How Japan financed global reflation (Bernanke printing press)

How Japan financed global reflation
By Richard Duncan
FinanceAsia February 2005

In 2003 and the first quarter of 2004, Japan carried out a remarkable
experiment in monetary policy . remarkable in the impact it had on the
global economy and equally remarkable in that it went almost entirely
unnoticed in the financial press. Over those 15 months, monetary
authorities in Japan created �trillion. To put that into
perspective, �trillion is approximately 1% of the world´s annual
economic output. It is roughly the size of Japan´s annual tax revenue
base or nearly as large as the loan book of UFJ, one of Japan´s four
largest banks. �trillion amounts to the equivalent of $2,500 for
every person in Japan and, in fact, would amount to $50 per person if
distributed equally among the entire population of the planet. In
short, it was money creation on a scale never before attempted during
peacetime.

Why did this occur? There is no shortage of yen in Japan. The yield on
two year JGBs is 10 basis points. Overnight money is free. Japanese
banks have far more deposits than there is demand for loans, which
forces them to invest up to a quarter of their deposits in low
yielding government bonds. So, what motivated the Bank of Japan to
print so much more money when the country is already flooded with
excess liquidity?

The Bank of Japan gave the �trillion to the Japanese Ministry of
Finance in exchange for MOF debt with virtually no yield; and the MOF
used the money to buy approximately $320 billion from the private
sector. The MOF then invested those dollars into US dollar-
denominated debt instruments such as government bonds and agency debt
in order to earn a return.

The MOF bought more dollars through currency intervention then than
during the preceding 10 years combined, and yet the yen rose by 11%
over that period. Historically, foreign exchange intervention to
control the level of a currency has met with mixed success, at best;
and past attempts by the MOF to stop the appreciation of the yen have
not always succeeded. They were very considerably less expensive,
however. It is also interesting, and perhaps important, to note that
the MOF stopped intervening in March 2004 just when the yen was
peaking; that the yen depreciated immediately after the intervention
stopped; and that when the yen began appreciating again in October
2004, the MOF refrained from further intervention.

Chart 1
[link to www.investorsinsight.com]

Chart 2
[link to www.investorsinsight.com]

So, what happened in 2003 that prompted the Japanese monetary
authorities to create so much paper money and hurl it into the foreign
exchange markets? Two scenarios will be explored over the following
paragraphs.

In 2002, the United States faced the threat of deflation for the first
time since the Great Depression. Growing trade imbalances and a surge
in the global money supply had contributed to the credit excesses of
the late 1990s and resulted in the New Paradigm technology
bubble. That bubble popped in 2000 and was followed by a serious
global economic slowdown in 2001. Policy makers in the United States
grew increasingly alarmed that deflation, which had taken hold in
Japan, China and Taiwan, would soon spread to America.

Deflation is a central bank´s worst nightmare. When prices begin to
fall, interest rates follow them down. Once interest rates fall to
zero, as is the case in Japan at present, central banks become
powerless to provide any further stimulus to the economy through
conventional means and monetary policy becomes powerless. The extent
of the US Federal Reserve´s concern over the threat of deflation is
demonstrated in Fed staff research papers and the speeches delivered
by Fed governors at that time. For example, in June 2002, the Board of
Governors of the Federal Reserve System published a Discussion Paper
entitled, "Preventing Deflation: Lessons from Japan´s Experience in
the 1990s." The abstract of that paper concluded "...we draw the
general lesson from Japan´s experience that when inflation and
interest rates have fallen close to zero, and the risk of deflation is
high, stimulus-both monetary and fiscal- should go beyond the levels
conventionally implied by baseline forecasts of future inflation and
economic activity."

From the perspective of mid-2002, the question confronting those in
charge of preventing deflation must have been how far beyond the
conventional levels implied by the base case could the economic policy
response go? The government budget had already swung back into a large
deficit and the Federal Funds rate was at a 41 year low. How much
additional stimulus could be provided? A further increase in the
budget deficit seemed likely to push up market determined interest
rates, causing mortgage rates to rise and property prices to fall,
which would have reduced aggregate demand that much more. And, with
the Federal Funds rate at 1.75% in mid- 2002, there was limited scope
left to lower it further. Moreover, given the already very low level
of interest rates, there was reason to doubt that a further rate
reduction would make any difference anyway.

In a speech entitled, "Deflation: Making Sure ´It´ Doesn´t Happen
Here", delivered on November 21, 2002, Federal Reserve Governor Ben
Bernanke explained to the world exactly how far beyond conventional
levels the policy response could go. Governor Bernanke explained that
the Fed would not be "out of ammunition" just because the Federal
Funds rate fell to 0% because the Fed could create money and buy bonds
of longer maturity in order to drive down yields at the long end of
the yield curve as well. Moreover, he said, "In practice, the
effectiveness of anti-deflation policy could be significantly enhanced
by cooperation between the monetary and fiscal authorities. A
broad-based tax cut, for example, accommodated by a program of
open-market purchases to alleviate any tendency for interest rates to
increase, would almost certainly be an effective stimulant to
consumption and hence to prices."

