Friday, 21 June 2013

Counter-economics for the Japanese Economy: Interest Rates and Growth

Japan provides one of the most interesting cases of economic booms and bursts the world has ever experienced and provides a staggering example of how the real world is affected by the state of the economy. Since the Japanese real estate bubble of the late 1980's, the economy has gone through what has been dubbed as the Japanese lost decade(s). Strangely, although many indicators show that the economy has been growing and things should be doing much better, it does not really feel like this to most economists and certainly not to most residents. (Click to enlarge graphs; all data from

The above indicate that both government and consumer spending have been on the rise for the past 15 years, and although confidence has seen its ups and downs it nevertheless is approximately at the same levels as during the late 1980's boom, as it was during the mid-2000's. Thus why no growth? Population (which has been slowly declining) would matter in these data only if aggregate consumer spending was less than before. Yet, this does not appear to be the issue. In addition, increased government spending also adds to aggregate demand, thus making its rise even greater. Interest rates, both interbank and central bank, are at all-time lows, which means that people should have incentives to invest or spend. This should, theoretically boost the economy and take it out of the recessionary cycle. Right? Wrong.

Despite what prevalent economic theories proclaim, interest rates are not dictated by policy but by the market. Using, the basic supply and demand knowledge from Economics 101, it is easy to see that when supply of funds is greater the interest rate paid to keep those funds in the bank is lowered. Conversely, when the economy is booming and people tend to spend more than they save, demand for money is higher by the banks (since they need it to lend more and thus have more income), making rates higher. The graph below should further clarify the subject.
The line indicates the long-term trends in savings and as you may see it has been clearly rising over the past 15-18 years and has only recently shown signs of slowing. This should also make us understand why bank credit has also been falling since the mid-1990's, with a mild recovery in the mid-2000's. Since savings have been on the  rise for the last 15 years, then people had no incentives to invest, thus no incentive to borrow money.
Thus, not surprisingly, the increase in the M2 money measure (whose increase has also been slowed down since the early 1990's) was driven by the increase in the monetary base. When the M0 trend was slowing in the mid-2000's, the rise in private sector loans made up for that loss, thus keeping the M2 trend stable.

Where I am getting with this? Bear with me for a second. Up to now, economic thinking has taught us that the central bank dictates policy, lowering rates in times of recession so that people can borrow with greater ease thus boosting investment and consumption; raising rates in times of growth, to hold things from exploding. Nevertheless, this successful policy is not an issue Japan can be proud of. Deflation has set its game in the country over the past few years and is not about to leave any time soon. Whether you call the situation a liquidity trap or anything else it matters very little to the people. Then big question is how this can be changed.

You cannot have too much of good thing and QE in Japan is living proof for this. We cannot know what result Shinzo Abe's policies will have on the economy, but we can nevertheless be optimistic that they will continue to put an upwards pressure on prices. This should induce investment and growth in both the medium- and the long-run. We are forgetting though that QE is nothing more than an asset swap, supposedly forcing banks to lend more money since they have all that excess liquidity in their hands. What it does not say is how much banks will lend and how willing are customers to assume those loans.

As mentioned before, economists traditionally believed that monetary policy, as dictated by the Central Bank, was tantamount to countering crises and recessions. After years of education, finance practitioners have also grown accustomed to the "fact" that the interest rates are dictated by the almighty Central Banker. These are the gospels of monetary policy and, along with "unorthodox" measures like Quantitative Easing are supposedly the most important facets of the Central Bank's function.

This understanding of the world dates from the monetarist view of the 1950's. The previous understanding of how the world functions can be found in Keynes's "Tract on Monetary Reform", where it is stated that interest rates are mainly formed by the continuous interaction between banks and customers and not the Central Bank. When demand for money is higher (i.e. customers want to borrow) banks increase their interest rates both so that they can attract more funds (to loan out later) and as a response to the increase demand for their supply (if demand for a good is increased then, all else being equal, price would rise).

While it is true that increasing or decreasing the interest rate has some effect on the overall state of the economy, it is however also true that the trend is dictated by the economy and not by the central bank. Thus, in the case of Japan, although the interest rate has been kept at very low levels over the past decade we have seen no significant increase in bank lending (other than the slight increase in the mid-2000's) or investment. This can only lead to one conclusion: people are more prone to save than to spend or invest, thus keeping the interest rate down.

The question then becomes when do people tend to spend more. The answer is relatively obvious: when they have more money and feel wealthier, as Ben Bernanke states. Low interest rates should in theory boost lending but the fact is that lending is also high when interest rates are high. The rather counter-intuitive to economic thinking, conclusion we may reach is that if interest rates are increased then both consumption and investment can potentially rise. The reason is that higher interest rates also boost spending. The maths are really simple (formulas from Wikipedia)

The future value of an annuity depends on both the interest rate on money and the number of periods. If a person wishes to save €100,000 in the next 10 years at a 1% interest rate then he will have to save approximately €790 per month. Increasing the interest rate to 3% would mean that the amount he saves would be decreased to 720 per month. The difference between these amounts is the potential increase in private consumption. The intuition behind these calculations is that people wish to save for their future, keeping a specific number in mind.They save enough to reach that number, but when assisted by increased interest rates they can save less and also reach their goals. This has a three-fold advantage: it assists people reach their goals, makes uncertainty about the future fall, increases current spending making investment and inflation grow and subsequently rises asset and stock market prices fulfilling the "feeling wealthier" notion. 

Although the idea appears to be strange, eliminating uncertainty about the future which is what makes savings fall and consumption rise. Quoting Bernanke,
"To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. (...) The issue here is whether or not improving asset prices generally will make people more willing to spend. (...) If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand." 
In addition, while realizing that higher wages and lower unemployment would make 65% of people spend more as a recent poll suggests, we tend to forget that the only thing which could make wages increase is an increase in consumption and spending. Then why shouldn't we use this doctrine in the US or other countries a reader might inquire. For the simple reason that Japan is facing stagnation not for the past couple of years but for the last 2 decades. Risk aversion is now deeply rooted in the Japanese culture and only a strong shock would be able to bring them back to a more sustainable path.

Critics might argue that raising interest rates would mean more trouble in repaying existing loans or creating new ones. What is forgotten here is that with an increase in the price level means that the real value of the loans will be decreased, thus allowing them to repay them with more ease. In addition, the increase in the level of prices should increase investment and consumption, leading to higher nominal wages, again assisting with loan repayments.

What should not be forgotten here is that the aforementioned policy cannot go on indefinitely (although the program should not have a specific end date) because of crowding out effects. When the economy reaches (or is close to) full capacity, government spending should be significantly decreased to counter for the expansion in consumption and investment. This should (in theory at least) bring the country to a more stable growth path than the current one.

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