Chih Kwan Chen


June 17, 2012


Japan has been suffering for more than fifteen years a mood darkening economic stagnation. We call this phenomena as "Japan Syndrome". "Japan Syndrome" can be defined as caused by a set of unique monetary conditions that will perpetuate itself. The actual economic growth or lack of it, inflation-deflation, unemployment rate and so on are just the end results when the set of monetary conditions are applied to a society, so the end results vary from society to society even if the same set of monetary conditions is applied. Viewing from this angle, The United State of America has probably entered the trap of "Japan Syndrome", too, since the existing monetary conditions are very similar to that of Japan since the onset of "Japan Syndrome" in 1995. The purpose of this article is to analyze this "Japan Syndrome American Style" and see why the condition will most likely perpetuate itself for a long time to come.

In the next section how the set of monetary conditions, that defines "Japan Syndrome" has triggered "Japan Syndrome" in Japan, is reviewed. "Japan Syndrome American Style" and how it is interacting with American economic outcomes are discussed in Section 3. Section 4 is devoted to the analysis about why the set of monetary conditions tends to perpetuate itself. The final section contains further discussion.

2. "Japan Syndrome" in Japan and its global impacts

"Japan Syndrome" in Japan has been triggered by the massive money creation in the hands of the central bank, Bank of Japan, in the middle of 1995 in order to drop the short-term interest rate to near zero. Let us see why Japan wanted to take such a drastic action. Japan's giant real estate based bubble had collapsed by early 1990s and her economy had entered a prolonged slow growth period. The short-term interest rate was hoovering around 2 to 3 percentage points at that time. However, as the 1991 to 1992 global recession ended, Japan's trade surplus against The U. S. expanded anew. In response to the rapidly expanding Japan-U. S. trade imbalance, the currency market naturally took Japanese Yen higher and higher versus U. S. Dollar in order to reduce the imbalance between two countries. By 1995 Japanese Yen had risen to 80 Yen per Dollar from around 130 Yen per Dollar at 1992. The drastic near-zero-interest-rate policy of Japan was not taken to fight any non-existent financial or economic crises at that time, but was designed to counter the rising Yen so that Japan can continue its policy of accumulating huge amount of trade surplus year in and year out. For that reason we call the near-zero-interest-rate policy of Japan as "Currency Manipulation of the Second Kind". Indeed as the near-zero-interest-rate policy has been launched, massive waves of Yen-Dollar carry trade had taken Dollar up quickly versus Yen, and by the middle of 1998, Yen had dropped to 170 Yen per Dollar.

Japan's near-zero-interest-rate policy was supported strongly by the Clinton Administration under the catch phrase of "Strong Dollar Policy". However, as has been pointed out in article 1, this near-zero-interest-rate policy has not only assigned Japan into a prolonged economic stagnation called "Japan Syndrome", but had triggered a series of events at both sides of Pacific Ocean. Though we will refer the details to article 1, a quick review is provided below:

With the normal two year delay for a major movement in currency to be transmitted to the trade balance, the second wave of runaway U. S. trade deficit had started in the middle of 1997. Huge amount of trade-deficit generated foreign owned dollars flooded into the money pool outside the commercial banking network, Wall Street firms borrowed lavishly from the fresh influx of dollars into the money pool, and used the borrowed money to blow the now infamous dot-com bubble. As the dot-com bubble expanded, many ordinary investors had turned into instant speculators to make handsome sums by buying into high-tech stocks as the old saying that every one looks like a genius in a stock market rally. Thus consumer spending picked up, U. S. economy boomed, Clinton Administration became very popular, and Wall Street people made a lot of money by selling dot-com company stocks to amateur speculators. Unfortunately, the go-go boom did not last long and soon was knocked out by the shock wave originated from Asia.

