World's third largest economy in distress

by David Taylor

The global financial crisis was a point in time. That’s precisely what a crisis is. It comes and it goes. At the crisis point you can go one of two ways: you can recover and become stronger; or you can sink deeper into the mess that led to the crisis.

The world was met with a global financial crisis several years ago, and I would argue we are now moving further into the mess that could have been tackled head-on in 2009. This week just past saw yet another symptom of a global financial system still in major need of repair. It’s another example of how fragile the world’s global economy remains.

I refer to the Japanese economy. It takes the number three position on the word economic stage… behind the United States and China. It’s one of those economies that doesn’t tend to make the headlines unless something particularly good or bad happens. Last week the Bank of Japan (BoJ) announced that, from January next year, it’ll inject $137 billion into its banking system every month. It’s already working a trillion dollars into its economy, but that’ll run out by the end of this year.

On the bank’s agenda is inflation – but not in the same way as Australia. Japan has been fighting off deflation, not to mention several recessions, for a decade. The bank’s set a target rate of inflation of 2 per cent. That’s fairly ambitious and pretty close to Australia’s inflation rate of 2.2 per cent (released at the end of last week).

In addition, the BoJ says it will hold its cash rate steady at 0.1 per cent. That’s roughly in line with the rest of the world. It’s just another bank with its foot firmly on the accelerator, hoping the wheels will gain traction with the road at some point.

So there you have it. Billions of dollars are literally going to be handed over to the banks in the months ahead (in exchange for mortgage-backed securities, i.e. quantitative easing) in an attempt to get the economic wheels turning again, boost demand, and hopefully bring about some reasonable level of inflation.

I just have two questions: Why do this now? And second, just how serious a state is the Japanese economy in to warrant such an enormous stimulus measure? And yes it is enormous. I say that because the BoJ has indicated it will keep pumping $137 billion into the banking system every month until it starts to see some healthy level of inflation.

On the question of why do this now…  It’s partly political and partly necessary. Fact is the Japanese Prime Minister, Shinzo Abe, is under pressure to put the Japanese economy onto a sustainable growth path. Perhaps even more pressing is the need for the economy to seize the opportunities available to it now. The opportunity I’m talking about is the ability to print money.

Printing money has become politically palatable. Here’s why.

 The global financial crisis came about because credit markets froze. To save the entire financial system from collapsing, federal governments stepped in (using taxpayer’s money).  When that money ran out, government’s began to borrow more (hence the problems that the United States and Europe are currently facing). To make borrowing cheaper for everyone, central banks from all around the world began dropping interest rates to zero. Again, it proved relatively ineffective. The only ‘trick’ left is to literally hand money to banks for free in the hope that they will lend it out for extremely low interest rates. Central Banks too are promising to keep interest rates low for governments.

This strategy is having mixed results. It has achieved somewhat lower unemployment in the US, but nothing to write home about. In Europe and China, the policy settings have been a little different but the effects have been the same. There’s been a marked decline in the cost of money, but no real evidence of improving economic growth or significantly lower levels of unemployment.

Japan has now decided to crank up the volume. And this goes to that second question about just how much in need of repair the Japanese economy is. The market reaction alone would suggest Japan was in need of a serious shot of adrenalin. You see having already pumped billions and billions of dollars in to the banking system, the idea of creating money to do it all over again would normally be laughed at. Today it’s treated with respect by financial markets. In fact in the lead up to Prime Minister Shinzo Abe’s announcement last week (and with some level of ‘money printing’ already underway), the Nikkei shot up around 25 per cent higher and the yen had dropped around 10 per cent. The conclusion: It’s effectively become ‘politically correct’ to print money when your economy is in obvious distress.

Here’s where it gets really interesting.

The rule book has been thrown out. Governments and central banks are now primarily concerned with survival.

Japan’s primarily focused on achieving inflation and avoiding yet another recession. The Unites States is focused on driving down unemployment, while euro zone countries are looking to get out of a deep economic contraction while reducing their deficits and government debt.

The data within these economies also highlights the seriousness of the problems. Spain’s unemployment rate released at the end of last week stood at 26 per cent. Youth unemployment is over 50 per cent. Unemployment in the US is hovering just under 8 per cent despite billions of dollars having been thrown at the economy already. And prices in Japan are still in reverse.

It wouldn’t pose such a problem to the stability of the global financial system if these countries didn’t dominate so much of world trade, but they do. In fact the two countries that have announced some of the most serious central bank action are the largest and third largest economies in the world. It would also not be such a serious problem if both Japan and the United States weren’t using the same strategy to work their way out of the economic malaise.

This is a point being missed by a lot of market commentators at the moment but it’s a crucial one. The managing director of the International Monetary Fund even made reference to it at the World Economic Forum in Davos last week. The United States and Japan have decided the best way to emerge from their economic crises is to lower the value of their currencies through quantitative easing.

It’s the one policy solution that the euro zone doesn’t have because they share a common currency. It’s been made possible in both the US and Japan because markets have become addicted to central bank ‘money printing’ and the affect it has on short term borrowing rates and equity markets.

A ‘race to the bottom’ currency war between the US and Japan though has risks attached to it. I was speaking to a senior strategist from Morgan Stanley Wealth Management during the week and he said it was something we need to keep an eye on. That was an understated way of saying something could go wrong.

His argument was that with any extreme policy measures, especially when taken on by the world’s largest and third largest economies have obvious risks attached. One is that inflation will become a problem, but more likely, is that another asset bubble will be created. This is even separate from the trade distortions (crowding out) that’s created from two of the world’s major economic powers driving their currencies down to stimulate export demand.

We are in a world now where all major world economies are looking shaky. We’re also in a world where extreme economic policies are not only accepted but are also welcomed by markets. It’s led to two of the world’s major economies into a currency war that’s been fuelled by cheap money and artificial interest rates. As the strategist from Morgan Stanley said it’s all very well to put these policies into place to assist with the ‘great escape’, but who’s decided when or how they will be unwound. The US Federal Reserve says it’ll all come back when unemployment comes down. But what if it doesn’t?

From a strictly Australian point of view, the economic risks fell back a little last week with better-than-expected manufacturing data out of China. The local share market is now around 20 month highs.

However given Europe, Japan, and the United States are among China’s largest trading partners  the conclusion is simple… around 5 years after the global financial crisis, Australia is still very much at risk from bad decisions being made on the global economic stage. Even the normally sanguine Wayne Swan conceded that in a press conference last week. You know it’s serious when the politicians put politics aside and just tell the truth. It’s when the stakes have become too high.

David Taylor


The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.

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