financial world.
It is sad that Japan has become the testing ground for every wrong-headed academic idea under the sun. It is a shame for the Japanese who have every bit as much claim to have created the modern world as the British and the Americans thanks to their brilliance in consumer electronics and their deeply impressive work ethic. It is a shame for South Asia, which must now face a future in which regional peace is threatened, as it always is, by the economic decline of its most powerful local guarantor. It is a shame for the wider world, which can ill afford to treat its third largest economy as a source of journal case studies.
This essay examines the problematic nature of the Japanese economic strategy as currently constituted. It is worth a word on how we got here. Japan is currently embarked upon a very old experiment, the same one that Diocletian undertook when he clipped the coins of Roman citizens, the same one the French revolutionaries turned to when their monetisation of confiscated church lands proved to be hopelessly optimistic. In response to a deflationary period of more than a decade, the Japanese have decided that an inflationary response is needed to stimulate growth, and to provoke that inflation, they will debase the currency.
One premise of this approach, which is seldom questioned, is whether it is in any way necessary. It is an unquestioned assumption amongst modern economists that deflation is a grave evil. This is, at first glance, difficult to understand – a sustained downwards movement in the general price level does not sound particularly menacing to somebody on a fixed wage or pension who is now able to buy more with a limited budget. Indeed, seen from this perspective, capitalism should, by its nature, be deflationary as the competitive market means that producers are always attempting to find new methods of production and distribution that allow them to cut costs. Paul Krugman has argued that deflation is bad as it reduces the willingness of people and firms to borrow and spend, that it worsens the real position of debtors as their debts become proportionately more expensive as time goes by, and that it can lead to unemployment thanks to wage rigidity. The key argument for discovering why governments find deflation to be an evil is the second one; it increases the proportionate value of their debts, and when the government concerned is the Japanese one, which owes a mighty 140% of GDP and counting, inflation is the only possible method the government has at its disposal of repaying its debts.
But inflation is a fickle servant. It is ostensibly surprising that quantitative easing has not created inflation, given that it involves massively increasing the supply of money despite there being no corresponding increase in the real production of an economy. As it is, the inflation that has arrived has been in assets, not in consumption items. There is a good reason for this – the consumer accounts for around 70% of a Western economy. The money being created has gone nowhere near the consumer. Instead it has been channelled exclusively into financial institutions. There has been a corresponding inflation in the prices of the assets that financial institutions buy – like stocks, real estate, commodities, but not in the items that consumers buy, as the consumer has not had extra units of money to spend. This is, of course, a wealth transfer from consumer to financial institutions, although few progressive politicians appear to understand this.
The relevance of this to Japan is that such inflationary policies are particularly dangerous where an economy has been suffering from deflation. Indeed, history records that the most severe periods of inflation in a developed economy have usually been preceded by deflation, Weimar Germany for instance. Why is this? Theoretically the process looks something like this: in a deflationary environment corporations and people have an incentive to hoard cash; this in turn reduces the velocity of money (the speed of circulation, or, rather, how many times the same money is spent in the course of the year); in response the government creates money and starts handing it out (in Japan’s case to banks); however, initially this is unsuccessful as the recipients continue to hoard (on this point, Japanese quantitative easing began in 2001). Eventually, the government goes for the big push, ramping up its money creation (as per the Three Arrows strategy) to the point where the public starts to lose faith in the currency. Then, the dam breaks. All the money that has been hoarded up is suddenly dumped into the market and starts circulating quickly as consumers choose to exchange it for goods as they no longer want to hold currency. At this point, hyperinflation takes hold, prices start being bid up, and wages climb to follow them. The question that you have to ask is whether the line can hold in Japan.
Abe’s Arrows: Quantitative Easing, Stimulus Spending and Structural Reform
To answer this question, you need to understand the policy which lies at the heart of this sorry mess: ‘Abenomics’. Most people have heard of Japanese Prime Minister Shinzo Abe’s three arrows, but few could identify what they are. As such, it would be useful to draw them out before continuing this essay.
[pullquote]Not only is Quantitative Easing not working in Japan, but the scale of the Japanese experiment is such that both market and consumer are starting to realise that it won’t work anywhere at all.[/pullquote]The first arrow is a vast scheme of quantitative easing. I have outlined my principle objection to quantitative easing above – it is arguably the most anti-poor, retrograde financial policy it would be possible to conceive. It engorges the asset rich at the expense of those who rely on a cash wage, reallocating value from the productive economy to the rentier class. It is incredibly frustrating hearing feted French economists talking about the crisis in capitalism entailing the need for more redistribution – this looks nothing like capitalism; it is a warped mixture of seigniorage, paternalism and a socialist desire to meddle that is eroding the value of wages. Involving the government yet further to redistribute even more of the value created and earned by individuals offers no conceivable benefit when held against a corresponding policy of leaving well alone.