At the time when Japan has started its near-zero-interest-rate policy in the middle of 1995, many small Asian countries were pegging their currencies to U. S. Dollar staunchly, following the advice from popular U. S. economists. As the waves of Yen-Dollar carry trades lifted Dollar up rapidly versus Yen due to the wide interest rate difference between tow countries, the currencies of those Asian countries also appreciated rapidly versus Yen just as U. S. Dollar was. Japanese manufacturers lost incentive to outsource low level manufacturing activities to those Asian countries, and those countries started to suffer substantial trade deficits. Many hedge funds at that time were also blindsided by the advice from those popular U. S. economists and believed that the peg to U. S. Dollar was like "gold", so they eagerly snapped up higher yielding Dollar denominated sovereign bonds issued by those Asian countries. By that way those Asian countries enjoyed good life for a while. When the hedge funds finally realized that those Asian countries were just spending their money but without the matching production, they ran to the exit at once, and triggered the Asian financial crises. The Asian financial crises was the last straw to break the back of Japanese banking system. In order to hold up the collapsed banking system, Bank of Japan flooded the market with more and more fiat Yen, and thus sealed the fate that interest rate in Japan will stay near zero for a very long time. Japanese people are diligent savers to augment their insufficient retirement fund. As the interest income diminished, they naturally have pulled back spending, the economy tanked, Japanese Government went into massive scale deficit spending to stimulate the economy and Bank of Japan created more money to buy up Japanese Government bonds that sealed the fate of near-zero interest rate further, and so on a vicious cycle is formed to trap Japan into the "Japan Syndrome".

In the aftermath of the Asian financial crises, IMF stepped in to save those fallen Asian countries. IMF forced spending cuts at the same time to force those countries to de-peg their currencies from U. S. Dollar. The currencies of those Asian countries fell big versus U. S. Dollar, and their international competitiveness returned. The return of those Asian countries' competitiveness immediately threatened their rivals like Russia and Latin America countries. By the middle of 1998 Russia with her currency also pegged to U. S. Dollar defaulted on her sovereign debts, and de-pegged her currency from U. S. Dollar. By the middle of 1999 the tide of financial crises and de-pegging from U. S. Dollar reached Latin America countries. At the Russian default in the middle of 1998, a giant hedge fund loaded with Russian sovereign debts ran into trouble. Fearing a financial chain reaction, Wall Street big boys jointly intervened to save the giant hedge fund, under the urge of then FED Chairman Greenspan. With that crises, Clinton Administration finally recognized the folly of the "Strong Dollar Policy" and joined Japanese Government to intervene in the currency market to bring down the high flying Dollar. Shortly U. S. Dollar fell from more than 170 Yen per Dollar to 125 Yen per Dollar, and then by the middle of 1999 to 110 Yen per Dollar as the financial crises spread to Latin America. With the normal two year delay, U. S. trade deficit waned in 2000, the money influx to the dot-com bubble stopped to grow, and the bubble started to unravel, causing huge losses for those amateur speculators.

3. "Japan Syndrome American Style" and the U. S. economy

The short-term interest rates in The U. S. has been pushed down steadily since the early part of 2008 when FED had realized that the bubble was deflating. It was only after the collapse of Lehman Brothers, the peak of the whole financial crises that had begun in August of 2007, FED panicked and finally pushed the short-term interest rates to near zero. Thus U. S. economy has fallen into the trap of "Japan Syndrome", too as will be discussed here.

Looking from the consumption side like GDP and consumer spending, it is quite obvious that the recovery has been very sluggish. It is rightful for many to claim that they do not feel the economic recovery at all. However, we cannot claim that the sluggish recovery will continue for a long time to come just based on the slow recovery phase up to this point. To say that we are in a "Japan Syndrome" so the sluggish economic growth or non-growth will continue for a long time, we need to understand why the recovery is so sluggish and then derive a logical reasoning to explain why such a condition will continue for foreseeable future to create the "Japan Syndrome American Style". Unfortunately it is not easy to understand why the recovery has been so slow by looking into the consumption side, so we study the other side of the coin, the income side in this section.

