Spike and Crash Syndrome (Lessons from Japan in 51 Quotes)

"I’ve been telling my patients for years that sugar acts like a drug in the brain. It causes blood sugar levels to spike and then crash, leaving you feeling tired, irritable, foggy, and stupid. Eating too much sugar impairs cognitive function, which may explain why Odom doesn’t always make the smartest decisions on the court."1


Another symptom of a sugar spike is the hunger in the crash. The effects of economic stimulations are similar. It certainly succeeds in stimulating an economic spike but in its wake comes the crash leaving the economy “tired, irritable, foggy and stupid”… and hungry. So a cycle of spike and crash is initiated.

The roaring twenties, the stock market crash of 1929 and its aftermath; the Japanese miracle and lost decades (yes, its almost 20 years from that fateful December 29th, 1989); the go-go years of the 1960’s and the stagnation years of the 1970’s; the LTCM, Y2K and the 2000 Tech Bubble combo are all examples of the spike and crash syndrome.

The stimulations can be phased over many years or force fed to the economy in monetary policies of the zero bound and quantitative easing and fiscal policies steeped in Keynesian deficit spending traditions. Instability in a downward spiral ensues.

It is no secret that I find the Japanese experiment with spike and crash policies as the best hunting ground for research insights. The Japanese kept feeding their economy candy and has been living with an economy in spike and crash mode for the past (almost) twenty years.

A tremendous body of research material is available on the Japanese experience. Gathering the research evidence to tell the story of Japan will guide us into informed decisions regarding the unfolding of the current global economic crisis which by no means is contained or resolved. These are the findings as reported by insiders who have unsuccessfully been trying to bend the markets to their will. They lament the spike and crash outcomes of endless stimulations.

“In light of Japan’s experience, it seems to be a characteristic that effects of a bubble are asymmetrically larger in the bursting period than in the expansion period.”2


Candy rush one – Zero bound interest rates, a monetary policy debt trap.

Every monetary stimulation feeding liquidity into the market has the effect of reducing interest rates (all else being equal). These stimulations accumulate and compound in the economy over time. Removal of stimulations are preached but seldom practiced. Only when serious structural defects impede economic control objectives would attention turn to slowing the accumulation of stimulations in the economy. Inflation pressure is one such structural defect. Channelling inflation into assets allows stimulations to approach the zero bound interest rate structure.

Manipulated low interest rates encourage investment into productive assets under a false economic signal of an overabundance of savings. In this case there is no true savings, only the imposter of Central Bank liquidity provision.

Central Bank liquidity supplements income through the availability of cheap debt particularly against collateral of assets. Reaching the zero bound is an inevitable outcome of the monetary policy trap of stimulating liquidity for debt formation. A stasis trap for a dysfunctional economy.


Candy crash one – Empty shelves and long term banking distress.

The constant candy of low interest rates caused a fundamental change in conservative bank lending practice. The economic signal of such a low interest rate convinced otherwise prudent bankers that lending risk, particularly against collateral which is rising in price, is insignificant. It never is and the candy crash arrives in the form of debt defaults.

The now crystal clear structural mismatch in interest rates and risk leaves banks in the impossible position of producing loan products in a high risk environment while pricing (with zero bound interest rates) is as if near zero risk exist. The result is very restricted debt formation, even very peculiar debt formation as can be seen later. Debt saturation prevails.

A fundamental and often much maligned source of income to banks is the income derived from borrowing short and lending long – trading on the transformation gap. Interest rates at the zero bound is not compatible with transformation gap profits.

This is how researchers found the structural disconnect in Japan:-

“In retrospect, such aggressive lending at low interest rates seems to have been pursued by financial institutions taking excessive risks compared with their profit outlook.”3

“Constraints on the expansion of bank loans include such problems as (1) the decline in the risk-taking ability of banks resulting from the erosion of their capital due to nonperforming assets; (2) the lack of profitable projects; and (3) the inability of many firms to borrow money because of the debt incurred on previous projects. Even if firms can borrow money for a profitable project, they have to first repay the debt on other projects. Unless such problems are solved through appropriate measures corresponding to the respective constraints, the provision of funds will not result in the expansion of bank lending.”4

“In the meantime, some note the channel whereby, as the QEP flattens the yield curve, financial institutions that conduct short-term funding and long-term investment can make little profit out of maturity transformation, thereby exerting side effects on the banking system (IMF [2003]).”5


Candy rush two – Unlimited Central Bank liquidity.

The candy rush of low interest rates is but a derivative of the only power that a Central Bank has; that of providing money supply. The increase in money supply through debt formation is not measured due the argument that ultimately debt must be repaid with money. This is correct when the debt in fact gets repaid but fails once debt formation is pushed past the barriers of prudence. Then debt use becomes hard core and debt default becomes endemic.

The increase in “debt driven money supply” is not measured or managed but the decline in “debt driven money supply” imposes reality in debt default and requires economic structural adjustment. No structural adjustment takes place since increases in “debt driven money supply” does not exist in official monetary policy. Central Bankers become perplexed at the distress staying power of structurally mispriced debt formation, engineered and maintained by them, when debt driven money supply crash after the stimulatory spike.

The Japanese unveiled the policies of Quantitative Easing at a zero interest rate in March 2001 as “unprecedented worldwide”. Quantitative Easing failed Japan as proven by the persistence of Japanese structural problems into 2009. The argument that the BOJ did not do it aggressive enough seems a bit threadbare given the experience with Quantitative Easing in the USA thus far.

“Japan’s economy experienced prolonged stagnation following the burst of the asset price bubble in the early 1990s, despite several short-lived recovery phases. During this period, general prices measured by the consumer price index (CPI) gradually reduced their growth rate, followed by a continuous and modest decline from 1998 to the autumn of 2005. Over this period, the CPI dropped by a total of about 3 percentage points (Figure 1). In addition, the broad-based influence of the generation and bursting of the bubble spread to firms and financial institutions. In this economic environment and as Japan’s economy headed toward recession triggered by the bursting of the global IT bubble, on March 19, 2001 the Bank of Japan (BOJ) adopted a new monetary easing framework, the so-called quantitative easing policy (QEP), with a view to stemming the continuous price decline and setting the basis for sustainable economic growth. The QEP under a zero interest rate, a policy unprecedented worldwide, consisted mainly of three pillars: (1) to change the main operating target for money market operations from the uncollateralized overnight call rate to the outstanding current account balances (CABs) held by financial institutions at the BOJ, and provide ample liquidity to realize a CAB target substantially in excess of the required reserves; (2) to make the commitment that the above ample liquidity provision would continue to stay in place until the CPI (excluding perishables, hereafter “core CPI”) registered stably at zero percent or an increase year on year; and (3) to increase the amount of outright purchases of long-term Japanese government bonds (JGBs), up to a ceiling of the outstanding balance of banknotes issued, should the BOJ consider such an increase to be necessary for providing liquidity smoothly.”6


Candy crash two – Liquidity speculations, displaced hope and a state of “fallacious stability”.

The liquidity provisions go hand in hand with debt driven demand for asset speculations. Banks being at the epicentre of the liquidity provisions channel the debt formation to the asset classes. A notable favourite due to its relative liquidity is channelling money into equities. Proprietary speculation is not necessarily the only means for this channel includes activity such as financing restructures, mergers, acquisitions, derivatives such as stock futures and options, and margin accounts. Real estate is (was) another favourite due to its perceived “risk free” status.

The Japanese experience is described thus by researchers and it holds a lot of very useful hints on the outcomes for the present global economic crisis:-

“Large Japanese banks had capital ratios of barely above 8% at the start of the 1990s, with about half of the 8% accounted for by unrealised capital gains on their equity positions. Since then, banks have been writing off bad loans by basically using operating profits and realising latent gains on equity positions. This meant that every time equity prices plunged, banks faced the risk of not being able to meet the Basel standards or having to slow down the pace of bad loan write-offs. As of March 1998, latent gains stood at 2.7 trillion yen for the top 20 banks, only 15% of what they were in 1993, almost a negligible portion of their capital base. What has filled the gap is a sharp increase in other components of Tier II capital, mostly subordinate bonds and loans.”7

The ultimate effect of unlimited liquidity and zero or near zero interest rates is to trap the economy in a loss making stance that is cheap to carry. The normal market mechanisms of forced liquidation are suspended but it also suspends the economic recovery. Policy makers and economic participants foster a hope of escape “when the economy recovers”, thus one only needs to carry the structural defects cheaply for long enough. Japan has been carrying for 20 years.

