Gary North's REALITY CHECK
Issue 197 December 12, 2002
THE MONETIZATION OF EQUITY
It has finally happened. The Bank of Japan, Japan's
central bank, has begun purchasing stocks held by the
nation's commercial banks. The BoJ creates digital money
to buy the shares. The shares now in the BoJ's possession
serve as legal reserves for the expansion of Japan's money
supply.
This has begun to move the monetary system from credit
money to pure fiat money. The ability of the central bank
to expand the money supply will no longer be limited by
people's willingness to borrow. Now the only limit will be
the willingness of sellers to sell. In a time of economic
slowdown and a premium on cash, there are few limits on
hard-pressed sellers' willingness to sell.
The first effect of this increase in the money supply
is this: commercial banks will spend the money they have
received from the BoJ. Money created is money spent.
Money does not sit idle in any bank's account. Banks make
money by lending money or by buying assets, such as
government debt. If an low-risk asset pays anything above
zero, the bank will buy it if there is no better
opportunity. Better something than nothing; better a
little income than no income.
When the bank buys an asset from someone, the asset's
seller becomes the owner of newly created money. He spends
it or invests it or deposits it in his bank. So, the money
is passed from buyers to sellers. It will stay in
circulation. It will remain in someone's bank account.
The second thing that happens when the BoJ purchases
equity is that the commercial bank gets rid of a
depreciating asset, or a high-risk asset, and transfers it
to the BoJ.
Japanese banks are unable to meet the capital
requirements that were imposed in 1988 at the Basle Accord.
The richest nations, known collectively as the G-10
nations, agreed to higher capital requirements for their
commercial banks. This was a year before the Japanese
economy peaked. Japanese banks are allowed to use the
value of stocks in their portfolio to count as part of
their capital requirements. The Japanese stock market was
a bubble in 1988. The shares were rising. Japanese banks
had money to lend because their capital looked secure.
Beginning in January, 1990, the Japanese stock market
started down. It has never again approached the December,
1989 high. Bank capital therefore began to shrink at the
same time that poor real estate loans ceased to produce
interest income. Japan has never been able to meet the
Basle Accord's timetable. But Japan is too big to fail.
There is no way for the other nations to impose meaningful
sanctions on Japan for not enforcing the Basle Accord.
Over 100 countries have formally adopted the terms of
the Accord. Predictably, only a handful of them have
actually met the Accord's requirements, which are
restrictive in the expansion of money in a fractional
reserve banking system. When banks slow their lending
because they have hit legal restrictions in the form of
capital requirements, economies that have been growing
cease growing. This is politically unacceptable to
politicians and central bankers.
Policy-makers want the benefits of a pure gold coin
standard -- stable prices, no boom-bust cycle -- but
without the political restrictions of a gold standard:
public control over the money supply through bank runs in
gold coins, the inability of governments to sell lots of
new bonds to banks without raising interest rates, and
economic growth determined exclusively by factors in a free
market. A gold coin standard is the mark of decentralized
control by individuals over the economy. Politicians and
central bankers resist this development.
So, we see the authorities on a tightrope. They do
their best to avoid mass inflation, but they also want to
avoid deflation and recession. Their prior policies of
monetary expansion created a politically popular economic
boom. New policies designed to keep prices from rising
threaten to stop the boom.
THE SITUATION IN JAPAN
In Japan, the economic boom stopped in 1990 and has
never reappeared. Japan's commercial banks have been
trapped in a tightening noose. Their Basle-imposed capital
requirements have risen at the same time that the market
value of their capital has been falling: bad real estate
loans, falling share prices, and bad industrial loans.
This has led to a refusal of the commercial banks to
lend to innovative small companies, which are the basis of
most economic growth. These companies find it difficult to
sell shares because of the normal regulatory process, but
also because of falling share prices. The result has been
a lack of economic growth. The Japanese economy has been
staggering for over a decade. It gives few indications
that it is ready to rebound.
Japan's aging public has lost faith in the system.
Voters are not agreed on what needs to be reformed, so the
government changes nothing of substance. It just does more
of the same. It spends more money. It runs large
deficits. The debt burden per capita rises continually.
Japan has become the world's strongest piece of
evidence that the Keynesian policy of economic growth
through deficit spending does not work well. The Japanese
economy does not recover despite 13 years of deficits.
The central bank has expanded the money supply in
order to keep the general price level from falling. It has
reduced short-term interest rates almost to zero. Still,
the economy refuses to improve. The stock market continues
to fall. The nation's investors, which includes the
commercial banks, have lost faith that the stock market
will ever return to its 1989 level.
All politicians fear price deflation, which is
regarded as the chief mark of recession. Debts that were
voluntarily contracted when prices in general were higher
become an increasing burden on debtors when prices fall,
i.e., when the value of money increases.