We label four components of Personal Income as "Progressive", they are, "Private Wages and Salaries", "Nonfarm Proprietors' Income", "Interest Income" and "Dividend Income". The monthly values of the aggregate of those four progressive components are plotted as the black curve in the graph at the right. The scale of the curve is logarithmic so a straight line, like line A in the graph, means a steady percentage growth. From the nadir of 2009 the black curve bounced back with a faster growth rate until the spring of 2010, and then it has settled in a slower but steady growth rate as represented by line A in the graph. Line A represents an annualized growth rate of 4.2%, consistent with the average annual growth rate of nominal consumer spending. This consistency then indicates that we can indeed use the aggregate of the four progressive components of Personal Income as an alternative to study why the growth in consumer spending is so slow in this recovery. The next step is to look into the four progressive components separately to see which component is causing the slow growth of the aggregate.

In the graph at the right, "Private Wages and Salaries" is plotted as the green curve, "Nonfarm Proprietors' Income" as the blue curve, the sum of "Interest and Dividend Income" as the purple curve, and "Interest Income" as red dots without connecting lines respectively. All those curves are plotted with the same logarithmic scale as the black aggregate curve, but the vertical positions of those curves are shifted up and down to fit them into one graph.

The green "Private Wages and Salaries" curve formed a broad bottom during 2009, and has started to recover since 2010 with a steady rate of about 4.7% a year as indicated by Line B in the graph. This growth rate is, of course, slightly higher than the aggregate black curve. However, we should note the behavior of the green curve in recent six months. The winter of 2011 to 2012 was exceptionally warm to the degree to affect seasonal adjustments in various government data. From that point of view, we should expect a boost of the growth rate of the green curve in the past winter. But the green curve shows no sign of such pick up of the growth rate. Rather the green curve has started to curve around in recent months. If this slow down continues and the green curve eventually breaks down through Line B, we should take that as a fore warning signal of the coming of another recession.

The blue "Nonfarm Proprietors' Income" curve bounced up strongly from the nadir of the recession, but its growth rate has slowed down substantially from the latter half of 2010. Currently it is growing like 5.2% a year, substantially better than the black aggregate curve.

The purple "Interest and Dividend Incomes" curve has experienced a slow growth from the nadir of the recession. It is this component serving as the drag to the overall recovery rate of the aggregate black curve. To see what is going on in this purple curve, Interest Income alone is plotted as the red dots respectively. We can see that the Interest Income indeed has dropped sharply and stayed down since 2010. The diminished interest income is the culprit of slowing down the whole recovery and points out the futility of FED's stimulative policy of creating huge amounts of fiat money.

In any society there is a group of prudent consumers who save diligently for their after retirement era. There is also a group of irresponsible consumers who only consider the pleasure of life at present time. Then there is a large group of consumers in the middle ground. During the bubble Wall Street firms threw huge sums of money to consumers, inducing them to borrow and spend. The group eagerly jumped on that bait was, of course, the group of irresponsible consumers. Since Wall Street was able to borrow so much money from the money pool into which flow-back dollars generated by the runaway U. S. trade deficit pour, it was not sufficient just to lend to the irresponsible consumers to use up the borrowed money. Thus all kinds of tricks were introduced to pull in the consumers in the middle to join the drunken party of "borrow, borrow, spend, spend". Eventually Wall Street has realized the obvious that if consumers carry too much debt, they will not be able to service the burden of debts and will go broke eventually. With the default of consumers Wall Street serving as the middleman to recycle the trade deficit generated dollars back to consumers was wiped out, and that was the financial crash as summarized in Seminar Notes. The crash of 2008-2009 essentially marked the end of the era of "globalization" that had been pushed into the orbit since 1980s. FED's near-zero interest rate policy and the wanton creation of fiat money is the attempt to prop up the collapsed structure somewhat and get by at the time being. Let us see why such efforts will not restore dynamic growth and prosperity but only send the economy into the trap of prolonged "Japan Syndrome" next.

