Of debt, deflation and rotten
apples By Henry C K Liu
Deflation is a problem that looms over the
horizon when the US debt bubble bursts to slow
down the economy. Yet investors are motivated to
buy US bonds to lock in current high yields if
they expect the Federal Reserve, the central bank,
to cut short-term rates in the near future to
stimulate a slowing economy.
When investor
demand for bonds is strong, mortgage lenders can
offer lower mortgage rates for homebuyers because
high bond prices lead to lower bond yields. Thus a
pending economic slowdown in its incubating phase
actually fuels a housing bubble by the abundant
availability of cheap money. But there is no
escaping the fact that falling interest rates lead
eventually to
inflation, which discourages
bond investment. Rising interest rates, on the
other hand, while stimulating bond investment,
lead to deflation.
Neutral interest
rate and income disparity The Fed's
below-neutral interest-rate policy between 2000
and 2004 produced stealth inflation, by pushing
price appreciation to the asset side while prices
of consumer goods were kept low by US corporations
aggressively exploiting global wage arbitrage.
Domestic wages in the US have been kept low with
the threat of more offshore outsourcing of jobs.
The money that would have gone to domestic wage
rises went instead to corporate profits, which
have also been magnified by low debt-service cost,
leading to widening income disparity between
owners of capital and sellers of labor.
Alan Greenspan, outgoing chairman of the
Federal Reserve Board of Governors, explained this
distortion of income parity with the magic of
rising US productivity, which mathematically could
approach infinity when rising corporate profit
from imports is divided by stagnant domestic wages
and rising unemployment. The lower wages fall and
the higher unemployment rises, the more corporate
profit rises, and the more Greenspan marvels at
the miracle of US productivity.
Mounting
debt levels have enabled the United States to
celebrate sky-high productivity increases by
simply working less. To keep consumer demand up,
the public is taught to trade off wage income for
dividend income, which has been boosted by tax
cuts and exemptions on dividends, augmented also
by one-time cash-out refinancing of ever bigger
home mortgages reflective of ballooning price
appreciation. Instead of moving to a bigger house
made affordable by rising income, the same house
is providing consumers with windfall cash to
support consumption even as income stagnates.
This unsustainable bloodletting cure for a
sick economy is celebrated by neo-liberal
economists as a happy boom from free trade. The
trade apple is kept shining on the outside by
sucking nutrients for a slowly depleting, rotting
core, eaten away by a growing debt worm, turning a
sick economy into a terminal case.
Inverted yield curve and
recession The "term structure" of interest
rates defines the relationship between short-term
and long-term interest rates. The yield curve is a
graphic expression of the interest-rate term
structure. Historical data suggest that a
100-basis-point increase in the Fed Funds rate has
been associated with a 32-basis-point change in
the 10-year bond rate in the same direction. Many
convergence trading models based on this ratio are
used by hedge funds.
Of course what was
true in the past is not necessarily true in the
future, given that the rules of the fixed-income
investment game have been altered fundamentally by
deregulated globalization of money markets. The
failure of long-term dollar rates to rise along
with the short-term rate since late winter 2003
can be explained by the expectation theory as
applied to the term structure of interest rates,
as St Louis Fed president William Poole observed
in a speech to the Money Marketeers in New York
last June 14. The market simply does not expect
the Fed to keep the short-term rate high for
extended periods under current conditions. The
recent upward trend of short-term rates set by the
Fed is expected by the market to moderate or even
reverse direction as soon as the economy slows.
And reacting to the underlying weakness of
deceivingly robust economic indicators, the market
apparently expects the economy to slow, and
perhaps soon.
Greg Ip of the Wall Street
Journal reported on December 8 that Greenspan, in
a written response to a letter from Republican
Congressman Jim Saxton, chairman of the Joint
Economic Committee of Congress, about the meaning
of a "neutral" interest rate, said definitions of
"neutral" vary, as do methods of calculating such
rates, and that neutral levels change with
economic conditions.
Thus the concept of a
neutral rate, one that is neither above nor below
normal spreads over inflation rates, is made
useless by practical difficulties. This of course
is a standard Greenspan position on all economic
concepts as the Wizard of Bubbleland always drives
by the seat of his pragmatic pants, doing the
opposite of his obscure periodic ideological
pronouncements.
The Fed raised the Fed
Funds rate target to 4.25% in its December 13
meeting, continuing its "measured pace" policy of
13 steps of 25 basis points each, up from a low of
1% in June 2004. And with the 10-year yield now at
4.5%, a flat yield curve is imminent and an
inversion soon if the Fed, as expected, continues
its current upward interest-rate policy.
The Fed's statement accompanying the
December 13 meeting on interest rates did not
include any reference to "accommodative" rates as
it had described earlier hikes. The market
appeared to interpret this omission as the Fed
acknowledging that the short-term rate is now at
neutral; that is, on par with historical spread
above inflation rate.
Historically, a flat
yield curve signals future slow growth and an
inverted yield curve signals future recession. But
Greenspan dismissed the historical pattern by
arguing that lenders are now likely to accept low
long-term rates because of their expectation of
future low inflation, and this would stimulate
future economic activities. So stop worrying about
the inverted yield curve and learn to love a
global "savings glut".
The Fed also
dropped its usual reference to a "measured pace",
an omission that immediately encouraged
speculation that it would hereafter raise rates
only intermittently instead of at a gradual steady
pace of small steps of 25 basis points at every
Federal Open Market Committee (FOMC) meeting. Yet
the market remains nervous about the Fed's
acknowledgement of the need for "further measured
policy firming" that suggests more rate increases.
Greenspan will chair his last meeting this month.
Ben Bernanke, the incoming Fed chairman, will
chair his first rate meeting in March, as the Fed
does not hold rate meetings in February.
Yet there is no denying that the
debt-driven US economy is afflicted with
overcapacity. And if low inflation, as defined by
the Fed, is the result of stagnant wages, where in
the world is the future expansion of demand going
to come from without inflation? The answer is from
more debt collateralized by a further expanding
asset-price bubble.
Lower US interest
rates also lower the exchange value of the US
dollar, allowing non-dollar investors to bid up
dollar asset prices. Asset-price appreciation is
not registered by such economic indicators as
inflation, thus the Fed could continue its
below-neutral interest-rate policy to fuel an
expanding bubble without penalty. The US economy
has been delirious for some four years with
runaway debt that no one feels any need to pay
back as long as real interest rates remain
negative or below neutral, while no one seems to
worry that debtors can ill afford to pay back
debts as soon as real interest rates rise about
neutral. With the short-term rate at 1% and
real-estate prices rising by more than 30%
annually, a full price mortgage can be amortized
in a little over three years by market trends.