“However, if interest rates are close to zero percent, financing costs of the above excesses will become quite small. When the economy recovers, nonperforming loans could become collectable, excess inventories could be sold, and excess equipment could become operational. In anticipation of such developments, the current situation of extremely low interest rates gives an incentive for corporate management to postpone the resolution of these excesses.”8

“Okina and Shiratsuka (2004) conclude that the QEP did not have the effect of reversing the financial market’s expectations that deflation would persist. They say this is because the transmission mechanism from lender to borrower was blocked and the monetary easing effect did not spill over to outside the financial system.”9

“From these results, Sadahiro (2005) concludes that the effectiveness of the increase in the monetary base was lost during the period when interest rates were zero.”10

“In this context, a historical example that made a strong impression on me is the financial depression in Japan in 1927, when at the peak of financial uncertainty banknotes increased by an amazing 38 percent compared with the previous day and the BOJ was forced to issue ¥200 banknotes that had been printed on only one side. Even as recently as 1997, when financial system uncertainty increased following the collapse of the Hokkaido Takushoku Bank and Yamaichi Securities, the growth rate of the balance of banknotes (end month, year-on-year basis) increased rapidly from 6.5 percent in September, to 8.3 percent in October, and 13.6 percent in November.”11

“Since financial institutions were able to maintain their operations as far as they were managing to meet their funding needs, what was then predominant was something like a state of fallacious stability. Without sufficient information, there existed no strong criticism of this situation. This fallacious state of stability made it possible to prevent systemic crisis. At the same time, however, it considerably weakened the momentum needed for establishing bankruptcy procedures for institutions in trouble and for constructing a comprehensive safety net. It was the very success of buying time that forced the authorities to buy more time, and thus the whole process of handling the nonperforming-asset problem was prolonged.”12

“Disclosure practices among industry participants complemented this norm- and reputation-based approach to bank failure. With MOF support, troubled financial institutions traditionally minimized disclosures of nonperforming assets, often while liquidating portfolio assets in order to show a profit. These measures helped to maintain an aura of financial soundness while mergers and other financial assistance were arranged behind the scenes”13 (MOF is the Ministry of Finance)


Candy rush three – Forbearance lending and loan restructures

The hunger in the bust after the spike asserts itself in renewed efforts to stimulate. The argument is made that the solution to the structural distress is another stimulatory spike. Out comes the stimulatory candy for another spike and crash cycle. Restructure and refinance; roll-and-hope strategies of not collecting debt while not disclosing non performing status (Non Performing Loans or NPL’s). Note that Forbearance Lending is sometimes called “Evergreening”.

“After the collapse of the asset price bubble, Japanese banks are said to refinance firms, even in cases where there is little prospect of firms repaying the loans extended. This phenomenon is known as “forbearance lending.” We find the evidence which is consistent with the view that forbearance lending certainly took place, and that it suppressed the profitability of inefficient nonmanufacturing firms.”14

“This suggests that forbearance loans were mainly provided by rolling over short-term loans, since banks hesitated to provide long-term loans to heavily indebted firms.”15

“It is quite likely that when a bank engages in forbearance lending, (1) that bank behaves as a risk-lover because it effectively becomes a dominant shareholder; (2) at the same time, it wants to put off disposal of NPLs due to insufficient loan-loss provisioning; (3) it thinks that the liquidation of the firm would not pay, since the price of land collateral has plummeted; and (4) it still harbors wishful thinking that the land price will recover in the future.”16

“In short, even after the bursting of the bubble, banks continued to provide loans to the real estate industry at interest rates that did not reflect the firms’ credit risks. This finding seems to suggest that banks engaged in forbearance lending as Hoshi (2000) discusses.”17


Candy crash three – Endless stream of bad debts and economic inefficiencies

The carries and the management of expectations, funded and controlled by the Central Bank petrified the economic inefficiencies for long term economic decay.

“However, this paper shows in addition that, even in the absence of this crisis, the NPL problem was stifling Japanese economic growth through the practice of forbearance lending. Forbearance lending not only props up inefficient firms, it also encourages inefficient firms to avoid making the efforts necessary to raise their profitability.”18

The endless stream of bad debts eliminated any liquidity driven acceleration of inflation because the owners of the money lost their future spending ability. The liquidity helps to carry any inherently doubtful debts until it becomes a default. The “carry” becomes a systemic default when the bank fails. Not allowing the banks to default or fail gave rise to the zombie bank phenomenon.

Follow for example the “jusen” companies of Japan involved in facilitating the last phase of the Real Estate Bubble in Japan. These entities received Central Bank and Central Government support after the collapse of the Real Estate bubble in 1991. Jusen non performing loans were almost 40% of portfolio and in spite of the support were all insolvent by 1995. These are the bailout lessons from Japan.

“In Japan, regulatory forbearance began when the first Ministry of Finance inspection of the jusen, in 1991, showed 40 percent of all loans on the books to be nonperforming and the response was a 10-year regulatory restructuring window. (By 1995, 75 percent of all jusen assets were nonperforming, and this part of the industry had to be shut down.) Since then, the equivalent of regulatory forbearance in Japan has largely taken the form of weak supervision standards, which continually allowed banks to resist classifying as nonperforming their dubious or even underwater credits. As a result, most observers of the Japanese banking industry in time came to dismiss each successive private or official announcement of the scale of the ‘‘bad loan’’ problem as a gross understatement, and correspondingly to regard all banks’ capital positions as overstated. By the late 1990s, it had become commonplace for private analysts to conclude that in aggregate the entire Japanese banking industry was insolvent, or even that each of the 21 large banks was individually insolvent.”19

“The ratio of publicly disclosed bad loans to total loans in the banking sector stood at 3.6% as of March 1998. Based on the self-assessment by banks, problem loans amount to 11.0% of total loans.”20

“The bad loans based on the official definition stood at 19.5 trillion yen for the top 19 and regional banks as of March 1998, while the problem loans based on the self-assessment totalled 71.8 trillion yen.”21

“It is not easy to grasp the extent of the bad-loan problem in Japanese banking. As Hoshi and Kashyap (1999) explain in detail, there are several different definitions of bad loans, and moreover the definitions have changed over time.”22

“The reality was that up to a certain point both the financial supervisory authority and management of financial institutions seemed to have expected the economy and land prices to recover before long. If that were the case, the nonperforming-asset problem would have been fixed without any special treatment. In particular, land price was the key element that decided the volume of nonperforming assets, since small and medium-sized enterprises and non-bank financial institutions had heavily invested in real estate with the money borrowed from banks during the speculative bubble years.”23

“The NPL problem for banks and the debt-overhang problem for firms are different sides of the same coin. The change in the distribution indicates that Japanese firms suffered from an increasingly serious debt-overhang problem in that not only did average firms face higher debt-asset ratios, but also firms with high debt-asset ratios ended up with more severe debt-overhangs.”24


Candy rush four – Debt driven demand

The economic justification for stimulations is based on the concept of unutilised or under utilised factors of production, particularly the availability of employable labour. Thus, in summary, the economy must be stimulated to absorb such labour which absorption would provide the necessary demand for the increased production. The stimulation takes form in increased liquidity provision which, as expected would lower interest rates.

A cycle of fallacious business decisions based on a manipulated price for the use of money supported by easy credit for consumers heralds in the candy rush of debt driven demand.

