IceCap Asset Management discusses Japanese model and resulting monetary policy

IceCap Asset Management wrote a very interesting investment letter in which it discusses the Japanese model for handling a bank solvency driven financial crisis and the resulting monetary policy (h/t ZeroHedge).

Today, future economic historians are lucky enough to both see and experience what will happen as Europe (lead by Germany), Japan, Great Britain and the United States fully engage in the biggest, coordinated, money printing experiment in the history of the Universe. 

In its simplest form, only three scenarios are possible: 

1) Money printing has absolutely no impact on prices rising or falling
2) Money printing results in a return to the 1922 German experience
3) Money printing results in a return to the modern day Japan experience

No worries though - the very competent hands of today ’s central bankers, on the surface at least, appear quite confident that their money printing games will successfully engineer a very serene road to prosperity. The mere mention of the probability of scenarios 2 or 3 occurring are casually dismissed as easily as an offering of a third espresso. 

However, what should make you a little concerned is that central bankers in both 1922 Germany and 1990 Japan came to the very same conclusion before they commenced their devastating money printing strategies. 

Any investment manager worth their salt these days will tell you that the probability of scenario 1 occurring is lower than the real odds of England winning the next World Cup. 

The elimination of scenario 1, naturally leaves us with a tug of war between a hyper-inflationary World or a deflationary World. Both outcomes are certainly extreme, yet what else could you expect when we have the World’s biggest central banks implementing extreme monetary policies in the form of money printing?...

The 1922 German hyperinflation experience was undoubtedly propelled by printing massive amounts of money. Yet, the Japanese money printing experience has had no impact whatsoever on inflation. 

Here we are in 2012, and the World’s four main central banks (USA, Britain, Europe and Japan) continue to print gobs of money. Will the outcome be 1922 Germany or 1990 Japan? 

An important point to understand is whether the printed money actually flows through to the economy. In the 1922 German case – yes, it definitely did. The printed money circulated in the economy causing the German Mark to plummet against other currencies which resulted in extreme inflation. 

Today, trillions of Dollars, Yen, Euros and Pounds are being printed – yet this new money is certainly not being distributed into the economy. Instead, big banks everywhere are hoarding the newly minted cash for a rainy day. In economic parlance, this is referred to as a “liquidity trap” meaning there is plenty of cash available, however the cash remains trapped and is not being used. This makes today’s situation, perilously closer to the Japanese experience. 

Chart 1 ... shows the amount of money not being distributed into the economy by the very big American banks. Once this money is eventually released (via loans) into the economy, the cost of things could rise very quickly – similar to 1922 Germany. 

We (and many, many others) have been very critical of the American, European and British central banks. We freely admit that these people all have very good intentions – they truly do want the World’s economy to return to normal.

So is that why they adopted the Japanese model for handling a bank solvency based financial crisis and engage in misrepresentation about the condition of the banks?  Is that why they adopt extreme policies that negatively impact the vast majority of their society?

Yet in our opinion, it is their analysis of the problem that is leading them to make a very big mistake.

Your humble blogger agrees with this observation whole heartedly.

There are two problems with their analysis.

First, they assume that banks cannot operate with negative book capital!  This is absolutely not true.

Second, they assume that the economy cannot 'recover' from all the excesses in the financial system being recognized.  Iceland, which followed the success of Sweden, has shown that this is not true.

 The central banks fully believe that the World is currently suffering from what they would call – an aggregate demand problem. They believe growth is slow around the World because people and companies are not spending as much money as they normally would. 

To many of the big banks, stock brokers and mutual fund sales people, this “aggregate demand problem” sounds no different than any other economic slow down – it’s a part of a normal business cycle. And during a normal business cycle, the solution to encourage people and companies to spend more money has always been 1) lower interest rates and 2) increased government spending. And if the situation becomes untenable as it is today, you can add 3) money printing to the list. 

The reason this combination isn’t working today is due to the flawed belief that all of this extra money sloshing around in the economy will naturally entice people and companies to spend their hard earned (and borrowed) money again. 

As this blog has documented, zero interest rate policies actually create a headwind to spending.  Both retirees and savers reduce demand to make up for the loss in income on their savings.

With trillions in freshly printed money, sub 2% growth, widening government deficits and continued bailouts to banks, it has become crystal clear that the central banks’ money printing strategies are not working. 

The reason it isn’t working is simply due to the fact that all of this free money being provided to the banks, is not being distributed back into the economy. US and European banks are hoarding this free money and as a result - the transfer mechanism is broken.

The reason for hoarding free money has to do with the banks' solvency problem.  Since all banks are hiding losses on and off their balance sheets, the interbank loan market is frozen as it is impossible for banks to determine which banks are solvent and which are not.

At the same time, zero interest rate policies are suppressing aggregate demand and with the reduction in aggregate demand comes a reduction in the demand for new loans.

Finally, banks have the risk free option to make money on the free money they have been given by keeping it in an interest earning account at the central bank.