Month: September 2013

The Redundancy of Supply-Side Economics in Abe’s Japan

Great expectations surrounded the announcement of Shinzo Abe’s economic revolution in Japan to pull the economy out of its 20 year slump. The revolution involved a huge overhaul of public policy, with a three-pronged attack on the macroeconomic conditions beleaguering the nation.

The first prong, a tsunami of monetary stimulus and cheap credit released by the Bank of Japan’s new governor Haruhiko Kuroda was designed to end the deflationary spiral. The second was a similarly immense fiscal stimulus package worth $116 billion designed to offset lacklustre investment from the private sector. But it was the third arrow, a series of supply-side reforms, that was perceived to be key to improving the competitiveness of Japanese firms and bolster long-term growth.

At best, these supply-side measures will prove to be only mildly stimulative to the Japanese economy if it begins to recover from its 20 year slump. By contrast, if the economy falls into another recession and the continued deregulation of Japanese labour markets is pursued aggressively, the result could be damaging.

 So let’s star our analysis by looking at the channels through which labour market reforms increase productivity. The first channel allows low-productivity sectors and unprofitable enterprises to shed labour more easily. The second channel is then designed to allow firms to hire workers more easily, and consequently pick up the previously fired workers. Therefore, in a healthy economy, structural reform redistributes labour from unproductive employment towards productive employment.

In conditions of economic malaise however, the second channel operates rather weakly. It is easy to see why. When aggregate demand is depressed even productive firms may be saturating the market with unsellable produce and as a result, they are hardly likely to increase employment until aggregate demand recovers. Thus, only the first channel operates at full capacity, and labour is fired at increasing rates. Synthesising these two channels in dampened economic conditions therefore results in heightened levels of unemployment, whilst aggregate demand is depressed even further.

If Abe’s supply-side plan is to recognise any success in this case it will have to hope that the effects of monetary and fiscal stimulus hit the economy before the labour market deregulations do. But even in this event (which admittedly is the more likely one), the third arrow of growth will inevitably fail to boost growth substantially.

The fact of the matter is that Japan’s crisis is one of a huge debt-deflation overhang, and one of depressed demand. That is; it is cyclical in nature, not structural. The huge time-frame and multitude of bogus recoveries would seem to imply that the recession is not a normal one, and the implication is correct; the problems are odd. But the peculiarity of the problems does not make them structural.

In an economy suffering from supply-side malaise, firms are unable to compete internationally and produce anything of meaningful values. In this situation, the current account deficit will rise due to domestic inefficiencies (since domestic production will be unable to compete with imports, and exports will falter).When the current account deficit rises, the currency devalues by the natural mechanisms. When the currency devalues imported inflation will rise. And when inflation rises the central bank will attempt to remedy the problem via contractionary monetary policy. Thus an economy suffering from supply-side inefficiencies should be characterised by having:

  • A deficit on the current account.
  • A weak currency
  • High levels of inflation
  • Contractionary monetary policy

These symptoms validate the experience of the USA in the 1970s, when it suffered from stagflation. Indeed, the problems in that situation were supply-side, and the required response was microeconomic in nature. But 1970s America is very different to 2000s Japan.

The Japanese economy for the past 20 years has shared none of the symptoms of stagflation. It has enjoyed persistent current account surpluses, a strong currency (the government has had to step in on numerous occasions to weaken the Yen in the past 20 years), persistent deflation and the most expansive monetary policy seen in history.

This should all point to the fact that Japanese firms are highly competitive on an international-scale. Whilst many academic economists may not realise this reality, one merely has to look in their own home to validate the reality. Japan’s firms are at the forefront of global innovation, and export their products vigorously to western households and businesses.

If Japan’s economy thus does not suffer from supply-side ails, and an economy stifled by over regulation then Shinzo Abe’s measures will be largely fruitless. If the demand-side stimulus measures hit the economy fast, the microeconomic reforms will be redundant. If however, implementation of the fiscal and monetary attacks wavers, the microeconomic reforms could cripple the situation and prolong the pain even further.

The reality stabs policymakers in the face every day. Japan’s problems are demand-side, failing to recognise this jeopardises the livelihood of millions of people.

