Testing times. For a while, it seemed as if the European-wide bank stress test in July could become the circuit-breaker by providing transparency on banks' exposures and serving as a catalyst for consolidating and recapitalising the banking system. However, investors have continued to harbour doubts about the stringency and relevance of the test. Moreover, the publication of the results has so far not sparked the hoped-for major consolidation or recapitalisation of the banks. As a consequence, the ECB last week had to extend its policy of providing unlimited amounts of liquidity at the weekly, monthly and quarterly tenders through year-end in order to stop-gap banks' continuing funding problems.
Capital, not liquidity is the solution. Alas, as we have pointed out repeatedly, we don't believe that liquidity is the solution. At best, it buys time to solve the underlying problems. At worst, it reduces banks' and their owners' incentives to ship in what's really needed - fresh equity capital. The shareholders of privately owned banks are naturally reluctant to agree to equity raisings as it dilutes their stock. And the owners of public sector banks - central governments, regional states or municipalities - are cash-strapped and face opposition from their electorate to throwing more money at the banks. Hence, many banks are forced to continue to delever their balance sheets by shrinking their assets rather than raising equity. With many banks unable and perhaps unwilling to extend additional credit to the private sector, the economic recovery is bumpy, below-par and brittle (BBB), which in turn feeds back negatively into banks' profitability and government finances - yet another vicious circle.
Some governments' problems resemble those of the banks. If governments cannot fund themselves in the markets (as was the case for Greece), they would normally have to ‘raise capital' through hiking taxes and cutting spending immediately. Yet, just as bank shareholders oppose capital raises, governments' stakeholders - the electorate - typically oppose the drastic fiscal measures, too. Hence, governments who cannot fund themselves in the markets have to rely either on their central banks to plug the hole through the printing press or, if that's not possible, on other governments and the IMF to provide fresh loans. The first option - direct central bank financing of governments - is ruled out in the euro area by the Maastricht Treaty. This puts the onus on the second option - loans from other governments and the IMF, as in the case of Greece.
Enter the EFSF. The vehicle for such loans is now in place and almost fully operational - the European Financial Stability Facility (EFSF), which was set up by the euro area member states to provide credit to governments in trouble in exchange for a stabilisation programme. And with government bond yield spreads for some peripheral countries like Ireland or Portugal continuing to widen, it becomes increasingly likely that euro area governments' hopes that the mere existence of the EFSF will calm markets and ensure that it will never be used could be disappointed.
EFSF use might be the circuit-breaker... The use of the EFSF by one or several countries would be a double-edged sword. On the one hand, it might become the long-awaited circuit-breaker for the European sovereign debt and banking crises. This could be the case if the adjustment and restructuring programmes attached to the EFSF loans are credible and also address the banking sector's woes in the respective countries by directing a part of the EFSF loans to plug holes in bank balance sheets.
...or the start of a bigger crisis. On the other hand, the use of EFSF loans might backfire and aggravate the sovereign debt crisis, through two avenues. First, if the onus of the adjustment programmes attached to the EFSF loans were primarily on budget consolidation rather than on restoring economic competitiveness and recapitalising and consolidating the banking sector, markets might doubt the sustainability and credibility of the effort. Second, especially if a large country with commensurately larger funding requirements like Spain were to borrow from the EFSF, the fund's issuance of (likely) AAA rated bonds could lead to a crowding-out of other highly rated bonds such as French OATs and German Bunds.
Crisis could migrate to the core... As we see it, there is a significant risk that the sovereign debt crisis in the euro area periphery could migrate to the core. If so, it is not obvious that governments in the core countries would be willing or able to respond with massive fiscal belt-tightening. In Germany, the coalition government has been weakened by internal divisions and has lost its majority in the upper house. In France, President Sarkozy is facing stiff opposition to his pension reform plans and faces a presidential election in 2012. In Italy, Prime Minister Berlusconi has lost his parliamentary majority and is facing crucial confidence votes over the next few months. And neither the Netherlands nor Belgium has a government at this stage.
...pressurising the ECB into action. With governments constrained, it is possible that, should the debt crisis migrate to the core, the burden would fall on the ECB to support sovereign debt. As the bank had already decided to buy government bonds of then ‘dysfunctional' peripheral markets, we believe that it would be difficult for the ECB to refuse extending its purchases to core euro area government bonds, should the sovereign crisis migrate to the core. Autumn looks set to bring new challenges to Europe.
Introduction
In the wake of the financial crises, both American and Europe are seeing higher debt burdens, fiscal deficits stretching far into the future, and hints of deflation. Investors are naturally asking which countries might be ‘the next Japan'.