Offshore dollars not necessarily owned
by foreigners Non-dollar investors in US
dollar assets are not necessarily foreigners. They
are anyone with non-dollar revenue, such as US
transnational companies that sell overseas or
mutual funds that invest in non-dollar economies.
The New York Fed estimates that, at
year-end 2003, foreign central banks held $2.1
trillion in dollar-denominated securities,
"equivalent to more than half of marketable
Treasury debt outstanding". Yet foreign central
banks do not own these dollars free and clear.
They acquired export-earned dollars in their
economies by the governments issuing sovereign
debt denominated in domestic currencies. Much of
the dollars reserve held by foreign central banks
come from dollar profits of the export sector.
Such profits are earned mostly by offshore
joint-venture or wholly owned operations of US and
other foreign transnational companies and
financial institutions.
These US
subsidiaries do not repatriate their off-source
earning to avoid high US taxes. They convert their
dollars to domestic sovereign debt instruments
that pay high yields to profit from inter-currency
interest rate arbitrage. Some 60% of Chinese
export is traded by non-Chinese companies, and the
ratio is expected to increase as China further
privatizes its state-owned enterprises. The
exporting economies exchange high-yield domestic
sovereign debt instruments for US dollars to buy
low-yield US bonds.
Unlike investors,
hedge funds do not buy bonds to hold, but to
speculate on the effect of interest-rate trends on
bond prices by going long or short on bonds of
different maturity with denomination in different
currencies. They finance their transactions with
loans from the repo (repurchase agreement) market,
which trades collateralized short-term loans at
rates that closely track Fed Funds rates. An
inverted dollar yield curve will cause distress
for repo players who borrow dollars short-term to
invest in longer-term instruments.
While
hedge funds do not set the direction of the
market, they do exacerbate market volatility. The
proliferation of hedge funds and the continuing
rise in the amount of money they command through
astronomical leverage allow market trends to be
excessively affected by short-term speculation.
Hedging, instead of a strategy for protection, has
come to mean taking on ever higher risk for higher
returns.
The inverted dollar yield curve
can be read as a signal that market speculation is
betting on a coming global recession by betting
against high short-term dollar rates. Thus
traditional term structure is being made to stand
on its head. Instead of an inverted yield curve
forecasting a future recession, market expectation
of a future recession is producing an inverted
yield curve, which reinforces the likelihood of a
future recession.
Global savings glut
is only a dollar glut There is another
factor that distorts the historical term structure
of interest rates, the denial of which has caused
Greenspan to describe a flat yield curve as a
conundrum. Fed chairman-designate Bernanke argued
in a speech last March 29, while still a Fed
governor, that a "global savings glut" has
depressed US interest rates since 2000. Echoing
this view, Greenspan testified before Congress on
July 20 that this glut is one of the factors
behind the so-called interest rate conundrum, ie,
declining long-term rates despite rising
short-term rates. Bernanke noted that in 2004, the
US external deficit stood at $666 billion, or
about 5.75% of US gross domestic product (GDP).
Corresponding to that deficit, US citizens,
businesses, and governments on net had to raise
$666 billion from international capital markets.
As US capital outflows in 2004 totaled $818
billion, gross financing needs exceeded $1.4
trillion.
Yet this shows only the flow of
funds without identifying the ownership of such
funds. With deregulated global money markets,
money can change location without changing
ownership as funds move electronically around the
world in search of the highest returns. What
Bernanke did not say was that a sizable amount of
this money belongs to US entities.
Bernanke argued that over the past decade
a combination of diverse forces has created a
significant increase in the global supply of
savings, in fact a global savings glut, which
helps to explain both the increase in the US
current-account deficit and the relatively low
level of long-term real interest rates in the
world today. He asserted that an important source
of the global savings glut has been a remarkable
reversal in the previous flows of credit to
developing and emerging-market economies, a shift
that has transformed those economies from
borrowers on international capital markets to
large net lenders.
Eurodollar owners
not necessarily foreigners In the United
States, domestic saving is currently dangerously
low and falls considerably short of US capital
investment. Of necessity, this shortfall is made
up by net borrowing from foreign sources, in
essence by making use of foreigners' savings to
finance part of domestic investment.
The
word "foreign" is misleading; it is more accurate
to refer to offshore sources, including
eurodollars owned by US corporations, institutions
and individuals. The US current-account deficit
equals the net amount that the United States
borrows abroad, and US net offshore borrowing
equals the excess of capital investment over
domestic savings, but not necessarily national
savings because many US corporations, institutions
and individuals own substantial offshore or
eurodollars. Still, Bernanke reasoned that the
country's current-account deficit equals the
excess of its investment over saving.
In
1985, US gross national saving was 18% of GDP; in
1995, 16%; and in 2004, less than 14%. It seems
obvious that despite Bernanke's predisposed
observation, the current-account deficit equals
the excess of US consumption, not investment, over
domestic savings. In a globalized money market,
national saving is composed of both domestic and
offshore savings.
Theoretically,
investment cannot, as a matter of definition,
exceed savings, a concept aptly expressed by the
formula I = S (total investment equals total
savings) framed by economist Irving Fischer
(Nature of Capital and Income, 1906) that
every economist learns in the first day of class
in neo-classical macroeconomics. For total
investment to be equal to total savings, the
demand for lendable funds must equal the supply
for lendable funds, and this is only possible if
the rate of interest is appropriately defined. If
the interest rate were such that the demand for
lendable funds was not equal to the supply of it,
then we would also not have investment equal to
savings. Thus the Fed interest-rate policy is
responsible for over- or under-investment in the
US economy.
Foreign countries with dollar
trade surpluses with the US increased reserves by
issuing local-currency sovereign debts to withdraw
the trade-surplus dollars in their economies,
thereby, according to Bernanke, mobilizing
domestic savings, and then using the dollar
proceeds to buy US Treasury securities and other
dollar assets. In effect, foreign governments have
acted as financial intermediaries, channeling
domestic savings away from local uses and into
international capital markets. What Bernanke
neglected to say was that much of this money
belonged to off-source subsidiaries of US
corporate parents. These US corporations achieve
profitability by cross-border wage and benefit
arbitrage through outsourcing. The net effect of
lowering dollar interest rates by outsourcing also
reduces interest income for US pension funds,
dealing a double blow to American workers.
A related strategy has focused on reducing
the burden of external debt by paying them down
with the funds from a combination of reduced
fiscal deficits and increased domestic debt
issuance. Of necessity, this also pushed
emerging-market economies toward current-account
surpluses. The shifts in current accounts in East
Asia and Latin America are evident in the data for
the regions and for individual countries.
Bernanke also asserted that the sharp rise
in oil prices has contributed to the swing toward
current-account surpluses among the
non-industrialized nations in the past few years.
