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Great Leap Forward

WSJ Warning on Japan’s Fiscal Sphincter

You have to wonder what they are snorting over at the Wall Street Journal. Read this and weep: Tokyo Panel Urges Abe to Tighten Finances

Here’s the conceit.

“Fiscal reconstruction has become all the more important” because of Prime Minister Shinzo Abe’s aggressive monetary and fiscal stimulus measures, the report said, while warning that a loss of fiscal rectitude could send bond yields higher and undermine the efforts of the Bank of Japan to stimulate the economy.”

Aggressive monetary and fiscal stimulus? Loss of fiscal rectitude? Have we gone all Freudian, worrying about Japan’s anal sphincter?

Here’s our WSJ’s take on Japan’s loss of anal rectitude:

“…the central bank launched an aggressive bond-buying program in April. The BOJ’s change in stance initially pushed bond yields down. But uncertainty over the impact of buying on such a huge scale—up to 70% of newly issued debt—saw yields bounce back up.  As the country’s currency, the yen, broke above 100 to the dollar earlier this month for the first time in more than four years, bond yields climbed along with equity prices. When they hit 1% on May 23, a level not seen in more than a year, the equity market’s upward march halted.”

Bernanke’s QE has been described in exactly the same terms: aggressive bond-buying. What exactly does that mean? Uncle Ben enters your home with an AK-47 and demands to buy all your bonds?

I don’t think so. Rather, the Fed and the Bank of Japan offer to buy bonds at a price you like. At a higher price, you sell; by the mathematics of prices and yields, that means returns on bonds will be low. Indeed, that is the goal of QE—no matter how ill-advised the policy might be.

Note the impact in Japan when “markets” reacted against that nation’s new version of QE: yields rose all the way to 1%!. Read that carefully. One Percent. Oh, those damned Bond Vigilantes are holding the entire nation hostage! Better tighten the nations’s fiscal belt to keep that fiscal sphincter under control. Otherwise, the Vigilantes might demand a whopping 1.1%! Who knows, maybe even a bankrupting 1.2%!

All of this silliness comes on the heels of a new report by an advisory panel to Japan’s finance minister that warned “Unless the government moves ahead with and makes progress in fiscal consolidation, the BOJ’s policy could be viewed as an act of debt financing by the central bank, causing bond yields to rise, and canceling out the effects of its monetary easing.”

Oh My Goodness: debt financing by the central bank! Could cause bond yields to rise! Vigilantes on strike.

No, you morons. Government deficits always increase reserves in the banking system. That places downward pressure on the overnight interbank lending rate. Selling bonds normally relieves that pressure. But if you’ve already achieved ZIRP (zero rate target) then you don’t need to sell them.

For operational reasons, you might be required to sell bonds (this is a typical requirement) even with a ZIRP. In that case, the bonds will sell at a small premium over what the central bank pays on reserves. If the overnight rate rises above target, that triggers an open market purchase by the central bank. “Debt financing” by the central bank! Oh, my!

So-called “debt management” policy can complicate matters a tiny bit. If the treasury tries to sell, say, 30 year treasuries but the market prefers 2 year bonds, then you can drive the rate on the longer maturities up a bit. Maybe all the way to 1.1%!

Is this scary? Is there an alternative? Of course there is. Leave excess reserves in the banking system and simply pay a base interest rate on them. Or, sell 30 day bills and pay a slightly higher rate. Or 5 year maturities. And so on. The farther you go out the maturity structure, the greater the potential for capital losses when the central bank reverses policy and starts to raise overnight interest rates. That is why it is normally hard to push long term sovereign government rates below about 2%.

In any case, the Central Bank can always determine the rate on bills or bonds, no matter what the maturity, if it deals in those maturities in a sufficient quantity. That is not usual behavior and probably is not desirable. But it is a policy choice.
Is there any chance that Japan will become subject to the whims of Bond Vigilantes, who vote against the solvency of Japan, Inc? Of course not. Japan is a sovereign currency issuing nation. It will make all payments as they come due. The interest rate it pays on reserves and bills and bonds is always potentially under its control—all it needs to do is to exert its discretionary power to set the relevant rates.

So the following argument made in the report is pure nonsense:

The report also noted that a rise in bond yields would also complicate the task of the exiting the so-called quantitative easing program down the line. Under a newly introduced inflation target, the BOJ is obliged to achieve 2% price growth, and the bank has said it would keep its aggressive easing in place until it secures that target. The report said that “even if the BOJ wants to reduce its government bond purchases, it won’t be able to do so unless there are alternative buyers of bonds in the market.” Without private sector buyers, long-term interest rates could go up far beyond levels in line with economic growth rates, the report warned.”

