Quantitative Easing (QE): Are We Making A Mistake?

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The current path of monetary policy in the form of quantitative easing (QE) world wide and particularly in the United States is following a dangerous trajectory, one that has a historical precedent without looking back several centuries. This disastrously flawed monetary experiment has plagued Japans economy and its people since the 1990s, almost 30 years and yet there is still no progress to show for it.

Does that sound like insanity? Here is the informal yet popular definition of insanity: doing the same thing over and over again and expecting different results – Albert Einstein.  You would expect that the economists and politicians would give up by now and try something different? Alas, you’d be wrong. They are in fact trying something different, but that comes in the form of doubling down on the mistakes of the past.

This article is about quantitative easing (QE), what it is, and what we learned from it (if anything). Japan has been experimenting with quantitative easing for decades with little progress to show for it.

The policy “experts” in the United States and Europe believe that if they can tweak Japan’s mistakes just right, that everything will work out. But what if, I fear to ask, what if it is necessary not to retool but to completely rethink and discard the policies of the past decades? This would require for politicians to admit being incorrect, so don’t hold your breath. Whether you are in the United States, Europe or anywhere else in the big blue ball they call Earth – the topic of quantitative easing affects your life, every day.

Starting At The Beginning (Of The End?)

Last summer, the Central Bank of Japan announced new quantitative easing measures to attempt to stimulate its economy which has been in terminal decline for decades. GDP has barely been able to expand above 2% for years.

Japan GDP

Japan’s economy was a powerhouse throughout the 1980s. Businesses purchased treasures around the world, properties such as the famed Pebble Beach Golf Course. At one point there was even a scare in the United States that the Japanese would buy America, just like today there is a scare that China will buy America. This won’t happen for the same reasons it didn’t in the 1980s. Debt, not savings, is fueling the buying, now and then.

That all ended with a bust when Japan’s economy faltered and the Nikkei stock index collapsed.

Nikkei

Since then Japan’s economy has not been able to grow proportionately to the rest of the world. Instead, Japan’s economy has faced deflation, a condition where prices fall from one year to the next as demand for goods decreases. Largely this is a symptom of the gradual change in Japan’s demographics. This has prevented the economy from expanding to a level that would be sustainable and healthy to grow production. At the same time, the Japanese government has been creating a massive amount of debt, not making the cost of living any easier on the population, as this chart on Japan’s Debt/GDP ratio shows:
Japan Debt/GDP

The Bank Of Japan Starts Quantitative Easing

Over the years, the Bank of Japan has taken measures to increase inflation by printing an excessive amount of currency.

In the simplest definition, “inflation” is the increase of the supply of currency (debt) in excess of the supply of money (assets).

The process of inflation has been rephrased in recent years by policy thinkers and economists as “Quantitative Easing”, otherwise known as QE (here’s an excerpt from an article discussing how the economy works):

At the heart of quantitative easing is the belief that when there is no economic growth that through intervention governments can stimulate growth, however this has its limitations and dangerous consequences.

Through QE a central bank will sell newly created currency (notes) to member banks. This is equivalent to you owning a printing press and creating currency for yourself and your family. In theory, the banks, now with increased reserves as a function of the newly obtained currency would lend it to businesses, consumers, investors and so forth – thereby driving the economy and stimulating investment and consumption.

In addition to the distribution of currency to member banks, the central bank purchases long-term debt from the government (Treasury). Again, the theory that the central bank is working under is that through the purchasing of bonds with newly issued currency, this increases the demand for bonds, thereby pushing the prices of bonds higher and likewise moving the interest rate lower. You can read more about how bonds and interest rates work in: Interest Rates Vs. Bond Prices: How Do Bonds Work?

With unbound QE, and an unyielding demand for government debt, from newly created currency (also debt) purchased by the central bank, the program to keep interest rates as close to zero has thus far been successful.

Whereas U.S. interest rates have been moving higher, the Japanese government bond rate has effectively been kept near the 0.0% target rate. The bond is currently yielding 0.074%.
U.S. 10 versus JP 10

Return On Investment In Quantitative Easing

A bank’s primary function is to make a return on investment, to make a profit. One of the primary ways they do this is by lending to borrowers at an interest rate that is higher than the cost of obtaining the newly printed currency from the central bank – the difference (spread) thus making up the profit. They charge an interest rate for the money they lend out. Additionally, the power of fractional reserve banking allows the bank to use $1,000 in deposits (actual currency received from depositors) and to lend out a little over $9,000 from that $1,000. This is where the so called stealth quantitative easing comes into play.