“First, it was not correctly recognized that “while debts always remain, assets may become lost.” This was partly because the vast majority of people, including policy makers, believed, up to a certain point in time, that “asset prices, even if they decline now, will recover in due course.” Second, it was not correctly understood what kind of mechanism might be triggered when asset prices decline while the nominal value of debt is held constant. A possible explanation of this lack of understanding may have been something that could be called tacit dominance of the “zero-sum fallacy,” i.e., that capital gain and loss should offset each other, and thus be neutral with regard to economic activity as a whole. A capital gain, even if it is unrealized, corresponds to an increase in net worth. However, once such capital gain has stimulated expenditure—via the wealth effect on consumption—or has been used for aggressive capital investment with debt-financing, and these expenditures turn out to be “excessive” ex post, or in plain words, wasted, the subsequent decline in asset prices will end up as “negative-sum,” not “zero-sum.” This comes close to what happened in Japan in the last two decades.”25


Candy crash four – Excess capacity, oversupply, unemployment and disappearing “wealth effects” (asset bubbles).

Then came the time when debt driven demand could no longer be sustained and the ills of a leper economy became exposed. Bits and pieces just kept falling off. Stimulations would bring short term spikes followed by deeper and deeper crashes. Stimulation and hope took the place of structural reform and austerity. Asset bubbles collapsed under the weight of unsustainable debt formation. Aggressive inflationary policies and inflation targeting did not work.

Unemployment became structurally ingrained and themes of restricted access for youth and senior citizen employment emerged together with falling salaries and wages.

Here’s what the researchers found.

“This decline in final demand intensified inventory adjustment pressure, and production activity shrank significantly. The economy was thus caught in a vicious cycle (decline in demand →decline in production activity →decline in corporate profits and labor income →further decline in business fixed investment and private consumption), with real GDP recording negative growth for five consecutive quarters from the fourth quarter of 1997 onward (for the first time since the start of GDP statistics in 1955).26

“In response, the jusen companies turned aggressively to real estate lending. This move coincided with the speculative excesses of the “bubble” era, and the flow of a torrent of cash into the jusen companies from the agricultural cooperatives. Agricultural cooperative lending was spurred in part by the exemption of the jusen companies from MOF administrative guidance that imposed limitations on real estate lending in the banking sector. MOF inspections of the jusen companies in 1991—the first ever—revealed that almost 40 percent of their loans were nonperforming. Under MOF guidance, 10-year restructuring plans were undertaken for each of the jusen companies. Concessionary interest rates and longer repayment schedules were negotiated on loans to the jusen companies, on the assumption that improved land values would eliminate the problem. Consistent with the implicit norms outlined above, the founding banks took the biggest loss on their loans (by eliminating all interest), and the MOF circulated an ambiguous memo suggesting that the founding banks and perhaps even the MOF itself would guarantee repayment of the principal of all loans made by the agricultural cooperatives, which were generally perceived to be the weakest institutions involved, other than the jusen companies themselves.”27

“Moreover, the possibility that the effectiveness of inflation targeting in achieving sustainable growth may depend on such factors as property prices seems to present particular difficulties in setting a target, since most of today’s problems in the Japanese economy were triggered by asset inflation including the rise in property prices.”28

“…, during the bubble period, debt-asset ratios were so low on average that they were not likely to exceed the threshold level. It is also because banks took credit risks aggressively during the period, as evidenced by the increase in the land collateral ratio. The threshold itself was therefore likely to be higher. At that time, the euphoric sentiment prevailing in the economy led people to anticipate further rises in asset prices. By contrast, in the second half of the sample period, as firms’ debt-overhang problem became serious, average debt-asset ratios increased and the threshold declined so that forbearance lending became pervasive.”29

“One of the significant characteristics of the bubble period is that the expansion of capital stock appeared particularly in investment in structures (Bank of Japan [1997b]). A typical example is the large increase of floor space in the Tokyo metropolitan area, triggered by the increase in demand for high-quality office buildings that took place in the late 1980s. Construction of a number of large office buildings with long building periods was begun in 1990–91, the very last years of the Heisei boom, prolonging the capital stock adjustment process that followed.10
10. Relating to this point, Yoshikawa and Ohara (1997) reported that construction in process in fixed assets, as a proxy for a large-scale fixed investment such as factory construction and other large building projects, increased remarkably in 1990–91. Based on such findings, they argued that complete adjustment of capital stock took a long time, since the lives of factories and buildings are longer than those of equipment.”30

“First, during the period soon after the bursting of the bubble economy, the initial stage of adjustment began with adjustments to overtime pay, followed later by adjustments to bonuses. Nevertheless, regular salaries were growing during this period, and it was not until 1998 that nominal wage adjustments making an overall negative contribution occurred. Around 1998, reflecting an increase in the number of firms that suspended pay raises in response to the deepening economic recession, the growth of regular salaries dropped to nearly zero. Then in 1999 and 2000, with the economy slowing further, the firms that had already made adjustments using overtime pay and bonuses began to eliminate annual wage hikes and reduce regular salaries, to the extent that even the average growth rate in regular salaries turned negative. In contrast, looking at employment adjustments shown in Figure 8, it was not until 1997 that the contribution from employment changes adjusted for population factors turned negative for all age groups in total. During this period, growth in the number of younger employees aged 24 and under turned negative in the mid-1990s, suggesting that firms began restricting the hiring of younger workers. Around 1996, the rate of growth in employment of older workers aged 55 and above turned negative, suggesting that older workers were encouraged to take early retirement (or were simply laid off).”31

“Our analysis has shown that nominal wages in Japan are not permanently downwardly rigid, and that nominal wage cuts do occur after a certain amount of time passes.”32


Candy rush five – Fiscal debt spending

Monetary stimulations failed and Japan reverted to Keynesian fiscal stimulation spending. Japanese National Government debt grew by an astonishing 400% from 1990 to 2007 and has since stagnated around 2007 levels.

”as a result of the successive implementation of fiscal stimulus measures, the fiscal deficit became the largest among major industrial countries”33


Candy crash five – Moral hazard, loss of fiscal discipline, regulatory self-preservation with exploding taxation and relative international currency weakness.

Keynesian fiscal stimulations also failed the people of Japan as they rush towards the end of a second lost decade. Central Bank independence is a mirage in these circumstances.

The extension of monetary policy to utilise exchange rate policies to achieve monetary objectives are particularly short-sighted. Massive Yen interventions to depreciate the yen and stimulate GDP through export expansion were frequently proposed as part of monetary policy.

This type of economic psychotic behaviour allows one country to transfer GDP from other countries to itself in the short to medium term. Eventually yen balances so distributed to the rest of the world will be swapped for Japanese Central Government Bonds though bonds, particularly Treasury Bills are near substitutes for cash at the zero bound. Again it is the proposition of leading Central Bankers to use any conceivable means to achieve short sighted monetary objectives. Using exchange rate policy as part of monetary policy to fund long term Central Government debt is a significant temptation in 2009. These policies would only transfer misery in a global economy in crisis.

Central Bank secrecy and opaque behaviour becomes firmly grounded in regulatory self-preservation. Critical questions must be answered, “How many of the stimulations and bailout policies are driven by regulatory self-preservation and when will the crushing tax burden appear?”

“Japan’s financial problems in the 1990s find obvious parallels in the bank and savings and loans crises experienced by the United States in the previous decade. For a time, banks in both systems managed to function well under quite distinct, politically contrived safety nets with deep roots in regulatory self-preservation. Eventually, however, both systems succumbed to an identical economic logic rooted in moral hazard”34

“In both cases, a non-institutionalized reputational system hinging on the MOF’s policy dominance gave way to greater institutionalization as political competition increased and politicians began to assert control over the policymaking process.”35 (MOF is the Ministry of Finance)

“…it is close to impossible to obtain public support for closing banks without the disclosure of the whole picture of the true state of the nonperforming-asset problem and banks’ business conditions. On the other hand, given that a huge amount of nonperforming assets already existed and bankruptcy procedures against troubled institutions and comprehensive safety net were not established, disclosing information on the problem might have aroused serious concern over the financial system, and may thus have triggered a systemic crisis.” “During this process, information on the magnitude of the nonperforming-asset problem and the soundness of individual banks and the banking sector as a whole was kept within limited circles, including the financial supervisory authority and the Bank of Japan; disclosure to the public occurred only gradually.”36

