Myth, Perception, Japanese Deflation and Widow-Makers

The Method of Measuring Value

Fiat money is a myth used to measure the relative value of goods and services. If people are provided with value like food, housing, and education, then money matters less. Across the world, people are provided unequal amounts of social services and how people perceive money therefore varies with where they are raised. In capitalist countries, people must to a greater extent self-fund healthcare, education, and other personal expenses, so one may argue on average that citizens of more capitalist countries like the US place more value on money than less capitalist countries. Money matters in socialist countries like Sweden as well, but in socialist countries the goal of money is to be more of a pure consumption tool, as government taxation takes care of most healthcare and education related expenditures.

In most economic textbooks, the big mac index is used to demonstrate the relative purchasing power of a currency. By using USD as base currency, as in the above chart, one can measure the strength of other currencies relative to USD by comparing actual vs implied exchange rates.

Why Money Perception Matters

Explaining why money is perceived differently in different societies is important because how citizens perceive money ultimately determines future inflation. Despite the importance of money as a relative value measure, countries across the socialist and capitalist spectrum fail to educate their citizens about money. For example, both American and Swedish education might teach kids about money through math and social studies, but classes focused on basic fundamentals of money and how it impacts personal finance, trade deals, transactions, resources, and disputes are rare in both countries. The truth is that decisions about how we spend our money are perhaps the most vital decisions in our personal lives outside of family; how else can we afford to feel safe and secure. The definition of money according to academia is that money is any verifiable and generally accepted item as payments for goods and services, debts, and taxes. If the value of money remains stable for a long time, then no normal person thinks about money, but when the domestic currency depreciates quickly (inflation) money is on everybody’s mind; just ask the Venezuelans. If history serves as a guide to the value of money, then what is generally accepted as money at one point in time might not be so in another. The fall of Rome around year 500, Spain’s fatal reliance on silver in the 1500th century, Germany after WW1, and even US in the 80s, exemplifies how inflation leads to economic instability and perhaps even fall of empires. To protect against a drop in the value of money, most governments across the world now yields increasing power to central banks to deal with financial uncertainty. The problem is that these central banks are repeating past errors, as they are currently printing more money than ever to boost the economy. The historical odd duck for money printing is current Japan, as Bank of Japan’s (BoJ) accommodative monetary policy has led to deflation rather than inflation, which is something worth investigating when inflation is a hot topic in the markets.

Depending on your perception; what do you see?

Money Perception with an Example

Before discussing central banking, Japan, inflation, and deflation, it is important to dig a little deeper into perception of money, as the current value of money is perhaps the ultimate cost measure for living. A country where social services like healthcare and education is provided for through a more efficient use of taxes deemphasizes money as a necessity and as a status symbol relative to those countries with less efficient taxation. In Sweden, tax funded education on average creates a culture of respect. For example, intelligent Swedish students do not become doctors to make money, as the Swedish healthcare system provides low incentives to achieve wealth. Instead, the driving force behind becoming a doctor is influenced by a compassionately educated society where basic needs are taken care of to a greater extent and those who become doctors in Sweden simply earn respect. If you ask a typical US person if US should adopt a universal healthcare system, which most likely lowers doctor salaries, the likely answer is no, as a US person would argue that lower salaries disincentivize smart students from becoming doctors. No system is better or worse, but somehow Sweden and US are both known to educate great doctors even if Sweden’s education system comparatively deemphasizes the importance of money. The value of money also changes with decreasing or increasing faith in large government and private institutions. Zimbabwe is a great example, as their 100 trillion dollar bank notes show the distrust of their citizens in the banking system. No matter if a country is more socialist or capitalist, it is clear that humanity is entering a period in history when central banks will print money and maintain low interest rates in perpetuity even if a likely outcome is inflation. Therefore, understanding the societal function, purpose, and impact of money, has never been more important.

Trillion dollar note.

