Japan’s Economic Wormhole*

Japan’s Economic Wormhole[1]

The December 12th TLR contrasted the belief of Inflationists that America is on the cusp of an inflationary spiral and of Deflationists who believe that America is doomed to years of ongoing deflation … and concluded that both are right. We today are living in a world in which there is both spiraling asset inflation in stock and bond prices and relentless deflation in the price of goods and services … and that’s not going to change …, until, of course, it does. That’s a good thing not a bad thing. (“The Confrontation Between The Inflationists and The Deflationists” was the third of three recent commentaries addressing economics and economies, the first being “What if There were No More Recessions” in the November 26th TLR, and the second, “The Dismal Science,” in the December 4th TLR).

Weird, right?

But meaningful – this economic cycle indeed is different from prior economic cycles.

A broad coalition of Central Bankers led by the Federal Reserve has labored for the last 10+ years towards the common goal of a global inflation rate of 2{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35}. They sought a balance … and they achieved a balance. The global economy has been stabilized. For example, there is little or no financial volatility. The Chicago Board Options Exchange’s volatility index – referred to as the VIX – has flatlined. Interest rates have been tamed. They are at historically low levels … and have remained steady for years. Moreover, for the first time in history, the world is experiencing negative interest rates – more than $17 trillion worth – and the global economy is not suffering as a result. The unemployment rate also has stabilized – at the lowest levels for the past 50 years. And although economic growth has been anemic, it’s been consistently positive, yet another historical post-recession first. Gross Domestic Product has remained in a solid, positive range …, and there is no sign of an imminent recession, extending the current expansion further into wonderfully uncharted territory. Of greatest significance, however, is that the world’s leading currencies – the US Dollar and the currencies of its largest trading partners, the Euro, the Pound, the Japanese Yen, the Swiss Franc, the Korean Won and the Chinese Yuan – have been locked in a narrow, coordinated range. Central Bankers therefore appear to have harmonized the relative values of the world’s major currencies, an historically unprecedented achievement!

Central Bankers therefore have managed to engineer a Goldilocks economy after the horrific Great Recession. They have used “hard economic science” to gently tap the economic accelerator when it’s been appropriate to do so and, at other times, they have tentatively applied the economic brakes. They’ve deployed a variety of sophisticated monetary policy tools – Quantitative Easing (QE creates money out of thin air – QE1 began in 2008, QE2 in 2010, QE3 in 2012, and QE4 in September 2019), open market operations (moving money into and out of banks), adjustments to the discount rate (raising or lowering short-term interest rates), and by issuing Forward Guidance (telling the world what they would do). They’ve printed enormous amounts of fiat currencies and flooded the world with paper money. Interestingly, in doing so, they’ve followed the example of Japan.

Just as the world’s Central Bankers were compelled to grab control of the global economic reins after 2009’s Great Recession, the Bank of Japan’s role was given primacy by the bursting of Japan’s asset-price bubble in 1989. Without having an historical roadmap to guide its actions (other than to avoid the policy failures that followed the Great Depression), the Bank of Japan attempted a variety of strategies intended to soften the economic blow. Although staffed by Japan’s best economic minds, the BOJ’s tactics initially exacerbated the country’s economic pain. Its policies led to a period of slow growth, deflation and low interest rates (referred to as “The Lost Decade”). That outcome bears significant similarities to the tepid growth, deflation, and low interest rates experienced in America and the EU in the decade following the Great Recession. Interestingly, despite the use by the BOJ of the same monetarist strategies subsequently employed by the Fed (with greater size and speed), Japan’s slump has largely continued (with the additional similarity that its stock market also has seen significant gains). The inability of the BOJ to ignite pre-bubble growth is a product of both a start-stop fiscal policy and poorly thought-out tax policy, and Japan’s declining demographics – Japan’s population is falling because of a too-low birth-rate and an anti-immigration policy. GDP growth depends on increasing labor and increasing consumption, both of which require an increasing population. If demographics indeed is destiny, Japan’s stagnating future is writ large. Because of the similarities of tepid growth, product and service deflation, low interest rates and a rising stock market, Japan has been a testing ground for the monetary policies of the Fed. It is America’s economic wormhole into the future.