The current-account surpluses of oil exporters,
notably in the Middle East but also in countries
such as Russia, Nigeria, Indonesia and Venezuela,
have risen as oil revenues have surged. The
aggregate current-account surplus of the Middle
East and Africa rose more than $115 billion
between 1996 and 2004.
In short, events
since the mid-1990s have led to a large change in
the aggregate current-account position of the
developing economies, implying that many
developing and emerging-market countries are now
large net lenders rather than net borrowers on
international financial markets. In practice,
these countries increased foreign-exchange
reserves through the expedient of issuing
sovereign debt to domestic money markets, and then
using the dollar proceeds to buy US Treasury
securities and other dollar assets. Bernanke calls
this mobilizing domestic savings.
While
Bernanke accurately describes the conditions, he
obscures the causal dynamics. There are few data
on the ownership of international capital and the
prospect of hot money that zaps around the globe
electronically being most US-owned is very real.
When dollars are moved from Singapore to New York,
there is no information on who owns those dollars.
The so-called global savings glut is hardly the
result of voluntary behavior on the part of
foreign central banks. It is the coercive effect
of dollar hegemony that has left the trading
partners of the United States without a choice.
The US trade deficit is denominated in
dollars, which can only be recycled into dollar
assets. Local-currency sovereign debts are issued
by foreign treasuries to soak up the
current-account surplus dollars. That foreign
central banks end up holding larger dollar
reserves can hardly be viewed as national savings.
Foreign central banks merely exchange domestic
sovereign debt for dollars that are US sovereign
credit instruments.
Further, Bernanke
ignored the obvious fact that rising dollar-asset
value has distorted the aggregate debt-equity
ratio in the global credit market. As US assets
appreciate while Japanese assets depreciate, US
borrowers can carry more debt with the same
debt-equity ratio than Japanese borrowers. This
has in fact reduced margin requirements for all
sorts of leverage financing in the US. Banks give
not only full-market-value loans, but
full-expected-future-market-value loans in an
ever-rising bull market. History is very clear on
the accelerating damage that margin calls did in
the 1929 crash, a fact that apparently escapes
Bernanke, despite his image as a dedicated student
of the 1929 crash.
Rising
foreign-exchange reserves breed domestic
deflation The exporting economies ship real
wealth to the United States in exchange for fiat
dollars that cannot be spent in their own
economies without first being converted into local
currencies. If the local central banks exchange
the trade surplus dollars in their economy for
local currencies, local inflation will result from
an expansion of the money supply while the wealth
behind the new money has been shipped to the
US.
Thus most foreign governments issue
sovereign debt in local currencies to soak up the
dollars in their economies, few of which are owned
by their own citizens and many owned by foreign
investors and traders, and turn them over to their
central banks as foreign exchange reserves. The
net effect is deflationary for the exporting
economies because sovereign debt reduces the
local-currency money supply.
Local
sovereign debt is used to cover the loss of real
wealth by export to the US for dollars. Thus the
true financial health of any economy is measured
not by the amount of foreign-exchange reserves
held by its central bank, but the net
foreign-exchange reserves after deducting the
outstanding sovereign debt, the dollar equivalent
of which is determined by the exchange rate
between the currencies. This is why exchange-rate
revaluation affects not only trade
competitiveness, but also capital-account balance
between economies of different currencies.
The glut Bernanke refers to is only a
dollar glut that in fact impoverishes the
exporting economies. There is no global savings
glut at all. While the exporting economies
continue to suffer from shortage of capital,
having shipped real wealth to the US in exchange
for paper that cannot be used at home, their
central banks are creditors holding huge amounts
of dollar-denominated debt instruments. It is not
a global savings glut. It is a global dollar glut
caused by the Fed printing money freely to feed
the gargantuan US appetite for debt.
At
first glance, the United States has become the
world's biggest debtor nation. Japan and China
have become the world's biggest creditor nations.
The US owes Japan more than $2 trillion. At the
end of third-quarter 1998, 33% of US Treasury
securities were held by foreigners, up from just
10% in 1991. Some 30% of foreign-held assets were
US government bonds ($1.5 trillion), and 12%
corporate bonds. Again, the word "foreign" is
misleading. It is more accurate to use the term
"offshore", for many of these securities are owned
by offshore US entities. By last June 30, more
than 50% of outstanding US Treasuries ($2
trillion) were held by foreign central banks. But
the foreign governments have liabilities to
offshore US entities that own their sovereign debt
instruments.
Total US federal debt exceeds
$7.6 trillion. Yet Japan desperately needs US
investment and credit. The US economy has been
booming for more than a decade with only two brief
recessions, each bailed out by the Fed injecting
massive liquidity into the banking system, while
during the same time the Japanese economy have
been sliding downhill in a deflationary spiral,
with its sovereign debt receiving junk ratings.
The same happened to South Korea and will soon
happen to China, where the initial euphoria of
dollar addiction will eventually turn to pain.
While there are many well-known factors
behind this strange inversion of basic economic
logic, one factor that seems to have escaped the
attention of neo-liberal economists is the US
private sector's ability to use debt to generate
returns that not only can comfortably carry the
cost of debt service but also conflate asset
values with astronomical price-earnings (p/e)
ratios.
Japan has been cursed with an
opposite problem. Its long-term national debt
exceeded its GDP in 2004, and the ratio of its
long-term national debt to GDP was double that of
the US in 2004. Japan has been unable to utilize
further sovereign credit to back the investment
needs of its private sector. As a result, Japan
looks to international capital (mostly from the
US), money (more than $2 trillion) that really
belongs to Japan. Japan has been selling
increasingly larger stakes in its supposedly
successful industrial enterprises to US
transnationals.
But the foreign-capital
injection comes in the form of US dollars, which
are converted by the central Bank of Japan (BOJ)
into Japanese government bonds, adding to the
already excessive national debt. Substantial
amount of Japanese government bonds (JGBs) are
owned by non-Japanese investors, though it is
difficult to know exactly how much. The moves
toward zero yen interest rates temporarily helped
the Tokyo equity market, but whether it represents
a sustainable recovery is still very much in
doubt.
Central banks fear deflation
more than inflation Although Greenspan
never openly acknowledges it, his great fear is
not inflation, but deflation, which is toxic in a
debt-driven economy. "Price stability" is a term
that increasingly refers to anti-deflationary
objectives, to keep prices up rather than down.
What has happened to Japan for the past
decade is a terrifying warning to Greenspan. The
fundamental problems separating the US and
Japanese economies are structurally different, yet
the financial symptoms of economic imbalance are
strikingly similar. Japan, with its huge trade
surplus denominated mostly in US dollars, is the
world's greatest creditor nation externally, but
the world's greatest debtor nation internally. The
United States, the world's greatest debtor nation
externally, is the world's greatest sovereign
creditor through dollar hegemony. What happened to
Japan was that even with the world's largest
holding of dollar reserves, the country was unable
to ward off a protracted deflationary financial
crisis caused structurally by exporting wealth for
paper that is useless in Japan. The more dollars
Japan earns, the more its domestic sovereign debt
expands, along with the expansion of its
foreign-exchange reserves, causing more sever
domestic deflation.
For the US, even when
the Fed can print dollars at will, it will be
unable to ward off a debt crisis; in fact the more
dollars it prints, the more seriously it adds to
the crisis. At some point, even paper debts cannot
be repaid by printing more paper because of the
exponentially ballooning interest spiral. Paying
interest on unpaid interest will soon accelerate
the debt crisis. Debt, if not repaid by gold, must
be repaid by work; and the Fed, by printing more
paper money, actually destroys what little real
productive work is still available in the US
economy. In fact the financial-services sector, a
euphemism for the debt-manipulation sector, is
producing most of the new jobs in the United
States. Such jobs create financial value by
pushing paper around at increasing speed.
A look at the Japanese debt economy in the
past decade will give some idea of what awaits the
US debt economy when deflation hits. The Japanese
government is in an inescapable debt-death spiral
by virtue of the fact that nominal GDP is falling
at an annual rate of about 5%. Stabilizing the
government's debt-to-GDP ratio would require that
nominal GDP rises at a rate equal to the interest
rate on its outstanding debt, or about 1%. The
fact that nominal GDP is falling at a 5% rate
means that Japan's debt-to-GDP ratio will rise at
least 6% a year, even without a sudden need to
recapitalize insolvent banks. That debt-GDP ratio
is now 130%, and at 6% a year it will double in
just over a decade. That fact will itself
accelerate the collapse of the JGB market unless
deflation is reversed.
The current US
debt-GDP ratio is only 76%, but the trend is not
different from the Japanese debt spiral. The
Japanese crisis was caused by export while the US
crisis is being caused by import.
The
Japanese trade surplus, coupled with a
capital-account deficit, the opposite of the US,
has been leaking yen into dollars faster than the
BOJ can inject more yen into the yen money supply
because of the so-called liquidity trap. In fact,
the Japanese Treasury has been withdrawing yen
from the Japanese money supply by selling JGBs at
a rate faster than the BOJ can inject new yen into
the banking system.
Similarly, the US
trade deficit, coupled with its capital-account
surplus, has been leaking dollars into the global
dollar economy faster than the Fed can inject
dollars into the US domestic economy. This has
happened because some time in the past decade, the
global dollar economy has outstripped the US
domestic economy through globalized trade financed
by dollar hegemony, as more and more dollars
stayed offshore even if they were owned by US
entities rather than foreigners.
The
notion that a strong dollar is in the US national
interest no matter who owns it is at best
controversial and increasingly foolhardy. It is
where the dollars are based that determines
whether a strong dollar is good for the US
national interest. A strong dollar in a global
dollar economy is only good for offshore dollar
owners, not US residents.
Foreign trade
restrains domestic growth Going forward in
the current deregulated global trade regime, every
one of the Group of Seven (G-7) economies can only
grow by making sure that the rest of the world
grows at a faster pace.
There was a period
during the Cold War when the more advanced US
economy grew at a slower pace than those of its
allies in the Western bloc, much to the benefit of
the whole bloc. The future of the world economy
depends on more economic equality, not by
shrinking the size of the G-7 economies, but by
expanding the economies outside the G-7 at a
faster pace. It is clear that this needed shift
toward economic equality cannot be achieved
through neo-liberal globalized trade. This is
because trade without global full employment does
not yield comparative advantage to the poorer
trading partners. Say's Law, which asserts that
supply creates its own demand, is only true under
conditions of full employment. Comparative
advantage in free trade is Say's Law
internationalized, true only under conditions of
global full employment and shrinking cross-border
disparity of wages.
Dollar hegemony makes
trade surplus denominated in US dollars a
mechanism to drain wealth from the trade-surplus
economies to the global dollar economy, which is
not congruent or limited to US political
territories. This is caused by more than the fact
that the dollar has been a fiat currency since
1971, a paper instrument detached from any specie
of intrinsic value. The real factor is that
dollars are not spendable outside of the global
dollar economy, thus are useless for domestic
development in non-dollar economies. The dollar is
not even fully useful in the US domestic economy
because of low yields in the domestic US market.
In the 1980s there were serious talks
about the merits of global dollarization, but the
idea went nowhere as long as dollars were
controlled by the US Fed to response only to US
needs. And US needs were not identical to US
benefits. Besides, the dollar issue is mainly a
technical issue of international trade. The real
issue for the world economy is that economic
development needs to replace international trade
as the dominant driving force of the world
economy, making the dollar issue a mechanical
rather than a fundamental one. With global wage
arbitrage and dollar hegemony, globalized trade
tends to be deflationary until cross-border wage
arbitrage works to push wages up rather than down.
Neo-classic economics requires all central
banks to view their key mission as fighting
inflation. As a central bank, the BOJ's allegiance
is to the value of its currency, the yen, rather
than the health of the Japanese economy. In this
respect the BOJ is at odds with METI, Japan's
powerful Ministry of Economy, Trade and Industry,
which wants to preserve a cheap yen, which is
inflationary. This split is known as central-bank
political independence.
Central banks take
this view because they believe the health of the
economy depends on the soundness of money. They
reject the notion that the health of the economy
is the basis of a sound currency. The BOJ wants to
resist international market forces for a rising
yen while it also wants to resist domestic market
forces for a falling yen. Central bankers are not
above arguing that the monetary operation is a
success, though the economic patient died.
Yet there are good reasons central banks
fear deflation more than inflation. The Fed,
because of its unlimited power to print US dollars
since 1971, a privilege no other central bank
enjoys, can fight deflation in the dollar economy
by simply printing more dollars with short-term
immunity, as Bernanke suggested. In a deflationary
environment, currency buys more with the passage
of time and transactions are delayed in hope of
better prices. Deflation leads consumers and
corporations to postpone spending in anticipation
for still lower prices, and it wreaks havoc with
business balance sheets and discourages new
productive investment.
For Japan, with the
yen consumer price index falling at about 1% per
year, and the broader GDP deflator falling at
about 2% per year, deflation has become persistent
in Japan in recent years as the country continues
to enjoy a substantial trade surplus. Aside from a
temporary increase in 1997 when the consumption
tax was raised, prices have been falling in Japan
for the past decade. But the BOJ, unlike the Fed,
has been powerless to resist deflation in the yen
economy.
As shown by the Japanese example,
deflation is damaging to the financial health of
the banking system. An operative central banking
regime depends on functioning links between
monetary policy and banking policy. With
deflation, interest rates are forced to become
very low - close to zero, or even negative - below
neutral. Yet near-zero interest rates only
postpone, not eliminate, the need for banks to
deal with problem loans, because, notwithstanding
Milton Friedman's famous pronouncement that
inflation is everywhere and anywhere a monetary
phenomenon, deflation, the reverse of inflation,
is not everywhere and anywhere just a monetary
phenomenon. Deflation is a problem that cannot be
cured by monetary measures alone, as Japan has
found out and as the United States is about to.
Global deflation can only be cured by reforming
the international finance architecture to allow
international trade to be replaced by domestic
development as the engine for growth. Global trade
under dollar hegemony drains domestic currency in
the exporting economies with domestic currency
sovereign debs to enable the central banks to
accumulate dollar reserves. This causes domestic
deflation.
The perils of zero interest
rates With near-zero interest rates,
borrowers find it easier to meet their interest
payments to banks and the credit market, allowing
loans to remain performing even if the borrowing
firms are structurally unprofitable. A clear
example of this is the financial arms of the US
auto giants and their use of the commercial paper
market.
General Motors Acceptance Corp
(GMAC) now contributes more 90% of the distressed
automaker's earnings. GMAC is a financial-services
unit that finances more than cars; its main market
is now home mortgages. GM is considering selling
part of GMAC. Being detached from GM might allow
GMAC to improve its credit rating, now kept down
by the parent company's astronomical losses of
more than $1 billion each quarter, and thereby
cutting its borrowing costs and boosting its
profits from interest-rate spreads. The sale of a
big stake would also strengthen GM's balance sheet
but would also reduce the profit contribution from
the unit that has kept the parent firm afloat.
Already, GM's profit from financing has been
tightening as rising interest rates cut consumer
loan demand.
Total US mortgage volume
dropped 30% in 2004, to $2.7 trillion, as interest
rates jumped close to 100 basis points that
summer. This was particularly bad news for GMAC,
which had benefited from a boom in home
refinancing. Its mortgage profits fell 10% in
2004, to $1.1 billion. Still, GMAC earnings were
expected to hit $2.5 billion in 2005, guaranteeing
a dividend to GM in excess of $2 billion. But that
is down from $2.9 billion in 2004.
Deflation makes it harder for borrowers to
repay loan principal. Deflation weakens
debt-to-equity ratios. A high nominal interest
rate in an inflationary environment can be a
negative real interest rate after inflation
adjustment, in which case banks are actually
paying their borrowers. Conversely, a zero nominal
interest rate can be a high real rate in a
deflationary environment.
Under a national
banking regime, banks are performing their duty as
long as they support the national purpose. In
Japan's case, the banks' role was to support
export. Even if the banks did not make a profit or
their corporate borrowers could not meet debt
service temporarily with current cash flow, the
banks were serving the national purpose as long as
the borrowing corporations were gaining market
share in the global market.
Rational
expectation and irrational exuberance The
BOJ, as a central bank since the Japanese Central
Bank Law came into effect in April 1998, has been
struggling to revive the country's economy,
stagnant for more than a decade. By comparison,
the US Central Bank Law came into being in 1913
and within two decades led the US economy to its
greatest collapse.
At its monetary-policy
meetings (MPMs), the BOJ decides the guidelines
for market operations that cover the inter-meeting
period of about half a month or a month ahead.
Market participants, on the other hand, often
engage in funds transactions that become due in
three or six months. This requires them to
forecast movements in the overnight call rate
during the period between the next MPM and the
maturity date of their transactions. Consequently,
when the outlook for interest rates is uncertain,
market forces will set interest rates on term
instruments, such as three- or six-month
instruments, substantially higher than the
prevailing overnight rate, defeating the purpose
of the BOJ's low-interest-rate policy.
Nobel economist (1995) Robert E Lucas's
theory of "rational expectations" postulates that
expectations about the future can influence the
economic decisions independently made by
individuals, households and companies. Using
mathematical models, Lucas showed statistically
that the average individual market participant
would anticipate - and thus could easily
neutralize - the impact of government economic
policy. Rational expectation theory was embraced
by Ronald Reagan's White House during his first
term as US president, but the theory worked
against Reagan's "voodoo economics" instead of
with it. The Fed's allegedly more transparent
posture under Greenspan reinforces rational
expectation by the market, which, coupled with a
"measured pace", can neutralize the impact of Fed
interest-rate policy to correct what Greenspan
calls "irrational exuberance".
The BOJ
zero-interest-rate policy in effect stopped the
toxic interaction between economic activity and
the financial markets by removing concerns among
market participants that they might face
difficulties in getting funding because of a
liquidity squeeze in the market. In the meantime,
the Japanese Financial Function Early
Strengthening Law and other legislation enacted in
the autumn of 1998 attempted to provide a
framework for the stabilization of the financial
system.
In March 1999, about a month after
the adoption of the zero-interest-rate policy,
major banks were recapitalized by injection of
public funds. But the "convoy system" of bank
mergers shelters the weakest banks at the expense
of the strong. Moreover, fiscal spending was
increased significantly to stimulate economic
activity. But the yen money supply did not expand
because of a recurring trade surplus denominated
in dollars. The zero-interest-rate policy masked
the symptoms, but it did not address the disease.
There is visible evidence that something
similar will happen to the United States when
deflation hits. Many US companies would in fact be
walking dead in a deflationary environment even if
interest rates were set at zero. The recent trend
of mega-mergers reflects a drastic consolidation
in key sectors. Deregulated markets favor size as
a way to achieve market efficiency. Yet size has
repeatedly demonstrated itself as a disadvantage
in times of distress, as LTCM, Enron, GM and GE
have demonstrated.
Zero interest rate
powerless to stop deflation Interest-rate
policy can be a stimulant or a depressant in an
inflationary environment. But a zero-interest-rate
policy can have unintended adverse effects in a
deflationary environment. Since the cost of money
is near zero, there is no compelling reason for
banks to lend money, except for earning fees to
refinance loans made earlier at higher interest
rates. This creates problems for banks down the
road by reducing future interest income for the
same loan amount.
The narrow spread in
interest rates will also reduce bank profitability
and force banks to raise credit thresholds,
shrinking the pool of qualified borrowers. It can
also cause a distortion in income distribution in
the household sector by denying interest income it
would have otherwise earned by savers and
pensioners. It can create problems for pension
funds and insurance companies.
Structural
economic and financial reforms can be delayed by
too much easing of otherwise necessary cash-flow
pains. Market participants' risk perception can be
dulled. Institutional investors, such as
life-insurance companies and pension funds, can
then face difficulty in finding good investment
opportunities to pay for long-term commitments
made previously at high interest rates.
In
the US, where loan securitization is widespread,
banks are tempted to push risky loans by passing
on the long-term risk to non-bank investors
through debt securitization. Credit-default swaps,
a relatively novel form of derivative contract,
allow investors to hedge against securitized
mortgage pools. This type of contract, known as
asset-back securities, has been limited to the
corporate bond market, conventional home
mortgages, and auto and credit-card loans. Last
June, a new standard contract began trading by
hedge funds that bets on home-equity securities
backed by adjustable-rate loans to sub-prime
borrowers, not as a hedge strategy but as a profit
center. When bearish trades are profitable, their
bets can easily become self-fulfilling prophesies
by kick-starting a downward vicious cycle.
Total outstanding home mortgages in the US
in 1999 were $4.45 trillion, and by the end of
2004 this amount grew to $8.13 trillion, most of
which was absorbed by refinancing of higher home
prices at lower interest rates. When Greenspan
took over at the Fed in 1987, total outstanding
home mortgages in the US stood only at $1.82
trillion. On his 18-year watch, outstanding home
mortgages quadrupled to $8.821 trillion by the end
of third-quarter 2005. Much of this money has been
printed by the Fed, exported through the trade
deficit and reimported as debt. Given that new
housing units have been about 5% of the US housing
stock per year, at the rate of about 2 million
units per year, the housing stock increased by
100% over a period of 18 years while outstanding
mortgages increased by more than 400%.
The
BOJ's zero-interest policy, combined with general
asset deflation in the yen economy, has caught the
Japanese insurance companies in a financial vise.
Both new loan rates and asset values are
insufficient to carry previous long-term yields
promised to customers. Japan does not have a
debtor-friendly bankruptcy law, as the US has. At
any rate, insurance companies, like banks, cannot
file for bankruptcy in the US. As a regulated
sector, insurance companies are governed by an
insurance commission in each state, which normally
has a reinsurance fund to take care of unit
insolvency. The funds are nowhere near sufficient
to handle systemic collapse. The same happened to
the US Federal Deposit Insurance Corp (FDIC) in
the 1980s.
The insurance sector in the US
will face serious problems as the Federal Reserve
again lowers the Fed Funds rate targets and keeps
them near zero for extended periods. Several
segments of the insurance sector, such as health
insurance and casualty insurance, are already in
distress for other reasons. Government-insured
pension schemes are under pressure as troubled
industrial giants such as General Motors default
on their pension obligation, along with the
airlines.
In the era of industrial
capitalism, a low interest rate was a stimulant.
But in this era of finance capitalism flirting
fearlessly with debt, lowering rates creates
complex problems, especially when most big
borrowers routinely hedge their interest-rate
exposures. For them, even when short-term rates
drop or rise abruptly, the cost remains the same
for the duration of the loan term, the only
difference being that they pay a different party.
While debtors remain solvent, investors in
securitized loans go under. Credit derivatives
have been the hot source of profit for most
finance companies and will be the weapon of
massive destruction for the financial system, as
Warren Buffet warned.
Central banks are
still applying industrial-capitalism monetary
economics to the new finance capitalism. This
mismatch is the main cause of the multi-wave
financial crises that began in 1982 in Mexico and
developed with full force of contagion in 1997 in
Asia. In fact, in more than two years since its
1999 zero-interest policy announcement, the BOJ
has significantly expanded money as measured by
the monetary base, which is bank reserves plus
currency in circulation. However, broader measures
of liquidity that are more closely associated with
general price increases have not grown nearly as
rapidly for reasons stated above. The growth rate
of broad money, which includes individual and
business deposits at banks, has hardly increased
at all while BOJ holdings of foreign-exchange
reserves continue to increase. Moreover, bank
lending has not increased because of a liquidity
trap, caused by stubborn preference for liquidity
on the part of market participants.
As the
Japanese trade surplus adds to Japan's dollar
reserves, yen deposits and loans remain stagnant.
Even after adjusting for loan writeoffs, bank
lending was down 2.6% in 2002 and consumer prices
continued to fall. Japan was soaking up the
trade-surplus dollars in its economy with
sovereign debt denominated in yen and investing
the dollars in US securities. Instead of issuing
sovereign credit to stimulate the Japanese
economy, Japan was issuing sovereign debt to stall
the Japanese economy. Japanese asset depreciation
translates directly into dollar asset
appreciation.
Deflation in Japan fuels
stealth inflation in the US The reason the
increase in the growth rate of the yen monetary
base has not resulted in higher growth of loans
and deposits at Japanese banks, or a rise in
Japanese prices, was not, as some economists
suggest, that the increase in the yen monetary
base has not been sustained long enough. Nor are
more increases needed in reserve balances banks
hold at the BOJ, a key component of the monetary
base. The reason is that the institutional
anti-inflation bias of the central-banking regime
has deprived policymakers of any historical guide
in overcoming persistent deflation.
The
rounds of global deflation in the 1990s were
caused by financial crises resulting from the
systemic effects of dollar hegemony as sustained
by a global central-banking regime regulated by
the Bank of International Settlements (BIS). The
neo-liberal globalization of trade and finance
prevented all non-US-dollar economies from
effectively increasing their local-currency money
supply for domestic development.
To avoid
speculative attacks on their currencies aiming to
remain below market exchange rates to compete for
export market share, all increases in
local-currency money supply must be channeled to
fuel export for trade surplus in dollars. This is
a self-neutralizing game. As trade surplus mounts,
market pressure increases to revalue the currency
upward. To deal with this market pressure, the
central bank needs to soak up more dollars from
the domestic economy to hold as foreign-exchange
reserves.
This shrinks the exporting
economies' own-currency money supply while adding
to the dollar money supply to fuel the dollar
economy at the expense of non-dollar local
economies. Consumers in non-dollar economies are
robbed of purchasing power because low wages are
necessary to compete in the global export market
to accumulate trade surpluses in foreign
currencies, mostly US dollars. At the same time,
sovereign credit cannot be used to finance
domestic development to raise domestic income, for
fear of inducing speculative attacks on the local
currencies.
Unlike Japan, the deflationary
threat in the United States was halted by the Fed
lowering the Fed Funds rate to 1% by June 2004
mostly because the Fed can print money at will
with no penalty.
Central banking and
non-performing loans A recent BOJ report
highlights the nature of the non-performing-loan
problem in the Japanese banking system, in effect
arguing that NPLs are not simply the legacy of the
old bubble days, but reflect continuing problems
in the banking sector. There is truth to that
observation, but the BOJ report fails to note that
the NPL problem is a bastard child of central
banking.
The BOJ argues that the NPL
problem must be addressed quickly. And there is
also truth to that view. Problem loans do exert a
heavy toll on banks. Heavily burdened banks lose
the ability to focus on new lending to new
business opportunities. A banking system that is
weighed down by bad loans cannot fulfill its role
of gauging risk and return and channeling savings
to the most profitable investments. Banking
problems also exert a heavy toll on the economy.
Borrowers who are not servicing NPLs are
frequently owners of assets - property, buildings,
capital equipment - that are not being used
productively or profitably in a free market. And
below-neutral interest rates allow NPLs to linger
as if they were performing loans.
All this
is valid, but only in a central-banking regime.
Under a national banking regime, these problems
remain, but they take on a very different
character. Under national banking, rather than
private bank profits deciding what should be
financed, the national purpose decides what is
financially profitable. Furthermore, the claim
that cleaning out NPLs in the Japanese banking
system under a central-banking regime will revive
the Japanese economy has not been empirically
verified, even after years of painfully waiting
for Godot. It is only part of the snake-oil cure
promoted by the Washington Consensus to perpetuate
US dollar hegemony.
It is true that
unresolved NPLs freeze non-performing assets in
place and prevent them from moving to more
profitable activities. But it is also true that
under central banking, some profitable banking
activities may well be detrimental to the economy
as a whole. The US economy is full of examples of
this truism. The result is a robust financial
sector and a sick real economy. There are signs
that dollar hegemony is causing the same damage it
caused to the exporting economies also to the US
economy. The saving grace in the United States is
its debtor-friendly bankruptcy regime, left over
from the days of national banking before 1913 when
the US economy was under the domination of British
capital. But the US bankruptcy regime now does not
protect domestic debtors from foreign capital
because most of the capital now comes from
domestic pension funds. Most of the funds in the
US capital-account surplus go into US sovereign
debts with no insolvency risk as the US can print
dollars at will. Thus the liberal US bankruptcy
regime restructures distressed US companies by
liquidating equity positions and discounting debt
held by domestic pension funds and abrogating
labor-contract liabilities, but does not hurt
dollar creditors who invest overseas.
Under conditions of excess capacity,
failure to deal with NPLs will lock in excess
capacity, worsening deflationary pressures. But
solving the NPL problem in the wrong way, through
massive layoffs for example, will only add to
deflationary pressure. The solution requires more
than simply reducing or writing off debt.
Over-indebted borrowers are almost always
overextended businesses, having expanded into
activities with little economic benefit or
prospect of payoff. In the case of Japan, the
overextended business is export of manufactured
products for money that is useless in Japan. The
Japanese auto sector destroys more than the auto
sector in Detroit, it also weakens the Japanese
domestic economy.
Addressing the problems
of distressed borrowers requires substantial
restructuring in order to identify a profitable
business core, and in some cases liquidation of
the borrower is the only alternative. The Japanese
economy has been historically structured toward
export. It would be unthinkable to liquidate the
entire export sector.
However, it is quite
possible to make the export sector earn yen
instead of dollars. A yen trade surplus would
contribute to curing deflation in Japan. But it
will still not solve Japan's export-based economic
malaise because the US will not be able to buy
Japanese goods if it cannot pay for them with
dollars. To get yen, the US might actually have to
work for money instead of merely turning on the
printing press.
The Japanese export engine
has become unprofitable not only because world
trade is shrinking. The solution to the NPL
problem lies not in liquidating the export sector,
but in redirecting it toward yen-earning
developmental institutions. The catch is that this
redirection from foreign trade to domestic
development cannot be accomplished by relying on
neo-liberal market fundamentalism operating in a
central banking regime.
The market favors
trade over development because the market treats
development cost as an externality. When someone
other than the recipient of a benefit bears the
costs for its production, for example education
and environmental protection, the costs of the
benefit are external to its enjoyment. Economists
call these external costs negative
"externalities". These externalities amount to a
market failure to distribute costs and benefits
fairly and efficiently within the economy.
Globalization is basically a game of negative
externalities. Inhuman wages and working
conditions, together with neglected environmental
protection and cleanup, are other negative
externalities that protect corporate profit. It is
by ignoring the need for development and by
externalizing its cost that the market can deliver
profitability to corporate shareholders.
Development can only be done with a revival of
national banking in support of a new national
purpose of balance growth the will benefit all
equitably, rather than the systemic transfer of
wealth from the general public to a minority
owners of capital, mistaken as growth.
For
the 44 trillion yen ($384.6 billion) in loans to
corporations classified by Japanese banks as
bankrupt or in danger of bankruptcy, the harsh
choices are clear. But a more corrosive problem
arises with loans that are technically performing
but are taken by companies that are barely able to
keep afloat, have little prospect for long-term
survival, and have no possibility of ever paying
back the loan. These firms may be able to scrape
together their required interest payments in
Japan's low-interest-rate environment. How many of
the roughly 100 trillion yen in loans that "need
attention" fall into this category and are likely
to become non-performing loans is at the heart of
the dispute about the size of Japan's bad-loan
problem. This highlights the futility of a
central-bank interest-rate policy as a tool to
deal with deflation.
The critical issue is
how to deal with these walking-dead firms before
they spiral into bankruptcy, and while there is
still financial value and employment that can be
salvaged. In the United States, this problem can
be seen in the slow death facing General Motors.
But the answer is not retrenchment through
layoffs. The answer lies in turning these
distressed firms from export dinosaurs to
development dynamos domestically, regionally and
globally.
Instead of exporting cars and
video games, Japan can export education, health
care, environmental technology, management
know-how, engineering and design, etc, systems to
generate wealth overseas rather than products to
absorb wealth from overseas. This holds true for
all exporting economies.
Yet the delay in
addressing the NPL problem has not spared Japan
the pain of unemployment. Thus the NPL problem is
merely a symptom, not a cause, of the economic
malaise Japan has placed on itself by continuing
to pursue export for dollars as a national
purpose.
Export for dollars not a
viable national purpose For economic
growth to increase in any country it is necessary
not only for productivity growth to increase; it
must also accompany productivity growth with
consumption growth. Productivity is the amount of
goods and services that workers can produce in a
fixed period of time, such as a day or year or
with a fixed amount of capital. Productivity
growth is driven by the ability to move productive
resources - labor and capital equipment - from
low-productivity, low-value activities to
high-productivity, high-value activities.
Consumption growth in a modern economy cannot rely
merely on quantitative increase. It must take the
form of qualitative improvement. A higher level of
living standards includes a rising level of
health, culture, morals, aspirations and
sensitivities.
With Japan caught in a
liquidity trap, zero interest has had the effect
of the BOJ pushing on a credit string
domestically. But profits are being made by market
participants who borrow cost-free yen to invest in
low-yield US Treasuries, deflated real estate in
Japan and distressed yen and dollar debts. The
purchase of US Treasuries caused a temporary
inverted-yield curve in US debt market in the late
1990s, making long-term rates lower than the
short-term Fed Funds rate target set by the
Federal Reserve. This amounted to a black hole of
unlimited drain on the future of the Japanese
economy.
With potential yen depreciation,
this problem is further exaggerated, motivating
market participants to borrow yen to invest in
instrument-denominated in dollars. Overseas
investors had built up arbitrage positions between
JGBs and yen swaps on the assumption that swap
rates would not fall below JGB yields. But 10-year
swap yields were about 1.3% (November 27, 2002),
9.5 basis points below the 10-year cash JGB yield.
This prompted liquidation of JGBs against swaps,
leading briefly to serious contagion to other
markets. This type of mini-crisis is now
commonplace and hardly attracting notice in the
financial press. One of these days, it will add up
to a major systemic crash.
The fact is
that Japan, and really the whole world, cannot
solve its financial problems without facing up to
the reality that no free market or deregulated
markets exist now for foreign exchange, credits or
even equity anywhere. Arbitrary, secretive and
whimsical intervention on a massive scale hangs as
an ever-present threat over the global system of
financial exchange. Individual self-preservation
moves and short-term profit incentive will bring
the global system crashing down some Tuesday
morning. This is what Alan Greenspan means by the
need of central banks to provide "catastrophic
insurance".
But the bursting of the
Japanese bubble in 1990, followed by the long
period of financial deflation, put the
life-insurance institutions in the position of
having asset returns that have fallen below
interest payment commitments to policyholders.
Their own reserves have been insufficient to
absorb this shock. On the one hand, reserves were
reduced to a minimum during the bubble as
regulations on the use of capital gains and
constraints on reserves were relaxed.
On
the other hand, market values have depreciated
considerably since the euphoria has ended. Under
these circumstances, the life-insurance funds had
to reduce their guaranteed returns on new policies
as soon as possible, for their financial health to
be restored. But this revision did not take place
until 1995, when the guaranteed rate went from
4.5% to 3.5%, the latter still being excessive
given Japan's deflationary context. Thus these
institutions continued to sell policies likely to
generate losses up until the second half of the
decade.
The importance of these financial
institutions led the Japanese Ministry of Finance,
as well as the institutions themselves, to conceal
the weaknesses of the sector while waiting for a
recovery. As long as policies were not canceled or
did not mature, the opaque accounting system
allowed losses to be hidden from public view. But
as deflation took hold, such losses began to
surface visibly. Despite the high level of returns
offered, market saturation and economic recession
led to a fall in new policies. This in turn led to
a persistent cut in the current resources
available to the insurers.
Reimbursing
contracts reaching maturity by liquidating
corresponding assets would lead to more forced
revelation of losses. To prevent such liquidation
of assets, the insurers must therefore ensure that
current resources were higher than those in use:
hence they were forced to bid up returns to
attract new investors. This led to the development
of Ponzi-style finance. Savings were attracted at
a high cost and were meant to be invested, but in
reality were used to mop up losses on existing
policies. Financial charges rose as high-yield
policies reached maturity.
From 1996
onward, the losses associated with the returns gap
were declared in the Japanese insurance sector.
The fall in stock-market values and the
leveling-off of interest rates led to a collapse
in investment incomes and latent capital gains.
This double bind on the profit-and-loss account
led to the failure in May 1997 of Nissan Mutual
Life, whose disastrous management triggered a
slump in household confidence. The fall of new
subscriptions had been aggravated by an explosion
of policy cancellations; in short, there had been
a run on the funds, though less violent than in a
real banking crisis. The weak macroeconomic and
financial situation of the late 1990s thus led to
a self-fulfilling deterioration of solvency. To
satisfy their rising liquidity constraints, the
Japanese life insurers, which found it
increasingly difficult to borrow, were led to
liquidate depreciated assets in ever-increasing
volumes, exacerbating deflationary market forces.
Since 1997, each new bankruptcy
announcement has reduced the credibility of the
Japanese insurance sector as a whole and
intensified the crisis. While all institutions are
not in the same dire situation, low accountancy
standards tarnish all actors and reduce the
solvency of the sector as a whole, thus becoming a
self-fulfilling prophecy of doom. Official
pronouncements by the authorities, as well as from
the profession itself, have been that latent
capital gains in life-insurance portfolios should
make it possible to mop up losses, a position that
was previously applied to banks until their
recapitalization in 1999.
This argument is
still faulty. On the one hand, latent capital
gains (net of latent capital losses) have in
essence been exhausted. On the other hand,
cleaning up balance sheets by liquidating assets
in the middle of a crisis actually nourishes the
downward pressure on asset prices, reduces the
solvency of asset owners and worsens the need for
liquidity. This aggravates a vicious circle of
financial deflation, from which life-insurance
companies cannot escape by their own devices. At
the heart of the Japanese economy, these
institutions have now become an important factor
in worsening uncertainty and sustaining
deflationary macroeconomic pressures.
As
with the banks, Japanese life-insurance companies
are "not just another financial-services
institution". They have a systemic influence on
the economy, which is directed through three major
channels: 1) household savings; 2) long-term
financing; and 3) financial markets. Pensions in
Japan are mainly financed by capitalization.
Within this system, the life-insurance
institutions manage the major share of individual,
long-term savings, as well as a substantial share
of the savings collected by pension funds.
Overall, the financial holdings of the 18 mutual
funds are drawn from 96% of households and account
for more than one-quarter of their savings.
Confidence by savers in these institutions
is vital to the stability of behavior and the
long-term equilibrium of the economy. Conversely,
doubts concerning the solvency of mutual
life-insurance funds are leading to a general
feeling of insecurity about the future,
encouraging cautious behavior and a fall in
consumption, which in turn is feeding deflationary
pressures. The last two bankruptcies have affected
3.5 million savers, and may cause them to lose
part of their long-term savings.
A major
lesson from the Japanese crisis is that
institutional investors can raise systemic risk by
intervening in the financial markets. All such
investors must therefore be subject to supervisory
rules and strict prudential standards. This has
been common knowledge concerning banks for a long
time. It is a lesson learned with respect to the
Long Term Capital Management (LTCM) hedge-fund
crisis in the US and it is beginning to be learned
for pension funds and for the life-insurance
industry.
Henry C K Liu is
chairman of a New York-based private investment
group.
(Copyright 2006 Asia Times
Online Ltd. All rights reserved. Please contact us
for information on sales, syndication and republishing
.)