“To such a criticism [outright purchases of Government Bonds], the BOJ has pointed out that (1) in the end it would essentially be the same as underwriting, which is prohibited by the Fiscal Law; (2) most central banks in industrialized countries mainly conduct the outright purchase of short-term government bills for monetary operation purposes; (3) it would impair fiscal discipline; and (4) it might increase long-term interest rates. For example, the BOJ contends that, based on its historical experience, once outright purchase by a central bank is built-in as an automatic funding source for the government, it would become extremely difficult for both the government and the central bank to exit from it. Against this, there is the following counterargument regarding the loss of fiscal discipline: as long as the BOJ is an independent central bank, it can suspend outright purchase or conduct open market selling operations at its own discretion. Hence, the BOJ’s outright purchase at the present juncture may not necessarily put future fiscal discipline at risk.”37

“This recognition brought again to the fore the importance of injecting public funds into financial institutions so as to correct their undercapitalized status, thus revitalizing their financial intermediation function. In March 1998 some ¥1.8 trillion in public funds was injected into 21 major banks. In October, public funds appropriated for financial system stabilization, based on the Financial Reconstruction Law and the Financial Function Early Strengthening Law, were increased to ¥60 trillion and an additional ¥7.5 trillion was injected into 15 major banks, followed by a ¥2.6 billion injection into four regional banks. In the meantime, the Long-Term Credit Bank of Japan and Nippon Credit Bank, both suffering from huge nonperforming assets, were placed under special public administration in accordance with the Financial Reconstruction Law in October and December 1998, respectively.”38

“A second package of legislation passed in late 1998 provides a framework for the recapitalization of distressed banks. The legislation replaced a ¥13 trillion recapitalization fund that was eliminated at the insistence of opposition parties. The law provides for the RCO to purchase the common stock, preferred stock, or subordinated bonds issued by, and to extend subordinated loans to, banks whose capital is below various prescribed levels. The capital will be supplied upon application by a bank, provided that various conditions are met. These conditions, also largely the product of opposition party demands, are designed to reduce moral hazard stemming from the use of public funds to prop up weak institutions. Together, the two sets of legislation contemplate the use of ¥60 trillion (US$550 billion), or approximately 12 percent of Japan’s GDP, to protect depositors and restore the health of the banking sector”39

“I believe that a policy of aggressive depreciation of the yen would by itself probably suffice to get the Japanese economy moving again.”40

“I agree with the recommendations of Meltzer (1999) and McCallum (1999) that the BOJ should attempt to achieve substantial depreciation of the yen, ideally through large open-market sales of yen. Through its effects on import-price inflation (which has been sharply negative in recent years), on the demand for Japanese goods, and on expectations, a significant yen depreciation would go a long way toward jump-starting the reflationary process in Japan.”41

“If the yen did not depreciate as a result, and if there were no reciprocal demand for Japanese goods or assets (which would drive up domestic prices), what in principle would prevent the BOJ from acquiring infinite quantities of foreign assets, leaving foreigners nothing to hold but idle yen balances?”42

“In the 1940s, U.S. monetary policy was geared to containing long-term interest rates, but resulted in the collapse of the government bond market due to inevitable pressure for a rise in interest rates. Because of this, in the 1950s the Federal Reserve Board (FRB) concluded an Accord with the Treasury which stated that the FRB was not responsible for the movement of long-term interest rates.”43


Candy rush six – Coupons and vouchers.

The suggestions of restricted stimulations aimed specifically at achieving spending objectives often find its way into proposals for the issue of coupons. Coupons to purchase a specified item distributed by Government aimed at forced stimulation of aggregate demand. Japan embraced the coupon experiment for a candy rush.

“At one point the Japanese government did attempt to stimulate spending through “consumption vouchers”,47 but there was no way to ensure that vouchers would have been used for spending that would not have taken place anyway.
47 These vouchers, known as “Regional Promotion Coupons,” were part of the Emergency
Economic measures proposed in November 1998 and implemented in early 1999.”44

Candy crash six – Sending displacement and coupon barter.

The Japanese recipient of the coupons used them in place of normal spending and saved the money which they would otherwise have spent. Just another failed experiment. Barter with coupons and outright discounted sales of the coupon or the product will take care of a situation where a recipient has a coupon but no need to use the coupon. Again an inherent “waste” is built into the suggestion resulting in a candy crash deeper than the initiating candy rush.


Candy rush seven – Banking restructures.

Many of the above quotes have dealt with banking restructures as part of the macro environment. Banking restructures are lauded as having saved the economy from “systemic failure” but the price paid in long term economic stagnation far exceeded the systemic cost of a short term economic cleansing, even though it may have been a brutal adjustment. Consider the price paid by Japan carefully and judge its relative value.


Candy crash seven – Survival of the weakest

Central Government and Central Bank interventions looked at size and regulatory self-preservation to create an economic, business and banking paradox which haunted the Japanese economy for two decades with no end in sight. Researchers describe this as a “no exit” policy to promote the survival of the weakest in an environment of information monopoly distributed on a “need to know” basis. These policies are a licence to rip-off consumers of banking products while locking up the economy in “carry” mode.

“The financial regulators were able to avoid systemic problems by playing the leading role in the formation and enforcement of the following well-developed set of informal norms governing bank distress: (1) Survival of the weakest: Interest rates and other regulations were set to permit the survival of the weakest member of the banking industry, whose numbers were kept manageable by high barriers to entry. In addition to enhancing the durability of the industry as a whole, the survival of the weakest norm supported pricing arrangements that allowed the weakest member to stay in business, while allowing more efficient producers to earn super-competitive profits. These economic rents were used to compensate for the monitoring and rescue operations undertaken by the stronger firms. (2) No exit (no failure): Almost a corollary of the principle of survival of the weakest was that of no exit—no member of the banking industry was allowed to exit (fail), other than through merger with a stronger member. This enhanced stability both by preventing the failure of weaker members and by increasing public confidence in supervisory capabilities. (3) Responsibility and equitable subordination: When the danger of financial failure grew, the parent or principal source of funding for the failing entity was expected to take responsibility by extending financial assistance and by subordinating its claims to those of other creditors, even if not legally required to do so. This norm encouraged monitoring by stronger firms, by imposing both monetary and reputational costs on stronger players who allowed smaller institutions to fall into difficulty. (4) Implicit government insurance: The preceding norms led naturally to a norm of implicit insurance provided by the government. If strong members were expected to assist weaker members and if no member of the industry were allowed to fail, some entity had to backstop the strong members. Thus, an implicit grant of government insurance was inherent in the operation of the other norms. Put differently, the responsibility norm extended even to the government.”45

“Competition must be limited and entry barriers must be high to channel a stream of rents to the banking sector. Regulators must maintain a near monopoly on information serving as the basis for prudential policy. Similarly, disclosure of problems in the industry must be limited in order to protect regulatory reputation and avoid stresses on an underdeveloped institutional framework. Competition-distorting incentives may be needed to encourage informal resolutions of bank distress.”46


Candy rush eight – Deposit Insurance and bank safety nets.

Transferring banking risks to government supported entities and often implicitly to Central Government enabled the unimpeded flow of stimulations to the economy. A processed sugar intake for a near instantaneous sugar spike. The economy developed an addiction to the sugar spikes. Obese, too-big-to-fail entities emerged.

Candy crash eight – Arrival of the too-big-to-fail banks posing significant systemic risk (economic domino effect of failures).

Governments and Central Banks believed that by aggressively posturing as the alpha dog they can dominate the economy into submissive acceptance of flimsy, thinly funded and hopelessly overexposed to risk, safety nets. The safety nets failed at the first sign of trouble and those relying on the safety nets fell right through into the arms of Central Government. The obese too-big-to-fail left only tatters in its wake when weak safety nets gave way to Central Bank and Central Government bailouts.

