Mike Bird on the Eurozone, Abenomics, and the Fed Balance Sheet

Mike Bird is a reporter for The Wall Street Journal and covers global economics and markets from the Journal’s London office. Today, he joins the show to discuss recent developments in central banking across the world. David and Mike discuss how the Eurozone has dealt with some of the serious turmoil it has faced in recent years as well as Japan’s “Abenomics” program geared toward raising inflation and implementing structural reforms. Finally, Mike shares his thoughts on the Fed’s plan to reduce its balance sheet and what impact that will have on the global economy.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Mike, welcome to the show.

Mike Bird: Hi, David. Thanks very much for having me.

Beckworth: Well, thanks for coming on. We have engaged on Twitter and the blogosphere before so it's great to chat with you in-person. So tell me, how did you get into economic and business journalism?

Bird: That's a good question. It was very much by accident. I think most of the people I know there's basically two ways into economic and financial journalism generally, which is either a strong interest in economics and finance or a strong interest in journalism, and then slowly finding your way to finance. For me I actually did history at university, and very slowly became more interested in economic history during the time that I was there. Thankfully, we had some great economic historians at our university and to be honest, it was a very fertile time. So this was the very early 2010s. Obviously, a lot going on in terms of economic debate in the public sphere then. I became increasingly interested and somebody pointed out to me, just as I was finishing university a job working for a free London based business newspaper called City A.M as their economics correspondent. I didn't think I'd get it because I had no experience. I hadn't really [inaudible] journalism before, but I got it. And yeah, I haven't looked back really. It's an enormously enjoyable job.

Beckworth: Yeah. And you've written for Business Insider as well. Along the way.

Bird: Yes.

Beckworth: Okay.

Bird: Yeah.

Beckworth: So you've hopped along some different media outlets, and now you're at The Wall Street Journal and a very prestigious publication and you write from London and you have, is it one or two columns a week you put out?

Bird: It varies.

Beckworth: Okay.

Bird: I think, generally about two. But it really depends on what's happening. I mean, one of the great things about working here is that we don't have much pressure to churn a specific number of pieces. If you have something interesting to say, there's nothing stopping you writing five a week, if you don't, you take a week out whatever. Yeah, which is one of the really good things about the Journal.

Beckworth: Yeah. And I love following your work, because you seem to cover topics that I find very interesting. And that's why I have you on the show. I have you on the show, for that reason. So very selfish motives here. But no, we're going to have a fun conversation, for sure. So what I want to do is take a tour around the world because you know this topic well and take a look at central banking, where we are here at the end of 2017. This show will probably come out in early 2018. So this is maybe a state of central banking end of the year 2017.

Bird: Cool.

Beckworth: And I want to begin first in Japan, because you've written a lot and even in your own personal tweets and stuff, you've had a lot of interest and focus on Japan. And Japan has been great for anyone who cares about monetary policy or just economic conditions because they soon will-

Bird: Yeah.

Beckworth: ... be the leader of the experiences and problems that the rest of the advanced economies soon will be facing. They were the first ones to get to zero lower bound on interest rates. They were the first one to try quantitative easing so back in 2001 to 2006. First I should say recent experience with quantitative easing large scale asset purchases, there's some early historical experiences. But that's the first modern one and now we're in the current period and they're doing something called Abenomics. So tell us what Abenomics is and what is your sense of what it's accomplished and where it's going.

Abenomics and its Accomplishments

Bird: Sure. So Abenomics is just the very basics of it. Shinzo Abe, Japanese Prime Minister was elected in a pretty big victory towards the end of 2012. Slightly later, the next year he brought in Haruhiko Kuroda, who's the governor of the Bank of Japan. Abenomics is very aggressive even by Japanese standards reflationary and expansionary economic policy. And a huge part of that is the monetary policy arm. I think in an interesting way, Japan has somewhat less central bank independence. It was very clear when Kuroda came in that it was to exercise Shinzo Abe's vision which obviously, Kuroda shares. But the two don't operate very independently from each other in the way that some people might think of it if they're British or American. It's very much intertwined.

Bird: I guess the basic way to look at it is the three arrows, which is how they started off. I'll get round to this in a minute. But I think one of those arrows is a bit of a red herring, the three arrows are monetary policy stimulus, fiscal policy stimulus, and structural reform, effectively designed to all be done at the same time. Yeah. And that was the basis of it. It's been running since 2012. Shinzo Abe has since won two additional elections, so secured himself a mandate really, it's actually not too long until he'll be the longest serving Prime Minister of Japan in I think something like 120 years.

Beckworth: Interesting.

Bird: Yeah, yeah.

Beckworth: So this is a big deal over there, because they have for at least a decade, they've been wrestling with deflation, sluggish growth. I mean, your whole point that they're trying to reflate the economy, and many people in Europe and in the US might be bothered by that notion. But they literally have been fighting the opposite of the 1970s that we've experienced in the rest of the world. They've had to wrestle with that. And it's not just low prices with good growth, it's been low prices, low growth, just a very stagnant experience. And so they've wrestled with it, and what is your sense of what Abenomics has accomplished? Well, actually, before we get to that, let me step back. Let's put some perspective on what they've done. So they've done large scale asset purchases, right?

Bird: Yes, yes.

Beckworth: And they've done a lot, right?

Bird: It's been, as I say, extremely aggressive. The asset purchases are not really comparable in scale to anything that has been done in another major economy. I think that the closest comparison is probably Switzerland, which you wouldn't really call a major systemically important global economy. In terms of comparing it to the ECB or the Fed, the asset purchases are considerably larger, to the extent that now the Bank of Japan's balance sheet is about 520 trillion yen, or 4.6 trillion US dollars, so slightly larger than the Fed's. And when you remember that the Japanese economy is considerably smaller than the US economy as a proportion of GDP, you're talking about over 90% of GDP, the size of the Bank of Japan balance sheet, in comparison to I think something like 23 or 24% for the Fed. So it really is much larger.

Bird: To be honest, they started their post crisis policies much later, in a way. They didn't have as bad an experience in 2008, nine, ten. And really, as you say, Abe came in, not with an effort to revive the economy from a post 2008 slump, but really to revive it from what was by then a couple of decades of stagnation. Yeah. So in a way, it's a slightly different effort than the one that's been made in the US or the UK or the Eurozone, which is very much about recovering from 2008. And it's more designed to combat a deep and seated problem that Japan has, as you were saying, they've had either no inflation or deflation for a very long time. They've had a very low economic growth. And as you may be able to tell, I'm much more optimistic and positive about the prospects for Abenomics and what it's done so far than I think the general narrative has been.

Beckworth: Yeah, that helps answer a question I had, in the US, there's been a lot of political pushback against the Fed's efforts. So Ben Bernanke, the former Fed chair had a hard time doing QE two, QE three. And there's still this desire to shrink the balance sheet. What's been interesting to observe Mike, about this is that in the US, QE was often very unpopular. And I can just imagine if you had upped the scale tremendously like it was in Japan, it would be even more hated by some individuals. But my sense is in Japan, it's been well received overall, is that your sense as well?

Bird: I think it's to some extent, well received. There's a few different moving parts here. I don't attest to being an expert in Japanese politics, by any stretch of the imagination. But I do wonder whether some of the progress that Abe has made on making his economic policy program mainstream and accepted has been from the fact that he's a conservative, he comes from the political right, rather than the political left, which is slightly different to the way a lot of this has gone in the Western world, where people on the left are somewhat more associated with expansionary economic policy. And though you do get resistance in Japan. You can imagine there are places where, for example, the price of everyday household goods I think it's often things like junk food, almost, where the prices of certain things haven't risen for maybe 20, 25 years, and they're starting to see price rises, and no one likes the additional small price rise to something that they know that's been fixed for a very long time.

Bird: And this gets to the deep seated problem in Japan in that you didn't just have deflation, you had a deflationary mindset. Unions had stopped asking for wage hikes, people did not expect wage growth, and in many ways did not require wage growth, because their living costs were not rising. Property prices didn't rise dramatically, land prices didn't rise dramatically. And so really what they're combating is somewhat different from the experience in the Western world.

Beckworth: Yeah. So it was a different problem, as you mentioned. And I want to be clear to my listeners, I personally I'm not against deflation, per se, if it's associated with rapid growth, but Japan didn't have that. Japan was stagnant on all measures. So it's not just a fear of deflation, it's a fear of a number of symptoms that were associated with deflation, the bad form of deflation. Now they're also in addition to doing massive amounts of asset purchases that dwarf what the Fed has done, they're also aiming to pin down interest rates as well. Is that correct?

Bird: Yes, this has been a really interesting shift in the Bank of Japan that I think has been under discussed, which is in 2016 they moved towards what they call yield curve control. Effectively, they established that just to give a bit of background to this, the Bank of Japan cut their benchmark interest rate into negative territory. And what they've realized I think, relatively shortly after doing that, is that the expansionary impact that you might get from a lower interest rate wasn't necessarily enough to offset the potentially negative effects on the way banks operate. Banks really seem to struggle with negative interest rates. These are places where they've got fairly low margins anyway and have for a very long time in Japan, and they struggle to make money basically.

Bird: What the Bank of Japan moved to is yield curve control, which essentially fixes the 10 year Japanese government bond yield at zero percent. In reality, it ranges between minus naught point 1% and plus naught point 1%. Anywhere above or below those levels, the Bank of Japan will effectively intervene, either by cutting or raising its asset purchases to meet that goal. It allows the yield curve to be a little bit steeper further out. So you don't have the incredible flatness or negativity that you had in parts of 2016.

Bird: And the really interesting thing, I think about this, and it's something for the economics nerds among us, is that the Bank of Japan from 2013 to 2016 had the most overtly monetarist policy in that it was based on expanding the Bank of Japan's balance sheet and really the monetary base by a certain number of trillion yen per year, it was an explicit monetary target. And what they moved to with yield curve control is really quite a credit test target. They've aimed essentially to track financial conditions to fix financial conditions as measured through the 10 year JGB at a specific level, and they will now and they have been varying their asset purchases, depending on whether they're hitting that target or not. So I think there's a really interesting step change there in that you had something that would have been recognizable to Milton Friedman, in the first place the targeting of monetary aggregate, changed to something that's really very much focused on financial conditions.

Beckworth: Yeah. It's almost mind blowing from my perspective over here. They are targeting the 10 year government bond yield at zero percent.

Bird: Yeah.

