US Not Going Down Japan's Road
In our prior article on the government's willingess and ability to create inflation, we noted that Japan is often held up as an example of a country that was unable to inflate despite having a fully paper-based monetary system. But while the crash of Japan's credit-fueled stock and real estate bubbles resembles our own situation, the monetary policy responses in each case have been markedly different.
It's true that the Japanese authorities did not create any enduring price inflation after their credit crash. But a quick look at the data shows that this is because they opted not to do the one thing that can reliably create eventual inflation: rapidly grow the supply of money in circulation.
Comparative Growth in the Broad Money Supply
The same cannot be said for the 2009-era Federal Reserve. The following graph compares the cumulative growth in the broad money supply of both Japan and the US for the first 14 months after the starts of their respective post-credit crash recessions (April 1992 for Japan and December 2007 for the US):
The difference is quite dramatic. 14 months after Japan's recession began, the Japanese money supply had cumulatively grown by less than 1%. Here in the US, 14 months after the start of our recession, the money supply has already increase by almost 11%.
Japanese money growth eventually picked up the pace a bit, but the money supply never increased fast enough to offset the deflationary effects of the post-bubble recessions. It also never grew at anywhere near the rates we are currently seeing in the US. The next graph shows year-over-year broad money supply growth for over a decade following the start of Japan's initial post-credit crash recession, with the US's money growth thus far included for comparison.
Money supply growth in Japan spent the first year not growing at all, the second year or so growing at an annual pace of 2%, and the rest of the decade-plus period growing at an average rate of about 3%.
By comparison, the US is just 14 months into its post-credit crunch recession and it has already ramped its annual money supply growth rate up to around 10%. And there is almost certainly more to come via the Fed's ongoing monetization of mortgage debt, small business debt, credit card debt, auto loans, student loans, and (as the Fed has threatened) Treasuries.
What of the "quantitative easing" we are always hearing about? "QE" took place when the Japanese central bank flooded the banking system with liquidity in the hope that this would stoke lending activity. But the banks just sat on the excess reserves instead of lending them out, and Japan's broader money supply didn't really grow much in response.
That Japan's QE failed to ignite widespread inflation is taken as proof, by many, that even a central bank capable of printing money is powerless to create price inflation. But a comparison with US policy response shows that this conclusion doesn't fit the facts.
The following graph, which shows the rate of growth in the monetary base in the US and Japan, indicates some pretty clear differences in policy thus far. First, Japan didn't begin QE until almost a decade after their initial post-bubble recession. Second, while it may be called "quantitative easing" in both cases, the Japanese just didn't ease to the same quantity as our Federal Reserve has:
There are a couple of caveats to this chart. One is that the majority of growth in the monetary base has been in bank reserves, the size of which may have permanently increased due to the Fed's recent decision to pay interest on excess reserves. More importantly, and regardless of the origin of the reserve increase, one could rightly make the case that these reserves might not make it out into the wider economy to stoke inflation.
But this is why we began the discussion with a look at broader monetary aggregates. The second graph in the first section demonstrates quite clearly that the broad US money supply is already rising far more rapidly than it ever did in Japan. It's not valid to wonder whether the Fed is capable of increasing the broad money supply when the data shows that the broad money supply is rising at a double-digit pace.
Perhaps having learned from Japan's example, the Fed is directly pushing the money out into the economy via its assorted monetization facilities rather than taking the Japanese approach of sitting back and hoping that banks start lending. Whatever the reason, there's no question that the Fed is able to increase the broad money supply.
Opposite Policy Constraints
It is widely understood and agreed upon that substantially increasing the amount of money in the economy will eventually lead to inflation. Yet the Japanese authorities did not take this course. Did they not think to even try it? Did it just never come up at any Bank of Japan meeting for an entire decade?
We think a more plausible explanation stems from the fact that Japan was a nation of savers. Forcing up inflation via broad currency debasement would have harmed Japanese voters by undermining the purchasing power of their savings. As a result, accepting the mild (if lengthy) deflation was likely a more politically viable option than flooding the economy with money.
While bad for savers, inflation is good for debtors because it reduces the purchasing power-adjusted burden of debt. Here in the United States, the authorites face exactly the opposite constraints as those faced in Japan in the 1990s. Our nation is highly indebted and has a low savings rate. In this situation, deflation is a lot more painful than inflation. Politics demanded that Japan avoid inflation - and politics now demand that the United States embrace it.
Whatever the reason, it's very clear that the policy response being pursued by the US is vastly different from what took place after Japan's credit bust. Those predicting a repeat of the Japanese experience should take note.
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