“In this capacity as “institutional designer,” few governments in the past decade have made policy choices more controversial and costly than those relating to deposit insurance and other components of the bank safety net. As recent events in world financial markets have demonstrated, on this central issue of institutional design the stakes are high; the results may best be described as dismal. While governments have expended enormous resources to promote bank stability, systemic banking insolvencies in the last two decades have been commonplace.”47

“Arguably, the most serious problems in the United States were caused, not by the explicit portions of the safety net, but by the development of the “too-big-to-fail” norm and the FDIC’s selection of resolution techniques for failed banks that protected virtually all uninsured depositors”48

In the past decade [1989-1999], however, changes in the economic, political, and regulatory environments following the collapse of the “bubble” economy caused the implicit safety net to fail spectacularly, leaving a gaping hole in Japan’s bank regulatory infrastructure.”49

“Thus, while government safety nets are designed to promote bank stability, they simultaneously provide incentives to increase bank risk, making bank failure mores likely. This necessitates a panoply of additional regulatory structures, including bank examinations, capital requirements, and portfolio restrictions, to limit excessive risk taking.”50

“The complete demise of the implicit safety net might accurately be dated to 1997. Autumn of that year witnessed the collapse of Japan’s 10th-largest bank and its fourth-largest securities firm, as well as the failure of a major life insurance company and a second-tier securities house. Significantly, major shareholders and firms affiliated with these failing institutions refused to come to their aid. Moreover, stronger, unaffiliated institutions resisted the MOF’s attempts to broker rescue mergers. This episode represents a watershed in regulatory approaches to failing banks in Japan, indicating that the ground rules for the operation of the safety net were open to complete revision. Although MOF officials scrambled to reassert the “no failure” norm through public statements that no other major banks would be allowed to fail, credibility in the financial structure fell to an all-time low. Events of the past several years, therefore, exposed a legal and policy vacuum of considerable dimensions. For decades, while operating under a comprehensive, implicit safety net, there was little need for a highly developed institutional structure to govern deposit protection and bank closure. Post-“bubble” economic, political, and regulatory conditions rendered the “no failure” norm inoperable, yet no coherent substitute was in place to address the serious problems facing Japanese banks.”51


Déjà vu

Extracting these quotes from highly regarded sources gave me a heightened sense of déjà vu. Compare for instance a global picture of “witnessed the collapse of Japan’s 10th-largest bank [vis-à-vis Northern Rock in the UK] and its fourth-largest securities firm [vis-à-vis Bear Stearns], as well as the failure of a major life insurance company [alternatively AIG as an underwriter of financial risk] and a second-tier securities house [vis-à-vis Lehman Brothers]”. It is in fact almost impossible not to stumble for one parallel to another. The forbearance philosophy inherent to the jusen companies and the political pressures which resulted in a change in the accounting practice to no longer price debt assets on a mark-to-market basis is a parallel and its potential warning for Freddie Mac and Fannie Mae that I find most depressing.

Observe the Japanese outcomes when you contemplate your immediate and longer term financial future. Any investment in prudence and austerity would probably outperform risk hugging behaviour at this stage of an unfolding economic drama. I leave you with one last quote:-

“Even as the economy stalled in 1992 and 1993, following the largely unanticipated bursting of Japan’s asset bubble in the early 1990s, forecasters appear to have remained optimistic about Japan’s medium-run prospects, with most observers predicting a bounce-back to high growth rates within a couple of years. Exhibit III.1 presents forecasts of Japanese GDP growth made by Federal Reserve Board staff, private economists surveyed by Consensus Economics, and IMF staff. For each year, actual growth, the red bars, is compared with forecasts of growth in that year made one year earlier, the blue bars, and forecasts made two years earlier, the black bars. The exhibit makes clear that forecasts fell off much more slowly than actual growth rates, and only in the latter half of the decade did a fundamental reassessment of the outlook for Japan appear to take place.”52

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
29 June 2009

Ps. The 1st quote is not a lesson from Japan. A special thank you to each of the authors quoted for enriching us with their insights and creative phrases like “regulatory self-interest”, “survival of the weakest”, “evergreening” and many more.


© Sarel Oberholster

Your comments are always welcome. Please email me at ccpt@iafrica.com with any views or observations. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


References:
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12. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 96.
13. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 30.
14. Sekine Toshitaka, Kobayashi Keiichiro, and Saita Yumi, (2003), Forbearance Lending: The Case of Japanese Firms, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 2003, pp 69.
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24. Sekine Toshitaka, Kobayashi Keiichiro, and Saita Yumi, (2003), Forbearance Lending: The Case of Japanese Firms, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 2003, pp 75.
25. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 90-91.
26. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 68-69.
27. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 33.
28. Okina Kunio, (1999), Monetary Policy under Zero Inflation: A Response to Criticisms and Questions Regarding Monetary Policy, BOJ - MONETARY AND ECONOMIC STUDIES/DECEMBER 1999, pp 165.
29. Sekine Toshitaka, Kobayashi Keiichiro, and Saita Yumi, (2003), Forbearance Lending: The Case of Japanese Firms, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 2003, pp 78.
30. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 76.
31. Kuroda Sachiko and Yamamoto Isamu, (2005), Wage Fluctuations in Japan after the Bursting of the Bubble Economy: Downward Nominal Wage Rigidity, Payroll, and the Unemployment Rate, BOJ - MONETARY AND ECONOMIC STUDIES/MAY 2005, pp 19.
32. Kuroda Sachiko and Yamamoto Isamu, (2005), Wage Fluctuations in Japan after the Bursting of the Bubble Economy: Downward Nominal Wage Rigidity, Payroll, and the Unemployment Rate, BOJ - MONETARY AND ECONOMIC STUDIES/MAY 2005, pp 27.
33. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 55.
34. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 39.
35. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 43.
36. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 93.
37. Okina Kunio, (1999), Monetary Policy under Zero Inflation: A Response to Criticisms and Questions Regarding Monetary Policy, BOJ - MONETARY AND ECONOMIC STUDIES/DECEMBER 1999, pp 170.
38. Mori Naruki, Shiratsuka Shigenori, and Taguchi Hiroo, (2001), Policy Responses to the Post-Bubble Adjustments in Japan: A Tentative Review, BOJ - MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001, pp 74.
39. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 38-39.
40. Bernanke Ben S, (1999), Japanese Monetary Policy: A Case of Self-Induced Paralysis?, Presentation at the ASSA meetings, Boston MA, January 9, 2000, pp15.
41. Bernanke Ben S, (1999), Japanese Monetary Policy: A Case of Self-Induced Paralysis?, Presentation at the ASSA meetings, Boston MA, January 9, 2000, pp18.
42. Bernanke Ben S, (1999), Japanese Monetary Policy: A Case of Self-Induced Paralysis?, Presentation at the ASSA meetings, Boston MA, January 9, 2000, pp20.
43. Okina Kunio, (1999), Monetary Policy under Zero Inflation: A Response to Criticisms and Questions Regarding Monetary Policy, BOJ - MONETARY AND ECONOMIC STUDIES/DECEMBER 1999, pp 171.
44. Ahearne Alan, Gagnon Joseph, Haltmaier Jane, and Kamin Steve and Erceg Christopher, Faust Jon, Guerrieri Luca, Hemphill Carter, Kole Linda, Roush Jennifer, Rogers John, Sheets Nathan, and Wright Jonathan, (2002), Preventing Deflation: Lessons from Japan’s Experience in the 1990s, International Finance Discussion Papers Number 729 June 2002, Board of Governors of the Federal Reserve System, pp32.
45. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 29-30.
46. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 41.
47. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 22.
48. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 40.
49. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 23.
50. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 25.
51. Milhaupt Curtis J, (1999), Japan’s Experience with Deposit Insurance and Failing Banks: Implications for Financial Regulatory Design?, BOJ - MONETARY AND ECONOMIC STUDIES/AUGUST 1999, pp 35.
52. Ahearne Alan, Gagnon Joseph, Haltmaier Jane, and Kamin Steve and Erceg Christopher, Faust Jon, Guerrieri Luca, Hemphill Carter, Kole Linda, Roush Jennifer, Rogers John, Sheets Nathan, and Wright Jonathan, (2002), Preventing Deflation: Lessons from Japan’s Experience in the 1990s, International Finance Discussion Papers Number 729 June 2002, Board of Governors of the Federal Reserve System, pp12.

Twin Peaks – The Past... The Future?

