Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)

I have no doubt that Milton Friedman would have congratulated Bank of Japan governor Haruhiko Kuroda on the fact that Japanese bond yields continue to rise.

This is what Friedman said about the level of bond yields and interest rates in 1998:

“Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”

Lets take it again – “As the economy revives, however, interest rates would start to rise”. Hence, the fact the Japanese bond yields are rising – and have done so since he presented his monetary policy regime change in early April – is a very clear sign that Mr. Kuroda’s efforts to get Japan out of deflation is working.

However, not all agree. This is  in the Telegraph quoting Richard Koo (Ambrose as we know do not agree with Koo):

“Richard Koo…an expert on Japan’s Lost Decade, said the sell-off in recent days has shown that the BoJ may not be able to hold down yields “no matter how many bonds it buys”. This could lead to a “loss of faith in the Japanese government” and the “beginning of the end” for its economy, if handled badly.”

Richard Koo obviously do not understand the monetary transmission mechanism. The purpose of what the Bank of Japan is doing is not to keep bond yields down. The purpose is to increase the money base and increase inflation expectations (to 2%). Both things are of course happening and the markets have not lost faith in the Japanese government or the Bank of Japan. Rather the opposite is the case.

Yes, nominal bond yields are rising – as Friedman and every living Market Monetarist said they would. However, real bond yields have collapsed since the introduction of Japan’s new monetary regime as inflation expectations have picked up. Something Mr. Koo for years has denied the Bank of Japan would be able to do.

Furthermore – and much more important – the markets do not think that the Japanese government is about to go bankrupt. In fact completely in parallel with the increase in inflation expectations the markets’ perception of the Japanese government’s default risk have decreased. Hence, the 5-year Credit Default Swap on Japanese companies has dropped from around 225bp in October last year to around 70bp today and at the same time the CDS on the government of Japan has declined as well – albeit less so.

This is actually not surprising at all. As monetary policy has been eased the expectation for nominal GDP growth has accelerated and as a natural consequence the markets are also starting to price in that the debt-to-NGDP ratio will drop. This is simple arithmetics.

Hence, the markets today feels significantly more comfortable that Japan will not default than was the case prior to Shinzo Abe and his Liberal Democratic Party won the Japanese elections in September last year.

So it might be that Richard Koo is thinking that Abenomics is the “beginning of the end” for Japan, but I rather think that Abenomics might be the beginning of the end for Mr.Koo’s theory of the balance sheet recession in Japan.


Nick Rowe has a blog post on the same topic.

Update: Scott Sumner basically put out the same post as me at the same time (at least the headlines are very similar). Scott, however, is slightly less optimistic about Abenomics than I am.

Update 2: And here is Marcus Nunes on a similar topic (why Richard Koo is wrong).

Leave a comment


  1. W. Peden

     /  May 25, 2013

    Yes: the rise in bond yields makes me think that this time it really may be different for Japan.

  2. The balance sheet recession was already finished, at the latest in 2010. Deflation was never a problem, Japanese do not delay their spending, the need for food or the newest technology even if prices fall.

    Abeconomics is giving an already well performing economy (apart from some ageing issues and temporary rows with China) with further unnecessary fuel. Fuel in a form of Japanese competitive devaluation that in turn aggravated the problems in the euro zone, weakened China and created therefore global disinflation via weaker commodity prices.

    SNBCHF.COM link above

    • George,

      I debated Richard Koo last year in Lithuania. He certainly did not argue that the Japanese balance sheet recession was over.

    • marksadowski

       /  May 26, 2013

      “Abeconomics is giving an already well performing economy with further unnecessary fuel.”

      According to the Conference Board, aggregate hours in Japan fell by a staggering 7.8% between 2007 and 2012, implying substantial labor market slack. If Japan is doing so well why is Abeconomics so popular?

      “Fuel in a form of Japanese competitive devaluation that in turn aggravated the problems in the euro zone, weakened China and created therefore global disinflation via weaker commodity prices.”

      1) The increase in Japanese imports year on year far exceeds the increase in exports, thus adding to global aggregate demand (AD). China and the eurozone should be thanking Japan.

      2) Since when has the BOJ become responsible for the the macroeconomic stabilization of China and the eurozone?