Modern Central Banking

The requirement for perceiving money as valuable is having trustworthy institutions responsible for governing its value. As a result, these institutions including central banks are forced to become more transparent to increase public trust. Despite trust levels differing vastly between countries, most central banks across the world follows Japan’s lead when conducting fiscal and monetary policy. While Japan conducted what I call new school monetary policy in a vacuum in the 1990s, western central banks including ECB, BOE, and the FED now seem to coordinate across borders. Together, through trial and error, these players have created a monetary policy roadmap to avoid economic depressions after economic crashes and this roadmap includes different steps. The first step in new school monetary policy to prevent a depression is lowering interest rates to encourage borrowing and investment. When nominal interest rates like the US federal funds rate hit zero or perhaps even negative in response to undesired outcomes, the second step is to monetize treasury bonds so that governments can create bailout packages to prevent systemic risks in the economy. When these bailout packages lead to unintended effects like asset bubbles, the third step is to provide stimulus directly to the people, which has not directly been done by BoJ. The main danger when going from the second to the third step is populism. The owner of assets are typically the wealthy and in asset bubbles they make lots of money, while the commoners are left behind. A strong leader can say that these bailout packages should go straight to the people creating a dangerous precedent, as cash power can be used to manipulate votes short-term. However, what worries me the most with the money handouts is how that money impacts prices in the real economy. In the new digital economy, it is much easier for business to raise prices with the click of a button. For example, many restaurants now show their food menu via a QR code instead of a physical menu, which means restaurants are theoretically able to charge dynamic pricing. If, for example, the price of food or raw material increase, restaurants and other businesses can immediately push the cost to consumer without changing prices physically. Just like Japan printed money to fight of multiple crisis’, the western world has entered into a period of unbounded money printing. This money printing has not lead to the kind of inflation that is measurable by the FED, but rather it has led to a potential twin asset bubble in the equity and fixed income markets. Fixed income instruments have an inverse relationship with rates so when FED lowers the federal funds rate, which is a rate charged to banks for borrowing from the FED, the price of bonds go up all else equal. It also leads to a lower yield on bonds so it forces investors with cash on hand to look for alternatives in order to generate a rate of return. That is why a lot of these investors have turned to the equity markets, which has reached peak valuations in a period when the world has suffered from a global pandemic. Many smart people now believe that this will lead to an overheated economy.

This picture depicts how bonds and equities are negative correlated; that might not be true anymore.

The Japanese Economy and Political System

Together, fiscal and monetary policy shapes a complex global economy by determining through business investment and consumer consumption how economic resources are allocated. The outcome of a certain policy differs depending on how businesses and consumers interact with the policy. For example, if country A raises interest rates, then businesses might invest in county A’s currency, but only if country B raises interest rates by less. Economic policy is no longer done in a vacuum so countries continuously use economic policy to compete for resources. Like monetary and fiscal policy in most countries, the Japanese leadership’s vision includes policies to reduce unemployment and to maintain both a stable exchange and inflation rate[1]. The current version of Japan with a political system heavily influenced by the US was developed after World War 2. Despite this American influence, Japan’s welfare policies and perception of money is perhaps more similar to Sweden, as these policies include state pensions and universal health care, which means poor Japanese people have less components of life to worry about than less wealthy individuals in the US. Japan is currently a democratic constitutional monarchy in which leadership is divided into three branches; the executive, legislative and judicial branch[2]. Every four years the Japanese votes into power a ruling party; a voting system similar to many western countries. Since early 1990s, Japanese leadership has mostly consisted of a coalition between multiple parties led by either the centrist Democratic party or the conservative Democratic Liberal party. As of the 21st century, the head of state is still the emperor, but he is only a symbol and it is instead the prime minister that directs the executive branch. Included in the executive branch is the department responsible for developing Japan’s fiscal policy, which is the ministry of finance. The financial ministry used to be the most powerful part of the Japanese cabinet, but lost its responsibility over both banking supervision to the Financial Service Agency and conduction of monetary policy to the Bank of Japan in the 1990s. The FSA, BoJ and the ministry of finance are therefore responsible for executing Japan’s fiscal and monetary policy, which means they are the three most important agencies for protecting the Japanese economy against inflation and deflation.