Reckless monetary policies of the past gave rise to predictable outcomes. The reckless fiscal policies which follow the reckless monetary policies are a matter of global historical record. The most recent modern example of the consequences of reckless monetary policy going sour in a developed economy is the tale of Japan. We take up the tale in the behaviour of the stock exchanges. The Nikkei 225 peaked on 29 December 1989 at 38913.

That is the recent historical lesson. The second tale is being written. It is the tale of the USA’s experience with reckless monetary policy following in the footsteps of Japan. The DJII peaked on 9 October 2007 at 14165.

Are these peaks twins? Yes, but they are not identical twins. Each will write its own tale while both walk a similar road. Perhaps you would question why they should be twins, as I have done many times. The inevitability of the outcome is in the political process. The leaders act as the voters want and the voters’ expectations give rise to an inevitability in behavioural patterns which favours extreme monetary and fiscal policies. Thus we travel on the same road.

Having a road map is useful. Let’s take a look at Japan and match the peaks. Then we can index both the Dow and the Nikkei to each other’s peaks and observe the parallels.


(Click on the chart for a larger image.)

It comes as a shock to observe the similarities of the unfolding tale of the Dow with the historical tale of the Nikkei. The date scale on the x-axis starting with 29 December 1989 is that of the Nikkei, for a look at the past. Identical twins they’re not but twins they certainly are. Perhaps the Fed can claim success for a delay in the big leg down but when it arrived it took the Dow further down than the Nikkei.

Then came the rebound. No surprises there yet but the Dow seems to be encountering heavy weather to match the Nikkei rebound in duration and relative move. The first phase took the Nikkei down from 38913 to 20222 by the 1st of October 1990. The rebound peaked on 19 March 1991 at 27007, about 6 months and 34%.

The Dow rebound, with preliminary top at 8574 on 8 May 2009 from a bottom of 6547 on 9 March 2009 is about 2 months old for a 31% rise. Perhaps the Dow can find the legs to match the Nikkei for a rise to 8773 with 4 months remaining, but they’re not identical twins so do not bet on it.

That was the past. We can take a glimpse at the future by changing the date scale to the Dow top of 9 October 2007.


(Click on the chart for a larger image.)

This look into the future is most unpleasant. Perhaps economic sanity will return but I cannot even find one little green shoot to indicate that the tough love policies of economic sanity is on any agenda. Thus we’re walking the Japanese roadmap of fiscal exuberance and the monetary madness of quantitative easing.

This unpleasant roadmap projects a Dow looking for a bottom some time after 2026. This road map says any buy-and-hold strategy between now and 2026 is bound to result in long term losses. This road map says a Dow 5000 interim bottom some time towards or after the middle of 2010 is likely. The long term bottom indicated by this chart is a Dow around 2600 but even that level is not yet “in” so to speak.

Looking at the next 17 years to gauge long term trending is useful for strategy but what about the near term?



(Click on the chart for a larger image.)

The micro view to October 2010 projects the following outcomes, painting in broad strokes:

 The next bottom to reach about 5000 in the Dow some time around or after mid June 2010.

 The current rebound top may be in on preliminary data (2 months and 31%) but the up trend can last another 4 months.

 The Nikkei bottomed about 8 months earlier than the Dow before the first rebound.

 Dow volatility to range between 9000 and 5000 but considerably less than the first stage of the down move.

 This is a traders market rather than an investors’ market.

 A relentless downward move into the interim bottom once the rebound top is in.

The future does not need to be a near repetition of the past yet humans are predictable in their behaviour. The inevitability of a similar outcome is based on similar macro monetary and macro fiscal policies. The thesis of this roadmap for the future can be broken by a change in the monetary and fiscal inputs which are the dominant variables in the current economic model. It is for you to judge the likelihood of a similar or dissimilar monetary and fiscal future for the USA as opposed to that which Japan has implemented.

The future is not foreordained nor does it belong to anyone. A future outcome based on dominant input variables has strong economic predictive powers. A continuation of current monetary and fiscal trends will almost guarantee a twin outcome with the Japanese experiment.

Trade with care and caution. Invest with even greater care and caution.



Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
23 May 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

A Mother of a Low Hanging Fruit

I am always amazed by the popular slogans. I wonder if the “low hanging fruit” slogan is still in use. “Green sprouting” is the latest craze but the low hanging fruit which I will be discussing will not excite the green sprouting crowd.

First a basic economic rule. The price of a fixed rate bond is inversely related to the interest rate. Thus the price of a fixed rate bond goes up when interest rates fall but the price decreases when interest rates rise. Nothing spectacular but for the reality of interest rate calculations of time value of money and a massive oversupply of government debt. A bubble market always finds its nemesis in the law of supply and demand.


Component One: An explosion in supply of Central Government debt (Over supply).

USA Central Government debt growth is now in an exponential curve. The Japanese experience was similar for about 15 years but they had a Current Account Surplus to generate a cash flow to finance the expansion of their Central Government debt. The USA does not have that luxury.


USA



It is also clear that the Japanese expansion in Central Government debt has stopped and levelled off at about 4 times the amount prevailing at the start of the Japanese crisis. It is of interest that this phenomenon coincides with a mild decreasing trend in the absolute level of USA Treasuries held by Japan (See Major Foreign Holders of Treasuries in Component Six). An inability to fund more Japan national debt coincides with an inability by Japan to fund more USA debt.


Japan


The projections by the British Government follow a similar patter. Unprecedented expansion of the Public Sector Debt. It must be very disconcerting to have experienced their first failed bond auction at such an early stage in their planned expansion of Public Debt. Perhaps some price (interest rate) competition with other national governments may help to sell more UK Public Debt. That will not necessarily be in the spirit of international co-operation on maintaining low interest rates but then again the UK government answers to the UK taxpayer.




United Kingdom





The race to increase Government spending is on. Will price competition only rear its head when the forces of supply and demand deny a government access to the funding markets? Which nation will place national interest first and be the first to break ranks?


Component Two: Historic low interest Rates

The inverse relationship between the price of bonds and the interest rate translates into very expensive Government Debt at a time when they all have plans to expand government debt exponentially. Extreme demand for debt at near zero interest rate levels must surely be another economic absurdity. Can it be possible that they actually believe that they can happily print any shortfall at the Central Bank without destroying their ability to attract any investors to their bond auctions? Better yet, can the printing press be a substitute for bond investors?



USA



The prevailing Target Rate in the USA is Zero to 0.25% (see also the chart in Component Four). The Japanese equivalent is 0.10%, the European Central Bank equivalent is at 0.25% and the UK equivalent is 0.50%. These rates are all in that interest limbo state called the zero bound. The question still to be answered is can they fund their public debt expansion plans at these absurd interest rates?


Component Three: Divergence in long term yields.

The failing bond auctions were not the only signal from the market. The market does not like the heady mix of expensive pricing and an explosive over supply and is reasserting a term premium. Oops, here is a green sprout for higher interest rates. There is no guarantee that interest rates will not rise in spite of depressionary conditions when Central Governments suck every last saved global penny into their debt expansion plans.


USA





Component Four: The interest burden is rising.

Actual interest costs are rising in spite of historic low interest rates due to the exponential growth in supply of Central Government debt. Observe also the interest rate trap. Can Central Governments afford any rise in interest rates? Do taxpayers have the spare cash to service higher interest costs should interest rates rise? That pesky law of supply and demand which eventually got the housing bubble will also get this supply, demand and interest rate structural distortion.

Long term interest rates just do not want to co-operate with Governor Bernanke’s promise to “keep interest rates lower for longer” a long standing proposed strategy of his. Does he have the power to hold long term interest rates down with the printing press or will the market call his bluff. The now well established divergence in the 30 year treasury rate and the acceleration of the trend to diverge since the beginning of 2009 indicate that the market is calling his bluff. I suspect the market will win in the stare down just as the debt bubble eventually had to succumb to market forces.



USA


USA






Component Five: Lambs to the slaughter.

Private Investors have grown their Central Government Debt portfolio at an unprecedented rate. Who will they sell to when the market asserts the law of supply and demand to re-price these bonds? Even more compelling is the potential losses baked into this cake of historic exposure to treasuries when interest rates start to rise. Can the Global Economic Crisis absorb a Global Bond Crisis?