Aside from this point, it should also be noted that quantitative easing has no ability to provoke growth. Printing a lot of money and concentrating it in the hands of those who only buy particular classes of asset can cause inflation in the price of those assets, all other things being equal, so a stock may rise 20% without any corresponding improvement in its underlying earnings. However, GDP is the sum of production in an economy, and a shot of quantitative easing changes the price of production in its currency denominator; it does not, in itself, produce anything other than hardship for households on fixed incomes.
What is striking about Japan’s quantitative easing scheme is its size. In April 2013, the Bank of Japan announced a programme of $1.4trn. To give that some context, this is not only equivalent to a quarter of Japan’s annual GDP, but also sufficient to buy every single thing produced in the whole of Australia for a year. It is a staggering amount, and not even the maddest Keynesian could claim that the programme was insufficient to generate growth under their terms. The result? Two quarters of growth followed by a sharp downturn, the cost of living at a five year high and record trade deficits every month since January last year. Not only is quantitative easing not working in Japan, but the scale of the Japanese experiment is such that both market and consumer is starting to realise that it won’t work anywhere at all.
The second arrow is $116bn of stimulus spending and tax allowances. These are allocated, on paper anyway, towards the long-game assets that Japan needs to remain an economic powerhouse but that governments are notoriously shy of funding, assets which range from infrastructure renewal projects to corporate tax breaks that support R&D spending or the hiring of new staff. This is not a bad programme in and of itself, indeed the investments which it supports are those that would be rational for any major government. Where the policy falls down is again in terms of the refusal to accept that most very basic of economic tenets – opportunity cost. Instead of taking the view that one yen spent on building up business and infrastructure to last for decades was worth the sacrifice of one yen spent on consumption for today, the government have decided to have both. As such, the debt mountain continues imperiously towards the heavens.
The final arrow is the most difficult of all – structural reform. This is the most nebulous part of the strategy and the most difficult to enact in the real world as true structural reforms involve massive immigration. Japan suffers from a declining birth-rate – every Japanese woman produces 1.36 children on average, well below replacement rate. To continue to make the same welfare payments to the aging Japanese workforce over the coming decade, Japan needs 16m immigrants. At present, net immigration according to the World Bank is around 70,000 a year. And even in the unlikely event that Japan becomes significantly less insular and more welcoming to mass immigration, the British experiment teaches that those 16m workers will quite probably come with a further 16m dependents, creating a cyclical need for more immigration to cover the entitlements of the new immigrants. The Japanese public have shown no appetite for mass immigration so far, nor for massive families, and I doubt very much that they will do so now whatever the long-term economic consequences.
Even on paper then, Abenomics bears many of the hallmarks of the magical thinking that occurs when policy makers decide that their superior intellects allow them to implement policies without costs. In the real world, Japan continues to chug merrily onwards towards the rapids. Just look at some of the recent economic data: real wages have just fallen for the 21st consecutive month, consumer confidence has slipped to nigh-on a two year low, bank stocks (a key indicator of the health of the domestic economy) are in a bear market, and influential pundits are predicting that the latest figures will find that inflation is growing at the fastest rate since 1982.
How hyperinflation will start in Japan
For what it is worth, here is how I think it will pan out: Japan is only a viable investment destination for as long as the returns offered by the stimulus addicted Nikkei and JGB markets exceed the depreciation in currency relative to the dollar. Once it becomes clear that there is no real return in the market worth the risk premium, money will start to drain out. Japanese consumers will, at this point, start to lose confidence in quantitative easing as its headline impact is supposed to be on asset prices and asset prices are falling; they will then start to spend, quickly exchanging depreciating yen for tangible products. At this point, the situation will tip in to hyperinflation, and all economic hell will break loose not just in Japan but in all the major world economies sold the snake oil of quantitative easing.
All actions have consequences. The hangover analogy is over-done, but true. In a bid to avoid the hangover of our prior excess in 2007/8, the world’s economies have been on a binge. Not only has the binge made them very little better in the short term, it is compounding the problems we will eventually face in the long-term. The refusal to face the consequences of mis-pricing risk in 2007/8 has meant that we have completely corrupted the market pricing mechanism now. This cannot go on forever, and when the hangover hits, Japan will feel it first.