Beckworth: Just think about what that means over the next 10 years. People who buy these bonds are effectively paying the government in real terms to take theirs, "Here's my money, please give me less back in 10 years." But apparently people are more concerned about preserving principle than getting the positive return. So that's the mindset. I mean, that's what they're facing really. Those low yields are a symptom of I think the deeper problem they're wrestling with.

Bird: Yes.

Beckworth: But it is fascinating. You're right, the Japanese have always been more monetarist in spirit when they've done their large scale asset purchases. The first QE they did from 2001 to 2006, they were very explicit. They were trying to expand... They were thinking about the liability side of their balance sheet, expanding the amount of reserves, the monetary base. And Ben Bernanke had some speeches where he mentioned what the Fed was doing was very different. The Fed was doing the credit approach, they were more concerned about the asset side of the bank's balance sheet, their central bank's balance sheet. They were trying to affect credit spreads, interest rates. And now what you're saying is that they've shifted to that direction as well. They're much more concerned about yields, credit spreads and those financial market issues.

Bird: Yes, absolutely. It's been a really interesting shift to watch. And I think we'll probably get on to this, if we talk about the ECB a little bit later. But part of the issue here, I think, is the semi political constraints on the central bank in terms of there are only so many JGBs in the world, and the Bank of Japan doesn't really want to be seen to buy up the entire government debt market. One of the reasons that they changed policies was because they were buying something to the tune of 80 trillion yen a year in Japanese government bonds and the yield curve control policy means that they're really now, even though they technically still have a target to buy about 80 trillion yen, they're only really now buying more like 50 trillion yen. It extends the potential lifetime of the policy, somewhat. They don't hit those constraints as early on.

Beckworth: Yeah. So again, another mind blowing observation, they're buying up most of the government debt over there. And at some point, they would have all the government debt if they kept doing this. And so the yield curve targeting allows them to get to a similar objective without having to buy as much. But I guess it then raises another interesting question, aren't they also buying ETFs, exchange-traded funds?

Bird: They are. They are. Which has been a really interesting thing. And I think it's something that... There's a way of looking at it as an interesting thing, and there's a way of saying there's no need to overplay the importance of this. Now it's always seemed more acceptable for central banks to buy government issued assets rather than private sector assets, even though you could look at the Fed, the ECB and the Bank of Japan and say, "Okay, well, the Bank of Japan is buying ETFs but the ECB buys corporate bonds, the Fed bought MBS." And you could meaningfully say all of these, to some extent are private sector assets.

Bird: I think the issue specifically with the Bank of Japan and ETFs, it's not that important from a macro perspective, it's relatively small in terms of the proportion of what they buy. I do think it probably has an effect in those Japanese equity markets in that knowing psychologically that the central bank is now effectively the buyer of last resort in the equity markets has some power to, and I know there are some concerns about there are major Japanese stocks where the Bank of Japan is now a considerable holder via its ETFs. And one of the largest owners in several big Japanese stocks. And you've got to think to yourself, how does the Bank of Japan act as a corporate steward? Are they're going to be an active investor, are they're going to be turning up at corporate meetings and exercising their shareholders rights? It's an interesting step change. But as I say, I think it doesn't have a huge macro impact, and I'm not sure whether it's too different from the private sector asset purchases that have gone on in Europe and the US.

Beckworth: Okay. And just for the listeners who aren't clear these ETF, these exchange-traded funds, can you explain to them why it means that the Central Bank of Japan is effectively buying up the stock market of Japan? Explained what they are here.

The Bank of Japan’s ETF Purchases in Context

Bird: Sure. So the exchange-traded funds are effectively a vehicle that will buy a basket of stocks. So you or I could buy a Japanese stock ETF and you can put any amount of money into it basically, and it will buy a proportional number of Japanese shares across say the topics or the Nikkei 225 index. The thing is when the Bank of Japan continues buying these and eventually owns enough ETFs that it owns large parts of corporate equity in the Japanese market, it becomes a major shareholder in some of the big Japanese manufacturers, some of the big banks. And it's not immediately clear how that works in the long run.

Beckworth: Okay. So I guess my question is, how aggressively are they buying up the ETFs?

Bird: They're buying them up fairly rapid clip. To be honest, I wouldn't be surprised if they change the ETF policy in relatively short order. I don't know whether they'd go into corporate bonds, or they'd just continue buying JGBs. But I think there may be an element there. I think there was a signaling effort behind it. But that they actually can't buy that many ETFs. And I don't think the Bank of Japan wants to be a majority shareholder in major Japanese companies…

Beckworth: Right. So that's-

Bird: Yeah.

Beckworth: ... the political issue that comes up. If they just put their monetary policy in autopilot, this is for the sake of argument, but they keep doing what they're doing, they put it on autopilot, they come back in six months, they own the entire Japanese stock market. The Government of Japan via its central bank owns the stock market. That would be pretty radical. Right?

Bird: It would be pretty radical, yeah. And it's an odd form, I guess of nationalization in that it's owned by the central bank, rather than the government. But I mean, the difficulty being that JCBs, you buy JGBs you just sit on them. It has a monetary policy impact, it has an impact on the economy, those eventually mature, you either sell them back to the market or you reinvest the proceeds, you do whatever you want. But effectively, the government and the monetary authority have a relationship with each other that's well understood and has been for a very long time. As you alluded to a little while ago, these are not the first asset purchases that have ever happened. There are a number of schemes during the Great Depression. In fact, Japan did some overt monetary financing during the Great Depression. This is a historical relationship that's well known.

Bird: What I think is somewhat less known is what business the central bank has buying up large sections of private companies and exercising ownership rights there. I don't think it's a problem that the Bank of Japan wants to have to be honest. I don't think the upside of buying lots and lots of Japanese equities is worth it to them for the downsides of working out what on earth they're going to do with them in the long run.

Beckworth: Yeah, I think this speaks to the fact that these policies are so radical, and yet they're being tolerated by the public over there, which means that the public understands the significance of the problem they're facing. The deflationary drag, the stagnation they have. That the central bank has resorted to these radical policies and there's not been a big backlash against them. So let's move on from the specifics of what and how they're doing it to the results. Do you see results from these policies?

The Results of Abenomics

Bird: Personally, just to lay out, there's a very strong narrative in terms of this. A large part of that comes from financial journalists, that Abenomics hasn't worked. That it doesn't work. I think that's slightly embedded around the fact that Japan has had a long period of deflation and the fact that there's a general perception that monetary policy, this is pushing on a string argument, I think is fairly popular among financial journalists. I disagree personally, in my career and the reporting that I've done and the economic analysis I've done personally, I do think it's worked. I think Japan has been going through its most impressive period of economic growth on a number of different metrics since the early 1990s, and this is in the period pretty much since Shinzo Abe took office, certainly since Haruhiko Kuroda was appointed in 2013.

Bird: I think if you look at nominal GDP growth, that's a very obvious place to start looking because it's what the central bank's effectively aiming to control. It's Japan's most impressive period of economic growth on that statistic in again, 25 years. If you look at real GDP growth, again, it's been consistently above what economists regard to be the potential output of Japan. If you dig into some other real economy metrics, particularly in the labor market, it's been very, very strong. Participation rates are extremely high, even by any historical standard, unemployment rates extremely low. You've got a job to applicant ratio in Japan now of over 1.5, which is basically unheard of in most of the developed world. Yeah, I think it's worked, is the basic answer.

Bird: I think it's really worked considerably better than a lot of the other reflationary policies around the world. I think that it's a fascinating playground for monetary policy, to be honest. Japan is so far ahead in many ways, from the rest of the developed world. And I think people should take note of the fact that actually, when you look at what's happened since 2012, the past four or five years, it does seem to have worked a lot better than the popular perception.

Beckworth: Okay. So there's been an inflection point in the economy that coincides with the adoption of these policies under Abenomics. So-

Bird: Yes.

Beckworth: ... one takeaway is it is working, it's radical, but it is working. Japan's on a better path than it was before. All right, very nice. Well, let's move on then to Europe, let's talk about the Eurozone and the European Central Bank or the ECB for short. How has the Eurozone economy been doing lately?

The State of the Eurozone Economy

Bird: Well, it's been a great year to be covering this. So I cover European financial markets, certainly more than anywhere else, and the European economy. It's been going pretty well, this year. It's been booming, I made a lot of jokes on social media about that booming is not quite technically correct. The growth is not quite strong enough for it to be a boom. But what it's done is it's broken out of the period that was, since about mid-2013, you had fairly reliable growth of around naught point three percentage points per quarter. And that's quarter on quarter growth. You had unemployment falling. But the growth wasn't stellar, it was slow.

Bird: In fact, what you've seen this year is growth pick up. The pace is more like double that. What you've also seen is fairly synchronized growth across different economies in the Eurozone. This is not a story about Germany accelerating very quickly, and everyone else trying to play catch up. French economic growth has been stronger than expected, Spanish economic growth has actually been strong for a few years now. Italian economic statistics have surprised the upside. You've seen a fairly broad based upswing, you've seen even more rapid falls in unemployment. There's some fascinating things happening in the German economy, particularly where unemployment is very low. And you're starting to see the, finally, you're starting see some prospects of the German economy potentially starting to overheat, produce some inflationary pressure, which is really what the Eurozone has been looking for, for a very long time.

Bird: But yeah, it's been actually a really good year. You've seen some of the political risks that people worried about earlier in the year abate. I would say it's probably been the strongest post crisis year for the Eurozone. In fact, I don't think that's really in contention. Yeah, so it's been a really interesting one to cover.

Beckworth: So this gives us hope for the Eurozone project then. There's still hope that it will survive.

Bird: I think so. I wouldn't underestimate the challenges. I think when I speak to Eurozone policymakers, they are still keenly aware that what happened in 2010, 2011, 2012 was a half-finished political project encountered some extremely serious problems. And came out on the other side in one piece by the skin of its teeth. And I think a lot of them realize that the project is still incomplete, they're not sure whether the Eurozone could face another serious crisis, even though the ECB has done a great deal to give them some time, at the very least, to sort these things out. But I think it's certainly more hopeful. There are a number of years where journalists in the UK and the US were very, very negative about the Eurozone, or I think they were slow to realize from about 2015 or so that actually the predictions of its immediate demise were not coming about. I think this has been the year that people have realized there's more prospects to the Eurozone surviving, making its way through than they'd thought certainly during the Eurocrisis.

Beckworth: Yeah. I mean, from an economic perspective, and I'm guilty of being one of those people who thought its future was doomed. But from an economic perspective, it does seem to have a lot of things going against it. It doesn't seem to be, at least on paper, an optimal currency area, where it doesn't seem to make sense to have a one size fits all monetary policy for these countries. They have very different business cycles and structurally different. There's not a unified, large fiscal policy transferring resources across regions. So on paper, it looked troubling. But I think what we've seen or learned, what I've learned, is that the political commitment to preserve the Eurozone is much stronger, or it's been strong enough to persevere this long, and maybe even further.