The currency that banks use to lend out comes from fractional banking derived by the deposits from their customers. The bank pays interest on the deposits from these accounts. The bank’s profits are the differential from what is paid to depositors versus what is charged to its lenders.

If you were a bank you would want to maximize the potential of the differential. You would want to pay as little in interest as you could from borrowing while at the same time receive as much interest as you could from lending.

Look at the interest rates above. In the United States, the government 10-year is yielding 2.48% whereas in Japan the same interest rate is 0.074%. Effectively, you could borrow money in Japan and then purchase new US government debt. You would earn a “risk free investment” on the differential, earning the 2.48% from the United States and paying the less-than 0.10% interest rate in Japan.

Being a bank, your goal is to maximize profits. There are no restrictions for banks stipulating they must lend funds to just Japanese companies and individuals. In fact, all of the major banks in Japan have international offices. These banks are more prone to lending out their extra funds in regions where they will receive the highest interest rates. That would not be in Japan.

Because of this, instead of investment capital staying in Japan where it could achieve its objective of investment into the economy, instead it is moving abroad. Japan’s inflation rate is still a paltry year-over-year 0.4% increase, as measured by the CPI.

Japan Inflation

It is important to note that inflation around the world is far higher. In the United States, year-over-year increases in interest rates are sitting at 2.5%. Even in Europe, inflation has topped 2% annually and is moving higher.
United States Inflation
Another interesting aside is that for anyone wanting to put this trade on, borrowing in Japan and lending the funds in another region of the world, that person would need to exchange Japanese Yen for United States Dollars, JPY for USD. Given the potential flow of capital out of Japan, it is easy to assume that the Japanese Yen would decline in value. As it turns out, that is not the case as this chart shows:
JPYUSD
As this chart shows, inexplicably, JPY is more prone to moving strengthening than weakening, which is great for Japanese consumers, but in the short-term could decrease foreign demand for Japanese products as the Yen appreciates, hindering Japanese companies from becoming more competitive versus their foreign counterparts.

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How To Reverse Course?

Quantitative easing is not working in Japan.  The Japanese Yen is not falling as the central bank would like for it to and as it theoretically should. Interest rates are at multi century and theoretic lows. And, now there are calls for the Bank of Japan to reverse course.

If the Bank of Japan attempts to reverse course, this could slow down the country’s economy even further. Higher interest rates would push the JPY higher in value relative to foreign currencies in the short-term, with a long-term impact of higher lending costs and negative pressure on the economy.

…instead of allowing the economy to function as a self correcting mechanism, throughout history governments have attempted to stimulate continued economic growth despite the unavailability of savings, through the creation of currency and the artificial simultaneous reduction in the interest rate, thereby artificially fueling demand and the illusion of a population that has a large amount of savings to fund future growth. These actions by central banks and governments create unsustainable artificial periods of economic growth, only to be followed by a very real economic contraction that has far reaching generational consequences on the population, something which happened following 2008.

Source

As such, following a period of one-directional policy, a reversal in course could be very disruptive to the economy, and may reveal system imbalances that result in economic shocks. Imagine landing a Boeing 747 plane on water. Like water, and unlike land, the economy does not sit still. Making that landing safely, and accounting for all the ripples in the water would truly be a remarkable accomplishment. But the probability of one small wave destabilizing the landing of the plane is extremely high, as such, the risks for economic consequences are elevated.

Does Quantitative Easing Work?

The theory behind interest rates being lower than they otherwise would be without central bank actions is that this creates increased demand for economic components (such as consumer goods), driving asset prices higher and creating a wealth effect, or an increase in job growth which would spur income and further demand in a self sustaining manner. The concept of the “wealth effect” is that if your home increases in value (on paper) that your propensity to consume will increase (as you start feeling more wealthy) and you will start spending more. The wealth effect and the whole reality of artificially creating economic demand misses one key point: If people do not have savings, and we know that asset prices cannot increase in any direction indefinitely (up or down) then what happens afterwards, when either artificially induced government demand stops, or people’s propensity to consume disappears as a function of not having savings or being maxed out on all debts?

Expanding the supply of credit (demand for bonds) and currency through fractional reserve banking and central bank creation of new currency (inflation) creates the effect of price inflation on goods that are purchased by those institutions or individuals that first hold the newly created currency.

In the case of the United States, quantitative easing has created increased valuations in real estate, bonds and the stock market. However, this supposed “wealth effect” has not improved the well-being of the real economy in the form of increased sustainable production, decreased unemployment, nor a decrease in the cost of living.

As such, the multi decade decline of Japan’s economy combined with their aging demographic is a stark warning to the United States, which is currently on a similar path of self destruction.

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