The other side of the coin is also true. When prices
in general fall, this is good news for creditors, who
experience a windfall profit: rising real income. But
there is a politically inescapable rule: don't alienate
debtors. Politicians understand this rule and follow it:
"There are more debtors who vote than creditors who vote."
It is a political liability to be an incumbent when prices
in general are falling, unless the fall in prices is being
produced by rising output. Even then, there are political
liabilities. Debtors want a return to the good old days of
rising prices, thus enabling them to pay off their debts
less expensively. They vote for politicians who promise
them depreciating money.
Officials with the Ministry of Finance, an agency of
the government, recently called on the Bank of Japan to
increase the money supply enough to create at least 3%
price increases per year. THE JAPAN TIMES (Dec. 3)
reports:
The Bank of Japan should set an explicit
inflation target of 3 percent to beat deflation,
two senior officials of the Finance Ministry
wrote in a joint article in the Financial Times
on Monday.
"The BOJ would have to adopt innovative,
nontraditional antideflationary policies," said
Haruhiko Kuroda, vice minister, and Masahiro
Kawai, deputy vice minister, for international
affairs at the ministry.
"These should include an explicit inflation
target of 3 percent to be achieved in stages --
such as 1 percent inflation within a year, and 2
percent to 3 percent within the following two
years," they said.
Toward this end, the BOJ should buy long-term
government bonds and other financial instruments
to provide more liquidity to the market and
constantly increase base money, the article said.
japantimes.co.jp
This announcement comes in the middle of one of the
most stupendous periods of peacetime monetary expansion in
history for any modern industrial nation. Click through
and look at the charts for Japan's Adjusted Monetary Base,
which has fallen from about 33% per annum to a "mere" 21%.
The M-1 money supply has risen in this period from under 5%
per annum in late 2000 to over 30% in the most recent
report.
This has drastically reduced interest rates: the
supply of money is increasing in the face of borrowers'
resistance to take on more debt. Government bonds return a
little over 1%, and the 3-month CD rate is barely above
zero percent.
What must be bothering the Ministry of Finance is the
M-2 growth rate. It is a little over 3%, up from less than
2% in 2000. The M-2 aggregate includes the public's
savings deposits in banks.
research.stlouisfed.org
The Japanese public is exchanging bank accounts for
currency. Currency pays no interest, but it is safe from a
bank default. In fact, widespread bank defaults would
produce a premium price for currency. "A bird in hand is
worth two under the bush." The lower that bank account
interest rates go -- now barely above zero -- the less
expensive it is for depositors to switch from a savings
account to currency.
Prices are falling slightly in Japan. The huge
discrepancy between M-2 and M-1 growth indicates that there
is a quiet run on the banks: the exchange of savings
accounts for currency. Cash is emperor in Japan. In a
nation filled with people who don't use credit cards and
who prefer currency, there is a lot of slack in between the
Adjusted Monetary Base and M-2. So, conclude the two
officials,
"Aggressive monetary reflation is needed most in
Japan," they said, adding that it would help
prevent the accelerated pace of bank and
corporate restructuring from imposing further
deflationary pressure on the economy.
Kuroda and Kawai also proposed that a "concerted
global reflation" policy be pursued by the
central banks of the United States, Europe and
Japan to minimize the risk of a delay in economic
recovery and price deflation globally.
"A tripartite strategy for global reflation would
bring major benefits to the world economy with
minimum cost," they said, adding that China
should also be involved because it, too, is
undergoing price deflation despite high growth
performance.
I love that last phrase, "undergoing price deflation
despite high growth performance." This makes high economic
output sound like a negative factor. It is if the public
is sitting around, hoping and praying for (say) higher
computer prices. "Save us from discounts!" Keynesians do
not admit that falling prices, when they are the result of
rising output, move the world away from scarcity in the
direction of greater wealth for all.
Japan's problem is not falling prices through rising
output. Rather, its problem is falling prices due to a
contracting economy, i.e., a shrinking division of labor.
The central bank-funded boom economy has turned into a
bust.
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RE-LIQUEFYING THE BANKS
At the end of November, a new era began in Japanese
central banking. To the extent that "the Japan disease"
spreads to other Western countries, so will the proposed
cure spread. The proposed cure is the monetization of
equity. THE JAPAN TIMES (Nov. 30) reported this.
The Bank of Japan began buying shares held by
banks Friday, taking on increased risk in a bid
to help banks unwind cross-held shareholdings
with borrowers.
Mitsui Trust Holdings Ltd. and a group of
unidentified banks asked the BOJ to purchase
several billion yen worth of stock by the end of
the day, the central bank said.
