BOJ Also Losing Credibility And Its QE War

Haruhiko Kuroda, Governor of the Bank of Japan
Photo Credit: Wikimedia Commons/Asian Development Bank

Move over Federal Reserve! You are not the only ones losing credibility and in the dog house! Japan’s equivalent of the U.S. Federal Reserve, the Bank of Japan (BOJ), is currently waging war against low growth using Quantitative Easing (QE) as their primary weapon. Just as the results of the Federal Reserve’s QE and Zero Interest Rate Policy (ZIRP) were big failures, BOJ’s QE program is also turning into a big flop, as chronicled in Japan: The Great QE Experiment Fails by Steven Knight and in the Wall Street Journal post (access requires subscription) The Bank of Japan Lays an Egg.     

How big a flop? Just as we did in looking at the non-success of the U.S. Federal Reserve’s QE, we answer the question by plotting Japan’s real GDP below.

The plot shows strong growth for almost thirty years after the start of the post-World War II recovery, followed by a period from 1973 to 1991 of still strong, mature growth of roughly four percent per annum. After 1991 Japan entered its infamous “lost decades” when it was increasingly dogged by economic stagnation. As demonstrated by the consumer price inflation rate for Japan plotted below, Japan has been constantly flirting with deflation since 1987.

To combat Japan’s low growth, BOJ pioneered the technique of quantitative easing beginning in March 2001, when it started to buy long-term Japanese government bonds. Later, the BOJ added asset-backed securities and equities. Over a four year period starting with March 2001, BOJ increased commercial bank current account balances from ¥5 trillion to ¥35 trillion. Yet despite this 700% increase in bank current account balances, economic stagnation continued and the inflation rate stayed stubbornly close to zero, becoming occasionally negative. The degree to which BOJ increased its assets by buying long-term debt instruments and equities can be seen in the graph below, taken from Japanese QE may remain ineffective without reserves rate cut.

As of now, assuming the 2015 projections were correct, BOJ’s assets from QE are somewhere between 60% and 80% of GDP. They are certainly not less than 60%. Henderson Global Investors reports them to be about 82% of GDP. The increase in Japan’s M2 money supply can be seen in the graph below.

I have already noted how QE appears to be at least moderately deflationary, rather than inflationary as one would expect from the large associated increases in money supply. Part of the reason for this in the United States has been much of the increase in money has not gone into the circulated money supply, but has been recaptured into excess reserves. This has been accomplished by the Fed paying a small interest rate to member commercial banks on excess reserves they place with the Fed. As a result about 81% of the new QE money was deposited in excess reserves. Japan has done much the same by paying a 0.1% interest on excess reserves, as opposed to the Fed’s payment of 0.2% on excess reserves.

Another part of the explanation for the deflationary effect of QE comes from the slowing of the velocity of money. Computing the velocity of money from the ratio of the GDP to the M2 money supply, we obtain the plot shown below.

As I noted in the post What Does Falling Money Velocity Tell Us?, the velocity of M2 money in the U.S. is similarly negative. From that post we had the relationship

where P is the price index, M is the amount of M2 money in the economy, V is the velocity of M2 money, and y is the real GDP. The Greek symbol Δ in the equation denotes a change in the quantity over a year. By “eyeballing” the data in the plots above we can obtain the following estimates.

ΔM/M ≈ 4.0%, ΔV/V ≈ -10.0%, Δy/y ≈ 2.0%, so that

ΔP/P ≈ 4.0 – 10.0 – 2.0 = -8.0 %

This admittedly very crude estimate therefore gives us a deflation rate of 8 percent, which probably overstates the actual case. However, it is good enough to tell us the dominating factor in determining the negative inflation rate is the decrease in the velocity of money. If we can explain the decrease in the velocity of money in both the U.S. and Japan in terms of QE, we would know why QE is deflationary and not inflationary, the way we would ordinarily expect.

In Why Have ZIRP and QE Failed?, I listed several speculations on why QE should cause money velocity to decline, although in that post I stated it in terms of less aggregate demand; if aggregate demand is less, the average dollar will change hands fewer times. I reproduce that list, suitably modified for Japan, below.

1. If the BOJ keeps real long-term interest rates at zero, people of retirement age who normally would have shifted their retirement savings from stocks to fixed income, high grade bonds  for safety of their nest-eggs, instead either keep their money in stocks with higher risk than bonds, or they keep their assets in cash. With no bond income, the retired must spend their capital to live. This means there will be a smaller amount of capital available in credit markets for productive investment. It also means that as their capital, on which they live, decreases, the retired become a great deal more frugal. Overall demand goes down, which implies deflation and reduced economic activity.
2. Real long-term rates of zero help to finance government deficit spending. Since the Japanese national debt is about 230% of 2014 GDP, the government claim on physical assets added by deficit spending is crowding out competing claims by commercial businesses. This causes less productive capacity, imbalances of supply and demand that create more unemployment and deflation.
3. A bad economic environment caused by government intrusions in the economy, together with low interest rates causes low investment in productive capacity by companies, but high borrowing to buy-back stocks. This causes low productivity and output, low employment, low wages, and the inflation of a stock asset bubble. This implies deflation and lower output. Similarly, low long-term rates encourage borrowing to buy real-estate, which helps to inflate a real-estate bubble.
4.  A real drop in incomes among the middle class causes families to become more frugal and spend less. This implies deflation and reduced economic activity.

The first three of these effects are definitely implied by low interest rates, and the last one acts to reinforce the effects of the first three.

If I had to guess, I suspect European QE would play out very similarly to how it has in Japan and the United States. One might argue we could get the increase in the money supply to more exactly cancel the decrease in the velocity of money by lowering interest in excess reserves, but how would we know other effects like corporate buy-backs or the inflation of a real-estate bubble, or even high inflation might result? If European QE does have similar effects to those in Japan and the U.S., that result should give us a very strong hint we should avoid QE like the plague. It would be much more productive to use monetary policy only to keep the value of money constant.

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