18 February 2016

Central banks fiddle while economies burn

By Mickey D. Levy

The Bank of Japan’s imposition of negative interest rates follows roughly 15 years of zero interest rates and quantitative easing that have failed to stimulate healthy sustained economic growth. The BoJ’s monetary policies are not the cause of Japan’s economic malaise and they will not be the solution.  Japan’s sustained underperformance and the dramatic negative response to the BoJ’s negative rates sends an important message to global central banks:  pushing monetary policy beyond its scope of capabilities while ignoring the true sources of economic weakness provides little economic benefit and only generates financial distortions and unintended negative side effects.

Japan’s malaise stems from an array of economic, tax and regulatory policies that have combined to constrain consumer spending and put a damper on business spending, and have led businesses to move their production overseas.  Moreover, the government’s failure to reform immigration policy or address Japan’s long-run demographic decline has cast a gray cloud over future prospects.

Obviously, these problems are beyond the capabilities of monetary policy.  To highlight the obstacles to sustained growth and the BoJ’s futility, consider the crippling economic impact of the sharp 60% rise in the value-added tax (VAT) in spring 2014 from which the economy has yet to recover, despite the BoJ’s dramatically enhanced quantitative easing.

Facing these headwinds, imposing negative rates on top of the BoJ’s massive asset purchases and liquidity infusion will do little to lubricate Japan’s credit channels and boost commercial bank lending, and will have little impact on the domestic economy.

When the BoJ buys Japanese government bonds (JGBs) in the secondary market, it generates a commensurate amount of excess reserves in commercial banks.  Now these banks will be charged 10 basis points to lend these excess reserves back to the BoJ.  The alternative to buying JGBs–that is, lending directly to the government to fund its massive deficit spending—is unattractive, as yields on JGB through 7-year maturities are negative.  Purchases of US Treasury or European sovereign bonds that provide higher yields require holding capital against them.

Unfortunately, the negative rates in Japan and extremely low yields on a wide array of debt securities have become a way of life in Japan.  In reality, they reflect economic underperformance, diminished rates of return on investment and weak loan demand.

Meanwhile, the Abe Administration is still aiming to impose another large increase in the VAT in spring 2017.  Ironically, amid fiscal tightening, economic commentators lament that the BoJ is running out of monetary policy tools to stimulate the economy.  Instead, why aren’t they demanding economic, fiscal and regulatory policy reforms that would lift potential growth?

To a lesser extent, the same themes are being played out in Western economies. In the US, the economy’s growth, productivity and wage gains have been disappointing despite the Federal Reserve’s unprecedented stimulus policies. The failure of nominal GDP to accelerate beyond 4% year-over-year reflects the limited scope of the Fed to stimulate the economy.  Yet commentators remain fixated on the Fed, with little attention paid to the critical factors that are stunting growth.

In the US, a growing web of regulations and compliance requirements is gumming up the credit channels—constraining credit available for consumer, mortgage and business credit.  Other new economic and labor regulations—often in the form of the fine-print and details that do not make headlines—also affect many non-financial businesses, raising their operating costs, reducing efficiencies and dampening expansion plans.  The tax hike imposed in January 2013 forced growth to pause.  Health insurance laws have widened the wedge between worker take home pay and employer costs of employment, and increased workers out-of-pocket costs for medical services.  And the corporate tax system—which is becoming more and more complex—harms performance and pushes US businesses overseas.

A critical lesson is that healthy sustainable growth cannot be achieved simply by turning on the monetary spigot and imposing negative interest rates while economic policies are constraining growth, distorting financial behavior and dampening future expectations. The common perception that monetary and fiscal policy are interchangeable levers that may be adjusted to fine-tune the economy is simply wrong.

Although many central banks, including the Fed and the European Central Bank, allude to the need for improved economic and fiscal policies, they have conditioned the public to rely on more and more monetary ease should conditions warrant it.   Economic commentators tend to adhere to this line of reasoning.

Instead, it would be far more constructive for central banks, economic policymakers and others to realistically identify the true sources of economic underperformance and develop appropriate policy tools to address them.  It’s obvious that central banks monetary policy over-reach—and financial markets reliance on it—is unhealthy.  Clearer articulation of this by central banks would be a step forward, but would be only part of the solution.  Achieving sustained healthier growth requires the implementation of pro-growth economic and regulatory policies, in broad strokes and down to the regulatory details.  Financial markets would reward such a favorable policy shift.

Mickey D. Levy is Chief Economist of Berenberg Capital Markets and a member of the Shadow Open Market Committee sponsored by the Manhattan Institute.