Bird: Absolutely. I would agree with that entirely. And I would never say that oh, I knew this all along. I'm also one of the people that thought the Eurozone did not have a future as a political or economic project. What I do think is that for a couple of years... What changed my mind particularly was the Greek crisis in 2015. The economic situation in Greece is still relatively dire, unemployment is extremely high, they've gone through something that in reality was probably on the scale or if not, in the terms of the headline figures, slightly worse than the Great Depression was for the US, truly terrible stuff. And they feel like this has been imposed on them by other Europeans, particularly by Germany.

Bird:  But when you go to Greece, you realize that the political appetite to return to a national currency and national economic policy is also extremely low. And that's true across much of southern Europe, even in the countries that really struggled economically. So it does give you the impression that there is life in the political project, even if only because the level of trust in national politics is so low, that even that low levels of trust in the European project are somewhat higher.

Beckworth: Yeah. It is truly amazing that a group of people would be willing to tolerate a great depression just to hang on to the hope of the Eurozone project. They're willing to endure the pain of a great recession, the Greek people, in order to be a part of the Eurozone project. So that does tell you how much they want it. Well, let's talk about the ECB a little bit more, the central bank. They have the Eurozone. You've written some recent articles you have one titled *ECB Taper Promises to Set Off Ripples Across Many Nations.* You also have one titled The ECB and The Fed are growing apart moving market. So is the ECB gearing up to taper and what does it mean for the world economy?

The ECB’s Tapering and Its Effect on Exchange Rates

Bird: I mean, the ECB is really, they've been very clever in vocalizing their tapering intentions in a way that hasn't upset financial markets particularly. They were very keen to avoid what happened in 2013 in the US, the Bernanke Taper tantrum. For those not aware, then Fed Chairman, Ben Bernanke signaled the tapering of quantitative easing, the purchases would fall in size and then stop, financial markets reacted fairly sharply. They wanted to avoid doing that, but the ECB has now twice cut the size of its monthly purchases. And everyone knows. Everyone who works in European financial markets in European economics knows that the European Central Bank has set some fairly strict limits on itself in terms of the proportion of debt that it can buy, the proportion of the government debt market and they can only buy so much debt for example, from Germany if they buy a certain amount from France. They're nearing the limits on some major countries in terms of what they can do. So they're tapering house, regardless of what happens to the economy, the tapering has to happen, really.

Bird: But they've done very well in terms of not provoking negative market reactions this year, despite the fact that they've effectively had to come out and admit that quantitative easing will come to an end or will slow down dramatically, probably into next year and potentially ending towards the end of next year or potentially beginning of 2019.

Beckworth: And does this have effect on exchange rates, other countries that are linked to the Euro? Can you talk about that a little bit?

Bird: Absolutely. Yeah, it does. It does. One of the really interesting things this year has been, and this is, in some ways how you can see it's been a clever tapering, the spread in yields between Germany and the US, I was looking at the spread between the two year German bond yield and the two year Treasury yield this morning, it's at about 2.5 percentage points, which is extremely large and shows what a gap there is between the prospects for the Federal Reserve raising interest rates and the ECB raising interest rates. A lot of people personally, I think, rightly expect the ECB to wait until at least 2019, before raising benchmark interest rates. If the Federal Reserve's dot plot is accurate, they'll raise rates several times before then.

Bird: What you would expect and one of the interesting developments in markets this year, what you would expect is for that to weaken the euro against the dollar, which hasn't happened this year. The euro is actually considerably stronger. We came into 2017, with a lot of people expecting the euro to test dollar parity. Goldman Sachs, for example, their FX guys who are great, but they expected the euro to fall below parity against the dollar. Obviously, it's up more like 118 now, maybe even higher or hopefully not much lower at the time that this is played. But you'd expect the euro to weaken on this divergence. And one of the really interesting things is that it hasn't, it's actually strengthened, and that's in large part on the back of those political risks. So we were talking about earlier abating.

Beckworth: Okay. So there's more hope in the Eurozone project long-term, which has increased the attractiveness of investing in Europe and has kept the euro higher than expected?

Bird: I think so. I think so.

Beckworth: Okay.

Bird: Particularly that French election earlier in the year did a huge amount to assuage international investors that there wouldn't be populist governments in large systemically important Eurozone economies, which was really important.

Beckworth: And this speaks to the question now, where is the Eurozone going? So one of the big critiques of the Eurozone is that they haven't had one fiscal policy or very coordinated fiscal policy across the different parts of the country. I know there's been talk about getting a bond backed by different government bonds within the Eurozone, kind of a safe asset over the Eurozone. Has there been any meaningful movement toward further fiscal integration in the Eurozone?

Bird: There's been, I think... Well, Emmanuel Macron elected in France earlier this year, he's an open advocate of fiscal integration of Eurobonds, of a common Eurozone budget. That said, the answer to that question is very little.

Beckworth: Okay.

Bird: The instrument I think you're referring to there, the safe asset, that's been a really interesting idea that's cropped up across a number of European institutions. The systemic risk board, the European Commission, the European Central Bank, there's been some very senior people buying into the idea of what was referred to by some academics as an SB. So it's a structured vehicle backed by the bonds of various Eurozone countries. That said, what all of these proposals are still missing is the buying of the German political system. Germans do not like the idea of sharing political policy with other countries in Europe, particularly France, particularly the countries on the southern rim of Europe. They don't want to and as long as they don't want to do this is going to be extremely difficult to achieve. And it's one of the big problems that the Eurozone still has.

Beckworth: But if the Germans do eventually buy into this idea, we would see a bond debt instrument from Europe that was backed by other government bonds throughout including Germany. So the SB would be a competitor to the US Treasury bond?

Bird: Basically, yes. The idea would be, I believe they'd tweak the idea, a bunch of academics that work on it, but you'd have a junior and a senior SB. You'd have a senior SB which is judged to be the safe asset, the equivalent of in the Eurozone, a German bond or in the US, the Treasury. And the junior one would be the high yield equivalent, with the basic idea being that if any Eurozone country defaulted, you can think of the SB as a CDO filled with European government bonds. And if any individual government defaulted, it will be the junior tranche of the bond that would default, and the senior will be protected. That's the basic idea behind it. I can certainly see the advantages for that in terms of the European banking system having a stable and common safe asset. But as I say, you really, really need the buy-in of the German government for this and I'm not sure they're yet particularly close to agreeing to.

Beckworth: Okay. Well, let's now move to your home, the United Kingdom. You're in London.

Bird: Yes.

Beckworth: So let's talk about the hot topic there, and that's Brexit. What is going on with Brexit?

Updates on Brexit and the British Economy

Bird: Well, it's always fun to talk about. Just to give a bit of background, at the moment the UK triggered what's called Article 50. It's the provision in the Treaty of Lisbon, which is the last major European Union treaty for leaving the European Union, which sets in place a two-year process of negotiating to leave. The stage that we are currently at in the negotiations is still negotiating the financial terms of the UK's exit from the European Union. So the UK needs to agree to a certain size payment to settle things like pension liabilities, obligations that we made before we left the European Union, things of that nature.

Bird:  We're not yet on to the bit where we hopefully talk about our future trading relationship with the European Union. We need to get past this bit first. It has been very much the only topic of conversation in British politics for a very long time. Everything for the past couple of years has revolved almost entirely around Brexit, the consequences or lack of them, how this affects British politics. It is absolutely everywhere, all the time. Yeah, we very much live in Brexit land now.

Beckworth: Okay. In a best case scenario, what do you see happening to the British economy because of Brexit?

Bird: I think it's still very much depends on the deal that the UK gets. I think it's reasonable and objective to say that there would be a serious short-term issue for the UK economy in the case that the UK left without a meaningful trade deal agreed. I think that the problem for the UK is that financial services are a huge part of the cross border trade that the UK does with the rest of the European Union. London is the wholesale banking center for large parts of the EU. And there are no meaningful trade deals in existence that allow the seamless access to cross border financial services that the European Union single market does. And the EU doesn't have that trade deal with Switzerland, it doesn't have that trade deal with Canada. They don't really exist.

Bird:  So I think the best possible outcome for the UK is that there is a trade deal that fairly closely resembles what we have at the moment, although the difficulty of that is that the UK did vote to leave the European Union and the European Union's rules on who can have that market access require applying the judicial control, the European Court justice, some political elements like free movement of people, which are redlines, it seems the UK politics surrounding them.

Beckworth: So in order for London to keep its advantages, this wholesale banking center, this financial capital for Europe, it would be an unusually generous treaty from the European Union to an outside political entity.

Bird: I think so. There's a couple of things on the European Union side that makes sense in that what they really don't want to do is incentivize any countries to also consider leaving.

Beckworth: Okay.

Bird: There's a bit of using the UK as an example because if you offer the UK a generous trade deal where nothing really changes, but you don't apply the laws and directions of the European Union, then what happens when Hungary or Italy or Malta turn around and say, "Well, we want that too. We don't want any of what's going on in Brussels, but we will have the trade deal. Thank you very much."? That's the difficulty that they face.

Beckworth: Okay. What about monetary policy? So what is the Bank of England been doing and where is it going?

The Direction of England’s Monetary Policy

Bird: Well, the Bank of England has been an on interesting journey since the EU referendum. Around a month after the EU referendum, the Bank of England did what it had been signaling and it cut interest rates, cut UK base rate by naught point two five percentage point. And just a couple of months ago, they raised bank rate again back to where it was before. What's happening in the UK now is actually quite different to what was happening for a number of years before. And the economic concerns in the UK have diverged quite sharply from a lot of the rest of the world. The UK's inflation is not only currently above target, but it's above target even at the three year forecast of the Bank of England, which is why they've started raising interest rates.

Bird: It's very rare these days to find an advanced economy where inflation is a meaningful concern. But the UK is now there. Yeah. And that's interesting for a couple of reasons. The reason that inflation is above target at the moment currently is really just related to the fall in the pound. Exports, sorry, imports have become more expensive, and the UK imposed a lot. And so inflation goes up almost mechanically. The reason that they think inflation, at the Bank of England, is going to continue to stay above target is partly because they believe that the supply potential of the UK economy is somewhat lower. That's partly due to Brexit, that's partly due to the UK's now extended run of very, very poor productivity growth. All of which together means generally with the labor market, as it is now in the UK, unemployment is now very low. Participation is very high, you're likely to see inflationary pressures if you don't see productivity pickup. And if you start, for example, effectively erecting protectionist barriers with parts of the world that you previously had free trade with.