The purchases are part of the BOJ's plan to buy
up 2 trillion yen worth of commercial banks'
shareholdings by September 2004.
Banks hold large amounts of stock issued by their
biggest corporate clients, a legacy of Japan Inc.
With cross-shareholding, banks shielded companies
from irate stockholders and corporate takeovers
and allowed them to carry through with long-term
projects.
Those stock holdings have slumped and are one of
the major threats to bank capital, resulting in
over 2 trillion yen in unrealized portfolio
losses in stocks and bonds at the end of
September.
The two-trillion yen figure is not so great a number
as it appears. Two trillion yen are worth less than $20
billion. Therefore, I regard this as a token purchase.
What does this token accomplish? It sends a message to the
investing public in Japan and also the world of central
banking. This message is simple: "There's more where that
came from." If the BoJ thinks that commercial banks are in
danger because of falling capital ratios due to falling
share prices, it will intervene to solve the problem.
This policy means that the Basle Accord is a dead
letter. It has always been a dead letter, as all such
accords are in a world without a world government. A
central bank can increase the domestic money supply at any
time, and thereby inflate the domestic economy, even in the
face of "tight" international capital requirements for
commercial banks. Central banks can relieve pressure on
their countries' commercial banks by monetizing bank
equity.
Corporate shares are easy to monetize. There is a
market for them, even the high-risk, low-profit stocks on
the JASDAQ, the equivalent of the NASDAQ. Have no fear;
the Bank of Japan is here!
The government requires banks to reduce the
balance of their shareholdings to a point equal
to or lower than their core equity capital by the
end of September 2004. The BOJ has offered to buy
up shares exceeding this amount.
All of Japan's major banks have signed up for the
stock purchase program, with the exception of
Sumitomo Trust & Banking Co., which has already
met the government's shareholdings requirements.
But what about the quality of the portfolio of the
Bank of Japan? The article continued:
The day before the purchases, BOJ stocks on the
Jasdaq over-the-counter market fell to a 16-year
low, reflecting concerns over how the purchases
might damage the quality of the central bank's
assets.
japantimes.co.jp
But what does it matter what the quality of assets is?
If the central bank is not only the lender of last resort,
but also the buyer of last resort, then all assets have a
potential market. If the central bank is buying any
category of assets, then existing holders of these assets
can cash out of their investments at any time. The point
is, the quality of any asset is measured by its liquidity,
and if the central bank is a buyer of last resort, then
everything deserves a AAA rating by Moody's -- everything
except the yen. This leads me to North's law of junk
investing:
"When you can sell junk assets to the central
bank for cash, then cash becomes junk."
CONCLUSION
In the ongoing debate between the those predicting
price inflation and those predicting price deflation, the
theoretical issue of the monetization of equity should not
be avoided. This is because monetary theory has turned
into monetary policy in Japan.
There are real inflationists out there: policy-makers
who recommend monetary inflation in order to produce price
inflation. There is not one visible policy-maker on earth
who recommends price deflation as a way to re-structure
capital values in terms of the new, post-inflation economy.
The entire world is a bubble economy, yet there is not one
public official with any influence who calls for central
banks to stabilize money, refrain from interfering in the
money markets and debt markets, and allow commercial banks
to sink or swim in terms of free market competition. To
recommend such a policy of non-interference is to recommend
the transfer of economic authority away from the central
bank to the investing public, including bank depositors.
The central bank, beginning with the Bank of England in
1694, was invented in order to thwart the economic
authority of the individual investor-depositor.
The monetization of debt is the central bankers' pay-
off to the national politicians who chartered the private
central bank as a quasi-government agency. If necessary,
there will be additional pay-offs to any organized
financial group that has sufficient political clout to be a
threat to central bank's monopoly over money.
A central bank is designed to achieve two primary
goals: (1) provide loans to the government; (2) to protect
commercial banks from depositors who might become part of
bank runs.
There is a third goal, which was tacked onto central
banks during the Great Depression: to provide sufficient
credit money to persuade consumers to keep spending,
thereby keeping the economy growing. This is the area of
agreement among all schools of economic opinion except the
Austrian.
This is why a central bank will not find resistance
when it adopts the policy of monetizing equity. Owners of
assets want to bring buyers with money to the national
auction when the buyers decide to sell. There is nothing
like a central bank's digital printing press to assure
sellers that buyers will have money to bid at the auction.
There isn't going to be long-term price deflation
until after the mass inflationary crack-up boom has taken
place, i.e., the collapse of bank money's value. This boom
era will be the junk money stage. Until it ends, would-be
buyers of goods and services will get access to money. If
they refuse to borrow, therefore refusing to spend, then
there will be a buyer of last resort: the central bank.
The reverse Midas touch will continue: turning junk
assets into junk money. |