Angels on pinheads. There is little likelihood that there would be no “private sector buyers” as banks with excess reserves will prefer to exchange them for higher-earning bonds. The Bank of Japan can always keep long-term rates low, but even if it did not want to do so the Treasury can simply refuse to issue long-term debt, focusing on short maturities instead.

(Usually the treasury deals with special banks—the dealer banks—that are pre-committed to buying treasuries. So the only question is over price, anyway, not over whether the market will take treasuries.)

Finally, the WSJ noted “The report urged the government to produce a credible and concrete fiscal reform road map that would include specific numerical targets, rather than just expressing a strong determination.”

But haven’t we recently learned that the Reinhart&Rogoff and Alesina arguments in favor of “fiscal consolidation” were all based on faulty empirical work and faulty theoretical reasoning?

Yes, we did.

21 Responses to “WSJ Warning on Japan’s Fiscal Sphincter”

DismayedMay 28th, 2013 at 3:25 pm

Thank you, Professor, for another dose of sanity in an insane world.

From a recovering U Chicago MBA.

Tyler HealeyMay 28th, 2013 at 6:09 pm

It seems that monetarily sovereign nations can engage in fiscal stimulus even at full employment, as long as it is combined with deflationary monetary policy.

jack strawMay 28th, 2013 at 8:35 pm

i agree…good retort. of course…the WSJ is interest in "return of capital" here as well. if you're all in in Japan and CURRENCY traders take notice…you can lose the bulk of your principle and have very little to show for it via interest rate compensation. the bottom line is Japan is not the USA…nor is anyone else for that matter. this is a reserve currency we're talking about here…you can i agree..for lack of a better word…"sacrifice it"…in order to try and generate economic growth. this has in fact happened (everyone abandoned the dollar in 2008) and yet instead of yields soaring, gold annihilating, stocks crumbling, the Stay Puff Marshmallow Man appearing etc you got…well, something kinda boring actually. we still don't have a recovery worthy of the name…nor do a i see one coming anytime soon. Federal largesse is just too much…the bulk of this recovery still goes to taxes thus lowering growth FAR below where it should be given all of what is going on. since the bulk of Government is transfer payments "you really don't have much to show for here." a simple diversified portfolio for the last 30 years has utterly annihilated every other asset class globally. but this is New York…all about the big time. LBO's, M&A's, "taking down countries" etc…etc. the media capital of the world is there for a reason…to "make this stuff happen"…and so far that's exactly what they've done.

L. Randall Wray L. Randall WrayMay 28th, 2013 at 9:00 pm

Tyler: unfortunately policymakers don’t even know what deflationary monetary policy is. QE is mostly deflationary. They think it is inflationary! So they are using fiscal austerity and also deflating through QE. Piling on the headwinds.

Johnny GarzaMay 29th, 2013 at 1:37 am

Dr Wray this is off topic I suppose, but I wanted to see what you made of this article from a few economist from the Fed Christopher J. Erceg and Andrew T. Levin Their article was posted last month here http://www.bos.frb.org/employment2013/papers/Erce
Would you possibly translate in laymens terms. Are they not saying in a nutshell they think they have figured out how to control wage decreases and still keep us from going into a depression?

L. Randall Wray L. Randall WrayMay 29th, 2013 at 2:05 am

Very silly stuff. Surprise, surprise, today’s unemployment was largely caused by the Global Financial Crash! Who wudduv known? That’s why Fed researchers get the big bucks. Their solution? Have that Wizard at the head of the Fed turn those dials to magically create jobs with well-timed monetary policy changes. Right. Might as well try to move the moon with the tools they’ve got. When you want jobs, do not turn to the Fed. Uncle Sam has the magic porridge pot and he can create the jobs directly.

Erik JochemMay 29th, 2013 at 10:05 am

got it. One question though: When WSJ talks about bond yields do they mean yields on the primary or on the secondary market ? I guess the latter, no ? Or is this distinction irrelevant and if, why ?

L. Randall Wray L. Randall WrayMay 29th, 2013 at 11:54 am

Erik they move together. You pay, say $98 to buy a bond that pays you $100 a year from now. Your yield is $2. That is why we say the prices and yields move in opposite directions. If you pay only $95 then your yield is $5.

Tyler HealeyMay 29th, 2013 at 12:00 pm

Thanks, Dr. Wray.