With the plunge of interest rates, Interest Income naturally falls off the cliff as the red dots in the first graph manifest. The consumer group immediately alarmed by the condition is no other than the group of diligent savers. With their savvy in financial calculation they notice quickly that their pre-crash saving plans have been blown away since the original plans are not going to generate enough saving for a comfortable retirement life due to the meager and meager interest income. Their natural reaction is to control the spending and save more. On the other side are the financial institutions. After experienced the crash and near death, those supposed financial experts finally have realized the folly of lending to not-credit-worthy consumers, resulting only to have massive amounts of defaulted loans. As those financial institutions tighten the lending standard, the group of irresponsible consumers that want to spend every dollar at hand are cut off from the credit line and cannot spend freely any more. As the very low interest rate environment prolongs, eventually more and more consumers in the middle group start to realize that they cannot count on the rising home and stock prices to bail them out, and they need to beef up their meager savings to confront their retirement life. With the trend of more saving and less free spending, the whole economy built on the assumption of wanton consumer spending stagnates. In order to stimulate the economic growth, FED creates more fiat money, prolongs further the very low interest rate environment, and thus causes more anxiety on the side of consumers toward more saving and more curtailed spending. Thus a vicious cycle is formed to push the economy into the trap of "Japan Syndrome".

Before concluding this section, let us look into another piece of information to assess why the monetary stimulus from FED, called Quantitative Easing, has failed to accelerate the economic growth. In the second graph at the right, Private Wages and Salaries are potted again as the green curve in logarithmic scale. Both the vertical and the horizontal scales are enlarged compared to the case of the first graph. The blue curve is the monthly average yield of 10 year T. Note. The blue curve is also plotted in logarithmic scale, but the scale is made up-side-down; higher the blue curve goes, the yield of 10 year T. Notes becomes lower and vice versa.

The yield of 10 Year T. Note is a good representation of long term interest rate that influences the desire of private businesses to invest and thus boosts the green "Private Wages and Salaries" curve. Let us start from the sharp jump of the blue curve from November. 2008 to December, 2008. After the collapse of Lehman Brothers, the majority of Wall Street players were finally convinced that the bubble had burst and the sky was falling, so stock prices plunged rapidly, and inflation had turned into deflation. Under such an environment, long-term bonds became the attractive investment tool. As massive amount of money poured into the bond market, the yield of 10 year T. Note plummeted to form the sharp peak of the blue curve. It was also around that time that FED started quantitative easing phase 1, nicknamed as QE1. QE1 is to create huge amount of money to buy up from U. S. Treasuries to the IOUs and mortgage backed securities issued by Fannie Mae and Freddie Mac. However, contrary to the expectation of FED, bond investors feared the massive money creation will ignite hyper inflation, so they sold 10 year T. Notes, forcing its yield to back up to the level of early 2008. The higher long term interest rate in turn deepened pessimism among private businesses, and had prevented the quick rebound of the green "Private Wages and Salaries" curve. What QE1 actually did was to generate huge flows of hot money toward Asia, Europe and Wall Street. Thus stock markets caught fire and bounced up from their crash nadir vigorously. Only from early 2010, private businesses, induced by the relentless rise of stock markets, turned to optimistic and started to lift the green "Private Wages and Salaries" curve.

At June, 2010 QE1 came to the end. From the fear, that without QE1 the economy will tank again, the stock market fell sharply. The fall of stock market lifted the prices of long term bonds. Thus the yield of 10 year T. Note dropped and the blue curve in the second graph rose. The green "Private Wages and Salaries" curve was suppressed by falling stock market but was boosted by the rising blue curve during the second half of 2010. The end result was a less dynamic rise of of the green curve in the second half of 2010. On November, 2010 FED started another round of quantitative easing, called QE2. With QE2 another torrent of hot dollars was created, and again boosted the stock market. With QE2 and the resulting rise of stock prices, buyers of 10 year T. Note shied away and the blue curve fell back to early 2008 level. The rising long term interest rate then nullified the stimulative effect of QE2 and the green curve, after the initial boost from QE2, started to curve downward after the initial sharp rise from November, 2010 to December, 2010. Then in March, 2011 Japan was hit by the giant earth quake, the international trade with Japan was disrupted, so the green curve had formed a distinctive shoulder in the spring of 2011. Even without the Japanese earthquake, the green curve would have formed a gentler shoulder anyway. The sharp rise of the green curve in July, 2011 was due to the demand of equipments and materials from Japan to rebuild from the earthquake.