This note argues that Japan fell into deflation not so much because of its own financial crisis and recession in the 1990s, but rather because of the interaction of four factors that, taken together, stymied attempts to exit deflation. These were (a) extremely high central bank independence with low accountability, (b) highly advanced aging of the population, (c) political institutions that over-represented the interests of older voters, and (d) a comfortable current account surplus to fund fiscal deficits.
We next compare the Japan case and the US/European cases, using the Japanese ‘four factor model' of deflation.
The starting point for both the US and Europe has been the same as for Japan, a deep recession triggered by financial system excesses. Just as the bursting of the housing and commercial real estate bubbles of the 1980s in Japan brought recession and deflation, the bursting of the housing and credit bubbles in the US has created several factors that threaten deflation. While these factors took time to build and their unwinding could last, we still view them as inherently cyclical, because policy remedies are available if pursued aggressively.
However, it is equally clear that traditional monetary and fiscal policies might not do the job, just as they failed to do in Japan, due to structural rigidities. Should the structural rigidities in the US and Europe in debt markets, housing markets and the financial regulatory systems fester, Japan-like deflation would become more likely. That is, as in Japan, policy errors of omission could turn a recession into a deflation.
Examining these various factors for the US and Europe, we find that the US is least likely to fall into inflation; Europe also seems unlikely to do so, but risks are higher than for the US. Finally, Japan seems likely to stay mired in deflation, barring unforeseeable changes in institutional arrangements in the legislative system and the monetary policy system.
The investment implication of this result is straightforward: The optimal investment strategy is to seek yield and monetary assets in Japan, and seek beta and real assets in the US. Europe falls between the two, although it has the advantage of starting at a more attractive valuation level for equities. In the world of fixed income, the tilt of different sectors of the yield curve will shift with the degree of deflation risk. Such yield curve movements can be the basis for investment strategies.
This conclusion is based on the view that regional factors will remain more important than global ones in determining inflation (and growth) outcomes. However, there is a risk scenario: Should the need for global debt reduction in the developed countries dominate, then widespread inflation in the developed countries would be the most likely outcome. Investment strategies would have to be altered accordingly.
Understanding these conclusions requires knowledge of what happened in the Japan deflation case, and how similar the Japanese case is to those of other countries. Hence, we start with a discussion of the Japan case.
1. The Japan Case
The enigma of Japan is not why deflation occurred; that happened for the same reason that deflation is knocking at the door in America and Europe now, i.e., a financial bubble that triggered a deep recession. The enigma is why deflation has persisted. Even more astonishing, Japan nearly escaped deflation around 2006, but then reverted (see Appendix I in the full report for a history of financial reform and deflation in Japan). Whether actively or passively, Japan made a social decision to entrench deflation. Escape was not only possible but was actually within reach in 2006. However, Japanese society decided to return to deflation. Understanding why requires a focus on the institutional structure of monetary policy decisions and social choice.
We believe that several factors - none of which was sufficient alone to cause deflation - combined to generate the result. These four factors are central bank institutions, demographics, the electoral system's representation of older citizens, and the current account balance.
Deflation Factor One: Central Banking Institutions
Recently, much attention has focused on the Bank of Japan (BoJ), and why it has not been more aggressive about monetary expansion. A key element was the revision of the Bank of Japan Law, which took force in 1998, and gave the BoJ a high degree of independence but a low degree of accountability. While tasking the central bank with monetary policy that "contributes to the sound development of the national economy through price stability", the law does not define price stability, and does not say who should make such a decision. Nor does the law specify any consequences for the BoJ should the goals not be met.
In practice, the BoJ waited until 2006 to present a definition of price stability. Until December 2009, the BoJ was the only body in government that had set any official definition of price stability. Then, when the newly elected Democratic Party of Japan (DPJ) came to power, it published a growth strategy in December 2009, with a 10-year goal of nominal GDP growth of 3% or more, and a real GDP growth target of 2% or more. The DPJ was subsequently explicit in saying that the difference, i.e., a GDP deflator growth rate of 1%, was its implicit understanding of an inflation target (i.e., price stability) for the country. However, the DPJ has been reluctant to declare an explicit inflation target, or to change the BoJ Law to reflect such a target.
There has been much debate about inflation targeting, but almost none about accountability. In fact, the ability of the government to hold the BoJ accountable for policy outcomes is extremely limited. The governor is appointed to a five-year term, and can only be replaced if the Policy Board itself deems the governor (or other officers) "incapable of carrying out his/her duties due to mental or physical disorder" (Article 23). In short, the officers of the BoJ, once appointed, are responsible to no one but themselves, until their terms expire.