Beckworth: Very interesting. Okay. We've taken a tour of central banking in the major advanced economies around the world, the Eurozone, the United, well, we haven't touched on the United States, we've skipped that one. But all the others, the ECB, Bank of Japan. And our listeners know the US experience from our other podcasts and from their own understanding if they follow this discussion. What lessons can we draw from these experiences with unconventional policies? There's been negative interest rates, we've had large scale asset purchases, there's been new ideas floated, Japan has tried yield curve targeting. What is the takeaway or takeaways from these experiences?

Lessons From Unconventional Monetary Policy

Bird: That's a good question. I think the most obvious takeaway, at least in the past couple of years has been that negative interest rates seem relatively unlikely as things stand to be employed in the future as a major policy tool of central banks. I don't think any major central bank has particularly had a particularly happy experience of employing them. They've been a tool or most of desperation of not knowing what else to do.

Bird: On the other hand, I think as we discussed earlier, the experience of Japan suggests that, suggests to me in any case, that quantitative easing probably works somewhat better than the popular narrative suggests. I think that that's very likely to be a tool in future. I think that the assets purchased in any future crisis are likely to be broader. You've seen that recently, anyway in the fact that the European Central Bank now buys corporate debt, and we've talked about Japan's buying of ETFs. Yeah, I think that quantitative easing is likely to be one of them. And potentially, to be honest, if there were another crisis tomorrow, I think you'd probably see quite a lot of outright monetary fiscal coordination, effectively the central bank directly funding fiscal stimulus. I think that's extremely unlikely, it's extremely likely rather.

Bird: One of the interesting idea that's been floated in the US recently is price level targeting. That's been really interesting and I think, I hope actually, we're going to see more discussion about that. Because the relative flaws with inflation targeting that have popped up since the crisis have become increasingly obvious. Price level targeting, I know you're a fan of nominal GDP targeting. And I think these are likely to crop up increasingly as potential answers that central banks need.

Beckworth: Okay. Well, I hope you're right in the level targeting front. I think all these other policies become more effective when you've got a level target to guide and anchor them.

Bird: Yeah.

Beckworth: Let's talk about some of the developments in the financial markets because you also cover those.

Financial Market Developments

Bird: Yes.

Beckworth: And you've talked about, one of your most recent articles about the stock market boom, a global stock market boom, global earnings have hit record highs. What all is going on there? Why is the stock markets so happy?

Bird: That's a good question. I think one of the things, and we've spoken about this a little bit when it came to Europe is this has really been the first year of synchronized global recovery. There are very hardly in recessionary territory. Emerging markets are doing relatively well. The Chinese economy hasn't slowed down by as much as some people feared that it would. And the Eurozone is growing, Japan is growing. US growth still seems to be strong, despite perpetual worries that the US is late cycle, that it's on the edge of a potential recession. That doesn't seem to materialize.

Bird:  Trade growth has picked up this year, something that's been lacking since 2008, which is really great for a lot of emerging market economies. And it's really good actually for the Eurozone and Japan. Yeah, I think that's a large part of it. The commodity price volatility that we've seen in recent years has dissipated a little bit, you had an earnings problem simply because so many large equities are commodity focused that when commodity prices crashed, a lot of those stocks did really badly. That seems to be out of the way. Even though there's a huge amount of discussion in politics, if you were just looking at economic statistics, economic metrics, this is one of the most... I was speaking to someone the other day who put it this way. They said that it's the most normal post crisis year so far, just in terms of the economy. And I think that sounds just about right to me. And that's been a major support for markets. And why you've seen such broad based improvements, certainly in equity markets around the world.

Beckworth: So the global economy is improving and this has been reflected in stock markets. This is a good thing. One of the issues you brought up in that conversation is the yield curve in the US has some potentially troubling signs coming from it. But there's been a different way to interpret it. And one interpretation is that it is pointing to a weakening of the US economy. Another interpretation is that maybe the long end of the yield curve is acting differently. Long-term interest rates in the US are acting differently because of all these developments in the world, the QE programs around the world, the shortage of safe assets around the world. How do you view the flattening US Treasury yield curve? Is it more benign? Or is it more troubling?

Bird: It's interesting. I think it's always worth paying attention to these metrics, because a really steep sharply flattening yield curve, as we have at the moment has been a decent recession indicator in the past. It's certainly worth keeping an eye on. But what you alluded to there, which is partly the large international buying of US Treasuries potentially wasn't quite as true at the time of the last US recession, and it really is true now. So I think you do have to look at it slightly differently. And actually, the UK is a good example here. The very, very long dated UK government debt, so thought of 40 and the 50 year maturity, they actually yield less a lot of the time than the 20 and 30 years.

Bird: And that is because in the UK, we have a large pension fund appetite for those very long dated UK government bonds. And it means that the yield curve is inverted at the medium to long and basically all of the time. It doesn't have any special economic signal. It doesn't offer any information. It really is just because there is a very large institutional buyer that has a perpetual appetite for that debt. It may very well be the case in the US that these are Japanese pension funds, Japanese insurers, Eurozone insurers, Eurozone pension funds, buying longer dated US debt. And that potentially, as you suggest, the yield curve doesn't offer as much explanatory information as to the state of the US economy than it did maybe 10 years ago.

Beckworth: Oh, I hope you're right. That's a very nice interpretation.

Bird: Fingers crossed. Fingers crossed.

Beckworth: Yeah, fingers crossed, for sure. Okay. In the few minutes we have left, I want to end on an article that you wrote on the dollar and the title of the article was, *A Decade After the Crisis, King Dollar Is the World's Tyrant.* And this actually does tie back into Fed policy, which we haven't discussed. So share with us what you covered in that piece.

The Dollar as the “World’s Tyrant”

Bird: Absolutely. Well, it's been a fairly popular narrative for a very long time now that the dollar's dominance of the global financial system might be at risk. It was popular before the Euro crisis, that the euro might supplant the dollar in a number of markets. It then became popular to imagine that the Chinese yuan would do the same thing. What we really wanted to explore in this story, and to explain is that the dollar's control, control is the wrong word. Because it's not the dollar controlling it. The dollar's influence in international markets is not only not diminished, but probably greater than it's ever been.

Bird:  We were looking at a number of different variables. But whatever you look at really, the dollar is still the overwhelmingly dominant global currency in terms of issuance of international debt, it's dominant almost completely in trade accounting. Banks in the rest of the world are still hungry for dollars to the extent that there are some markets for foreign exchange swaps that are extremely distorted and have been for a long time. Yeah, we really just wanted to look into this idea. And for me, it's one of the fascinating things to keep an eye on in terms of potential future crises, the dollar's grip is so strong, that any real shortage of dollars would pose a big problem for larger parts of the global economy.

Beckworth: So the dollar is still highly demanded across the world and dollar denominated assets, like treasuries we talked about a few minutes ago. And what was, meaning the pieces you tied this to the Fed tightening its policy, particularly the shrinking of its balance sheet.

Bird: Yeah, absolutely.

Beckworth: Speak to that.

Bird: So the Fed's shrinkage of its balance sheet, I think it's particularly interesting on this front, because private sector, or rather let's just say commercial bank lending, unsecured foreign exchange lending, has become increasingly difficult since the financial crisis, a number of regulatory efforts that have gone in, things like capital requirements, the requirement to hold a lot of high quality liquid assets have meant that US banks, for example, are fairly reticent to lend out a lot of dollars. Typically what they would do is lend a stream of dollars to say a Japanese or a European Bank in exchange for a stream of euro or yen. And the cost of doing that will effectively be the interest rate differential between the two countries.

Bird:  The higher capital requirements have made it much more difficult for them to do that. And in their place, what has happened is the reserves held at the Fed have become de facto the center of international dollar lending. It's very easy for those banks to exchange a reserve at the Fed for a reserve at the Bank of Japan, for example, without expanding their balance sheet and starting to hit those regulatory constraints. Now what happens when the Fed shrinks its balance sheet is a bit of a question mark from here. We spoke to a lot of analysts, a number of whom think that as the Fed shrinks its balance sheet, and they're shrinking the balance sheet at an increasing pace. So next year, they'll start reducing by $50 billion a month. They expect a fairly meaningful tightening in dollar funding as those US commercial banks become less willing to lend dollars to their international peers. That's particularly in Japan, the Eurozone and Canada. And so you might see some interesting things next year in those dollar funding markets. It's definitely one to keep an eye on.

Beckworth: Okay. Well, our time is up. Our guest today has been Mike Bird. Mike, thank you so much for coming on the show.

Bird: Thanks very much for having me. It's been great.

David Beckworth
Calendar Date: 
Jan 8, 2018
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Abenomics was an ambitious economic plan enacted in Japan, and its results may be greater than its critics give credit for.

Economic and Monetary Policy in Asian Economies

Mike Bird is a Hong Kong-based reporter covering financial markets across Asia. He previously worked in the Journal's London bureau, where he wrote about markets with a particular focus on currencies. A native of northern England, Mike won the 2016 Harold Wincott Award for young financial journalist of the year. Mike is a returning guest to Macro Musings, and he recently joined David to discuss economic and monetary policy in Asian economies, particularly China and Japan. 

David Beckworth: Welcome to Macro Musings, the podcast series where each week we pull back the curtain and take a closer look at the important macroeconomic issues of the past, present, and future. I'm your host David Beckworth of the Mercatus Center. We are glad you've decided to join us. Our guest today is Mike Bird. Mike is a Hong Kong based reporter for the Wall Street Journal covering financial markets across Asia. He previously worked in the Journal’s London Bureau. Mike is also a previous guest of the show and returns to discuss some recent developments in the Asian economies. Mike, Welcome back to this show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

Bird: Hi David. How are you doing?

Beckworth: Great. Glad to have you back on. And you've made a big journey all the way from London to Hong Kong and I have to ask Mike, as a previous guest and therefore as an owner and the holder of a nominal GDP targeting mug, did you take it with you to Hong Kong?

Bird: I absolutely did. It's on my desk at home, with a handful of other similar mugs that I stole from various places in London. Yeah, no pride of place.

Beckworth: Great. Great. So, you've got any nominal GDP converts in Hong Kong now?  

Bird: You know what? I don't feel like NGDP targeting has made quite the splash in Asia, that it has elsewhere. I don't think we're in quite the same place. I'm pretty sure Japan could still benefit from it, but it doesn't come up in discussion quite as much here. Or there are other problems I think, to deal with. Slightly less than a slower nominal GDP growth.

