Japan provides confirmation that quantitative easing hits real economy hard

In his Financial Times column, Jonathan Plender looks at how pursuit of monetary policies like zero interest rates and quantitative easing has caused structural damage to the Japanese economy.

Regular readers know that these monetary policies result from protecting bank book capital and banker bonuses at all cost under the Japanese Model for handling a bank solvency led financial crisis.

One of the costs is the pursuit of monetary policies that damage the real economy.

Regular readers also know that there is an alternative to the Japanese Model.  The Swedish Model requires that banks recognize today all the losses on the excess debt in the financial system.

Under the Swedish Model, the real economy is protected as it is not subject to carrying the burden of servicing the excess debt or damaging monetary policies.

Despite pursuing the Japanese Model for 2+ decades, Japan's leadership could still implement the Swedish Model today and end its ongoing financial crisis.

The debate about the effectiveness of unconventional monetary policy measures such as quantitative easing remains perennially inconclusive. Yet the experience of Japan suggests there is one clear negative outcome from ultra loose monetary policy: it does structural damage to the economy. 

The problem starts with an excessively low cost of capital. Average interest rates on new corporate loans, both short and long term, are down to an unprecedented level in Japan of almost 1 per cent, while the average interest rate paid on overall corporate lending is just under 1.5 per cent. At these levels too many inefficient businesses are being kept alive, says Jesper Koll, head of equity research at JPMorgan in Tokyo.... 

Also helping to keep inefficient businesses alive are the financial regulators engaging in regulatory forbearance and letting the banks engage in 'extend and pretend' to transform bad loans into 'zombie' loans.

The deeper problem is that this monetary ease tends to freeze the existing industrial structure. 

Looked at from the Austrian perspective of Von Mises, Schumpeter or Hayek, the Japanese bubble that burst in 1990 fostered economic distortions they dubbed “malinvestments” – credit-driven investments in real capital that prove loss making when a credit bubble implodes. 

The results of these misconceived investment decisions take a long time to work their way out of the system, while industries that expanded in response to high demand in the bubble are left with excess capacity. The elimination of this excess and the process of adjustment to a new industrial structure to reflect changed demands, which in Japan’s case means a greater service orientation to address an ageing population, is invariably painful. 

The reason adjustment takes a long time is under the Japanese Model regulatory and monetary policy is geared to slowing down the adjustment by allowing the banks to kick their problems into the future.

In effect, low funding costs in Japan have impeded the process that Joseph Schumpeter dubbed creative destruction because “zombie” companies have been kept afloat at high cost to the competitiveness of others. 

Worse, the public credit guarantees introduced to help the banking system lend to industry and commerce have had unintended consequences. The Bank of Japan fears the banks’ capacity for credit assessment is being diminished, while the restructuring of non-viable small and medium sized businesses is discouraged.... 

Please re-read the highlighted text as Mr. Plender has summarized why pursuing the Japanese Model is a fundamentally bad idea.

Tadashi Nakamae, eponymous president of Nakamae International Economic Research, believes Japan is entering the final stage of a structural adjustment that began in 1990, a Schumpeterian endgame; industries with too many companies need the less efficient to be wiped out so profitability can be restored. 

The rebalancing of the economy will involve high transitional unemployment, says Mr Nakamae, but the unemployed will ultimately find jobs in domestic services and agriculture. With corporate profitability healthier, the government’s tax revenues will increase and it will become easier to address the huge burden of public sector debt....

The Swedish Model does not try to pick winners or losers in the real economy.

Under the Swedish Model, banks absorb the losses that they would ultimately recognize if the bad debt went through the formal process of default and restructuring.

While the borrower's debt is written down to a level where they can afford to service the debt, the write down does not create any equity for the borrower.  As a result, if the borrower is a company it still has to compete to survive.