A Quick Note on Quantitative Easing- The Portfolio Composition is More Important than the Reserve Levels.

So I was recently engaged in a debate with a close friend of mine over what the repercussions of continued Quantitative Easing (QE) would be, and what the inflationary effects of QE would be. The debate began with agreement, with both of us acknowledging that the current program was largely ineffectual due to the huge amount of excess reserves in the US financial system. Differences did soon become apparent however when my friend expressed his concern over the inflationary effects of the program if it went on indefinitely. This was because of the difficulties of retracting the program if it were allowed to go on for too long. Retracting $2 trillion dollars is easier than retracting $20 trillion. With the reserves just sitting there in huge excess, surely Bernanke could taper the constant injections, but leave the money already there as is. Money at the moment is just sitting in the system floating about, so what’s the point of putting more in if it just makes the retraction harder? Surely the huge monetary base would keep liquidity high and interest rates low across the board. There is so much excess, why do we need more? Stop the program, leave the reserves there, and lending growth should be unchanged. The analogy is “If the shops can’t sell 10 apples, giving them 100 isn’t going to help them sell any more if the price doesn’t change”. And in other words again, people seem to think that as the money multiplier declines banks ‘park’ their money with the Fed, and do not ‘Lend it out’

This line of thinking however overlooks the actual mechanisms that drive the operations behind QE, and its theoretical framework. The fact is that QE works to drive specifically Long-term interest rates down with the purchase of Long-term assets. The answer lies in the fact that banks have strict portfolio norms that they follow, and that reserves don’t simply get “lent out”.

So let’s briefly address the “Lending-Out Misconception” first. This common misconception holds that when commercial banks hold too much cash in their reserve accounts with the central bank, they can expand their lending operations. They simply lend out this extra cash to the private sector and real economy. This is simply not true. The commercial bank has no actual control over reserve levels, and the link is indirect. (see for more http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf)

So, on to the more substantial point. If it’s reserves that matter and if there are excess reserves, what is the point of pushing even more into the system? The money is not being used as it is!

The point however is that it’s not the reserves nor the liquidity that expand lending. Rather, lending comes from individual banks changing their portfolio composition. In reality, when the Fed implements QE, what it does is buy long-term securities (henceforth simplified to be mortgages). Buying these mortgages helps to increase lending activity, not because the banks now have money in their checking accounts that they can lend out, but rather because banks strive to have a consistent level of long-term assets and liabilities relative to short term ones. When the Fed buys mortgages off of a bank. The bank will find itself with a more cash assets, and less mortgage assets. It’s portfolio’s composition will have changed. In order to address this the bank will strive to correct the portfolio and buy up mortgage contracts and assets off of the private sector. It will then credit the private sector with cash. Hence, when the Fed buys mortgages off of the banks, portfolio corrections means that it is really accumulating them off of the private sector. The private sector will then find itself with excess cash and the money should theoretically be invested or used.

Where the ‘flow’ of QE becomes important is in distorting the banking sector’s portfolio. As it stands, the banks are not inclined to correct their portfolios, and lending rates are not rising. But corrections back to normality DO nevertheless happen slowly, and the more balance sheets become liquid with cash exceeding mortgages, the more the banks will strive to correct their balance sheets, buying up mortgages off of the private sector.

Thus, QE works through the norms of the financial sector, and no matter how redundant inflating the monetary base through reserves may seem, it incentivises lending expansion regardless. Why are banks not so keen to rebalance their distorted portfolios? Is this situation permanent? The answer is a resounding no to the latter. Banks simply do not want to rebalance their portfolios because the returns on long-term assets have not been deemed valuable enough relative to those of highly liquid assets at the moment. In addition, the 0.25% interest rate payment that the Fed gives the sector for excess reserves provides an incentive to keep the asset compositions highly liquid. This means keeping the portfolios at above equilibrium levels of liquidity. That doesn’t mean that banks will completely disregard the portfolio norms however. Indeed, the more the Fed increases the liquidity of the balance sheets, the more the banks will strive to accumulate mortgages off of the private sector. Thus the private sector’s holdings of loanable funds increases, and interest rates fall.

 

*Disclaimer: I think I’m wrong