“The basic function of a central bank is to defend the value of the currency.”
Paul Volcker was the great US central banker of our time. Unlike Alan Greenspan and Ben Bernanke, he believed in taking firm action to avoid crises, rather than trusting in financial markets to regulate themselves. He also believed that politicians had to take the lead on structural issues such as employment, not central banks.
Thus it was no surprise he criticised current Japanese and US policy for not defending the currency in an interview last year:
“Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. I think it gets dangerous when they lose sight of the basic function of the central bank. The key issue concerns what this “function” should be. The basic function of a central bank is to defend the value of the currency,” he insists, as his highly successful experience in the 1980s “taught him how limited a central banker’s powers really are”.
Unfortunately for the Japanese people, the current Governor of the Bank of Japan, Haruhiko Kuroda, disagrees with Volcker, as does its Premier Abe. As the chart shows, they have allowed the yen to fall by more than a third versus the US$ since Abe took office in December 2012. Their major spending programmes have also caused the country’s debt to double to twice its GDP
MONETARY POLICY CANNOT SOLVE THE ISSUES FACING JAPAN’S ECONOMY
The problem is that Kuroda and Abe’s policies are fatally flawed. Their aim is to boost inflation in the belief this will somehow revive economic growth. But deflation is a symptom, not a cause, of Japan’s slowing economy, as UN Population Division data shows:
- Japan’s population peaked at 127m in 2010, and will decline to 108m by 2050
- Japanese women stopped having enough babies to replace the population 40 years ago, in 1975
- The current fertility rate is just 1.5 babies/woman, well below the replacement rate of 2.1 babies
- As a result, 1 in 2 adults are now over the age of 55, and 42% are over the age of 65
Printing money will not change these facts. Only structural reform of the economy, focused on the needs of its ageing population, could recreate former growth. But as in the West, Abe and Kuroda have preferred to avoid the difficult conversations this would require. Abe’s much-hyped “3rd Arrow“, which was supposed to focus on this, has instead become just a dart.
Thus 2 years after the new regime took office, there is a growing risk that Japan could be heading for a major crisis. In the short-term, the collapse of the oil price makes it highly likely deflation will return. Even Governor Kuroda now seems to accept this reality:
- 4 months ago, he said there was “no chance” that inflation would fall below 1%
- Last week, he admitted “It is likely to stay around 1% – including the possibility of going below 1%”
His panicked move earlier this month in response to this development, suggests however that he could be close to making a catastrophic mistake. I do not use this phrase lightly, but it seems vital to highlight how current policies could mean that today’s mild deflation could be potentially be followed by hyper-inflation.
William White, the former adviser to the Bank for International Settlements (the central banks’ bank), spelt out this key risk in a Financial Times article on Friday:
“Japan’s fiscal deficit is about 8% of GDP and its stock of gross debt about 230% of GDP. Were the average rate on government bonds to increase to 2%, and should potential nominal growth fail to rise, the deficit would rise above 10% of GDP. The pace of government bond purchases announced by the BoJ, almost twice the size of the general government deficit, would then have to rise further.
“Fears of still more monetisation and sharp price rises would put more upward pressure on bond rates, and downward pressure on the yen, in a self-fulfilling spiral that could quickly take inflation to very high levels. Such processes have been seen often in the past 100 years, not least in Latin America.”
White has a track record of being right. As readers will remember, he was the only central banker to warn of the Crisis before it happened – in both July 2007 and July 2008.
His earlier warning, back in April, highlighted the key risks. Executives and investors need to be well aware that Japan’s panicking policymakers are rapidly becoming a major threat to the global economy, as well as to Japan itself.