Japan QE, Moral Hazard, Bubbles and Economic Distortions
We don’t believe that here is a realistic case for completely abolishing all government and leaving everything to market forces. Financial sector regulation is obviously a case in point. However, one has to realise that government comes at a price, and we’re not just talking about taxes. Any intervention by a government or a central bank creates a distortion of the economy.
A very simple example would be the government ‘stimulating’ the economy by building a bridge to an island where the population is say 5 people. The economic rationale for the bridge is tenuous at best, but it does temporarily keep a team of bridge builders in work – at least until the bridge is built. The new bridge will shorten the time the 5 inhabitants need to spend in order to get to the mainland, but their economic benefit in terms of time (and thus money) will likely never justify the total cost of the bridge in a strict economic sense, especially when one considers that the ferryman was rendered unemployed once the bridge was finished. The economy has thus been distorted away from productive investment towards unproductive investment or mal-investment.
Another simple example is the fact that mortgage interest rates are tax deductible. This is well intended and goes along with the idyllic idea that people should all own their own home. But this is effectively a wealth transfer from renters to home owners through taxes, because of course these deductions need to be financed by government somehow. So the question becomes, should the government really transfer wealth from renters to home owners? And why is the government artificially inflating the housing market, and depressing the renting market?
Yet another recent example is the creation in the US of the CRA (Community Redevelopment Act), which forced financial institutions to lend more to what was perceived to be disenfranchised geographical areas and ethnic groups in the US. This was all well intended, but it inadvertently gave birth to large-scale lending through Fanny May and Freddy Mac, to sub-prime borrowers. These borrowers were deemed to be sub-prime for a reason, but because of the political imperative of making lending and home ownership accessible to virtually everyone, this lending exploded in scale and ultimately led to the collapse in sub-prime derivates, the effects of which are well know by now.
Looking at monetary policy as another example, both artificially low interest rates and an artificially high level of liquidity available is damaging to the economy’s ability to efficiently allocate productive resources or capital.
Interest rates should ideally be set by the capital markets, and should reflect an equilibrium price that balances the supply and demand for credit, thus clearing that market. In artificially lowering interest rates below equilibrium levels as set by the capital markets, the central bank effectively transfers wealth from creditors to debtors (which is hardly an incentive structure the government should encourage). What is worse, the artificially low interest rates diverts capital away from more sound investment projects towards more risky and lower return investment projects that would not have been financially viable if rates had been set by the market. This distortion inhibits value creation in the economy overall. Among many other things, it also interferes with the ability of pension funds to meet their return requirements, thus leaving large holes in their asset/liability matching for future pensioners.
Intervention in the capital markets through artificially low interest rates and excessive liquidity also creates highly destabilising asset bubbles in various asset classes. Artificially low interest rates also discourages saving and encourages spending, driving the two to unnatural disequilibrium levels and ultimately causing unsustainable private sector debt levels (which then turn into public sector debt once the government deems it necessary to institute some form of debt forgiveness or bail-out).
Conceptually, these points are not particularly profound, but they are quite important in the case of Japan, simply because of the sheer scale of the latest chapter in the quantitative easing saga of the BoJ.
Exactly how the BoJ is expecting to be able to avoid bubbles and other economic distortions as a result of its massive Quantitative Easing (QE), is mind boggling. Especially so since the BoJ is actually going to buy listed REITs (Real Estate Investment Trusts) on the open market. This has obviously already been front-run by the market, thus enriching speculative buyers of these assets. Of course, the BoJ now has to buy these asset classes at a higher price, and the only people that could possibly finance these purchases are the tax payers. So effectively the BoJ, just by making this announcement, has already created an economic distortion through a wealth transfer from tax payers to equity market speculators.
An additional point that should be raised here is that this type of direct intervention in the equity market will create moral hazard issues for the market as a whole. First of all, the funds that would ordinarily have been sensibly invested in other stocks based on their earnings potential and valuations, are now being diverted away from those ‘sound’ productive investments and into speculative REIT investments, simply because the average investor will attempt to front-run the BoJ. Secondly, once the BoJ has intervened once in a certain segment of the market, it is straight forward to assume that investors will subsequently try to guess which area of the market might be the next target for direct intervention. Could it be bank stocks? Could it be insurance stocks? Any sector that appears as a likely candidate for intervention will be bid up purely on speculation, thus again diverting funds away from sound investments, and creating another distortion in the market and in the real economy. Given Japan’s experience with housing bubbles in the past, it is frankly beyond incredible that the BoJ is potentially igniting another bubble in the same market. Below is a chart showing Japanese house prices going back to 1980:
Even in a reasonably functional economy, intervention with its resultant distortions is negative for the longer term outlook for that economy. For a dysfunctional economy such as the Japanese, that desperately needs restructuring, value creation, efficient capital allocation and investment, causing more distortions through bubbles and mal-investments because of excessive monetary ‘stimulus’, is potentially catastrophic and seems to us to be highly irresponsible.
Keep looking up, because that’s where prices are going – at least in nominal Yen terms…