Introduction
On December 17 Japan announced its latest economic stimulus package involving US 15.5 billion dollars in income tax cuts and US 78 billion dollars of additional funds to the Deposit Insurance Corp (DIC) to help protect deposits at financial institutions. It was subsequently announced that one third of the funds given to the DIC may be used to purchase new issues of preferred stock in financial institutions to address capital shortages. At the same time as this stimulus package was being announced, the Bank of Japan (BOJ) was busy selling 4 billion US dollars (for Yen) and making statements to the effect that they would like to see a stronger Yen. All of this activity resulted in the dollar/yen rate dropping immediately from 130 to 126 and the Japanese stock market rallying 5% . However, within the week following the release of the package the Nikkei had fallen 12% from its highs reached on the morning of the 17th and the dollar/yen rate had returned to 130. Yet again, government intervention in the capital markets had resulted in short term volatility. It is becoming almost laughable to observe senior politicians and treasury officials from the G7 nations regularly attempt to talk capital into moving in a direction which suits their political agenda, but which is opposite to the direction dictated by economic fundamentals.
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Although Japan's trade surplus with the US tends to be the focus of misguided political posturing and media attention, net capital outflows from Japan are 20 times the Japan/US trade surplus. Under the current conditions, with an extremely negative outlook for investment opportunities within Japan and a currency which looks like weakening substantially, record low interest rates within Japan are acting to force even more capital overseas in search of adequate investment returns.
In previous Gold-Eagle articles I have asserted that the ability of the US Federal Reserve to create unlimited amounts of money eliminates the possibility of deflation occurring within the US. The dramatic increase in US money supply during the past 4 months in response to a stalling local stock market and the Asian currency crisis has solidified my belief. However, the Japanese experience of the 1990s is often used by the deflationists to argue that the bursting of an asset bubble which has been fueled by credit expansion must lead to deflation. It is therefore worth exploring the situation in Japan and making some comparisons with the US.
Japan's Monetary Gap
Firstly, in any discussion of inflation and deflation we must always be very clear that we are talking about changes in the quantity of money, not changes in prices. Deflation is, by definition, a contraction in the total quantity of money. It is indisputable that Japanese asset values have plummeted since reaching a peak in December 1989 . It is also clear that the huge reduction in asset values which began in Dec 89 and has continued throughout the 1990s has resulted in the liabilities of the Japanese financial system becoming greater than its assets. This is precisely what happened in the US during the 1930s. However, unlike America in the 1930s, deflation has not occurred in 1990s Japan. ( Note - for the purpose of this discussion "liabilities" means "monetary liabilities".)
Monetary liabilities are created by the monetary agents (privately owned banks and the central bank) in the form of newly issued currency (Yen) and therefore affect the monetary balance sheet of the nation. Non-monetary liabilities (those created by, for example, finance companies) do not involve the creation of currency .
Whenever a gap between assets and liabilities occurs, the gap must be filled via a reduction in liabilities or an increase in assets. During the 1930s depression in the US the gap was closed via a reduction in liabilities, that is, banks failed resulting in deposit currency being wiped out. The total quantity of currency (liabilities) reduced to the point where the remaining liabilities were covered by the assets of the monetary agents. This is deflation. In 1990s Japan, however, the quantity of currency (liabilities) has increased. After growing at a moderate rate throughout most of the 1990s, currency creation has recently accelerated with assets on the BOJ's balance sheet increasing at an annualised rate of 70.7% for the three months ending Nov 30. Rather than suffer the short term agony which would result from the collapse of the weaker banks and a consequential contraction in the money supply to the point where the books were once again balanced, the Japanese authorities have chosen to "stimulate" the economy in the hope that the monetary gap would be closed via an increase in asset values.
The Outlook For Japan In 1998
The outlook for Japan is not good. The refusal of the Japanese government to satisfactorily address the gap on the monetary balance sheet means that the entire Japanese financial system remains insolvent and investment capital will continue to be driven overseas, primarily to the US. This will lead to further weakness in the Yen against the US dollar, which will in turn cause more high profile political grand-standing due to the escalating US/Japan trade deficit. The end result is likely to be even greater currency volatility and pressure on Japan to stimulate growth within its economy. Such stimulation will take the form of further increases in the money supply, causing more weakness in the currency, etc etc.
The possibility of Japan selling its holdings of US treasury debt has been widely discussed in recent months. Taking such an action would help fill the gap in the Japanese monetary system and strengthen the Yen, particularly if the proceeds were used to purchase gold which then became an asset on the monetary balance sheet. However, I am not optimistic that this will occur, for two reasons :
- The apparent willingness of the Japanese government to bow to US political pressure ( a large scale liquidation of US bonds by Japan would cause interest rates to rise in the US )
- US dollar assets are virtually the only investments which are currently providing the Japanese with satisfactory returns (both income and capital gain).
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Conclusion
If ever a nation needed to undergo deflation (a contraction in the money supply), it has been Japan in the 1990s. Using price/earnings ratios as a measure of relative valuation, the Japanese stock market in Dec 89 was more than three times higher than the current US market, and Japanese real estate valuations were even more unrealistic. Both the stock and property markets were supported by an enormous debt bubble which, when asset prices eventually collapsed, led to a large deficiency of assets against liabilities. Despite this fact, the Japanese monetary authorities have successfully prevented deflation from occurring and, in doing so, have maintained the gap between assets and liabilities which continues to stifle any hope of an economic recovery.
I continue to believe that whether we are considering Japan, the US, or any other modern democracy, in the short term (the time between now and the next election) deflation will always be politically unpalatable and will be avoided at all costs. The problem is, when you add a lot of short terms together you end up with a long term and, in Japan's case, a recession which is entering its 9th year.
The reader is invited to respond to Milhouse's wisdom via email: sas@hk.gin.net
Milhouse
29 December 1997
Also by Milhouse:
Gold Versus The Dollar
European Monetary Union
US Money Supply and the Demand For Gold
US / Japan Trade - Reality Versus Perception
Is Gold Still a Store of Value ?
Central Banks and Their Gold
The Intrinsic Value of Gold
Gold & Disintegration of U.S. Economic Influence
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