With its surprise decision last month, the Bank of Japan (BOJ) has joined the European experiment with negative interest rates. Is this a bold and brilliant policy move or the last gasp of failed policy? Unfortunately, it is the latter. Quantitative easing was always a risky experiment. From the start, it failed the test of intellectual coherence. With three years of experience in Japan, it is failing empirical tests as well. It is unclear whether policymakers have the knowledge, fortitude, and tools to reverse course and unwind this unfortunate experiment. Their ability to do so will have significant ramifications for Japanese insurers.
Deflation as the culprit
Let me repeat a thesis I stated three years ago: deflation is not the cause of low growth in Japan. To the extent that Japan’s economy has underperformed, it is the result of demographic, cultural, regulatory, and geopolitical factors. Policymakers are certainly correct to want to avert severe deflation; they are also correct to worry about ongoing and persistent deflationary expectations. But the utter obsession with achieving a 2% inflation target blinds us to the real causes of low growth. It may in fact stoke deflationary expectations as business leaders and the public continually see the BOJ fail to meet an arbitrary and meaningless target. And the execution of quantitative easing distorts financial markets in ways that are hard to predict but are likely to have ill effects at some point down the road.
The intellectual incoherence of public policy
Because an economy is a complex system, it is difficult to ascertain the long-term implications of current policy decisions. Our ability to “fine tune” economic performance is rather limited even in the short term. As much as we would like to believe otherwise, central bankers do not drive an economy the way a person drives a car. This does not mean that bankers or policymakers are useless. It does mean, however, that a certain degree of humility is important on the part of those who design, implement, and communicate policy actions. It also means that radical measures may have dramatic and unforeseen consequences. We simply do not know. Anyone who says otherwise is misguided or disingenuous.
The BOJ has conveyed to the public the following thesis: Deflation is the key driver of Japanese malaise. If we overcome deflation, strong economic growth will follow. Therefore, extraordinary measures are justified to achieve a 2% inflation target.
It would be nice if life were so simple. Why does the BOJ think that an invigorating infusion of inflation will lead to a virtuous cycle of growth? The argument for current policy is something like this:
- Short-term interest rates are reduced to zero or below. This creates an incentive for banks to lend and makes it easier for borrowers to borrow.
- Asset purchases stimulate the economy in multiple ways. They reduce long-term interest rates, making it easier to finance long-term capital investment. They put cash in the hands of investors who have sold assets; these investors now need to look for new channels of investment. They increase other asset values—especially equities, but possibly real estate as well—leading to ebullience on the part of investors and consumers. This is the wealth effect, a policymaker’s oxycodone.
- Collectively, these measures weaken the yen—or avert overvaluation. This makes Japanese exports more competitive. Also, funds that are repatriated from overseas operations buy more yen to stimulate the domestic economy.
It is quite a good story. It is not silly to think it may lead to growth. But it is missing an essential element: Who exactly is creating this growth? Where are the ideas coming from? Are Japan’s business leaders and entrepreneurs empowered to implement them? These are critical questions, especially in the context of Japan’s shrinking workforce and a culture and regulatory framework that are averse to change.
Emerging empirical evidence
The BOJ has indeed expanded its balance sheet. It has put a lot of money in a lot of hands; there is money to borrow and it is ostensibly free or virtually so. The Nikkei has risen and the yen is down. The weak yen has helped exports in some industries. We’ve seen an uptick in Tokyo construction. Though economic growth is low, unemployment is at its lowest level in 20 years.
Perhaps the BOJ should declare success and move on.
But policymakers and the press are preoccupied with creating inflation. And inflation remains low. The singular attention paid to the consumer price index (CPI) is phenomenal and counterproductive. Are we really to believe that zero inflation is the primary barrier to growth? Are we really to believe that a modest uptick in inflation will bring out the consumer wallets? That it will drive businesses to spend and invest?
If money is free and if corporate balance sheets are awash with cash, but we are not seeing investment, isn’t it rather likely that there are other critical factors? Perhaps there simply aren’t enough ideas out there waiting to be funded? Or perhaps the regulatory and cultural burden is too great? Or perhaps the demographic drivers – an aging and declining workforce – are profoundly hard to overcome, regardless of the rate of inflation.
There is at least one thing we can definitively say: For three years, BOJ policy has failed to promote robust growth. And now they propose to double down. They are doubling down in part because they have failed to meet their own favorite metric—the inflation target. But if the theory is flawed, and if the measures are flawed, isn’t this the public policy equivalent of throwing good money after bad?
Insurer balance sheets
Doubling down may be the worst case scenario for Japan’s life insurers. On the day of the BOJ announcement, 10-year Japanese Government Bonds (JGBs) traded at a remarkable yield of 10 basis points. A negative yield is certainly imaginable.
What does it mean when a 10-year government bond is yielding essentially nothing? Some or all of the following:
- The BOJ has remarkable power to manipulate the bond market, at least in the short term
- JGB owners/buyers believe in deflation, so they view 10 basis points as a plausible real yield
- JGB owners/buyers are extremely unfazed by the possibility of rising interest rates
- JGB owners/buyers have few other options
- Current JGB owners can’t decide whether to harvest capital gains in this apparently remarkable environment, so there is no selling stampede
In any case, with their singular focus on creating inflation—and in their belief that they can do this with monetary policy alone—the BOJ continues to create significant problems for Japan’s life insurers. Low rates make it next to impossible for insurers to provide the fixed income guarantees that were once a mainstay of the industry (and a crucial vehicle for Japanese savings and capital formation). They make it hard to service guarantees on existing business. They make it very hard to develop asset liability management strategies. Over the past decade, Japanese life insurers have dealt with low interest rates by repositioning sales towards protection products, lowering guarantees on new business to 1%, and introducing market value adjustments on certain contracts. Insurers are urged to lend, but find few opportunities in the domestic market. Instead, government bonds have grown to represent around 40% of industry assets. Some companies have lengthened duration in an effort to gain yield, at least partially hedging their positions to mitigate the risk of rising rates. But with the yield on a 30-year JGB driven to a paltry 1% and minimal progress on structural reform, insurers now seem to have little room to maneuver. Arguably, the longer that rates stay low as a result of central bank interventions, the greater the risk posed by the possibility of rising rates. If current policy persists, it will be difficult for insurers to provide any guarantees, and to the extent that they offer guarantees, to adequately manage associated risk.
A method to the madness?
Is there a method to the madness? Is this a bold and brilliant move on the part of the BOJ? If we are to believe in the importance of the metrics they define for themselves—inflation and economic growth—almost certainly not.
A central bank exists to promote stability in banking and financial services; this is an essential prerequisite for a healthy economy. But we are deluding ourselves if we believe that financial engineering on the part of central bankers will lead to optimal growth. Japan is a wealthy country and will remain so, but extreme measures are likely to create problems in the not so distant future. Current policy does not appear constructive or sustainable. It is certainly creating severe distortions in the financial markets. It could lead, ultimately, to a restructuring of Japanese government debt and, with it, a restructuring of Japan’s financial services sector and key segments of domestic industry. Can this be done in a manner that protects what Japanese value the most—stability and independence? Perhaps. But the sooner the BOJ recognizes the drivers of low growth, the futility of inflation targeting, and the limits of central bank power, the better off we will be.
Steve Conwill leads Milliman's Tokyo office. This article represents his views and doesn't necessarily reflect the views of Milliman.