By the end of July, 2011, the fear of another recession has set in. This recession fear in conjunction with the intensifying Euro crises had pushed down stock price sharply. With that trend, the yield of 10 year T. Note dropped sharply so the blue curve made a substantial jump. It was the sharp jump of the blue curve in conjunction with the demand from Japan that lifted the green curve in the latter half of 2011. As the emergency demand from Japan has waned, and the blue yield curve stagnates, the green curve has also grown much less vigorously, raising the worry of another recession as discussed before. This is the situation at present.

Through the analysis of the second graph, we may say that the result of FED's QE operations were creating stock market bubbles to induce the growth of private business, whereas long term interest rate jumps from the inflation fear and thus nullifies the effect of stimulus as FED hoped. That is the reason that the stimulus from massive money creation have failed to launch US economy back to its dynamic days.

4. How Can FED Drain Money, if needed?

When a central bank creates fiat money from thin air, it does not give the money away for free. It always uses the money to buy some thing or lend it to some one. When a central bank buys IOU issued by a third party, whether it is the central government or some agencies, it is equivalent to have lent the money to that third party. In the extreme case like in Japan under the "Japan Syndrome", the central bank even has bought common stocks. No matter how the central bank uses the money created, the total asset of the central bank reflects the total amount of money created by the central bank. The central bank always keep the asset that it has acquired at the value when it was purchased, called "mark to the book". For example, if Bank of Japan buys 1 billion yen worth of common stocks, on its book the common stocks are kept as worth 1 billion yen even if the issuer of the common stock may have ceased to exist and the stocks have become worthless. By this way that is not available to private banks and businesses, a central bank can always keep its asset and liability balanced since the one billion yen created by Bank of Japan to buy the common stocks will always stay as one billion yen liability of Bank of Japan. This kind of convenient accounting method enables central banks to do various financial magics that dazzle the untrained eyes. However, no matter what kind of financial magic a central bank may play, the rules of economics eventually will get even with the central bank and cause whatever consequences bad or good for the society.

The convenient "mark to the book" accounting method does no harm when a central bank is in the mode of money creation, but will cause problem when a central bank tries to drain liquidity from the market to slow down the economic activities in order to control inflation. The way for a central bank to drain liquidity is to liquidate its asset, and retire the money obtained from the liquidation. If the asset earmarked for liquidation is very short maturity instruments, there is no problem at all. The central bank can just wait for a short period and let the instrument mature and get the money back. In case the short-maturity asset needs to be sold, the market price will not be so different from the purchase price on the book. Of course, this kind of maneuver will increase short term interest rates. The long term interest rates will follow but with some lag. Thus the yield curve will flatten to indicate that the economic activity will slow down and the inflation will calm down as desired.

However, if the central bank does not hold enough amount of short maturity assets and needs to liquidate long maturity ones to drain liquidity from the market, a serious problem will arise. With the attempt to sell a meaningful amount of long maturity assets like long maturity bonds, the market price of the bonds will drop substantially, meaning the long-term interest rate will rise faster than the short term rates. This means that the yield curve will become steeper, indicating that inflation will intensify. Such result will send a wrong signal to the market and will heighten inflation expectation. When people expect the inflation will intensify in future, they will buy things in advance, and the heightened inflation will become a self fulfilled prophecy. To deal with such a confusion, the central bank needs to sell more long maturity assets to drive long term interest rates sky high until the economy cave into a big crash.

