Play­ing around with prices is a bad idea

The Pak Banker - - OPINION - Michael Schu­man

CALL me old fash­ioned, but I still think prices mat­ter. I vividly re­call the first time I stud­ied those sim­ple sup­ply-and-de­mand graphs as a col­lege fresh­man, and to­day, far too many years later, their ba­sic logic re­mains un­de­ni­able. When prices are right, money flows to the most pro­duc­tive en­deav­ors and economies work ef­fi­ciently. When prices are wrong, crazy things even­tu­ally hap­pen, with po­ten­tially dire con­se­quences.

That's why we should be very wor­ried about Ja­pan, where things are get­ting crazy. On March 1, the Ja­panese govern­ment sold bench­mark, 10-year bonds at a neg­a­tive yield for the first time ever. Think about that for a minute. The in­vestors who bought th­ese bonds not only loaned the Ja­panese govern­ment their money. They're pay­ing for the

Why would any sane per­son do such a thing? A govern­ment with debt equiv­a­lent to more than 240 per­cent of na­tional out­put -- the largest load in the de­vel­oped world -- should surely have to pay in­vestors a tidy sum to con­vince them to part with their money, not the other way around. But the bond mar­ket in Ja­pan has be­come so dis­torted that in­vestors be­lieve it's in their in­ter­ests to lend money at a cost to them­selves. The only ex­pla­na­tion is that prices in Ja­pan have gone hor­ri­bly, hor­ri­bly awry, and that has made the il­log­i­cal log­i­cal.

The cul­prit is the Bank of Ja­pan. The en­tire pur­pose of its un­ortho­dox stim­u­lus pro­grams -- quan­ti­ta­tive eas­ing, neg­a­tive in­ter­est rates -- is, in ef­fect, to get prices wrong: to press down in­ter­est rates below where they would nor­mally go and force banks to lend money in ways they nor­mally wouldn't. The BOJ, in other words, is try­ing to al­ter prices to change the in­cen­tive struc­ture in the econ­omy in or­der to en­gi­neer cer­tain re­sults -- to in­crease in­fla­tion, en­cour­age in­vest­ment and spark growth.

The prob­lem is that the BOJ hasn't achieved any of those ob­jec­tives. In­fla­tion in Jan­uary, by one com­monly used mea­sure, was a pa­thetic zero. Gross do­mes­tic prod­uct has con­tracted in two of the past three quar­ters.

In­stead, the BOJ is cre­at­ing new prob­lems by un­der­min­ing the price mech­a­nism. The cen­tral bank is buy­ing up so many govern­ment bonds that it has ef­fec­tively stripped them of risk to the in­vestor and cost to the bor­rower. In­vestors prob­a­bly bought up the bonds with neg­a­tive yields spec­u­lat­ing that they could flip them to the BOJ. Mean­while, since the govern­ment can now earn money while bor­row­ing it, the BOJ is re­mov­ing any ur­gency for Ja­pan's politi­cians to con­trol debt and re­duce bud­get deficits.

Worse, the cen­tral bank is un­der­cut­ting the very goals it's try­ing to achieve. By wip­ing out re­turns to in­vestors on safe in­vest­ments likegov­ern­ment bonds -- the yield curve on them is as flat as a pan­cake -- the BOJ is strain­ing the in­comes of savers and damp­en­ing the con­sump­tion that might help the econ­omy re­vive. If debt pres­sures fi­nally do push the govern­ment to hike taxes again, spend­ing will take an­other hit. This seems like am­ple proof that the BOJ's un­con­ven­tional strate­gies are go­ing too far. Yet shock­ingly, many econ- omists ex­pect the BOJ to do even more. "Ad­di­tional BOJ eas­ing … is a mat­ter of when, not if," HSBC econ­o­mist Izumi De­va­lier noted in late Fe­bru­ary.

None of this should come as any sur­prise. Ja­pan has ex­per­i­mented with get­ting prices wrong since the end of World War II -- for both good and ill. To pull the coun­try out of the ashes, Ja­panese lead­ers di­rected credit and em­ployed other tools to prod in­vest­ment. That spurred decades of hy­per-charged growth, but also led to mas­sive ex­cess ca­pac­ity.

In the 1980s, the BOJ kept money in­ap­pro­pri­ately loose in an at­tempt to counter the im­pact of a stronger yen on Ja­panese cor­po­ra­tions. That helped in­flate one of the great­est price dis­tor­tions in mod­ern his­tory -- Ja­pan's gar­gan­tuan as­set bub­ble. Since the Nikkei's crash, the cen­tral bank has re­peat­edly tried to ma­nip­u­late prices to cor­rect the fall­out from get­ting them wrong in the first place. The red flags for other coun­tries abound. Lead­ers in China, which used sim­i­lar price-al­ter­ing tac­tics to fuel its eco­nomic boom and is suf­fer­ing from sim­i­lar prob­lems as a re­sult, might want to ac­cel­er­ate their promised pro-mar­ket re­forms to help set prices right, and the econ­omy with them. For other cen­tral banks around the world, most no­tably the Euro­pean Cen­tral Bank, which has also adopted neg­a­tive rates, Ja­pan's case should of­fer a cau­tion­ary tale of the pit­falls of twist­ing prices too much.

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