Just when we think Krugman has finally got it, he writes yesterday, "[I]f we choose to raise less revenue from the rich than we can without hurting the economy, we will be forced either to raise more taxes from or provide fewer valuable services to everyone else."

Erik JochemMay 29th, 2013 at 5:54 pm

yeah, what you describe is the mechanism on the secondary market: with rates low relative to nominal value of the bond you earn an extra yield which adds to the one promised by the government when issuing the bond.__This last yield has to be something above the yield paid for reserve holdings by the banks so they get an incentive to move their central bank money into bonds. So this primary yield is a function of the yields payed on reserves or the overnight lending rate policy of the Fed and as such very much under control.__The additional ("secondary") yield due to lower rates is under control because the Fed can intervene at the secondary market at will and thus control the rates and the ensuing "secondary" yield (got that refreshed meanwhile from an article over at Bill Mitchell's).__

Erik JochemMay 29th, 2013 at 5:54 pm

So technically there doesn't seem to be a link between the secondary and the primary yield and that's where the confusion starts in the media. High yields on the secondary market (primary and secondary yield combined) don't mean high primary yields (I think) on the Primary market and low rates on the secondary market don't indicate buyers will go on strike in the primary market, because otherwise they would lose money that the governement is ready to pay in primary yields compared to lower or no yield for simple reserve holdings.__Thanks a lot for allowing comments.__

L. Randall Wray L. Randall WrayMay 30th, 2013 at 1:50 am

Yep. Why not just say the truth. The rich are too rich. We need to reduce their richness by taxing the hell out of them. Honest. To the point. Politically popular. Win-Win-Win.

L. Randall Wray L. Randall WrayMay 30th, 2013 at 1:53 am

Erik you lost me. I thought you were there, but maybe not. They are competitive. You can buy old bonds or new ones. Either way they must give you the same yield to maturity.

dannyb2bMay 30th, 2013 at 2:10 am

Isnt the lower interest income more than offset by the outright buyput of the security?
Grandma doesnt know anything about interest.

Erik JochemMay 30th, 2013 at 8:57 am

o.k. you're right, I don't get it. You buy a new bond – from the treasury – for 100 with a promised yield of 2 %. If you keep it until maturity the treasury will pay you back 102.
If I buy the same bond as an old one "on the market" for 90 I will also get back 102 but the effective yield is much higher (13.3 % instead of 2 % all other things equal). The promised yield from the treasury of course is the same in both cases. But an extra yield comes from the fact that I bought a 100 bond for 90.

nmmaierMay 31st, 2013 at 1:18 am

We are going to witness the collapse of the world's third largest economy with Abe's policy in Japan. It's not the Bond Vigilanties that are the problem. It's that 59% of the households in Japan own JGBs. Abe has told them that he wants 2% inflation. But their JGBs only pay .08%. The cracks are starting to appear with the rise in yields on JGB going from .5% to 1% causing the Nikkei plunge 7%. Watch what happens when housholds really start dumping their JGBs. If interest rates on JGBs go up 3%, the Japanese government will be spending 80% of its budget on interest payments.

PZMay 31st, 2013 at 7:27 pm

There seems to be lot of people who get causal relations backwards, like private sector funding the government and not the other way around. We should call them backwardians.

I wonder if operational people at the central bank or at the treasury could give some further educational courses on the topic how the government actually spends. Backwardians have been let down by the existing educational structure.

L. Randall Wray L. Randall WrayJune 2nd, 2013 at 3:16 pm

erik: no, the prices of existing (“old”) bonds adjust, too.Maybe I paid 90 years ago for a long maturity bond. But if the fed has lowered the overnight rate to near zero, i can sell that bond for a lot more now–this is why i get capital gains when rates go down.

here’s the big fear now. I am paying maybe 97.5 for a long maturity bond that will pay me 100 in some years. When the fed reverses course and raises its overnight rate (say to 5%) then i cannot sell the bond for anything like what i paid–no one will pay me 97.5 for a bond that will only get them 100 if they can now buy even short term bonds for 95 to get 100 a year from now. i suffer capital losses.

prices and rates move in opposite direction. old issues compete with new issues, so prices adjust.

L. Randall Wray L. Randall WrayJune 2nd, 2013 at 3:22 pm

MNN: place your bet! Suckers have been making that bet for 20 years now, losing fortunes. Japan’s policy has been terrible for 20 yrs, but it is a sovereign currency issuing nation. So in spite of all of its problems and as well completely confused policy, it will not collapse, and suckers like you will continue to lose fortunes.