Moreover, the selection process and approval process for the governor and other officers is opaque. By law, the Cabinet appoints these officers, and the Diet approves them. However, in practice there is no open debate during the selection process; moreover, Diet debate on the qualifications of candidates is extremely limited.
The persistence of this institutional framework is somewhat puzzling, in light of the actual performance of prices in comparison to the BoJ's own definition of price stability. In March 2006, the BoJ defined price stability as an overall consumer price index (including energy and all food items) between 0 and 2%, with a central value of 1%. Since adoption of the target however, the overall CPI has fallen below the lower bound in 28 of 51 months. Moreover, the BoJ's definition includes upward pressure on prices from the trend increase in oil and food. Excluding energy and food, the Japanese CPI change has fallen below 0% for 46 of the 51 months since the price stability definition was introduced.
The BoJ has defended its position on monetary policy on the basis of lack of evidence that more aggressive monetary policy would be effective. There is ample room to debate whether the BoJ's position is a correct reading of the evidence. However, the question is not why the BoJ defends itself, but rather why society has permitted the BoJ to be so independent and unaccountable in the face of virulent and persistent deflation. The fact that some Diet members from both major parties and some smaller parties are calling for revisions to the BoJ Law makes this question particularly pertinent.
Deflation Factors Two and Three: Demographics and the Electoral System
Japan's population began to age rapidly over 20 years ago. The working age population (15-64) peaked in 1995, at 87.3 million, and has now fallen to 81.5 million. Simultaneously, the older population (65+) has risen from 18.3 million to 29.0 million. The aging of Japan's population has increased this tendency to favor deflation, because a large share of the population lives on fixed incomes. Yes, nominal interest income has fallen sharply with the drop of nominal interest rates. However, complaints about this have largely faded, as pensioners see the benefits of falling prices, relative to their fixed incomes.
The next key element is a set of policy decision mechanisms (the legislative system, the bureaucratic system) that gives heavy weight to the old at the expense of the young. The most striking evidence is the strong correlation between the number of seats that a prefecture has in each of the houses of the Diet, compared to the ratio of old population to young. For the House of Representatives (Lower House), there is a strong negative correlation between the number of voters per seat and the old/young population ratio. This means that prefectures with more old voters are over-represented. Indeed, the coefficient on the old/young ratio is highly significant (t-statistic of 4.245), and the old/young ratio explains more than one quarter of the variance of the voters per seat ratio across prefectures (i.e., the adjusted R-squared is 0.270). Thus, even for the Lower House, there is a statistically significant tendency to over-represent older voters.
For the Upper House, the same calculation generates an even more decisive result. In this case, the old/young ratio explains more than one-third of the variance of voters/seat (i.e., adjusted R-squared of 0.336), and the coefficient on the old/young ratio is also highly significant (t-statistic of 4.929).
These results suggest that the voting structure of the Japanese Diet is heavily weighted in favor of older voters. The key fact for investors comes in the relationship of this over-representation with the economic interests of older voters: Since older voters tend to be pensioners and hold the largest share of financial assets (such as pensions, deposits and bonds, but hold little in equities), they as a group oppose inflation. Thus, a legislative system that over-represents older voters is prone to adopt deflationary policies.
Another element of the social decision process is the tendency of older people to have higher voter-turnout ratios than young people. Young voters have had persistently lower turnouts than older voters, and this was particularly true in the 1993-2003 period. This tendency for older voters to have higher turnout ratios is even more pronounced in Upper House elections than in Lower House ones.
In short, a demographic/electoral system trifecta lay behind the social decision that Japan made to permit deflation. The trifecta is simple: (a) older voters form a larger share of the electorate, (b) the electoral system is skewed to over-represent the old, and (c) older voters vote in higher proportion than younger ones. Under these circumstances, it is not surprising that the society chose deflation.
Deflation Factor Four: A Current Account Cushion
The fourth, and less visible, factor that abetted the social choice of deflation was Japan's current account surplus. This surplus gave the nation a cushion to run large fiscal deficits, and avoid the difficult structural reforms that are necessary to end the deflationary impact of non-performing assets. The deeper the recession, the more fiscal support that voters demand to ease the pain. These fiscal deficits were easy to finance, in light of the large current surpluses.