Japan's government structure.

Inflation

Famous economic monetarist, Milton Friedman, defined inflation as an increase in the amount of money in the system. However, most other economists instead narrowly define inflation as a sustained increase in prices. The interesting relationship between these two definitions is that price hikes tend to lag in response to money supply increases; it can take decades for price increases to materialize. In advanced economies, prices are measured by a basket of goods including grains, metals and utilities. This basket is now commonly known as the Consumer Price Index (CPI). The typical central bank generally targets around a 2% growth in the CPI, which economists argue is a natural function of sustainable economic growth. By targeting a stable 2% inflation, businesses and consumers can plan future investment and consumption. A relatively lower inflation rate in a higher interest rate environment tends to increase savings, while the opposite scenario tends to increase consumption and investment, all else equal. Billionaire investor, Ray Dalio, often describe two paths to creating unsustainable inflation. The first type is supply demand inflation, which means that a higher demand relative to supply of goods push up prices. Demand for goods is created through low unemployment or because there is a scarcity in the supply of goods. Demand is a function of economic growth, as a growing economy leads to low unemployment and wealth increases. In the beginning of the 1990s, Japan faced the second type of inflation, which is money supply driven (Cost-push inflation. Dalio notes that if a central bank lowers interest rates and prints money, then inflation is created depending on where all this excessive money ends up. The largest component of the inflation uncertainty is the expected inflation rate, which is determined by the perception of investors and users of the domestic currency. If the expected inflation rate is high enough, then lending and borrowing comes to a grinding halt and causes a banking crisis. The central banks are aware of this risk so they create their monetary policy to maintain a stable inflation rate. In Japan, the inflation rate has been way below 2% since the 1990s and that is also dangerous because it means the economy is growing slowly. If the inflation rate is too low, central banks generally pursues accommodative policy through lowering interest rates to force people to borrow money like in 1990s Japan.

Figure 1

Japan's Nikkei 225 index. Dates on the X-axis and corresponding index value on the Y-axis (Marketwatch).

The Widow-Maker

Despite BoJ’s perhaps excessive accommodative monetary policy, many Japanese and international investors have felt the pain for the past 40 years by investing in strategies that should perform in periods with inflationary monetary policy. As a result, the term widow-maker was born. The definition of a widow-maker is a poorly executed trade in securities, which erases your wealth and thus causes your partner to request a divorce or perhaps something worse. The original widow-maker was shorting the Japanese treasury market in the 1990s. The reason behind shorting the Japanese bond market was based on expectations of higher interest rates, as the Japanese economy normalized. However, rolling recessions forced BoJ to maintain historically low interest rates and provide quantitative easing at the beginning of the 2000s, which is essentially spending borrowed or printed money to positively influence the economy. When governments borrow or create money, they want to pay low interest rates just like home owners wants to pay a low interest rate on their mortgage. The troubles leading up 1990s started when Japan suffered heavily from the 1973 world oil crisis. Like many other industrial countries, Japan was dependent on foreign oil for production[3]. In the years following 1973, energy intensive industries in Japan transformed themselves through turning to alternative energy sources. This led to advances within micro circuitry and semiconductors, which spurred on growth in production of consumer electronics and computers. These technological advances together with financial deregulation guided Japan to a stock peak resulting in a majority of the largest corporations in the world being Japanese according to market capitalization Figure 1! However, it was not a boom but rather an asset bubble that was being formed in Japan[4]. When the Nikkei index started to decline in the 1990s, the Japanese banking system started to show signs of weakness and their banks turned insolvent.

Figure 2

BoJ's growing balance sheet in terms of billion of Yen.

