Good morning from Japan!
Behind me is the Tokyo headquarters of the Bank of Japan (BOJ).
It’s Japan’s equivalent to our Federal Reserve. And like the Fed, its mission has morphed from controlling inflation to combating deflation.
From the outside, everything seems hunky-dory: BOJ officials going about their daily business as usual … Japanese financial markets relatively steady … Japan’s GDP holding up OK for now.
Inside this building, however, lurks a monetary time bomb.
It’s a bomb that’s been gaining in potency for over two-and-a-half decades.
It packs more megatons than virtually any financial stress point in Europe or the U.S.
And when it blows, it could drag the economy of Japan, most of Asia and much of the world down with it.
I’ll explain exactly why in just a moment. But before I do, let me tell you how I got here.
Back in 1980, while I was working in Japan, one of Japan’s largest brokerage firms asked me to launch Gaikoku Saiken Nu-zu, a newsletter on foreign bonds.
I met frequently with officials of Japan’s banking and government community. I often covered the Bank of Japan. And I’ve been tracking it ever since.
Now, I can tell you flatly:
If you think the U.S. Fed is caught in a dangerous policy trap, wait till you see the massive hole that Japan’s central bank has dug for itself.
Here’s the crux of their dilemma:
Both the Fed and the BOJ have been pursuing the most aggressive easy-money policy in modern history.
Both have deployed the same two weapons of mass financial destruction — unbridled money printing and absurdly low interest rates.
And both central banks have done all this despite record federal deficits with massive government borrowing.
That’s the great monetary paradox of the 21st century, a paradox that both central banks share:
A. Big government borrowing and debts, which, by all accounts, should drive interest rates (especially long-term rates) dramatically higher, while, at the same time …
B. Massive, Herculean efforts by the central bank to smack down interest rates (especially short-term rates) to unheard-of lows.
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Those are the things that the U.S Fed and Bank of Japan have in common, and they are shocking enough. But it’s the four critical differences between them that are truly mind-boggling:
First, the U.S. Fed has been on its monetary rampage since 2008, when the U.S. housing market collapsed and Lehman Brothers failed. But …
The Bank of Japan has been on this tricky track since the early 1990s, when its commercial real estate market fell apart and some of its largest banks failed. That’s eight long years of extreme money easing in the U.S., compared to 26 years in Japan, or over three times longer.
Second, the U.S. Fed knocked its official interest rate down to nearly zero, a phenomenon so strange that even prominent Fed officials have expressed shock and awe. But …
If you think that’s extreme, consider Japan’s “new and improved” formula for monetary excess — below-zero interest rates: For much of the money that Japanese banks keep on reserve with the BOJ, instead of earning a yield, they must actually pay the BOJ 0.1%. (The BOJ’s goal is to penalize Japanese banks for not lending enough.)
Third, the Fed has pushed rates down by buying up all kinds of bonds. But …
The BOJ has gone far beyond bonds. In its zeal to hold interest rates down and to support its financial markets, it has broken radically with past practices by buying up Exchange Traded Funds (ETFs), Real Estate Investment Trusts (REITs) and other investments that the U.S. Fed wouldn’t touch with a ten-foot pole.
Fourth, the U.S. government debt is 104% of GDP, considered extremely worrisome. But …
Tokyo’s public debt is 229% of GDP, or more than double Washington’s. In fact, as Larry Edelson has pointed out, it’s even bigger than the debt burden of the chronically impaired country that has already nearly toppled global markets — Greece, with a public debt load that’s 177% of GDP.
Multiply out each of these four factors …
- The BOJ’s history of monetary excess, which is three times longer than the Fed’s …
- The BOJ’s below-zero interest rate policy, which is even more aggressive than the Fed’s zero-rate policy …
- The BOJ’s audacity to break radically with central bank practices, buying up ETFs, REITs and other investments …
- Japan’s budget deficit burden, which is more than double ours …
And you will see that a monetary eruption in Japan could pack far more power than the equivalent events in the United States.
Precisely how could that happen and
what would be the consequences?
For the answers, I just interviewed a very astute Japanese economist whom I’ve known since 1980. (He wants to remain anonymous. So I’ll refer to him simply as “Mr. X.”)
Here are his own words, which I’ve translated and edited for clarity:
“Yes, the BOJ’s situation today is indeed a time bomb. No one can say precisely when it’s going to explode. But I can say with near certainty that it will explode one day.
“There are three possible trigger events that could set it off.
“First, the yield curve in Japan. Right now it’s extremely flat because Japan’s short-term interest rates and long-term interest rates are both near their lowest levels of modern times.
“That may be what the Bank of Japan thinks it needs to support the economy and fight deflation. But it’s terrible for bank profits. How is it possible for Japan’s banks to make money when their profit margin is practically nothing, when they can’t charge hardly anything for their loans?
“So pressure is building on the Bank of Japan to finally let long-term rates rise for these banks to finally start making a bit of money.
“Second, housing. We have another real estate bubble in Japan. Never forget: It’s the commercial real estate bubble and bust of the late 1980s that started the deflation and that started the Bank of Japan on this crazy course to begin with. Now, here we are again with another bubble, this time mostly in the residential sector.
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“The pitch to real estate investors is twofold: ‘You can use real estate to reduce your burden of Japanese inheritance taxes,’ which as you know, are the highest in the world. And ‘you can get long-term mortgages for practically nothing.’
“So money is pouring into homes and condos, and despite the low fixed rates, many home buyers now favor variable-rate mortgages, which are even cheaper, but riskier. The result is that construction activity has surged, and we’ve now reversed from housing scarcity to housing overcapacity in many areas.
“Third, is inflation. What makes everyone think that deflation is forever? Are they too young (or maybe too senile) to remember how inflation used to appear suddenly in Japan? For example, what about the two oil shocks of the 1970s that instantly caused double-digit jumps in Japan’s wholesale prices?
“Any one of these pressures could force the BOJ to make a minor tightening adjustment and raise official rates slightly. And any such move by the BOJ could cause things to unravel very quickly.”
Mr. X did not seem anxious to spell out more precisely what he meant by “unravel very quickly.” So I didn’t press him and nor did I have to. I know what the consequences are, and he knows that I know:
- A collapse in Japan’s bond markets, which are hypersensitive to even minute changes in BOJ policy.
- The rapid exodus of foreign investors, who have flocked to Japan for safety.
- A collapse in Japan’s stock market, which could later become a contagion that rocks the rest of the world.
What’s Most Ironic about This Scenario
Most people don’t know that it was America’s top Treasury and Fed officials who first warned about a future disaster in Japan.
I know because I was in Tokyo at the time. The U.S. officials were visiting Japan and held a series of meetings with their counterparts at Japan’s Ministry of Finance and BOJ.
The essence of their message was this:
The BOJ must not continue this zero-interest-rate policy much longer. If the BOJ doesn’t soon phase it out, it will create such massive distortions in Japan that it could sabotage global financial stability and growth.
What’s even more ironic is that, in subsequent years, the Federal Reserve itself followed in Japan’s footsteps, pursuing essentially the same policies they had explicitly warned Japan against.
So did the European Central Bank.
And ditto for the Bank of England.
First In, First Out
What’s next? The most likely outcome is what I call the “first-in-first-out syndrome.”
Japan was the first major nation to enter the whacky world of zero interest rates. It could also be the first to exit.
And when it does, you had better be ready. Because higher interest rates in Japan could spread globally like a contagion.
And higher interest rates in the United States, no matter how long they are delayed, could cause even more financial turmoil.
Good luck and God bless!