Beckworth: Very different issues, different places in the world.

Bird: Yes.

Beckworth: Yeah. And Hong Kong is unique too. If we're talking about Hong Kong, they have a currency board, right?

Bird: Yeah, sure. They effectively have a dollar peg, which is a lot of the reason that I think Hong Kong works to a large extent, and the government's extremely committed to that. We wrote something on this a few weeks ago, but it's really barely moved in the past 30 years at all. Yeah. They've been very committed to that.

Beckworth: Yeah. So interestingly, the Fed sets monetary policy for Hong Kong effectively, right?

Bird: Yup. Absolutely, which is very noticeable in the Hong Kong housing market over the past 10 years or so. Yeah, no. I suppose there's two arguments there. There's always the long-term argument about whether it would make more sense for the Hong Kong dollar to be pegged to the yuan in some way. But to be honest, as an international financial center using a Hong Kong dollar basically being equivalent to a fraction of the US dollar, it makes a lot of sense.

Beckworth: Sure. What is it like working in Hong Kong? I recently spoke to a friend who worked for PIMCO, the big bond fund, on the west coast. And he mentioned how they would have to get up really early in the mornings to be awake when the markets opened in New York. Now you're in an entirely different market at the other side of the world. In fact, we're doing this podcast in my time in the evening. It's AM your time. So when you're working, I are you paying attention to the Asian markets? Do you have to wait odd hours for the US and European markets to open? What's it like?

Bird: Okay. You get a, I think, a fairly decent day and to be honest I think it's in some ways better than the day in London. I have a view that the US time zone is worst for global markets. This is why you get people like Joe Weisenthal waking up at like three in the morning because by the time everyone's awake and the market's open in the US, almost everything in Asia and Europe has already happened. So working here you get the benefit of getting up, usually shortly after the US markets have closed. You got to see what happened there. You start the day for everyone else early to mid-afternoon your time, the European market start opening. There's a very civilized close time for Chinese and Asian markets generally. They break for lunch and everything. It's actually quite enjoyable.

Bird: The thing that you miss out on is there's basically no overlap between the US and Hong Kong working days. You have to stay late or someone has to come in early there to make the overlap work. But other than that, no, it's pretty great. It's a nice way to set everything up for the day and also because so much more ... I imagine if you'd done this job 10 years ago, or certainly 20 years ago, a huge amount of stuff would be either local, or knock on effects from the US. And that's certainly not the case anymore. You get plenty of days of market action where China's the real driver of some of those things. And with the trade stuff, some of the moves are pretty exaggerated out here in Asia. So yeah, it's a good place to work, and it's a good place to cover markers.

Beckworth: Sounds like fun. You've been on quite the adventure from London to Hong Kong. You've been doing some interesting writing. You're covering the Asian economies. You're right there in the thick of things. As our listeners know, we're in the midst of a trade war, at least the early stages of it, between the US and China. So you're on the front lines there seeing things as they unfold from China's perspective, at least from Hong Kong. And we'll get to that in a bit. You also are near Japan, and cover Japan a lot. And you had a recent article, I wanted to start our conversation off on, and that article was titled *Japan is Giving Up on Activist Monetary Policy*. Now, before we jump into the article, maybe you can go back and just remind our listeners what is that activist monetary policy? Why was it warranted? Why did the Bank of Japan usher it in? And then we can get into the article.

Bird: Sure. Okay. Probably the easiest place to start with this, and then we'll track backwards a little bit is December 2012. Shinzō Abe, leader of the Liberal Democratic policy in Japan, which is a ... I don't even know how you'd describe it. It's a center, right mainstream part. It's almost always been in power the whole of post-war Japanese history, I think with one ... I can't remember whether it's one or two elections, but basically, Abe comes into power December 2012 with a reflationist platform. He appoints Haruhiko Kuroda as Bank of Japan Governor and Haruhiko Kuroda comes out with a QQE, quantitative and qualitative easing. The main part which, fairly enormous purchase the Japanese government bonds. Very large, even by the standards of the Fed, the Bank of England, and ECB quantitative easing programs. Larger I think, in comparison to the Swiss National Bank.

Bird: So basically they came out with huge scale monetary easing. And to address what at that point was about two decades of relatively stagnant nominal GDP growth, it was nice when Kuroda came in. He talks openly about nominal GDP. Abe himself had very loose nominal GDP targets in mind. There was a whole discussion of 500 trillion yen, the size the Japanese economy, that they would aim towards. They started off with this fairly huge monetary easing in 2012, which they ramped up again in 2014. So there was a period where Japan was pursuing, I would say, very activist monetary policy. And in my opinion, it's no coincidence that Japan is also now going through his longest period of nominal GDP growth since the 1991 bursting of the asset bubble in Japan.

Bird: It's not a coincidence that the labor market is probably at its tightest that it’s been since then, that wages are growing at their fastest since the early noughties. So basically Japan pursued very activist monetary policy, I think it's fair to say, from the very least, late 2012 or early 2013 until towards the end of 2016, after which I think things probably started to take a bit of a turn, which is part of what the article's about.

Beckworth: So Japan has an interesting backstory. It has what we're having now in the US and the Europeans. They're a trend setter of sorts. They've had the real low inflation environment, stagnant growth. So they're the avant garde of modern advanced economy challenges. They did QE before we did QE and they're doing things that we're not doing yet. And maybe we'll talk about some of those later in the program. And in your article, you talk about… they really pursued these tools. They've built up their balance sheet. It's worth mentioning, their balance sheet has grown so rapidly, and they've bought up things beyond government bonds. Is that fair? Like ETFs?

Bird: Yes.

Beckworth: Okay.

Bird: Absolutely. They really crossed the Rubicon on that front. And as you say, Japan really is the tip of the spear when it comes to you activist monetary policy. They've been buying a lot of ETFs, which has actually been very controversial. And I'm personally always in two minds about whether it's a good idea, in terms of the effect that it has on the equity market. I think they've run into probably more problems on that front than they'd like because it ends up giving the BOJ these weirdly large implicit ownership shares in some stocks. So one of the problems is they purchase ETFs linked to the Nikkei 225. And the Nikkei 225 is probably, if you've heard of any Japanese equity indexes, it's the one you'll have heard of.

Bird: But it's really structured more like the Dow Jones Industrial Average than the S&P 500. It's not market cap weighted. So you end up with some companies like Fast Retailing, which you may know the company, Uniqlo, the shops, and they own Uniqlo. They have a very unusually large share relative to their market cap in the Nikkei 225, which means the BOJ, because it's buying these ETFs is now a very large shareholder in the company that owns Uniqlo. And that poses it with problems beyond those, which were intended for monetary policy reasons. Because, how does the BOJ vote when it comes to major corporate decisions? Things like that. These are problems that the BOJ doesn't want to have, and it's inadvertently wandered into having them. And I don't think the macroeconomic impact of them owning those Fast Retailing shares is equivalent to the problem that they've now opened themselves up to basically.

Bird: But no. They've always been at the forefront. As you say, they did QE first. And in a way, Japan has, to be honest, I think to some extent suffered from that, in that they've had to forerun all of these policies. They've been doing QE in the noughties when there were no other examples of how to do it. When it came time for the Fed and the Bank of England to do QE in the immediate aftermath of the financial crisis, they were able to look at Japan and say, "Well, Japan has already done this, so what mistakes did they make? What were the successful parts?" Japan doesn't get to do that with anyone really, because it's always the first mover in these instances. Whether you think that's because of their demographics or whatever, they seem to be advanced part of monetary policy.

Beckworth: Let me go back to the ETF question. So you mentioned they're buying up a lot of corporate Japan and the running joke is if they kept buying up ETFs, they would own all of corporate Japan at some point. And you mentioned that issues of how they would vote at a shareholders meeting. Has the Bank of Japan actually faced that issue? Is it more theoretical or academic? Or is it a real practical concern now?

Bird: It's still more theoretical for now, but I think they more or less will. I'm not sure if theoretical is fair actually. I might revise that slightly to say they do face these issues. The BOJ has to decide how to vote now that they're protected slightly, in that what they will always tell you, and they're not entirely wrong. They don't own the shares. They own the ETF. So they would say that if you purchase an ETF, it doesn't give you direct a shareholding rights in those companies. And they're correct to say that. The fund has the direct rights, and the exchange traded fund. But I think that's probably missing the point to an extent, in that most ETFs do not have such dramatic majority ownership.

Bird: A huge proportion of the ETF market in Japan now is owned by the BOJ, so no, they do face these issues. Certainly in terms of ... I worry if there was ever a real corporate responsibility or accountability issue in Japan in a stock that the BOJ implicitly owns a large portion of, that they would run into the problem of how they dealt with that. At which point you'd have to discuss things like, is this state-owned? Does this count?" The BOJ is meant to be relatively independent. Should the government be influencing this? Again, I think these are problems that the BOJ ... The BOJ has enough problems without inventing its own problems on the side. Yeah-

Beckworth: Yeah. Actually it's becoming very controversial. Not just, is this state-owned capitalism? But also the issue of, "Well, should we be investing in this corporation? Are they socially-minded? Are they corporately responsible?" And that opens up another Pandora's box for the central bank. And understandably, if I were a central banker, I would want to avoid that debate.

Bird: Absolutely.

Beckworth: You mentioned the size of the balance sheet, it's rapidly expanded. They're buying ETFs, they've gone beyond these government bonds. Are they buying any foreign assets?

Bird: No. Not yet. This has been mooted by a couple of the doves on the BOJ board. It has been discussed. It's also been discussed by a couple of Abe's not full-time employed advisors, but the economists, the professional economists who have acted at some point as advisor to him. It has been discussed. To be frank, I don't think it's really on the table in Japan. And this is part of the article that I wrote, in that I think it feels very much like there was a tailwind behind Governor Kuroda and Prime Minister Abe, that ran for several years, which has now basically petered out. There is not much imminent prospect of interest rate hikes in Japan. But also I feel like the impetus for these big bang shifts in policy, where they really try and move the needle, 2013 and 2014 being the big examples of where Abe and Kuroda hand-in-hand trying to do shock-and-awe stimulus policies.

Bird: I feel like that period has ended. One of the things that Bank of Japan did in 2016, they switched to a yield curve target. I know we're going to talk about that slightly more later, but one of the things that allowed them to do is dramatically slow down the pace of a Japanese government bond purchases. Now, they didn't call it tapering in Japan, but they've cut government bond purchases by very nearly two thirds, the year-on-year numbers. So they still technically have an 80 trillion yen monetary base target, but it's nowhere near fulfilled. It was running, last time I checked it, at below 30 trillion yen. So they've really ...

