Making sense of trends and data

Japan and Trumponomics

Published 2.28.2017
Mondays (or in this case Tuesday) are when LWRAS considers broader economic and political forces that affect market analysis and projections. The focus for today is nominally Japan, however the potential effects of Trumponomics are considered as well.

In the 1980s, the economic power of the Japanese was feared. Japanese investors were said to be buying up all of America's prime assets and soon everyone would be speaking Japanese. Or perhaps that was a midwest phenomenon because the auto industry, which back then was based in Detroit, was having its head handed to it by Japanese manufacturers.

Then the real estate bubble in Japan burst, and ever since the Japanese economy has been moribund. However, the Japanese own most of their own debt, and so long as pensioners were content to remain invested in domestic debt, the internal Japanese economy puttered along. As the aging Japanese populace began to draw on those investment, the calculus changed.

This article at Quartz in 2015 made the case that the Japanese economy was growing again. Growth had happened before however, as the article noted, but if Japan was growing again, it would have been another success story for Keynesian policy. It was not. Japan is still suffering from deflation, even after four years of stimulus from its central bank. The Japanese consumer doesn’t care how low rates go, they simply don’t spend. In fact, the low rates might be making consumers think that they should hold onto every yen, just in case.

In an era of central-bank improvisation, no other nation has pushed the envelope as much. The Bank of Japan was the first to lower its benchmark rate to near zero in 1999, long before Europe, the U.K. and the U.S. did so in response to the 2008 financial crisis. In 2001, Japan began flooding its financial system with cash to try to spur inflation and growth, a practice called quantitative easing that was later adopted in the West.

When Japan’s central bank started pumping money into the economy, the predictions were for hyperinflation. Instead,

The deflationary landscape is deeply imprinted on the 20 million Japanese between ages 20 and 34 who grew up after prices started falling. Wage increases, rising stocks or banks that pay decent interest on deposits are all hypotheticals to them. They live in a world where anything they buy today might be had for less tomorrow. Their instinct is to do the safe thing and economize.

Part of the problem is that young people can’t find jobs because companies can’t fire older workers. Japanese consumer don’t react well to increased prices either. They expect prices to fall, and won’t buy if they get raised. It’s a vicious circle. Wages aren’t rising, so young people don’t see having money to buy the way their parents did. How might the Japanese condition relate to the US economy past, present and future?

Charles Gave’s piece, entitled, “The End of the Dollar Standard" is reprinted in the latter half of the linked newsletter. The dollar has been the reserve currency (or standard) since the end of World war. Until 1971, US dollars were backed by actual gold ingots. In 1971, Nixon took the US off the gold standard and began the fiat money era, US dollars aren’t worth some amount of gold now, rather they are worth what currency traders say they are worth based on the credibility of the US economy.

Because dollars were backed by actual gold and they were the world’s reserve currency, the world economy was basically a zero sum game. Expansion of credit in one country (say the US in the Great Recession) would result in a deficit to Japan (for example). The US would have to reduce its money supply because the gold would now be Japan’s, which would cause the Japanese money supply to expand. An expanded money supply in Japan would lead them to spend money and reverse the process.

It was the French to spurred the Nixon decision by demanding that the US settle its debts with France by transferring actual gold ingots, rather than their paper representative.

Subsequently, US dollars earned by Japanese firms have not been exchanged against gold, but rather “redeposited” at the Federal Reserve via a process of foreign exchange reserve accumulation. As a result, the US has not faced higher interest rates from its deficit with Japan and by extension from its habitual global current account deficit.

So now credit could continue to expand in both countries (all countries) without decreasing the amount of money available anywhere.

This money creation machine has only properly broken down during periods of high US inflation which have necessitated sustained tightening by the Federal Reserve. Experience has shown that the US central bank has kept obsessively focused on consumer price inflation and disregarded events in asset markets, even if stocks were surging, the dollar exchange rate was plunging and property prices were going stratospheric.

It isn’t only Japan that benefit (and had a hard time regulating) this “double pyramid” of finance. “Doube pyramid of credit” is the phrase the French Economist Rueff coined to describe the post gold standard world, as described more fully in Gave’s essay.

A fiat currency system cannot be judged suing gold standard rules. The fact that many economists and traders remember the days of the gold standard and its rules, and are more comfortable with them does not mean that a return to the gold standard is the answer.

The double pyramid of credit Gave claims helped hollow out the US industrial sector, as companies moved their factories offshore to lower costs by using cheap labor. Essentially the US has survived this long doing this because it is the world’s reserve currency. Ironically, early on in the Obama era there were people also concerned that the US would no longer be the worlds reserve currency.

Then as now, LWRAS is skeptical. Contra Trump, the US is not “a real mess.” The recovery from the Great Recession may not be as fast as some would like, but a recovery is underway. Throwing the financial sector into reverse won’t turn back the clock. Manufacturing may return to the US, but when it does, it will be more automated than ever. The first part of the letter made the same point about automation.

Gave thinks that so long as the US remains a superpower, it will remain the world’s reserve currency. No other country that has been suggested as a replacement as the holder of the world’s currency is as stable as the US— even as the country is more polarized than ever. The fact that so many "sure bets" for the next reserve currency have proved to be "false flage" is another reason for skepticism.

Gave suggests that the US deciding to become a surplus nation again will have significant spillover effects on the US economy. In particular, the 20% border tax Trump wants (which is meant to mimic what value add taxes (VAT) do in Europe) will substantially alter the playing field, effectively dismantling the double pyramid of credit.

Whatever the rights and wrongs of the global economic status quo, dismantling such a huge pyramid of credit threatens havoc for the financial system. Should the US return to a current account surplus, the rest of the world will move to an aggregated current account deficit. Since all other countries have a trade constraint, the system will inevitably start to contract, led by those nations already running a current account deficit. Such economies will have to tighten policy almost immediately, resulting in a big decline in domestic demand and so reduced imports.

This is the 1930s pattern of events. The interconnected world economy is complicated. Does Trump know what he is doing? Gave’s solution is to have the US continue to backstop the rest of the world’s economy. Trump’s slogan is “America First.” Will he understand the danger to the US if other economies collapse?

The US is not abandoning Asia, despite Trump's rhetoric. The US wants naval control of all the oceans, including those in Asia. To accomplish that, there must be US bases on Asian soil (as there is currently). Asian policy is one of the areas where it is clearest that most of Trump’s rhetoric remains aimed at his campaign supporters.

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