USA





Component Six: Reliance on foreign funding flows to fund treasury purchases.

Japan’s Foreign Trade flows can no longer support new purchases of US Central Government Debt and China seems to be heading in the same direction. Can the rest of the world keep up purchases of US Central Government Debt? What happens when countries in distress have to cash in their holdings of USA Central Government Debt? Who will buy the securities from them?


USA

Data Source: Department of the Treasury/Federal Reserve Board
Note: Series revisions in each year in May/June from 2002 onwards and Jan 08 data omitted between the current and historical series data.


Component Seven: Diminishing international trade and falling Global Foreign Exchange Reserves.

We can already observe signs of distress in Global Official Foreign Exchange Reserves. The IMF’s data on Official Foreign Exchange Reserves is signalling that total global reserves are falling and have been falling for two quarters. Again, a well established trend. Perhaps it would not be wise to rely on foreigners to buy into the explosive growth in Central Government Debt.




Let’s add up the Seven Components:

1. Over Supply of Central Government Debt - Prices must fall.
2. Historic low interest rates. The probability of interest rates rising is much higher than the probability for a further fall.
3. Divergence in long term yields points to rising interest rates and distressed bond auctions confirms this trend.
4. The actual interest amount payable is already rising sharply even though yields are still low and sticky. This poses an incredible risk of funding distress should investors fail to keep absorbing the explosive growth in Central Government Debt. Central Bank purchases of own Central Government Debt cannot take the place of investor money, or will they risk hyperinflation? The failed bond auctions indicate that this activity is probably already capped.
5. Who will buy from “Private Investors” their holdings of Central Government Treasuries and save them from further losses?
6. Relying of “Foreign Holders” to accelerate their purchases of US treasuries at a time when trade flows are falling and each nation has to deal with their own national economic distress would be perilous.
7. Who will buy USA debt from distressed countries when they cash in their reserves?


My cat gets convulsions in its jaw and makes agitated mewing sounds at the sight of a bird which he thinks it is within striking distance. Bond traders are also snapping their jaws and salivating away when looking upon the evidence of the bubble in Government debt. Let no-one shout “fire” in this crowded theatre for bond investors may get trampled as they run for the exits.

Watch for the next billionaire in the making when this mother of a low hanging fruit is plucked.



Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
17 April 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

The Misery of Unproductive Consumption

We celebrate productivity increases. You do not need to be schooled in economics to understand the basic truth that productivity increases are beneficial to humanity on many levels. It’s not just that the ultimate products will be cheaper. It inherently is a saving. A saving of energy, or resources, or pollution and it always contributes to a better world for all.

Daily we are bombarded with terms such as “Productivity of Capital”, “Productivity of Labour” or “Productivity of Production”. We praise those advances and award them productivity prizes. As we should.

But what about “Productivity of Consumption”. Is that not also a laudable achievement? Let’s have a closer look. Say my household switches off unused electricity using appliances, lights and equipment to reduce the household’s consumption of electricity by 20%. That would translate into the economics of productivity of consumption. My household would have increased our productivity of electricity consumption. Now many benefits accrue to my household. We obviously saved some money and as we literally did not sacrifice utility by simply excluding waste, we are on a pure winning streak. We made in a small way a contribution to preserving our planet. We basically did good, not so?

Let’s escalate this to a macroeconomic scale. Let every household around the globe carefully review its spending patters. Evaluate every expense for maximum utility. Do we need a new car or can we increase the productivity of our utility of our existing car. Same with the house. Do we scale down and still achieve a better utility? How high is the productivity of fuel consumption when driving a huge SUV? It is sad that the world needs a global economic crisis to refocus consumers on their productivity of consumption.

When it happens it has a profound economic impact. A good example is the oil crises of the mid 1970’s. I will not dwell on the excessive political undertones to this oil crisis but want to focus on the behaviour of consumers. Governments in this case intervened in the utility of gasoline to actually encourage, sometimes with extreme regulation, an increase in the productivity of consumption by consumers. Productivity of consumption was forced upon consumers when a national maximum speed limit of 55mph (1974) was enacted. Next Corporate Average Fuel Economy standards (CAFE) were enacted (1975). Even motor car racing activity was altered to recognise the need to increase productivity of gasoline consumption. Commuting to school before sunrise was another peculiar regulation imposed to presumably improve productivity of consumption but the unpopular daylight saving time measure had a too high utility cost and only prevailed from January 1974 to February 1975. Macroeconomic substitution away from oil based energy consumption took place on a large scale.

Extreme politicising of a commodity, the excesses of the go-go years of the 1960’s and not to forget the prevalence of price controls gave rise to a Global Oil Crisis. Thus it is no surprise that extreme politicising in the monetary economy, the bubble years post 2000 and the prevalence of price controls over the price for the use of money (interest rates) gave rise to a Global Financial Economic Crisis. The structural price distortion introduced by the Oil Crisis encouraged a steep rise in the productivity of consumption of oil based products globally. This “good” economic effect was retained in the economy and even the advent of a credit boom of cheap and easy money did not alter the once burned consumers. The truth is these twice shy consumers improved on their previous performance.

View the chart from a “Productivity of Consumption” perspective while being aware of the fact that the prices were controlled and the quantities were rationed during the adjustment process.



The first Oil Crisis in this chart is the period 1973 to 1980 and it is clear how productivity of consumption improved dramatically (by about 54%). The lesson was taken to heart and consumption remained flat for most of the 1980’s and 1990’s. The excess capacity of the previous period now combined with productivity of consumption to ensure relatively stable prices for 20 years. Investing in oil did nothing for investors who preferred the hot and sexy technology sector. Increased productivity of consumption did more for stable gasoline prices than any monetary policy ever did.

Consumers did not react immediately to further improve productivity of consumption when prices started rising towards the end of the millennium. Again it took the bubble pricing of another Oil Crisis, this time brought upon via a debt bubble, to drive home the need to further improve productivity of consumption. Again the ultra high prices altered consumption behaviour in a market which has a tradition of productivity of consumption. The USA economy had experienced inflation and growth over the 20 year period in which the consumption of petroleum products remained constant. That in itself is a significant feat. To top it of with a further drop of about 26% in consumption is breathtaking. Thirty six years later and the collective residential consumer consume only about 42% of the petroleum products they collectively consumed in the early 1970’s. Are we going to scold or praise the American consumer for this tour de force?

Here is proof of the paradox of credit booms. The consumption of petroleum products decreased right through the post 2000 bubble years and accelerated at the height of the credit boom.

It is incredible to note how tenacious the lesson of productivity of consumption is applied after such a crisis. We need to ask ourselves how a general change of behaviour by consumers towards a general increase in productivity of consumption will play out as a result of the Global Financial Economic Crisis. Can it be possible that consumption be reduced by 26% or even 54% generally and remain there for the next 20 or perhaps 36 years? The 1973 Oil Crisis says that it is not only possible but actually probable.

I would assert that the increased productivity in Oil consumption was without a doubt good for all the peoples of this planet. Yes, the initial adjustments were painful and finding the right mix of consumption and utility after the crisis took a while but in the end it was worth it. I would hold it as an absolute truth that an increase in productivity of consumption is good for all the inhabitants of planet earth.

Contrary to the increase in productivity of consumption which accompanied the Oil Crisis, we see that the current political response to the Global Financial Crisis is policies encouraging a lowering of productivity of consumption. The hypocrisy of sermons on Global Warming and a bone or two in the direction of green issues in the bailout packages opposed to extreme encouragement of a culture of lowering the productivity of consumption must confuse any half intelligent person.

Whenever I access my internet news channels, open my newspaper or switch on my TV, I am bombarded with almost fanatical encouragement by “leading” economists, political leaders, Central Bank Governors, and especially from the distressed banking sector all insisting that I must spend, spend and spend. Spend to save the economy. Here is a tax refund, please spend it. We are going to unfreeze lending so we can spend our way out of this economic crisis. Credit must flow so folks can get money to buy cars and houses. Wait one moment, what’s happened to productivity of consumption? Scrap that they say, all savings are bad for the economy and all efforts must be focused on stimulating demand.