Bird: One of the problems I have in financial journalism, and it spreads into monetary policy generally, is something that Milton Friedman identified, which is the confusion between the low interest rates and easy monetary policy. People say that because Japan's benchmark interest rates are low or even negative, it must have easy monetary policy. And they're not looking at two things. Where monetary policy should be. I would say that in Japan, if they had a one percent benchmark interest rate, that would make monetary policy extremely tight. Obviously that wouldn't necessarily be the case if the benchmark interest rate was one percent in the US. And these are different economies. A one percent benchmark interest rate in Indonesia would be insane. It would be insane in India. It depends on the structure of the economy as to whether monetary policy is easy or not. And I think people look at Japan and they say, "Well, they must have easy monetary policy because interest rates are low." And I'm not totally sure that's true. And certainly as you say, if you look at things like QE, they've really slowed down on that front.

Beckworth: Yeah. That's one of those things that I think people often get confused about it in economics, is not looking at the absolute level of the rate, relative to where it should be to have a healthy economy. And economists would call that the natural rate of interest, or the neutral rate. And as you said, it's different for different economies. But that's a hard point to get across. It's not something you can easily convey. And I know, again as a Central banker, it's probably an internal struggle just to get that point across, that low rates don't necessarily mean policy is easy. Now in your article, the tone of your article is that Japan is giving up, or the Bank of Japan has given up. And you've already said that the wind's pushing them forward to have left. Why is that? Why have they lost the political momentum to do these aggressive programs? And is it a problem that they are pulling back?

Bird: I think it's a problem. I think that this has been Japan's problem for a very long time, which is, versus stimulus that are simply not sustained for long enough, that that peeled back too quickly. I would account that the major reason for that is there is a very strong institutional bias against these policies inside the Japanese Ministry of Finance, and the Bank of Japan itself. That's something that's been going on for a very long time. You can see this quite clearly.

Bird: Deputy Governor Amamiya in Japan, of the BOJ, who was made Deputy Governor earlier this year. But he's a BOJ lifer. He's always had a very important place at the bank. And his main concern as expressed in his speeches, or one of his major concerns at the very least is the profitability of banks, which is something that crops up a lot. There's a discussion in Japan. Actually by the time this podcast comes out, I will have almost certainly written something else on it. Obviously they've had very flat interest rate curves for a very long time. And when you're in the business of borrowing short and lending long, that's a problem. So it has squeezed bank profitability.

Bird: Amamiya and others would argue that the transmission of monetary policy becomes weaker at this point because banks simply don't act as much when you do try and lower interest rates. This has been a big, as I say, big problem in Japan for a very long time. And it's something that will crop up over and over again. But it's one of those institutional shifts where it very much feels like the people who are minded in that direction have the upper hand. Kuroda had the upper hand for a few years, the doves had the upper hand. That definitely doesn't really feel like it's the case anymore. I'm not sure that I would say the hawks have the upper hand at the BOJ. That's probably going too far, but certainly the doves don't anymore.

Beckworth: Okay. So let me throw out my theory of why this tends to reoccur. As you mentioned, it's not just the current Bank of Japan, but going back for several decades in fact, as a way to make sense of the low inflation, even deflationary environments they sometimes have. And this is my take on what's going on, and probably isn't totally correct, or explain everything. But I think there's got to be some truth to it. And that is, Japan has an aging population, right? A lot of old people there. Older people tend to hold fixed income assets, so they're holding government bonds.

Beckworth: We know a lot of Japanese debt is held domestically, if not by the Bank of Japan itself. And so in order to generate inflation, they're going to have to impose some harm on these elderly people who hold fixed income assets. And since there's such an important political constituency, they never could credibly raise inflation to the target they want, or even more radical, do something like a price level target, or a nominal GDP level target. There just simply isn't the political support given, that a large part of the population is elderly and living on fixed income. What are your thoughts?

Bird: I think there's certainly something to that. There is certainly something to that. And you notice this with ... I think some people support inflation targeting in Japan, two percent inflation target that the BOJ now has, in theory. Now you do see the news stories out of Japan that when that means, a very popular ramen place that is raising its prices for the first time in 20 years, people suddenly are not so happy about it. So you do see there are ... And this is what happens when you fail to return your country to a stable nominal GDP path for what, now the best part of three decades, is that people become used to stagnant nominal GDP and they do behave in the way that you're talking about, in that they expect the fixed income products to a rise in value. They would struggle if they fell in value.

Bird: One thing I would say to that, that I'm always a little bit spiky on, with regards to the demographic explanations for low inflation, is that I would say the research on how demographics affects inflation is not that decisive. I feel like it's used in argument in markets quite regularly, and you hear this about Europe as well, where people just shrug their shoulders and say, "Oh, it's the demographics. The demographics in Japan are weak. The demographics in Europe are weak. They're not going to get inflation because they've got too many old people, not enough young people." I think there probably is something to that. One thing that frustrates me particularly, is you only need to look at the time-series chart of what happened in Japan.

Bird: Japan didn't inherit 10 million old people in 1990, 1991. There was a very clear break in pretty much every Japanese economic times series then. They had effectively a financial crisis, land prices, asset prices plunged, and they've struggled to get away from the aftermath of that. That would be the same in Europe with the financial crisis and the Euro crisis. It's the same to some extent in the US in 2008. So I'm not averse to the demographic explanations so much as I want an explanation of why these things all seem to happen in the aftermath of major financial crises. And in the case of, especially Japan and Europe, and I think to the US as well, and I'd imagine we're one mind on this, but the risks are very much skewed towards stagnation rather than too much stimulus. So I very much think that yeah, that's the problem. The idea that they might stimulate too much and old people won't do as well from that fixed income assets, I think it's a plausible case. They should try it anyway. But yeah, it's possible.

Beckworth: You're right. Good luck with that in Japan. But that's a great point you raise. And a very clear example is Japan. There is a discontinuous break with the collapse of the asset market. And I think if you come to the US, you look at estimates of these neutral rate or the natural rate. So the well-known Laubach-Williams, John Williams estimate of the natural rate, and everyone makes this point, which is fair, that it's been declining or more generally, that real rates have been ... There's been a downward trend for 30 years. But if you look at these estimates of the natural rate, there is a sudden decline in 2008, 2009, a very sharp one that accelerates the decline. And it happens in the US, it happens in the UK, it happens in Germany, in Europe.

Beckworth: So something beyond just this secular decline in this neutral rate occurred. And of course the most obvious candidate is the Great Recession. Not very hard to put those two together, which suggests there's something wrong with the policy response that followed and that maybe some of that decline could be made back up with the proper policy response.

Bird: Yeah, I think if we pursued more aggressive stimulus, but I think it's probably a mainstream opinion now. I would hope that the main central banks could have pursued considerably more stimulative policies in the immediate aftermath of the financial crisis. I think it's been clear. In the subsequent years, the Fed did QE two, QE three. It was clear that they could have pursued more. Initially the ECB most certainly could have pursued more. The Bank of Japan could have started out years earlier. I think if we reached a point where we realized, "Oh wow. Inflation is kicking up because we reached all these structural limits and now our economies are constrained by demographics and all sorts of other things." I think that would be a good problem to have. Reaching that frontier and saying, "Oh, here we are. This is the capacity of the economy." I think it would be nice to get there. I feel like we haven't actually been there in my adult life. I'd like to see it. That would be enjoyable. Yeah, that's a good problem, not a bad problem basically.

Beckworth: Yeah. So you raise a great point about this whole demographic argument, and generational issue. So you just mentioned in your lifetime you haven't seen this limit pushed. And just to go back to this demographic issue, and we will move on I promise, listeners. I think there's two angles, or stories you can tell. One is the one that I told, and you told a version of that. There's a political economy story. There's an older generation who one, they're living on fixed income, and that may be true in the US as well as in Japan. But also this generation lived through the Great Inflation, and they don't want to that experience. So there's a number of generational issues baked into this. The baby boomers in the US, and the elderly people in Japan that prevents them from experimenting with truly flexible inflation rates. That's one story. That's the one I was giving for Japan.

Beckworth: I think there's another one, and that's the secular story. And that is as the world has aged, they are by definition going to have more safe assets in their portfolios as they get older, that the fixed income ... And that's going to increase the demand for safe assets, which will raise the price but lower their yield. And in general, as the interest rates go down, it's going to affect how much money is spent, money demand. And so the demand for safe assets itself is a direct channel. And then there's the political economy story. But both of those are, I think, contributing to the malaise we see. And I think one attempt the Bank of Japan has tried, and you mentioned this earlier, and let's segue into that, is this yield curve control. So they are purposefully aiming to control at least the 10 year rate. Are they also aiming for any other parts of the yield curve? Or is just the 10 year?

Bird: They don't have specific targets for the other part of the yield curve. But the general idea, as I say, not specific targets, is they effectively thought, in 2016 towards the end of 2016, that the yield curve was much too flat, which if anyone remembers the summer of 2016 this was true in a lot of places. Yield curves around the world got very flat, Europe and Japan especially. And again, it goes back to that bank profitability issue. They were concerned with the fact that the differential on interest rates between say one in 10 years, was practically nothing. When markets behave in that way, yeah, it's very difficult for financial institutions to make any money.

Bird: So what they did was they brought in a target, for the 10 year yield which was, I believe the first one was zero percent, and had a sort of unspoken deviation that it could go from plus 0.1 to minus 0.1, and that it would trade in that band. Front end of the Japanese yield curve is negative, and they wanted the 20 and 30 year bonds to rise somewhat above that. And they succeeded to an extent. They do have a narrowly positive yield curve. I still find this to be a fascinating change of pace that I don't think gets commented on enough. In that, Japan QQE was the most monetarist of all the post-crisis central bank responses.

Bird: Kuroda came in, not just saying, "I'll do loads of QE." But with specific monetary based targets, which is not something that the Fed or the ECB did. The ECB used to have an M3 target. But this is real monetarist stuff. And then they switched to yield curve control, is probably the most nakedly creditist policy. And they switched pretty much overnight with very little commentary about the fact that they'd completely switched tact. And it probably speaks to some extent to what we were saying earlier about, the Bank of Japan has to be at the forefront of these things. But they switched to a policy that is almost totally based on their worries about banks being able to transmit monetary policy.

