The return of deflation in Japan has led to heightened expectations for more unconventional monetary policy and some have even called for the use of so-called “helicopter money."
We believe such a policy would be ineffective in Japan since the country probably can’t grow much faster on a relative basis no matter what additional actions the BoJ takes.
Adopting helicopter money would transfer risk from increasingly overburdened government balance sheets to central banks raising the risks to the global financial system.
In Japan, inflation has fallen back below zero with the April reading of the consumer price index posting a -0.3% decline over the past year. The return of deflation has led to heightened expectations for more unconventional monetary policy and some have even called for the use of so-called “helicopter money.” As the Bank of Japan (BoJ) meets this week to debate the need for additional actions, we believe that the new and potentially dangerous policy being discussed in Japan to fight deflation would raise long-term risks to the financial system.
The term “helicopter money” was coined in 1969 by economist Milton Friedman to make a hypothetical point about inflation. The basic idea is that central banks print new cash and give it directly to people to spend—figuratively dropping $1,000 bills from the sky. As an actual policy put into practice, helicopter money would more likely come in the form of tax rebates or, more likely, fund the expansion of government spending without the burden of ever having to repay the debt bought by the central bank.
The use of helicopter money is being discussed by policy makers in Japan in order to boost growth and work their way out of Japan’s enormous debt load that stands at more than double the size of the economy.
Population not policy
At first blush, GDP growth in Japan has been slow and the second to worst among the Group of 7 (G7) nations over the past 15 years, as you can see in the chart below. But we have to keep in mind that potential GDP growth can be thought of as the sum of growth in output per worker and growth in the labor force. For most countries this adds two positive numbers together, but not for Japan since it has had a shrinking population for two decades. In fact, Japan’s working age population has fallen by 9% since the start of 2000, per data from the OECD. That makes it hard to compare Japan’s growth to these other countries. To account for this, we can adjust GDP for the change in the number of workers. On a GDP per worker basis, Japan jumps to the second fastest growing economy among the G7, as you can see in the chart below.
Japan: economic growth limited by population—not policy
Source: Charles Schwab, International Monetary Fund data as of 5/30/2016
Looking at GDP this way tells us that Japan probably can’t grow much faster on a relative basis no matter what additional actions the BoJ takes without adding more workers. The BoJ’s actions have also been directed on ending the threat posed by deflation, or falling prices. But despite inflation that averaged 0.0% from 2000-2015, no economic stagnation took place in Japan on a per worker basis. On the contrary, Italy has seen 2.0% inflation over the same time period and yet the Italian economy was stagnant.
Inflation erodes the value of debt, but deflation does the opposite and hurts borrowers. The irony in Japan’s efforts to fight deflation to avoid a debt problem is that the Japanese government has built up massive debts in an effort to try to boost economic growth beyond any reasonable expectation of per worker output. The policies are not the solution; they are increasingly becoming the problem.
String of failures
None of the stimulus programs Japan has unveiled so far have done much to change the trend in economic growth. Japan’s recent efforts including the fiscal stimulus of “Abenomics” and the monetary stimulus from the boost to the BoJ’s QE asset purchase program that began in late 2014 temporarily lifted stock prices, but did little to change the pace of economic growth represented by Japan’s purchasing managers’ index, as you can see in the chart below. If these policies lifted the wealth of investors, almost like dropping $1,000 bills from the sky, and they didn’t spend it—why should helicopter money be any different?
Japan’s stimulus policies have moved stocks but not changed the trend in economic growth
NIRP stands for negative interest rate policy.
Source: Charles Schwab, Bloomberg data as of 6/06/2016.
Unlike prior efforts, the move this year to adopt negative interest rate policy, or NIRP, appears to have hurt the stock market in addition to doing nothing to boost the trend in growth. We hope the BoJ (and other central banks) consider this as a warning against adopting the untested and potentially dangerous policy of helicopter money. But, if not, where are risks for investors?
Japan’s shrinking population does not necessarily pose the same problem for Japanese companies as it does for Japan’s government. Companies can continue to expand output by shifting operations to workers in other countries and find customers outside Japan’s borders—especially given the rapid growth of the middle class in Asian emerging market countries. In fact, the companies have been doing this for two decades as the population has declined. Instead the main risk to investors may lie in a longer-term potential weakening of the global financial system.
Helicopter money would transfer risk from increasingly overburdened government balance sheets to central banks. This may result in a further loss of the already wavering credibility of central banks and other policy makers to stimulate growth during recessions. But even more worryingly, as we saw during the financial crisis, only institutions that are perceived as financially strong can expect their liabilities to be held by others as assets—this includes central banks. Weakening central bank balance sheets by inflating them with bonds that will never be repaid risks their financial strength. Given the interlinkages between central banks that facilitate the soundness of the global financial system a weak link anywhere in the system could prompt another crisis.
What we’re watching
Investors may be wise to be less concerned over whether central banks actions will suddenly spur better growth and instead be more concerned over whether the actions are potentially adding to longer-term problems. Fortunately, central bankers have not yet crossed the line and the solvency of the world’s major central banks is not in question. The head of Japan’s central bank has dismissed resorting to helicopter money as a policy tool, but he also vowed not to cut interest rates below zero before doing so in January. While current conditions warrant exposure to the global stock markets in line with long-term asset allocation targets, we will be on watch for a potential move by Japan to adopt helicopter money later this year that may elevate long-term risks and prompt a more defensive tactical allocation by investors.