The Inflation Tsunami (Part One of Three)
Over the past year The Amphora Report has written extensively on the topic of inflation, including in Guess What’s Coming to Dinner: Inflation! and The Inflation Tipping Point. While we prefer the monetary definition of inflation as growth in the supply of money and credit, we note that, beginning around mid-2010, the monetary expansion of 2008-09 began to feed through into consumer price inflation. This has continued to the present day and at an accelerating rate. Consumer price inflation data are now surprising to the upside just about anywhere one chooses to look: in Asia, Europe and, more recently, even in the US. To use a timely if tragic metaphor, the inflation ‘tsunami’ set in motion by a massive monetary expansion in 2008-09 is now making landfall around the world, pushing up prices for a broadening range of goods and services.
While the Japanese have been playing their part in this global inflation they have more recently upped their game in response to the Sendai earthquake. The Bank of Japan (BOJ) has printed some 15tn yen, or roughly $180bn US dollars, since the disaster struck. But the stimulus doesn’t end there. In response to a surge in the yen–a natural result of financial markets anticipating repatriation of Japanese capital to finance reconstruction–the Japanese Ministry of Finance (MoF) asked for and received the cooperation of most major central banks in intervening to weaken the yen, with the BoJ selling some 700bn yen (approx $6bn) for dollars, euros and other currencies. At one point reaching nearly 76 to the dollar, the yen has subsequently fallen back to 83, even weaker than it was prior to the quake. Coordinated FX intervention is rare and is one of the more blatant ways in which policymakers seek to manipulate the global economy.
We are always skeptical when central banks act as if they know better than the financial markets. Not only it is simply impossible for a handful of bureaucrats to regulate anything as dynamic as a modern economy or financial system but central banks also have a demonstrably poor track record. The credit market disaster of 2008-09 was a direct result of misguided central bank policy, specifically consumer price inflation targeting. Most modern central banks claim legitimacy because they keep inflation ‘under control’. Yet these are the folks that create fresh money in response to economic headwinds which are frequently of their own making. Orwellian rhetoric to the contrary, modern central banks are rightly understood to be the champions of inflation–if normally of the moderate sort–rather than its nemesis.
Let’s consider just why, exactly, the BoJ thinks it is doing Japan a favor by printing a huge amount of money and intervening to weaken the yen in response to the earthquake. Presumably it believes that this is going to stabilize the financial system and help with the coming reconstruction effort. But whereas the first point is probably correct to some degree, we doubt the second holds true. When a company loses a major factory to some natural disaster, it is a loss of productive capital. The company then has a choice to make. Should it rebuild the factory out of savings or, alternatively, allow itself to shrink instead and generate less future earnings? The correct decision, of course, is that which maximizes the net present value of the firm. If the cost of rebuilding exceeds the benefit of restoring the factory’s income stream, then the factory should not be rebuilt. Yet if the factory was profitable and costs less to rebuild than the expected future profits, the company should proceed with rebuilding.
How does printing yen and intervening in the FX market affect this decision? By driving down borrowing costs, it makes it appear less expensive to finance reconstruction. But as Japanese firms are large net savers, they don’t really have an incentive to borrow at all to rebuild; rather, they can dip into their extensive savings. As these savings are overwhelmingly denominated in yen, a weaker yen, therefore, makes it more rather than less expensive to rebuild. Yes, Japan is a large exporting nation so a weaker yen can be seen to support exports, but as a result of the earthquake which has destroyed or damaged much industrial capacity, Japan is now unable to export as much as before (at any given exchange rate) and will thus be relatively more reliable on imports during the reconstruction period. The BoJs action does not support the rebuilding effort. It in fact undermines it by preventing financial markets from adjusting in ways that would result in greater price discovery in import, export and financial markets and, therefore, a more economically efficient reconstruction process.
Moreover, long-term observers of Japan know that the last two decades have been characterized by endless fiscal stimulus of various kinds, resulting in chronic resource misallocation which has demonstrably failed to restore the higher rates of economic growth that were common from the 1950s through the 1980s.The legacy, however, is a massive public debt which needs to be serviced with tax receipts. As a country prone to major earthquakes, one could argue that, rather than build ‘bridges to nowhere’ in the 1990s and 2000s, the government would have better served the national interest by spending far less, thereby encouraging savers, including insurance companies, to build large reserves which would be available in the event of a disaster on the scale of the Kobe or Sendai earthquakes. The prospect of rebuilding after any major national disaster is intimidating, yet it would be somewhat less so today were government debt/GDP only around 100%–as was the case when the Kobe quake struck in the mid-1990s–rather than over 200%, as is the case today.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]