Japanification: The difficulty of kicking the QE drug

July 24, 2019 16:51
Japan is approaching its twenty-second year of policy loosening without convincing inflation. Photo: Reuters

Political risk is 'trumping' economics. With populism building, disparate prosperity exacerbated by quantitative easing (QE), and stirrings that globalization needs to reverse, a paradigm-shift is at play that may prove as forceful as the fall of communism in 1989, and even the New World Order after 1945.

Policymakers 'playing King Canute' look ill-equipped to deal with this. With their traditional reaction-functions having broken, central banks are already turning dovish again. This makes comparisons with Japan -- approaching its twenty-second year of policy loosening without convincing inflation -- more than a coincidence.

Much of this has precedent in Japan. There, asset prices in the late 1980s were ballooning - stylised by the valuation of the Emperor’s palace grounds (at US$139,000 per square foot) surpassing that of California’s total real estate. Tumbling asset prices from 1991 hurt banks’ balance sheets and collateral, contributing to economy-wide deflation by 1995. This prompted banks to write off loans, and the Bank of Japan (BoJ) in 1997-98 to mop up their commercial paper ('QE1').

A symbiosis started, where the Ministry of Finance presiding over escalating government liabilities became reliant on the BoJ to control debt-service costs. Caught in a liquidity trap, only in 2007 did Japan recoup its pre-1988 nominal GDP. This then proved temporary into the 2008/09 global crisis.

This does not bode well for other economies. They have taken four to nine years to recoup their nominal GDP lost since the 2008 crisis. Their inflation expectations are low, even after a decade of pump-priming liquidity. And, as we know from Japan, the only real benefit from QE is to support asset prices and keep bond yields low (see chart 1).

Comparisons with Japan are more than a coincidence

Bloated asset prices are a result of QE, but they are also a reason why, in such a febrile political climate, QE cannot be reversed - for fear of losing the baby (recovery) with the bath water. Therefore, the spoils of QE will continue to center on those (asset owners) that probably need it least.

Financial markets are rightly sensing Japanification, with government bond yields in Germany now below those of Japan. Germany’s bank margins are under pressure from negative policy rates, and some are describing the eurozone as “overbanked”. An ageing demographic, labor rigidities and pressure to devalue internally are other worrying comparators between core euro members and Japan.

Differences exist of course, but these are not reassuring. Japan in the late 1990s was acting alone, with demand-overheating being the G7’s main concern at that time, not deflation. By comparison, since 2008/09, major economies have acted swiftly, and in relative concert, to achieve similar goals, but, their inflation outlook is no more convincing. Japan has benefited from social cohesion: the LDP ruling for all but three of the past 64 years, including 1955-2009. This contrasts strongly with the disruption and growing populism in the US and Europe.

Difficult to kick the QE drug, and armories are reducing

In policy terms, there seem to be at least two common threads. First, that the QE ‘drug’ can be difficult to kick. The last time this happened was when the US pulled out of the Great Depression in the 1930s. Its QE then ran for 14 years, unbroken to 1951, despite double-digit inflation touching 20 percent in 1947. This was clearly a different time, but if it is a guide, we may be little more than half-way through our own QE journey.

Second, prolonging cheap money reduces central banks’ armories, diluting their ability to affect change. The dilemma now is whether they can re-equip themselves for future economic downturns, or – like Japan - preserve the status quo. Their 'skin in the game' suggests it will be the latter.

In which case, with the yield-clamp of QE in place, governments trying to preserve growth and appease disaffected, electorates may as well do something that justifies it. It is time to open the fiscal box.

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Hermes Investment Management’s senior economic adviser