He made similar remarks in Japan in May 2003 in a speech entitled,
"Some Thoughts on Monetary Policy in Japan". He said, "My thesis here
is that cooperation between the monetary and fiscal authorities in
Japan could help solve the problems that each policymaker faces on its
own. Consider for example a tax cut for households and businesses that
is explicitly coupled with incremental BOJ purchases of government
debt-so that the tax cut is in effect financed by money creation."
These speeches attracted tremendous attention and for some time
financial markets believed the Fed intended to implement the
"unorthodox" or "unconventional" monetary policy options Governor
Bernanke had outlined.

In the end, the Fed did not resort to unorthodox measures. The Fed did
not create money to finance a broad-based tax cut in the United
States. The Bank of Japan did, however. Three large tax cuts took the
US budget from a surplus of $127 billion in 2001 to a deficit of $413
billion in 2004. In the 15 months ended March 2004, the BOJ created
�trillion which the MOF used to buy $320 billion, an amount large
enough to fund 77% of the US budget deficit in the fiscal year ending
September 30, 2004. It is not certain how much of the $320 billion the
MOF did invest into US Treasury bonds, but judging by their past
behavior it is fair to assume that it was the vast majority of that
amount.

Was the BOJ/MOF conducting Governor Bernanke´s Unorthodox Monetary
Policy on behalf of the Fed? There is no question that the BOJ created
money on a very large scale as the Fed would have been required to do
under Bernanke´s scheme. Nor can there be any question that the money
created was used to buy an increasing supply of US Treasury bonds
being issued to finance the kind of broad-based tax cuts Governor
Bernanke had discussed. Moreover, was it merely a coincidence that the
really large scale BOJ/MOF intervention began during May 2003, while
Governor Bernanke was visiting Japan? Was the BOJ simply serving as a
branch of the Fed, as The Federal Reserve Bank of Tokyo, if you will?
This is Scenario One.

If this was globally coordinated monetary policy (unorthodox or
otherwise) it worked beautifully. The Bush tax cuts and the BOJ money
creation that helped finance them at very low interest rates were the
two most important elements driving the strong global economic
expansion during 2003 and 2004. Combined, they produced a very
powerful global reflation. The process seems to have worked in the
following way:

US tax cuts and low interest rates fuelled consumption in the United
States. In turn, growing US consumption shifted Asia´s export-oriented
economies into overdrive. China played a very important part in that
process. With a trade surplus vis-�-vis the United States of $124
billion, equivalent to 9% of its GDP in 2003 (rising to approximately
$160 billion or above 12% of GDP in 2004), China became a regional
engine of economic growth in its own right. China used its large trade
surpluses with the US to pay for its large trade deficits with most of
its Asian neighbors, including Japan. The recycling of China´s US
Dollar export earnings explains the incredibly rapid "reflation" that
began across Asia in 2003 and that was still underway at the end of
2004. Even Japan´s moribund economy began to reflate.

Whatever its motivation, Japan was well rewarded for creating money
and buying US Treasury bonds with it. Whereas the BOJ had failed to
reflate the Japanese economy directly by expanding the domestic money
supply, it appears to have succeeded in reflating it indirectly by
expanding the global money supply through financing the sharp increase
in the MOF´s holdings of US Dollar foreign exchange reserves. There is
no question as to if this happened. It did. The only question is was
it planned (globally coordinated monetary policy) or did it simply
occur by coincidence, driven by other considerations?

What other considerations could have prompted the BOJ to create �trillion over 15 months? A second scenario is that a "run on the
dollar" forced the monetary authorities in Japan to intervene on that
scale to prevent a balance of payments crisis in the United
States. This is Scenario Two.

During the Strong Dollar Trend of the late 1990s, foreign investors,
both private and public, invested heavily in the United States. Those
investments put upward pressure on the dollar and on US asset prices,
including stocks and bonds. The trend became self-reinforcing. The
more capital that entered the US, the more the dollar and dollar
denominated assets rose in value. The more those assets appreciated,
the more foreign investors wanted to own them. Because of the large
sums entering the country, the United States had no difficulty in
financing its giant current account deficit, even though that deficit
nearly tripled between 1997 and 2001.

By 2002, however, with the US current account deficit approaching 5%
of US GDP, it became increasingly apparent that the Strong Dollar
Trend was unsustainable. The magnitude of the current account deficit
made a downward adjustment in the value of the dollar unavoidable. At
that point, the Strong Dollar Trend gave way and the Weak Dollar Trend
began. Foreign investors who had invested in US dollar denominated
assets during the late 1990s naturally wanted to take their money back
out of the United States once it became clear that a sharp correction
of the dollar was underway. Moreover, many US investors, and hedge
funds in particular, also began selling dollar- denominated assets and
buying non-US dollar-denominated assets to profit from the dollar´s
decline.

