Call me old fashioned, but I still think prices matter. I vividly recall the first time I studied those simple supply-and-demand graphs as a college freshman, and today, far too many years later, their basic logic remains undeniable. When prices are right, money flows to the most productive endeavors and economies work efficiently. When prices are wrong, crazy things eventually happen, with potentially dire consequences.
That’s why we should be very worried about Japan, where things are getting crazy. On March 1, the Japanese government sold benchmark, 10-year bonds at a negative yield for the first time ever. Think about that for a minute. The investors who bought these bonds not only loaned the Japanese government their money. They’re paying for the privilege of doing so.
Why would any sane person do such a thing? A government with debt equivalent to more than 240 percent of national output -- the largest load in the developed world -- should surely have to pay investors a tidy sum to convince them to part with their money, not the other way around. But the bond market in Japan has become so distorted that investors believe it’s in their interests to lend money at a cost to themselves. The only explanation is that prices in Japan have gone horribly, horribly awry, and that has made the illogical logical.
The culprit is the Bank of Japan. The entire purpose of its unorthodox stimulus programs -- quantitative easing, negative interest rates -- is, in effect, to get prices wrong: to press down interest rates below where they would normally go and force banks to lend money in ways they normally wouldn’t. The BOJ, in other words, is trying to alter prices to change the incentive structure in the economy in order to engineer certain results -- to increase inflation, encourage investment and spark growth.
The problem is that the BOJ hasn’t achieved any of those objectives. Inflation in January, by one commonly used measure, was a pathetic zero. Gross domestic product has contracted in two of the past three quarters.
Instead, the BOJ is creating new problems by undermining the price mechanism. The central bank is buying up so many government bonds that it has effectively stripped them of risk to the investor and cost to the borrower. Investors probably bought up the bonds with negative yields speculating that they could flip them to the BOJ. Meanwhile, since the government can now earn money while borrowing it, the BOJ is removing any urgency for Japan’s politicians to control debt and reduce budget deficits.
Worse, the central bank is undercutting the very goals it’s trying to achieve. By wiping out returns to investors on safe investments like government bonds -- the yield curve on them is as flat as a pancake -- the BOJ is straining the incomes of savers and dampening the consumption that might help the economy revive. If debt pressures finally do push the government to hike taxes again, spending will take another hit.
This seems like ample proof that the BOJ’s unconventional strategies are going too far. Yet shockingly, many economists expect the BOJ to do even more. “Additional BOJ easing … is a matter of when, not if,” HSBC economist Izumi Devalier noted in late February.
None of this should come as any surprise. Japan has experimented with getting prices wrong since the end of World War II -- for both good and ill. To pull the country out of the ashes, Japanese leaders directed credit and employed other tools to prod investment. That spurred decades of hyper-charged growth, but also led to massive excess capacity.
In the 1980s, the BOJ kept money inappropriately loose in an attempt to counter the impact of a stronger yen on Japanese corporations. That helped inflate one of the greatest price distortions in modern history – Japan’s gargantuan asset bubble. Since the Nikkei’s crash, the central bank has repeatedly tried to manipulate prices to correct the fallout from getting them wrong in the first place.
The red flags for other countries abound. Leaders in China, which used similar price-altering tactics to fuel its economic boom and is suffering from similar problems as a result, might want to accelerate their promised pro-market reforms to help set prices right, and the economy with them. For other central banks around the world, most notably the European Central Bank, which has also adopted negative rates, Japan’s case should offer a cautionary tale of the pitfalls of twisting prices too much.
And for policymakers just about everywhere, Japan should be a warning that monetary policy has its limits and their attempts to influence prices are no substitute for real economic reform aimed at lifting potential growth. Let’s not forget, after all, those old supply-and-demand charts.
Michael Schuman is a journalist based in Beijing and author of “Confucius: And the World He Created.” -- Ed.