Massive sale of long maturity assets has another unintended consequence. As the price of the long maturity assets fall due to the central bank selling, the proceeds that the central bank receives will be substantially less than the value of the sold assets on the book of the central bank. For example, the central bank sells long maturity assets with a book value of 500 billion dollars, but only fetches a proceeds of 400 billion dollars. The liability of the central bank will be reduced by 400 billion dollars but the total asset will be reduced by 500 billion dollars. The 100 billion dollar loss must be covered by the capital of the central bank. If the capital of the central bank is just 100 billion dollars, its capital will be exhausted and the central bank becomes insolvent! To deal with such a situation, the central government needs to recapitalize the central bank and give it 100 billion dollars of cash. How can the central government raise the 100 billion dollar cash? The proper way is for the government to cut spending, raise tax or both to obtain the needed cash. Thus the economy will slow down and even fall into a recession, and the society as a whole will share the past sin of massive money creation in the hands of the central bank. The deceptive way to handle the problem is for the central government to issue additional 100 billion dollar long maturity bonds, the central bank will create 100 billion dollar cash to buy those newly issued bonds, and then the central government will give this 100 billion dollar back to the central bank as new capital, but postpone the question of how to pay back the money when those bonds mature. However, astute bond traders will not be fooled by such a deception and will bid up the yield of the long maturity bonds and sow the seed of a sovereign debt crisis in future.

Now let us look into the asset portfolio of the central bank of U. S. A., that is, FED. In the table at the right, maturity distribution of FED's assets at the week of June 6, 2012, and for comparison the maturity distribution of the week of December 26, 2007 at the threshold of 2008 - 2009 recession are shown. From the last row, "Total Asset", we can see that the total asset of FED at the end of 2007 was only about 820 billion dollars, but during the last four and one-half years, FED has created 1.9 trillion dollars. Why such a massive creation of money and what is the consequence of the creation? That will be the topic discussed next.

The performance of an economic entity does not depend only on the amount of money created by the central bank, but also depend on the speed that the created money flows through the society. As money flows through the society, it will generate more money, called the multiplier effect of money. If we are able to tag the money created by FED and distinguish them from the money of later generation, then we can actually measure the speed of the money flow, called the "velocity of money", explicitly. Unfortunately the tag of money created by FED is not possible, so various approximations are used to estimate the velocity of money. If we denote the amount of money created by FED as M, and the velocity of money as V, the production of the society, P, can be written as P = M • V. The 2008 - 2009 recession was the result of the burst of a huge real estate driven bubble, and many borrow-and-spend consumers defaulted on their loans. The Wall Street that served as the middleman to borrow from the pool of returning trade-deficit-generated foreign owned dollars and then lend to consumers would have been wiped out if without the massive aid from FED and U. S. Government. After that the remaining financial institutions shied away from lending to consumers. This has caused sharp plunge of the velocity of money, V. Thus the production P had declined big. FED tries to stop the falling of P, the production, and then engineer a rebound. However, FED is not capable to influence the velocity of money,V, so it increases the suppl of money, M to make the product of M and V, that is, the production P to stabilize and then to turn upward. It turns out FED needed to increase M three fold to achieve the task. To further stimulate the economy, FED has tried to suppress the long-term interest rates to stimulate the economy further. In order to achieve this objective, FED liquidated large sums of short-maturity assets and bought long-maturity assets. The end result is the highly skewed maturity distribution (skewed toward long maturity) as shown in the Table. The pre-crash maturity distribution is rather evenly spread over all the maturities. Then the danger of inducing another recession as discussed in previous paragraphs set in if FED tries to drain liquidity if the economy pick up and inflation lifts its ugly head again. This means that FED believes such drain-liquidity action will not be necessary so it is embarking on the strategy by pushing the maturity distribution heavily toward the long side. This also means that FED is anticipating the economy will be stuck in "Japan Syndrome" as far as eyes can see.

5. Discussion

The original globalization process has essentially self-destructed at the recession of 2008 - 2009, and is replaced by "Japan Syndrome". However, the poison left behind by the "globalization process", that is, the huge U. S. trade deficit remains. If this problem is not solved soon, another disaster is going to befall on the U. S. economy and will turn "Japan Syndrome" into a bottomless pit.