      3) With respect to falling commodity prices, never reason from a price change. Ask yourself why commodity prices are falling and then you’ll see that this is obviously a good thing for most countries.

  3. marksadowski

     /  May 26, 2013

    I finally went to the trouble of reading one of Koo’s papers recently just to see what all of the fuss was about and I’m almost sorry that I did. Koo’s paper is here:

    Click to access Koo-Ineffectiveness-Monetary-Expansion.pdf

    The passage I take the most issue with is on pages 11-12:

    “The post-1990 Japan managed to maintain its money supply (Exhibit 7) and GDP (Exhibit 4) from shrinking because the government was borrowing the deleveraged and newly saved funds from the private sector (Exhibit 9) Unfortunately there was a period in economics profession, from late 1980s to early 2000s, where many noted academics tried to re-write the history by arguing that it was monetary and not fiscal policy that allowed the US economy to recover from the Great Depression. They made this argument based on the fact that the US money supply increased significantly from 1933 to 1936. However, none of these academics bothered to look at what was on the asset side of banks’ balance sheets.

    The asset side of banks’ balance sheet clearly indicates that it was lending to the government that grew during this period (Exhibit 10). The lending to the private sector did not grow at all during this period because the sector was still repairing its balance sheets. And the government was borrowing because the Roosevelt Administration needed to finance its New Deal fiscal stimulus. In other words, it was Roosevelt’s fiscal stimulus that increased both the GDP and money supply after 1933.”

    There’s a reason why none of those academics attached much importance to the asset side of banks’ balance sheets.

    Koo acts like there’s a one-to-one correspondence between the banking sector’s assets and public and private sector liabilities, but that’s not at all true. For example, as Koo shows in Exhibit 9, banks held about 500 trillion yen and 250 trillion yen in private sector and public sector debt respectively in December 2007. But at the end of 2007 the total amount of non-financial private sector and public sector debt was about 850 trillion yen and 900 trillion yen respectively:

    Similarly in Exhibit 10 Koo shows that banks held about $16 billion in private and public sector debt each in June 1936. But in June 1936 the total amount of non-financial private sector debt and public sector debt was about $116 billion and $54 billion respectively (page 989:

    Click to access CT1970p2-11.pdf

    (Incidentally, why did Koo put the cutoff in 1936 instead of 1937? The recession didn’t start until 1937 after all. It’s probably because the asset side of the 1937 bank balance sheets are a lot less supportive of his already flimsy argument.)

    In both cases banks held only a fraction of each kind of outstanding debt. There is simply no clear relationship between debt and money supply. (Monetary policy is not credit policy.)

    More importantly, the period 1997-2007 includes the first Japanese QE (2001-2006) and the corresponding Koizumi Boom (2003-2007), which was also a period of pronounced fiscal tightening in Japan. Similarly, although the Federal Emergency Relief Work and public works projects funded by the New Deal were helpful in creating the swift recovery experienced from the Great Depression during 1933-37, as several academic studies have shown (e.g. Romer, Eichengreen, etc.) the recovery was primarily due to FDR’s ending of the gold standard and the subsequent devaluing of the US dollar.

  4. marksadowski

     /  May 26, 2013

    I was startled by the following passage that I found from a report Koo wrote in December:

    “But nightmare scenario awaits when private loan demand recovers. The problem is what happens when private loan demand recovers. Loan books could grow more than tenfold in the US and five fold in Japan and Europe if bank reserves remain at current levels, triggering inflation rates of 500% to over 1,000%.

    To avoid this outcome, central banks will have to mop up excessive reserves by raising the statutory reserve ratio, raising the interest rate paid on reserves, and selling government bonds. All of these measures will serve to lift interest rates, sending bond yields sharply higher and triggering a possible crash in the bond markets.

    A sharp increase in government bond yields could lead to fiscal collapse in countries with a large national debt. For Japan, where the national debt amounts to 240% of GDP, the results would be catastrophic.

    Expanding quantitative easing because it appears to be doing no harm is grievous error. Mr. Abe and his advisors may believe that all they have to do once their anti-deflationary policies succeed and JGB yields start to rise is have the BOJ buy more bonds. However, bank reserves under quantitative easing have risen to a level capable of fueling a 500% inflation rate, in which case the BOJ would have to sell, not buy, JGBs.