Not even a moment’s thought has gone into contemplating productivity of consumption. Spending our way out of an economic crisis is paramount to proposing that we waste our way out of an economic crisis. It just cannot be a valid proposition. Yet it is taken one step further, “Please everybody go out and borrow money so we can waste our way out of this economic crisis.” Can it be taken even further? You bet.

The next step up is that we the government will borrow money and waste our way out of the economic crisis when you clearly fail to adhere to our requests to spend more. Surely it cannot get any worse? It can. We the government will print money and waste our way out of an economic crisis.

It requires a mental paradigm shift to observe the folly of present monetary and fiscal policies against a macroeconomic test of productivity of consumption. First a credit bubble is created through excess monetary liquidity provision and artificially lowering interest rates to encourage an extreme lowering of productivity of consumption. Politicians fall in love with the policy of wasteful consumption for it generates a fantastic tax income stream albeit temporary. They want it back and they want it permanently.

The debt bubble just can’t and certainly should not return. Debt saturation collapsed the credit bubble and consumers are faced again with a requirement to increase their productivity of consumption. Any other productivity increase would be lauded, celebrated and prized. Not this one. Oh no, this productivity increase is vilified. This productivity increase is bad for the economy, so they say. This productivity increase must be attacked and corrected using the concerted full might of all the governments around the globe. Productivity of consumption is a menace to the national interest.

The saving grace of the global economy, the utility of the resources of our planet and the long term survival of our species is rooted in productivity of consumption. Productivity of consumption should be elevated to a top priority and not be warred upon. Policies of wasteful consumption for the sake of saving a financial economy built upon an extreme lowering of productivity of consumption will only extend the period of wasteful consumption.

Economics, contrary to what is currently propagated, abhors waste. Every human action has a strong bias towards productivity and maximising utility. Wasteful behaviour is unnatural to economics. The current policies aimed at minimising productivity of consumption and minimising utility in the interest of saving the global economy is hocus-pocus, snake oil economics which will do nothing to cure any economic ills. The economic patient will die of maltreatment and neglect while these policies will be preached with the fever of faith healers.

Bottom watchers, “bottom pickers, top pickers and in the end all become cotton pickers” was a refrain around trading desks, will tell you that persons will repent from increasing their productivity of consumption if only bank credit can be “unfrozen”. That is, turbo-charged-on-super-steroids bank credit distribution policies must be returned to save the global economy. Productivity of consumption had an economic lesson for OPEC and OAPEC. Perhaps the lessons of 1974 during the Oil Crisis are long forgotten and the political economists of today may have to be re-educated on the principles of scarcity and productivity of consumption. Filling the shelves with printing press funded debt products priced at zero interest rates is not going to reverse the trend to improve productivity of consumption as the burden to repay excessive capital on boom priced assets has re-taught the virtues of productivity to consumers.

Current leading global economic policies will heap more misery of unproductive consumption upon the global economy. So “caveat emptor”, let the buyer beware when the bottom pickers bear messages of debt paradise.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
27 March 2009


© Sarel Oberholster

General information on the 1973 Oil Crisis was obtained from "1973 Oil Crisis" at Wikipedia.


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Fat Chance

As a boy I attended an agricultural Secondary School, that is it specialised in agriculture (it is strange grounding for becoming an economist, I know). We had a teacher who would tell a wayward boy, “You’re taking a fat chance”. The reckless economic experiments to avoid the consequences of decades of money creation and monetary policy abuse are similarly taking a fat chance.

The same teacher gathered a number of older boys together at the request of a local farmer. He proposed to the school an educational real life opportunity to prune his orchard. The older boys (no child labour here) had to complete a course in pruning and do a practical evaluation in the school’s own orchard. The group of budding arborists were taken to the farmer’s orchard to fulfil the contract. Each boy was allocated a row of peach trees to prune. Each row had about 50 trees in it. Each boy was paid per tree pruned. It was a good workable system and the pruners were clicking.

Then the cheating started. The bullies quickly worked out that a row would randomly contain smaller trees easy to prune, average trees and other monstrous trees growing wild which could take hours to prune. They then formed a group, we called them the “Group of Rocks”, for they gathered rocks and set forth to mark all the small trees in the orchard with a rock in the first fork of the tree. Soon work was subdivided into all the small trees for the Group of Rocks, while the rest of the group had to content with normal and monstrous trees.

The rest of the group went to Mr Fat Chance and complained but he did not wish to disturb the status quo as the Group of Rocks was also the group normally considered “leaders”.

The next day only half of the remaining group of boys reported for pruning. The Group of Rocks were in full force. On the third day it was only the Group of Rocks who reported for duty. It now became clear that they would have to do all the work and the rock marking system collapsed. This did not please them so on the forth day nobody reported for duty.

The educational objectives of the school and the farmer all came to nothing. The farmer hired professionals and the school went back to teaching only in the classroom. I would have had an entirely different story to tell had the Group of Rocks failed in their bid to control the allocation of the pruning purse.

Macro evaluations and micro events are interchangeable. The economic playing field is now dominated by the “too big to fail”, the Government Supported Entity, the Public Private Partnership, organised labour and the Siamese twin of Government and Central Bank. This Group of Rocks has control over the national purse in the national interest. They get to allocate the national purse to themselves at the expense of all others. They do not have to suffer the discipline of market principles. The harsh reality of penalty for mistakes and reward for getting it right does not apply to them. They get the personal reward when the going is good and the public purse when the going gets rough. They live and operate on favour and the public purse; rather than live or die by the merits of the market.

Zimbabwe did the same. They printed money and handed it to their Group of Rocks. Ruthless Central Bank activity was combined with ruthless and determined Central Government policies. In the end we see that the Group of Rocks in Zimbabwe owns everything. Everything of hardly anything. Zimbabwe recently reported 94% unemployment so the printing presses were engaged in the national interest, not so? The printing presses averted unemployment in Zimbabwe, not so? The entrepreneurial incentive has been removed from the economy. The risk reward relationships of economic activity have been perverted.

There is a simple but profound lesson in the Group of Rocks. People will labour willingly and with enthusiasm while assuming the risks of randomness in a system based on merit. Is this not a principle inherent to the “American Dream”?

Favouritism and control over the public purse will enslave those outside the inner circle. Debt is but a result of this enslavement. Favouritism destroys the co-operative specialisation inherent to free markets, destroys initiative and encourages unemployment. Thus a belief in bailouts for the Group of Rocks; so called stimulations funded by monetary theft of the savings of the rest; and an explosion of the Sovereign debt funded from the printing press will not save the economy, nor is it in the national interest or international interest.

The printing press is the route to depression, unemployment and social unrest. This is the road to Zimbabwe. The debate about a deflationary depression or a hyperinflationary depression is of interest to those with a desire to protect their savings but let’s not forget that a depression is a horrible economic event. Yet, a deflationary depression is preferable to a hyperinflationary depression. A suitably determined Central Bank and Central Government can convert a deflationary depression into a hyperinflationary depression. Still the actual problem of a depression has not been attended to. Inflation or hyperinflation is not a remedy for a depression or unemployment. Fear not the deflation, or inflation, or even hyperinflation for these are merely symptoms of the control over the national purse. Fear depression for it does not care which flavour of flation accompanies it.

Free market principles where merit allocates the national purse in a fair rule of law system will restore the economic structural imbalances. This option does not suit the Group of Rocks and no prizes for guessing who gets to decide.

I find it incredible and disturbing that access to debt to be created with public debt is offered and praised as a solution for overindulgence in debt. Debt consumption is simply spending the future today and at some stage there is just no future left to discount to today. Does anyone really believe that the Group of Rocks will forgive the debt? The Group of Rocks will shackle you with debt and collect your labour or your assets, you choose.

Thus the economic world travels the road to Zimbabwe which on the economic roadmap is on the other side of Japan. Distances are measured in unemployment. To those with an unholy faith in printing presses I say; “Fat Chance” and prepare myself for the economic and social consequences of a printing press global economy.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
22 February 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .