Tuesday, April 26, 2016

How the Bank of Japan is Destroying Financial Markets

This week in horrible economic policy news, we learned that the central bank of Japan is top 10 shareholder in fully 90% of Japan's leading public companies. Admittedly, this probably sounds like an exceedingly mundane and boring fact if you aren't too familiar with how central banking works. But once you understand what's going here, you will recognize it for what it is--a scandalous economic policy that is destined to go down in flames, and take many innocent bystanders with it. In this post, we'll explain what this policy is, why it matters, and why this is another sign that the global economy is well on its way to the next collapse.

Central Banking and Monetary Policy*
The central bank can be thought of as the bank for banks. It is the institution where commercial and consumer banks store their extra cash, and it is well-known for serving as the lender of last resort to prevent bank runs. Individual banks never have enough money on hand to fulfill all the deposits that have been made with them. The reason for this is that some of the money stored by individual depositors has been given out in loans to other customers. This is where the name fractional-reserve banking comes from. At any given time, each bank only has a fraction of their total deposits on hand and ready to meet deposits. Though this fact is not commonly understood, there's actually nothing inherently underhanded or shady about it; it's just how the modern banking system works. And because modern banking works this way, all banks are always technically at risk for a bank run where many of their depositors come knocking all at once and demand more cash than the bank can provide. This can probably be viewed as the main reason that central banks came into being--to lend banks money when they are faced with a bank run.

In the aftermath of the Great Depression and with the steady rise of Keynesian economics, however, the US central bank, the Federal Reserve, eventually adopted a broader role. Now the Fed's mission is not only to serve as the lender of last resort, but to also manage the money supply (which is precisely what it sounds like, the amount of money in existence) in order to ensure a healthy economy. And in particular, the Fed's goal was to ensure both low inflation and low unemployment, often referred to as the dual mandate. And the basic way they go about pursuing this goal is by adding money to the economy (by lowering interest rates and/or directly injecting money into the system) when it is in a slump, and reducing money in the economy when it looks like it is overheating. In practice, the first part of that process, injecting more money, happens frequently, but the second part rarely does.

For our present purposes, the key thing to understand is that the central bank, in the US and elsewhere, literally has the power to create money out of nothing. When it wants to inject new money into the system, it will frequently buy US Treasury Bonds. And when it makes these purchases, it usually does so with money that, prior to the purchase, did not exist. It sounds strange, but it's the truth. The only difference between a counterfeiter and a central bank creating money is that it's illegal for the counterfeiter; if they were both using the money to purchase Treasury Bonds, the impact on the actual economy would be the same. Obviously, this is a very significant (and dangerous) power.

If the central bank does too much money creation, there's a risk of having massive inflation. In the current situation, however, with consumer spending down and oil prices down as well, most consumer prices are basically flat. Thus, most central banks have judged that the risk of inflation is limited, and that we might actually need more of it. You see, most mainstream economists view deflation (generally falling prices) as the supreme evil that must be avoided at all costs.** And to prevent this from occurring, they are pulling out all the stops to get more money into the economy and cause inflation.

What to Buy
We mentioned above that the Fed typically buys Treasury Bonds (US Government debt) when it wants to inject money into the economy. There's a good reason for this. Treasury Bonds are very heavily traded, which means they are easily bought and sold. It also means that the Fed's purchases or sales on any given day probably won't have a huge impact on the broader market; they're still a large player, but their presence is diluted by the actions of so many other investors. Another benefit is that the value of Treasury Bonds is relatively stable. And to the extent that the Fed profits off of the interest on US Government debt, that gets remitted back to the US Government at the end of the year anyway, just like all of the Fed's net profits. So, viewed in the most optimistic sense, this is sort of like one arm of the US government lending to another arm. (Yes, people pretend the Fed is independent, but we've previously explained how deeply silly this belief is.) In effect, the Fed's demand for US government debt, subsidizes the government's borrowing costs. And given that it's inevitable that the Fed's efforts to inject money will subsidize something, this is probably about the least distortionary effect. That doesn't mean it's a good thing, but it's probably the least bad.

A related point here is that it matters what the underlying assets are. Each time the Fed wants to inject money into the market, it acquires an interest in real assets. When it buys government debt, it gains an interest in the government's assets. If the US government were to default, then the central bank (again, effectively a different branch of the government) theoretically would gain some power over US government assets. Again, this isn't ideal, but you could do worse (as we'll see).

So to revisit, if a central bank is going to buy financial assets (and most, if not all, of them do it), the things it buys should have the following characteristics:
  • Highly liquid
  • Highly traded market (so the central bank doesn't make a big dent in the price)
  • Stable value
  • Limited subsidy impact
  • Neutral ownership interest (owning other government assets)
The Case of Japan
Now that we've laid out some general principles about how central banking is supposed to work, we can observe how the central bank of Japan is blatantly violating them. The unoriginally named Bank of Japan (BoJ), has had a policy of buying Japanese government bonds just as the Fed buys US debt. However, the BoJ has actually implemented an even more aggressive form of Keynesianism over the years than the US has. Indeed, the BoJ has purchased so much of Japanese government debt that it was starting to harm the liquidity of the market--that is, it couldn't find enough sellers to buy from. But since the threat of deflation still looms large in their mind, the BoJ turned its attention to purchasing other assets besides government debt, all in the name of trying to stimulate the economy by adding more money.

One of the asset types it turned to is an ETF, or exchange-traded fund. This is effectively a mutual fund that is traded on the open market, so it's effectively a basket of major stocks. Thus, once we peel back the layers, the fact is that the BoJ has been purchasing stocks for some time now.

And all of that leads us to terrible headline from Zerohedge yesterday, "In Shocking Finding, The Bank Of Japan Is Now A Top 10 Holder In 90% Of Japanese Stocks". That is, the BoJ has purchased so many stocks that it's now one of the dominant shareholders in 90% of the major public Japanese companies, which are listed in the Nikkei index (effectively, Japan's version of the S&P or Nasdaq).

This fact is shocking and problematic for a whole host of reasons. Let's use our original criteria above to spot a few:
  • Less liquid and less heavily traded - While the BoJ owns shares of large, highly traded companies, the fact is that stocks are much more prone to panic sell-offs than government debt. If the BoJ tried to sell off its stake, the value would likely decline rapidly.
  • Unstable value - Obviously, stocks are not known for having a stable value over time
  • Subsidy - The BoJ is now effectively subsidizing the shareholders of individual companies
  • Ownership - The BoJ, which is to say the Japanese government, has now accidentally gained a large ownership share of major companies.
Another important fact is that this completely distorts stock market prices and deprives investors of the ability to make accurate decisions. As it stands, the Nikkei has dropped over 13% over the past year. Imagine how much more it should have dropped, if the BoJ had not been using its money creation power to artificially prop up the prices. Given the significant holdings the BoJ now has, the difference is likely to be considerable.

Of course, few people like the idea of falling stock prices. But it's more important for stock prices to reflect reality than it is for them to maintain a certain price level. Stock prices are used to help allocate scarce investment capital among different companies; if the prices are manipulated, then the allocation will eventually be wrong too. As an example, if a company starts losing money, its stock price needs to fall. This will likely have some adverse consequences for management and help motivate them to improve performance. Additionally, it helps prevent new investors from pouring more money into the company at high prices, when other companies might be a better value. If the prices get distorted, the entire market process is liable to break as well.

The problems get compounded further if we assume the central bank is deliberately trying to prop up stock market prices, which there is some evidence for in the case of Japan, as noted in the Zerohedge piece. If this is the case, the central bank has exactly the wrong incentives. A typical investor in the stock market is looking for companies that may currently be undervalued and likely to perform well in the future. By contrast, the central bank's only incentive is to prevent prices from falling, regardless of actual value. And since the companies that are performing the worst are likely to have the fastest falling stocks, it follows that the central bank will tend to give the most money on the worst performing companies.

If pressed on the rationale for this program, the BoJ would likely argue that their actions are necessary to stabilize the economy (by injecting money generally) and protect small investors from getting wiped out. But here we must remember that stock prices are not an end in themselves. If a company is failing, the BoJ's action to prop up its stock will not save it. Indeed, it might actually cause the company to behave more recklessly as the executives in charge feel no pressure to change. At best, the BoJ could delay a stock market collapse; it can't actually prevent it.

There's also a strong corruption angle here. In a market environment where market prices are no longer based on the profitability and fundamentals of the underlying company, small investors don't have a chance. Even if they understand finance and economics, it's useless because the company's performance is no longer the key driver of the stock price. Instead, the key driver becomes central bank policy, and the only way for investors to make money is to guess (or quietly learn) the central bank's policy in advance. This opens up the opportunity for well-connected financiers to get tips, but the average small investor is going to be left out in the cold.

And all of this explains why this story is outrageous. The BoJ is printing new money to benefit public company shareholders. And in the process, it's massively distorting financial markets, subsidizing inefficient companies, denying small investors any chance at success, and, on top of it all, subtly nationalizing private companies. This policy is a clear act of desperation by the BoJ, and the unintended consequences are certain to be devastating. For now, it's barely keeping the Nikkei afloat. But when it finally crashes, the policy helps ensure the collapse will be as painful as possible.

*Before we get started, note that none of what follows should be taken as an endorsement of central banking. I share the view common among the Austrian School of economics that the net impact of central banks on the economy is decidedly negative. But that larger issue is not the subject of the present post. Thus, we're going to describe the central bank in a neutral way and describe the role that more conventional economists believe it should play in the economy.

**There are compelling reasons to reject this idea in general, but for our present purposes, we'll just stick with the mainstream view.

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