    Nomura | JPN”

    Yes, you read that correctly. Koo is predicting that the current Japanese large scale asset purchases have the potential to create 500% to 1,000% rates of inflation, a crash in the bond market and a complete fiscal collapse.

    I think it’s high time that people realize that the Emperor Koo has no clothes.

  5. Good day, Lars, nice post. I generally agree.

    But there is one more thing that seems critical to me.

    To me, the single most important thing is not so much what Richard Koo says (or, for that matter, more generally, what people like us say), but what the Japanese people think.

    Monetary policy is ultimately about the basic trust citizens have in their society and state, which at the end of the day issues currency (a liability versus the people), in exchange for acquiring assets from them.

    I have the sense that hyperinflation, and other extreme financial busts, ultimately reflect not only a failed economic policy mix, but also a preexisting lack of trust in one’s own society and state.

    The problem of the Weimar Republic (or more recently of states such as Yugoslavia) was not just that they were “printing money”. It was also that their citizens did not believe in the viability of their regimes as providers of civilized life, to put mildly. No wonder they had no faith in the currency. And no wonder their central banks were issuing currency without receiving anything of any value in exchange.

    What is therefore crucial is the degree of political support the Abe administration has among Japanese voters. If the people maintain a fundamental trust in their politeia, to borrow a term used by Aristotle and Plato, Abenomics will work, without leading to financial busts and hyperinflation. Yes, some banks may fail, but Japan should be able to sort that problem out.

    Today’s discussion in many Western countries, including the US, about the “huge” and “hazardous” risks associated with quantitative easing is ultimately rooted in various degrees of disconnect between citizens, elites, and the state.
    To me, it is a little sad and disappointing to observe that Western societies, at the moment at least, seem somewhat incapable of overcoming internal divisions, and to move to act in manner that can restore their economies. Perhaps the West is focusing too much on the failures of modern Greece, and forgetting the guidance provided by the successes of classical Greece.

    To get back to the more profane subject of Abenomics, the question for me therefore is whether the Japanese as a whole continue to have basic confidence in their society and state. The way the Japanese responded to the epochal 2011 disasters, and the extraordinary high level of political support that Prime Minister Abe seems to enjoy, suggest that this basic social contract remains unbroken, despite the many difficulties that exist.

    My relative optimism on Abenomics rests to a large degree on my sense that Japanese society’s relationship with the politeia remains intact and functional.

    But, yes, the fact that nominal rates have risen (and real rates collapsed relative to inflation expectations) is also a sign that things are moving in the right direction.

    Regards, Mikio

  6. Lars,

    Just to clarify: I think Abe and Kuroda are doing exactly the right thing.

    In the news piece you cited quoting Richard Koo, I was wearing my reporter’s hat, not endorsing his view. In a nsubsequent blog I explained why I disagreed with him.

    However, Kuroda said at the outset that he wished to lower long-term borrowing costs (no doubt he meant real not nominal) so he has created a rod for his own back. Moreover, Abe is extremely annoyed about the yield spike.

    Clearly, this was unwelcome from their point of view, even if you can construct a case that rising yields are basically a good sign.

    Ultimately, I think it is a storm in a teacup.


  7. Petar Sisko

     /  May 26, 2013

    “He advised numerous Japanese prime ministers on how best to deal with Japan’s banking crisis based on his experience at the New York Fed, and on economic crisis based on his theory on balance sheet recession.” Reality proved him (and the theory) wrong. Btw. Im not really comfortable with the notion that government “stuffed” the hole the private sector borrowing left due to drastic fall in wealth – and thereby saved a lot of national income that would otherwise be lost.
    To me, it sounds as if he implying that there is some optimal borrowing level (leverage ratio?) that could even be targeted by government.


  8. “Hence, the 5-year Credit Default Swap on Japan has dropped from around 225bp in October last year (just after Mr. Abe was elected Prime Minister) to around 70bp today!”

    That seems remarkable. I’m surprised more hasn’t been made of it. Would be interesting to see a ten-year graph…

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