Beckworth: That's a fascinating framing. I hadn't thought of that. But yeah, Kuroda was very monetarist, very explicit about the monetary base, tying it to a target. Something Milton Friedman would have said if you had talked to him. In fact there is this great speech, I think it's in 2000, the Bank of Canada, where he actually argues for what the Bank of Japan actually did. So before QE came in, Milton Friedman talked about the Bank of Japan should buy up assets until they hit some kind of target. So you're right. It's a good point. Very monetarist.

Beckworth: It's switched gears and it's interesting you mentioned the creditist view because Ben Bernanke himself when he was talking about QE in the US, he goes, "We're not going to be like Bank of Japan." And he was referring to the 2001 and 2006 QE episode in Japan, where they were much more thinking about the quantity of the monetary base. Bernanke goes, "We're looking at the other side of the Fed's balance sheet, the assets side and the credit markets and affecting risk premiums and term premiums." So interestingly enough, the Bank of Japan now has followed what the Fed’s doing, and at least the motivation for doing the QE.

Bird: Yes, absolutely. And then I think with all the central banks you end up with a blend of these things. You certainly have with the ECB as well, which has a fairly explicit financial operations in terms of long term refinancing, and as well as the monetary ones. And you'll hear central bankers talk about on the one hand, portfolio balancing effects, which I think are a fairly, monetarist explanation to these things. At the same time they're also talking about credit quite a lot.

Beckworth: Yeah. And to be fair, actually, I think you can also look at yield curve control as a very new Keynesian approach in this sense. So QE, if you think of QE, the portfolio balance channel story, that's about affecting term premiums, risk premiums. And you could tell this through the yield curve control is about affecting the expectation of the path of short term rates. So if you're able to manipulate that 10 year treasury yield, you're effectively saying you're manipulating the path of short term rates. So I guess one could make the case, or motivate at least, yield curve control from a much more new Keynesian, "Let's affect the path of short term rates."

Beckworth: But at any event, like you said, there's a portfolio of tools they can use. And this has been the latest innovation yield curve control. And I bring this up, and I'm glad you fleshed it out for our listeners because you have an article titled, "The Fed would struggle to match Japan's bond market control." So tell us, is the Fed interested in yield curve control?

Bird: Two Fed board members have mentioned yield curve control. I don't want to override the extent. They're not saying, "This was a great policy. We should follow along from Japan." I think they mentioned it and that it should be, or they would like to hear more about it in the context of a discussion about the Feds future monetary policy framework, which I don't think is unreasonable. It's worth looking at. It's worth discussing. I don't think that the Fed would be able to pursue it for a number of reasons. One of which is, the activity in the bond market reason, which is that the JGB market has been effectively euthanized. It does not exist as a particularly well functioning liquid market. About half of the tradable securities are owned by the Bank of Japan already. The level of activity in the rest of the market is low. And from that perspective, it's relatively easy to control a bond market.

Bird: The Bank of Japan set a 20 basis point trading band for the 10 year. The 10 year US treasury trades outside of that band relatively regularly. It would break those constraints if you didn't stop it from breaking. And the JGB simply don't. So it was easier for them to pursue from the beginning. I also think that for a large part of the post-financial crisis period, the market bet repeatedly, that the Fed would stay easy for longer than the dot plot was suggesting. And the market was correct to do that for most of the period after 2009 up until the interest rate hikes really started a couple of years ago.

Bird: And I think in the case that the Fed set say, a specific target on five year yields, or 10 year yields or whatever, I think the market will be fairly well inclined to test it fairly aggressively. And then what you would need is the Fed to either be extremely credible in its yield curve target, so credible that people didn't want to test it, which I don't think is likely. Or you would need them to pursue fairly massive asset purchases to defend the levels that they'd suggested. That's possible. The Fed can do these things with the right amount of commitment. My problem is, I'm not sure what problem the Fed is trying to solve by doing that.

Bird: It's shown relatively well, but with a decent amount of forward guidance, it can effect longer term rates away from the short end of the curve. I don't know what would be gained by setting explicit targets. As I say with Japan, the reason to bring in yield curve control wasn't the stimulus. It was to reverse some of what they were seeing as the negative effects of stimulus. You're actually trying to steepen the curve, not flatten the curve, which I think, most of the discussion from the US perspective is talking about flattening the curve.

Beckworth: And that's a great point. They're actually trying to raise the 10 year yield from such really low-

Bird: Yeah. And I feel like-

Beckworth: Whereas the Fed technically is lowering it.

Bird: Exactly. And I think it's slightly more credible when you're buying something in the range of 80 trillion yen a year in Japanese government bonds to say, "Well, we're going to buy it a little bit less." That's relatively credible. I don't think anyone's going to test you on that. They're not going to say, "No, you're going to keep buying 80 trillion." And so many people have been burned over the last three decades trying to fight and test the Bank of Japan, mostly in terms of expecting JGB yields to surge upwards, that there isn't really much of a constituency for testing the BOJ in Japan. Yeah, that's not the case in the Fed, so I think they would find it operationally very difficult to do, to speak to the bond market question. I don't entirely see the problem that they're trying to solve. And that this is easier to do when you're doing, and the direction that the BOJ did when you're trying to steepen the curve than it is to try and flatten the curve.

Beckworth: Yeah. So let me try and take the Fed side here. This is going to be tough for me to do, but play devil's advocate. I think they would reply, "Well yeah. We don't need it now, but maybe in the future. Maybe the next recession. We want something maybe that's a little more effective, bigger bang for the buck than QE. Maybe yield curve control is it. We want to avoid the zero lower bound because we have these problems. So it's just a tool, and we put it in our toolbox and be able to throw in some negative interest rates as well. So maybe it's more like a contingency plan than solving a problem right here and now." But I do take your point though. This is ultimately a question of, it has to be a credible threat, and/or a mix of a larger balance sheet or some of both. And is the Fed willing to go that path?

Beckworth: So it's a great point though, that Japan's case is very different than the US. But the US may try it anyways. It's worth mentioning, something along these lines did happen in the past. The Federal Reserve was pegging interest rates for the treasury coming out of World War Two, and then the famous Treasury Accord in '51, they broke that arrangement. But point being is the Fed was pegging these, I think it was short-term and a long-term treasury yield, and it was starting to create inflation and starting to create really rapid aggregate demand growth. And the Fed really felt like it was going too far, and they stepped back. Now that is a very different time and place. You didn't have global markets, and I think that's one of the key issues I wrestle with, is the size of the US Treasury market. And could the Fed truly be credible? And that's just a question I don't think we have a clear answer to.

Bird: Yes, absolutely. I think you're completely right to address the historical argument and also completely right to say it was very different. The US treasuries didn't operate in the same way as ... It's now the global benchmark safe asset. There are entire massive financial markets, larger than presumably the entire scale of all financial markets at the time in say the late 1940s, early 1950s, that are effectively traded off the back of these things. A lot of derivatives, all of that stuff, priced off treasuries. And I don't think it's the same. And I tend to regard the people who, and this spreads across a whole number of things, not just monetary policy.

Bird: But people who look fondly to the immediate post-war decades, I'm thinking particularly the 50s and 60s in terms of the economic outcomes and economic policies, I tend to think it's a little bit like the people who are usually on the other side of the political spectrum who look at say, "The late 1900s", as a benchmark of less aid there, and maybe a gold-related monetary policy and that these things are of a different time and place. And the conditions simply no longer exist. You can note them to say, "These things are possible. They have been done before." But I don't think often, they're particularly good policy prescriptions for those reasons.

Beckworth: That's a great comparison. A great analogy. The free market folks have their golden era, and the progressives have their golden era, and we all want to go back the glory days.

Bird: And neither of which we can have, is the bottom line.

Beckworth: There's good reasons and good arguments why that should be clear. But, let me lay out my fear of yield curve control, and actually not just yield curve control but of the Fed's operating system as it relates to this issue. And that is, it may take some time for the Fed to build up the credibility to get the yield curve control. So in other words, the Fed may have to buy up a bunch of securities before the markets take it seriously. A concern that I have with this proposal, is the effect it could have on the safe asset supply. Now advocates of this approach would say, "Well Beckworth, relax. This will actually lead to fewer treasuries bought by the Fed." And they'd point to Japan. But as you pointed out, Japan is very different. They were actually threatening to buy less to raise a 10 year yield.

Beckworth: And my concern is, it may take some purchases to get the credibility up of the yield curve control actually works. And if the Fed does that, it's taking these scarce valuable securities off the market. And that's one of the challenges with the QE. QE takes off treasuries, which are very fungible, used by many financial institutions, and replaces them with reserves which only banks and a few other financial firms can use. And I think it's important to keep the supply of treasuries as abundant as possible to the global financial market place. I was just looking at interest rates before the show. And the US treasury yields around 2.4, but if you go to Germany, it was like minus 0.09. Japan's minus 0.06. Switzerland minus 0.37. So they're all very low and just barely below a negative value. And if we start taking more treasuries out, I can just see this getting worse. And so, I want to walk that fine line between providing the right stimulus for the economy and a severe downturn, but not making it worse by removing a very valuable asset to the global financial system.

Bird: Yeah, I think that was completely reasonable, and I think that the ... Again, it comes back to the point of, "What are you trying to pursue?" Now, in the case of the US the question is, how much lower did the Fed want, say, the 10 year yield to be? Immediately after the financial crisis, during the most stimulated periods, how much lower do they want it to be than they felt they were able to push it there? And can you credibly set a policy that markets believe will allow you to hold it there? And in the case of Japan, you're completely right. The bang for its buck argument holds. They have managed to reduce purchases considerably. They were worried about the pace of purchases. They were worried about taking all these JTBs out of the market. I just don't see how that could be the case with the Fed.

Bird: And that's not even speaking to the point, the fact that expectations for the US economy are far more dynamic, because you’ll have the change in a year's expectations for upcoming GDP growth is far larger in the US than it is in Japan. Far larger. People rotate from ... Even look at treasury yields at the end of last year relative to where they are now. That's a huge move. There hasn't been a move of that size in Japan for years and years. I think as they say, I really think they'd struggle. I know I had to be fair, I do not think that the FOMC are going to come back and say they want this as a monetary policy framework.

Bird: But I think you have a ... what I worry that they'll do is pick something in the uncanny valley of saying they have a rough band in mind that they'd like the US to ... The 10 year to trade in. And I don't think that works. I think you either commit to doing it and you have a credible commitment, and the market thinks that if they tried to trade outside the bounds they'd been given that they will get burned, or you don't do it at all. I don't think there's a happy halfway yield curve control that they can pursue.