Chart 3
[link to www.investorsinsight.com]

The change in the direction of capital flows can be seen very clearly
in the breakdown of Japan´s balance of payments.

The preceding chart shows the balance on Japan´s current account and
financial account, the two principle components of Japan´s balance of
payments, going back to 1985. Traditionally, Japan runs a large
current account surplus and a slightly less large financial account
deficit, with the difference between the two resulting in changes
(usually additions) to the country´s foreign exchange reserves.

Beginning in 2003, however, there was a startling change in the
direction of the financial account. Instead of large financial
outflows from Japan to the rest of the world, there were very large
financial inflows. For instance, in May 2003, Japan´s financial
account reflected a net inflow of $23 billion into the country. The
net inflow in September was $21 billion. These amounts increased
considerably during the first quarter of 2004, averaging $37 billion a
month.

The capital inflows into Japan at that time were massive, even
relative to Japan´s traditionally large annual current account
surpluses. But, why did Japan, which normally exported capital,
suddenly experience net capital inflows on a very large scale in the
first place? The most likely explanation is that very large amounts of
private sector money began fleeing the dollar and seeking refuge in
the relative safety of the yen.

When the Strong Dollar Trend broke, had the BOJ/MOF not bought the
dollars that the private sector sold in such large quantities, the
United States would have faced a balance of payments crisis, in which,
in addition to having to fund a half a trillion dollar a year trade
deficit, it would have had to find a way to fund a deficit of several
hundred billion on its financial account as well.

Any other country facing a large shortfall on its balance of payments
would have experienced a reduction in its foreign exchange
reserves. The United States, however, maintains only a limited amount
of such reserves; only $75 billion as at the end of 2003, far too
little to fund the private capital outflows occurring at that time.

Once those reserves had been depleted, market-determined interest
rates in the US would have begun to rise, in all probability, popping
the US property bubble and throwing the country into recession. Under
that scenario, a reduction in consumption in the United States would
have undermined global aggregate demand and created a severe
world-wide economic slump.

The US current account deficit more or less finances itself since the
central banks of the surplus countries buy the dollars entering their
countries to prevent their currencies from appreciating and then
recycle those dollars back into US dollar-denominated assets in order
to earn interest on them.

Large scale private sector capital flight out of dollars presented the
recipients of that capital with the same choice. The central bank of
each country receiving the capital inflow had the choice of either
printing their domestic currency and buying the incoming capital or
else allowing their currency to appreciate as the private sector
swapped out of dollars. The European Central Bank chose to allow the
euro to appreciate. The Bank of Japan and the People´s Bank of China
chose to print yen and renminbe and accumulate the incoming dollars to
prevent their currencies from rising. If some central bank had not
stepped in and financed the private sector capital flight out of the
dollar, then sharply higher US interest rates most likely would have
thrown the world into a severe recession. It is quite likely that this
consideration also played a role in influencing the actions of the
Japanese monetary authorities during this episode.

Chart 4
[link to www.investorsinsight.com]

The BOJ/MOF stopped intervening in March 2004. By that time, the Fed
had indicated that it planned to begin tightening interest rates. That
put a stop to the private sector capital flight out of the
dollar. Therefore no more intervention was required. At the same time,
by the end of the first quarter of 2004, it was becoming clear that
strong economic growth in the US was creating higher than anticipated
tax revenues. That meant a smaller than expected budget deficit. In
July, the President´s Office of Management and Budget revised down its
estimate of the budget deficit from $521 billion to $445 billion. The
actual deficit turned out to be $413 billion. Thus less funding was
required than initially anticipated.

So, what did motivate the monetary authorities in Japan to create the
equivalent of 1% of global GDP and lend it to the United States? Was
it simply, straightforward self interest to prevent a very sharp surge
in the value of the yen? Was it globally coordinated monetary policy
designed to pull the world out of the 2001 slump and prevent deflation
in the United States? Or, was it necessary to stave off a US balance
of payments crisis that would have produced a global economic crisis?

Perhaps it was only straightforward foreign exchange intervention to
prevent a crippling rise in the value of the yen. Intentionally or
otherwise, however, by creating and lending the equivalent of $320
billion to the United States, the Bank of Japan and the Japanese
Ministry of Finance counteracted a private sector run on the dollar
and, at the same time, financed the US tax cuts that reflated the
global economy, all this while holding US long bond yields down near
historically low levels.

In 2004, the global economy grew at the fastest rate in 30
years. Money creation by the Bank of Japan on an unprecedented scale
was perhaps the most important factor responsible for that growth. In
fact, �trillion could have made the difference between global
reflation and global deflation. How odd that it went unnoticed.

This should have helped give you yet another perspective on Asia and
our current account deficit.

Your watching the global flow of money analyst,

John F. Mauldin
[email protected]

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