Deflation

These failing banks necessitated a massive bank recapitalization by BoJ, which led to the largest monetary experiment in history by pursuing debt monetization. In May 2021, BoJ’s balance sheet rose to above 716,900 billion yen, as depicted by Figure 2. This expansive balance sheet creates many financial unknowns, as more money and lower interest rates decrease the value of the domestic currency all else equal incentivizing consumers and businesses to spend and borrow money. The consensus view is that sustained inflation should occur when monetary supply growth outpaces economic growth[5]. Figure 3 and 4 shows both the exponential growth in money supply and GDP growth in Japan over the past 40 years[6]. The economic growth in the 1990s averaged around 1.5%, while the monetary base outpaced economic growth as depicted in Figure 3. The traditional view is then that Japan should experience inflation and perhaps an asset bubble, but Japan seems to be a deflationary exception. In 2021, the leading Japanese equity index Nikkei 225 has still not recovered from the 1989 all-time high. When the inflation rate in an economy decreases, it is called disinflation, but if the rate is below 0% then the economy is experiencing deflation. The theories why Japan has experienced deflation rather than inflation despite such expansionary fiscal and monetary policy are many and most likely it is the combination of all these theories that caused the deflation experienced by Japan. The first reason is that Japan is a very isolated country and that wages have not been rising. Low immigration and inability to create high quality stable jobs providing workers with new skills often leads to lower productivity and wage deflation. The second reason is that Japan consists of an aging population[7]. Older people need pension from the state pension system rather than being productive thus putting downwards pressure on prices. The third reason is advancements in technology, which also puts downward pressure on prices across the whole economy. For example, cars have become more fuel efficient, which lowers demand for oil. Free smartphone GPS apps instead of physical maps and powerful computers are now in your pocket. Also, educational videos are free on YouTube replacing expensive textbooks and the list can go on and on. Japan’s debt to GDP ratio is now above 250%. The only way to lower debt to GDP is raising taxes or cutting spending, but as long as debt to GDP remains high and increasing, it can harm the value of the Japanese Yen.

Figure 3

Growth in monetary base both in terms of change and terms of GDP.

Figure 4

Japanese GDP growth, %

Conclusion

In the 1990s, Japan experienced a banking meltdown resulting in rolling recessions. In response, BoJ and the ministry of finance have pursued expansive monetary and fiscal policy for the past 40 years. The Japanese experiment spearheaded policy for almost all western central banks and financial departments in the 21st century following the financial crisis in 2008. The global aim was to stop balance sheet expansion and perhaps raise interest rates as economic uncertainty from the crisis subdued, but central banks and governments never fully put their foot on the breaks. When economic problems later arose from COVID-19, global debt burdens inched closer to unsustainability. The big question as of August, 2021, is if we might see a rapid rise in future inflation. Japan taught us that the inflation theme may never really materialized even with excess stimulus. There were some clear reasons for a slow growing Japan including welfare programs, isolationism, immigration, demographics, and technological advancements. Technology will put downward pressures on everything, but not all countries have the same demographics, immigration, perception of money and welfare programs like Japan. Also, with advancing populism around the world it might push up the cost of trading. The clear winning investment strategy as a result of government intervention over the past 40 years have been borrowers in stable currencies and holders of well geographically diversified risk balanced 60-40 portfolios. With the world being so globally connected and with economic policy outcomes depending more on perceptions of a global world rather than isolated nations, we are moving into uncertain territory and herding behaviors are likely to scale. If this cause upward pressure on prices time will tell, but diversifying into alternative assets that can move with increasing prices including real estate, consumer staples, crypto, gold, land and TIPS, might be worth looking into.

//Stay Adaptive!

[1] https://asia.nikkei.com/Spotlight/The-Big-Story/The-money-pushers-The-world-is-embracing-Japan-style-economics [2] https://en.wikipedia.org/wiki/Politics_of_Japan [3] http://www.country-data.com/cgi-bin/query/r-7176.html [4] https://www.bis.org/publ/bppdf/bispap06.pdf [5] https://www.japanmacroadvisors.com/page/category/economic-indicators/money-and-credit/money-supply/ [6] https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?end=2019&locations=JP&start=1980&view=chart [7] https://asia.nikkei.com/Spotlight/The-Big-Story/The-money-pushers-The-world-is-embracing-Japan-style-economics