Moreover, the large deficits created a perverse incentive to go further into deflation. To the extent that deflation lowers nominal bond yields, the deficits remained easy to finance. Thus, the pressure for productivity-enhancing reforms - both in the public sector itself to contain spending and in the private sector to raise growth and tax revenue - was interdicted. So long as the current account surplus remains, the incentives to exit deflation will be weak, barring wholesale capital flight by domestic investors, which appears very unlikely to us.
Will Japan Change?
Will the factors that entrenched deflation in Japan change? If so, then deflation would end, growth resume, and asset markets adjust. Bond yields would likely rise, equities would likely rise, and the yen would cease its appreciation bias.
At this point, the likelihood of a change in the fundamental factors that created Japanese deflation seems low. The institutional structure of the BoJ is clearly under debate. There have been proposals from elements of both major parties for major changes in the BoJ Law to make it more accountable. In addition, the most successful party in the July 11, 2010 Upper House election was blunt in its criticism of the BoJ and in the proposals for changing the institutional structure. Moreover, the emerging talk of a near-term Lower House should tilt parties more towards an anti-deflation agenda - because the Lower House seat distribution is less skewed towards the old than is the Upper House.
That said, there are still powerful forces that are arguing against any change in the BoJ Law. Several former senior officials and former cabinet members have argued that new BoJ actions are unlikely to end deflation. The leader of the largest opposition party, the Liberal Democratic Party, Sadakazu Tanigaki, also expressed skepticism. And Prime Minister Kan, when asked a question on the matter by a member of his own party in public Diet testimony, said that no revision of the BoJ Law was necessary.
For the moment, therefore, there is only a low likelihood of a diminution of the strong independence or increase of accountability of the Bank of Japan.
On the question of demographics and political economy, some changes may have started. For example, the turnout among younger voters has risen sharply in recent elections. However, the aging of the population continues apace. And the issue of over-representation of older voters is not mentioned as a part of the debate on Diet reform. Of course, with the last major Diet reform, when the district system in the Lower House was changed in the mid-1990s, there was a reallocation of seats towards the cities, with the result of less over-representation of older voters. However, discussions of the next stage of Diet reform remain in their infancy.
Thus, the factors that produced and permitted deflationary policy seem likely to persist. The likelihood that Japan takes aggressive action to end deflation remains low. The market implication is that the tendencies for JGB yields to stay low, for equity prices to stagnate and for the yen to strengthen are likely to remain intact.
2. Lessons for the US
Deflation is unlikely for the US, for several very fundamental reasons: First, the institutional structure around the Federal Reserve and the background political economy of the US are highly adverse to deflation. Second, there remain both the will and the tools for the Fed and the government to adopt, in order to prevent deflation. Third, the international role of the dollar puts discipline on US policy that will work against permitting deflation to take hold.
Deflation Factor I: Central Bank Institutions
For the US, the central bank is independent, but its dual mandate is much broader and more transparent than that of the Bank of Japan. Indeed, the inclusion of employment as a specific goal for monetary policy is a key element that determines the Fed's policy stance. An explicit focus on job growth in addition to the price level means that deflation expectations are not likely to take root. Second, the Fed has made its inflation goals clear and investors understand them. To be sure, neither the BoJ nor the Fed has an explicit inflation target. But Chairman Bernanke favors making inflation objectives and the Fed's reaction function and tools to achieve them clear. Because of this policy approach, market participants understand that the Fed's implicit target is roughly 2%, and that officials use a range for core inflation to monitor their success. In contrast, both Governor Shirakawa and former Deputy Governor Muto have openly rejected the government's call for anything of the sort.
That transparency comes from within the Fed but it also is a product of the Fed's explicit accountability to Congress. That, too, has several dimensions. First, the process for appointment of the Chairman and governors is similar to that in Japan, but is much more open. The hearings in Congress on appointments to the Fed are lively and substantive - in contrast to the very short, largely pro forma process in Japan. In addition, the term of the Fed Chairman is four years, and is timed to expire one year after a new president takes office. This gives the new president a chance to change monetary policy. Of course, Fed governor appointments are for 14 years - far longer than the five years for the governor and monetary policy board members at the BoJ. However, most Fed governors leave the board long before their terms expire, giving the president many opportunities to appoint new members. To be sure, the process for selecting Federal Reserve Bank presidents is not subject to direct Congressional oversight. But the Board of Governors, who are accountable to Congress, plays a direct role in that process.
Second, the requirement for the Fed Chairman to testify frequently before both the House and the Senate in the US plays a powerful role in accountability. Governors and other Fed officials are also summoned to answer questions before Congress. While the BoJ governor does testify, the impact of such testimony on policy formation seems much smaller.
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