The Diminishing Effects of Japan's Quantitative Easing

Japan is the most indebted country in the world as measured by debt-to-gross domestic product (GDP). As of 2018, the Japanese debt-to-GDP ratio was at an all-time high at 254%. Government debt to GDP in Japan averaged 137.4% from 1980 until 2017. Japan's record lowest debt to GDP was recorded in 1980 when it was 50.6%.

The country is a case study in modern macroeconomic policy and exemplifies why governments and central banks cannot control the economy in the way that many textbooks suggest.

Japan's central bank, the Bank of Japan (BOJ), has pursued decades of unconventional monetary policy. Starting in the late 1980s, the BOJ has deployed strict Keynesian policy, including more than 15 years of quantitative easing (QE), or the buying of private assets to recapitalize businesses and prop up prices.

Despite these efforts, there is strong evidence that Japan's easy money policies only produced an illusory growth while failing to improve the fundamentals of a stagnant economy. The more Japan's leaders tried to stimulate their country's economy, the less it responded.

The money stock in Japan grew by 10.5% per year between 1986 and 1990. The discount rate fell from 5% in 1985 to 2.5% in 1987, fueling large-scale borrowing that many Japanese investors used to buy assets in mainland Asia, particularly South Korea. Asset prices climbed in Japan, a phenomenon that tends to occur whenever interest rates are artificially lowered for years at a time. Japan was effectively in a bubble economy propped up by cheap paper.

That bubble burst in 1989 and 1990. The BOJ, not yet an independent central bank, had raised interest rates from 2.5 to 6% between 1988 and 1990. This likely triggered the burst. Economic growth, which had been robust for years, slowed significantly. When recovery proved slow, Japan turned to Keynesian remedies: printing money, lowering interest rates and increasing the government deficit.

A series of rate cuts between 1991 and 1995 left the discount rate at 0.5%, just above the zero bound. Fiscal policy was aggressive during the 1990s when Japan attempted nine stimulus packages during the decade totaling 140.7 trillion yen or the equivalent of $1.3 trillion. These measures were unprecedented for a modern industrial power like Japan; yet, there was still no recovery.

The monetary and fiscal stimulus did accomplish one thing: it prevented prices of Japanese goods and assets from falling to a market-clearing level. Falling prices are a benign part of any recession and often help restore sanity, but Japan's fear of accepting any deflation meant consumer prices in Japan actually rose steadily until 1995. Beyond this point, the stimulative and inflationary effects from Japanese stimulus stopped having any meaningful impact.

By 1997 the Japanese economy was reeling from low growth, low interest rates, low inflation and a mountain of bad bank loans. From 1995 to 1998, Japanese banks wrote off more than 50.8 trillion in yen in bad loans. Though it was not yet called QE, the BOJ decided to help banks and bought trillions of yen in commercial paper between October 1997 and October 1998.

Growth remained tepid, so the BOJ ramped up asset purchases after seeking the advice of American economist Paul Krugman. Between March 2001 and December 2004, Japanese banks received 35.5 trillion yen in liquidity injections. The bank also targeted long-term government bond purchases, which lowered yields on assets.

Economic growth seemed to return between 2002 and 2007. However, as with most of the world, Japan's growth vanished during the Great Recession. Though Japan was slower to start a new round of QE than Europe or the United States, the BOJ launched quantitative and qualitative monetary easing (QQE) in 2013. As with most expansionary monetary policies, QQE failed to work.

More than 80 trillion yen in purchases was not enough and, in October 2014, the BOJ announced QQE2. Japanese stocks climbed 33% in the ensuing eight months, but there was still little evidence of real growth. Desperate, the BOJ announced negative interest rates in January 2016.

Japan's enormous public debts are a sore spot for investors. In his 2015 report, hedge fund manager Ray Dalio argued Japan's real debt burden, including private debts, relative to its GDP was around 449%, ranked 19 out of the 20 countries he measured. Huge debt servicing costs directly reduce the potential for savings or investment, limiting future economic growth and current returns.

Easy money policies from the BOJ harm domestic asset returns by suppressing local interest rates. They also harm overseas asset returns, since Japanese financial institutions have to pay out more on foreign currency hedges than they earn from foreign assets, such as sovereign bonds. An April 2016 report from Japanese markets analyst Shannon McConaghy reported that a "Japanese bank buying 5-Year U.S. Treasuries with perfectly hedged currency and duration risk would (lose) 0.9% a year."

Interest rate manipulation and a mounting huge fiscal deficit have not helped Japan's economy for nearly 30 years. The effectiveness of the Keynesian remedies employed should eventually be called into question; otherwise, the United States and Europe seem doomed to follow in Japan's footsteps.