What will it take for America to avoid Japan’s liquidity trap and enable the Fed to create economic growth and stability going forward?

The simplistic answer is that stability-plus-growth for a lengthy period depends at least in substantial part on a stable monetary system. For America and the world, that means a stable Dollar.

For millennia, the world’s monetary system has been dependent on gold, coins minted in gold and, more recently, paper money backed by gold. Economic instability resulted only when gold-as-a-currency has been devalued – either by reducing the amount of gold in circulating gold coins – the original means governments used to debase their currencies – or by inflating the value of paper currencies exchangeable into gold. The gold standard was the value-anchor for everything because until the mid-20th Century it was the only currency that was universally accepted. After WWII, a victorious America required its satellite allies mercantilist-satrapies trading partners to anchor their economic systems in the US Dollar …, and the world accepted the Dollar as the world’s currency only because it trusted that the U.S. would never allow its value to be compromised by excessive spending it was backed by gold – that is, America guaranteed (in the Bretton Woods Agreement) that the Dollar would always be exchangeable for gold at $35/ounce. That changed in 1971 when President Nixon took the Dollar off the gold standard. That act was followed by a decade of ever-increasing inflation that ended only when the Federal Reserve, under the leadership of Paul Volcker, squeezed the money supply to deflate the Dollar. That squeezing created soaring interest rates that brought the American economy almost to its knees back to reality …, and allowed the Dollar to regain the credibility it had lost after the excessive printing of paper Dollars to fund America’s Great Society programs and the Vietnam War. The U.S. continued its hold on that credibility under the leadership of Volcker’s and Nixon’s successors, all of whom built trust in Pax America, confirming America’s leadership of the free world and its role as guardian of the world’s monetary health. It was that trust that led the world’s Central Bankers (and their government counterparts) to follow the Fed’s lead after the Great Recession. Whereas currencies no longer anchor themselves to the price of gold, the world’s Central Bankers have willingly anchored their monetary policies and the value of their currencies to the Dollar under the leadership of America’s Fed. Coordinated Quantitative Easing by the world’s leading economies accordingly has flooded the world with cash, Central Bankers believing that the rising tide of cash would lift all boats …, as monetary floods historically have done. QE would benefit the poor with higher wages. It would restore the middle class by creating jobs. And it would fuel capital spending by the rich …, increasing prosperity for everyone.

Although it hasn’t happened quite as expected, the Central Bankers’ actions have led to an historically unprecedented period of economic growth and stability. Put another way, the Central Bankers’ coordinated monetary policy has manufactured stability through the construction of a basket of closely coordinated currencies …, as a substitute for the gold standard. The “Dollar Standard” reigns supreme!

What happens next?

The risk for the global economy is that the Dollar Standard fails as did the gold standard before it. The Dollar Standard depends on (1) maintaining the close coordination of the world’s Central Bankers and (2) maintaining the stability of the Dollar. As long as there is an economic balance – the maintenance of a common interest – among the world’s leading economies (the EU, China, Japan, Great Britain, Switzerland, South Korea, Taiwan), their Central Bankers will continue their close coordination. That depends in substantial part on a commonality of both economic and geopolitical interests. Maintaining the stability of the Dollar is U.S.-specific. It depends on funding America’s enormous money-printing operations and its massive fiscal deficits. Doing so requires that there be a corresponding increase in domestic demand and in the capital spending required to generate increased supply. Funding an increase in demand and in capital spending, in turn, will require more money-printing and fiscal spending. MMT anyone? Japan is further ahead of the U.S. in each respect. Japan will continue to be the macroeconomic trailblazer for the U.S. and the rest of the world. It indeed is America’s economic wormhole into the future.

Finally (from a good friend)

*┬® Copyright 2019 by William Natbony. All rights reserved.

[1] A wormhole is a theoretical hole in space and time, a “tunnel connection” such that a trip between two distant points is almost instantaneous.

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