Beckworth: Great advice. And once again, we can think Japan for all these innovations, should the Fed adopt the yield curve control. So the Japanese are the ones leading the way there in terms of monetary policy innovation. So thank you Bank of Japan. Well let's switch gears and look into China. You've also been writing on China. And before we talk about some of the issues of the trade war, tell us what's been happening to the Chinese economy recently.

Bird: Sure. The Chinese economy, what is happening too is the subjects of a cottage industry of economists and analysts. But it's been slowing down, is the bottom line. Now, whether you believe the headline economic data that comes out of China or any of the other estimates, I think there's a broad agreement that the growth rates have been at the very least, steadily declining. The main thing is that. Now what's happened at the same time is that, as growth slows, the fairly rampant growth of certain types of debt in China has become more and more of an issue. The government regards it as more and more of an issue. People in markets talk about it a lot more than they used to. So you've got these combining forces of a fairly high debt load relative to China's GDP per capita levels. Some sectors, the corporate debt sector, household mortgage related debt have really run up to levels that would have been quite surprising to people a few years ago. Those are the main things.

Bird: And obviously now you have the trade war issues as well. But what I find interesting actually about discussing China here relative to discussing China with people in the United States and Europe is, I think in the US and Europe, people think a lot more about the trade war than they do about the leverage and deleveraging issue. Whereas I think the closer you get, people are concerned about the trade issues. Don't get me wrong. That's a major issue for China. But the deleveraging and growth related issues come to the fore a lot more out here.

Beckworth: Now the run up of debt in China, correct me if I'm wrong, but doesn't this begin during the great recession, the financial crisis 2009? China goes all in with fiscal stimulus, is that right?

Bird: Yeah, to a large extent. Yes they did. And one of the things is they have slightly different policy tools. So it will be quite common for the Chinese government to pursue lending, but do it either through local governments, which became very popular, and local governments issued a lot of bonds recently, and certainly a huge amount of debt in the last 10 years. State-owned companies, it's very easy to do it through them. We've just spent some time talking about Japan and bank transmission channels and stuff like that. Not a problem for China because if you own the banks, and you own the companies, then you tell the bank to lend, and you tell the companies to borrow and they do it.

Bird: It's not as complicated. They've got their own problems, don't get me wrong. I'm not advocating that as a system to follow. But no, that is certainly not a problem. So there's been a huge amount of an SOE. It will be classed as corporate debt in an account system, but it's the debt of state-owned organizations, many of which have very strong implicit guarantee that they will be bailed out. So yeah.

Beckworth: You've written recently, an article about, China has a junk bond market and is tied to their property. Tell us about that development.

Bird: Property has become this increasingly important part of the Chinese economy. So for context, the Chinese home ownership was very rare until the late 1990s when there was a wholesale, national liberalization. It's now actually very common. Home ownership rate's very high. Home prices have run up a huge amount. I don't have the percentages to hand, but they are dramatically more expensive than they used to be. Many Chinese cities, you're talking about price-to-income ratios of some of the more popular cities, you're talking about close to 20 times over. Now for context of London is known as a very expensive city and it's somewhere like 10 times over. So that's the level we're talking about. This has been fine to an extent, in that a lot of people picked up these houses quite some time ago, and it was somewhat cheaper.

Bird: One of the problems is that this is also the main asset that most Chinese people, or most Chinese families hold is housing assets. So you are faced with a problem that will feel very familiar to listeners who are in the US and UK, which is that politically, it becomes impossible to allow house prices to fall. You need constantly expanding leverage to keep the prices rising, or even in some cases to keep them stable. You get a lot of strange activity in the construction markets, which is where you see the real estate developers issuing so much dollar debt, which goes into the Asia junk bond indices. Yeah, it's a slightly, to my mind, poisonous and excess that they found themselves in. And in a weird way, it is really the same issue that the US and UK found themselves in a few years ago, which is, it's the main asset that most people own. The prices are perceived to be something that goes up reliably. Too much leverage is built up, and the government becomes trapped in a sense, in that they can neither reduce house prices, nor reduce the debt load basically. So they become really trapped.

Bird: And in China, this is all complicated as well by the fact that local governments make a huge amount of their tax revenue through land sales. So they're very much incentivized to create this mad churn in the market. They're not incentivized at all, to slow things down on either the regional or the national levels. I wrote a piece yesterday about Chinese housing stats. Most Chinese houses or pre-sold. Unlike in the US there's no escrow systems. So Chinese developers can get hold of the money that people pay for an un-built house as soon as they get it, which means they run several years ahead of themselves in terms of funding. It's another form of ... It's the same thing as that dollar debt. It's a form of shadow leverage. It's a fascinating sector to cover, to be frank. It's very interesting and it's very important as well, in terms of the effect that it has on international markets and economies these days,

Beckworth: Yes. It sounds like it might not end well, but I've talked to some people who say there are these problems, but look, China has a huge stash of reserves. Over a trillion. They can always bail out the economy. What are your thoughts?

Bird: I think there's certainly something to that. And beyond even the scale of the reserves, I think one of the things that the Chinese government showed in 2015/16, is that the capital controls, at least during a fairly stressful scenario, maybe they don't work in a total hard-landing horror show scenario, but they work pretty well. They don’t work badly. It's not as hard as they might have thought, to stop people from, especially leaving the country with dollars, or converting the yuan into dollars. So they can exercise a lot of control. They've got quite a few fire blankets.

Bird: In some ways, the Chinese economy, certainly on the financial system side, we talked about the state-owned banks. To some extent, I'm still not sure it's enough of a market to have a major financial crisis. Now, I would say that the discussion about, "Will the Chinese property market blow up or not?" Is almost missing the point of what's already happening, which is, you don't need major defaults. You don't need house prices to crash. You don't need some sort of sub-prime crisis.

Bird: What is happening right now is you're seeing the productive efforts of millions of young Chinese people, millions of innovative Chinese firms, turned towards this poisonous real estate market because you can make guaranteed high returns. So you see an economy that it's almost approaching some Austrian concept of mal-investment, where you see huge amounts of capital and productive resources and bright minds deployed towards the sector where the only thing that comes out on the other side is increasingly expensive housing units with basically no yield because they're held for speculative reasons rather than for renting. So it's damaging, to my mind, even if you say the sector can pop, there will be no defaults, there will be no bubble bursting. It's still a problem even now.

Beckworth: Okay, fair enough. In the time we have left, let's talk about the trade war that's going on between the US and China, and let's zero in on the issue of China threatening to dump its treasuries. Now, many people say that that is much harder to do in practice, and that China's threats really aren't very credible. What are your thoughts?

Bird: I would agree with that thesis pretty much entirely. I think it's a bug bear of a lot of financial journalists now, the idea that that China could in an aggressive way, dump treasuries to attack the US. I saw a joke being bandied about the other day about, imagine explaining this to someone like Lighthizer, a long time China hawk. Ultimately what this threat would do is a drive up the value of the Chinese yuan if it worked. Which is exactly what the China hawks, and the US administration would love to see happen. They would love a stronger yuan, a weaker dollar on the back of that. I don't think it works. I think the logic is all wrong. You have trillions of US dollars of capital deployed to buy US treasuries at their current yields. So say the US treasury is ... I don't know exactly where it is. Say 2.5 percent people are willing to do this. At 2.6 percent, if China tried to start selling its treasuries, you're going to find willing buyers everywhere else. People would buy the treasuries, the yields would move presumably, but I don't think they would actually move that much.

Bird: And you would see China needlessly abandoning the reserves that it has really accumulated for a reason. I just don't think it's a reasonable thing. I don't think they ever considered when they're accumulating these reserves, they would be used as a weapon. It's intended as something to defend the Chinese currency, and selling them off would not only reduce their ability to do that, but it would run completely in the opposite direction to everything they've pursued. So I don't see it as a real risk, to be frank. And I don't think I've ever heard anything from anyone close to any Chinese policy makers, that suggested it was even considered as a potential in their arsenal to be deployed. I've never heard that.

Beckworth: Yes. And just to put some numbers on that argument, I'm looking at an article here, and I need to verify this number, but it says that China has a little over $1.3 trillion in treasuries. Does that sound about right?

Bird: Yeah. Something like that.

Beckworth: Yeah. And you look at the market for US treasuries, the marketable portion of US treasuries, the ones that actually trade is close to $16 trillion. So it's not a trivial amount, but it is pretty small. Yields are really low already. So in your worst case scenario, they go up a little bit. They actually, maybe alleviate some of the safe asset shortage problem, which is good for the US economy, but ultimately harms China. Some of the previous discussions on this very topic would be that China will lose its wealth because as they sell their treasuries they would lose value. But it's such a small share. I don't think it would make much difference as you point out, but it would affect the yuan. And I think the subsequent rise in the yuan would be very consequential for the Chinese.

Bird: Yes, totally. I think it will be consequential. I also think that there are other reasons that that pile of reserves could come in use at some point. Now, they're not explicitly, for example, defending Chinese financial institutions. Or for example, major real estate developers like we are just discussing, who have serious dollar liabilities who might run into trouble. They're not explicitly there for that, but I think everyone knows that the interaction between the private sector in the state sector in China isn't quite the same. And that they could maybe lean on these things. In extremes, a bank might be bailed out by Beijing using some of those reserves if it ran into problems with its dollars. And getting rid of them just runs completely in the opposite direction to that.

Bird: I think the only countries where you see this, where they genuinely try to quit the dollar, you get countries like Russia and Iran and Venezuela, where it's after they become pariahs in the international monetary system. They do it because they've already lost any advantages that they were gaining through having this stuff. So yeah, I don't see it happening with China.

Beckworth: Right. So they lose that buffer of funding there, they could use to help their economy if it does crash. And the other thing is, they would have to find some other security to invest in. Right? So if they did sell their treasuries, and have to go look for some others safe asset and the other two big producers, which a far second and third place would be Japan and Germany. And if you look at the yields on those securities, they're negative. So, they would be taking hits no matter how you look at it, how you slice and dice this problem. It's a no-win situation for China. So I do think this is a very hollow threat, not very credible at all.

Bird: Yeah, absolutely. I've had this discussion with people and that is always the question like, "What are you going to buy?" For starters, there's no real asset market where there's not just a trillion dollars in assets and other things sat around waiting to be snapped up. You're going to buy European bonds with the implicit credit risk of the southern European states? You're going to buy bonds which yield, as you were talking about, nearly minus a percent? It's just not realistic. It wouldn't be useful for them. I may know that.

Beckworth: Yeah. So with the analogy I like to use is that the US economy is a banker to the world. It provides highly liquid assets to the world. And if you're going to run on the bank, there better be another bank around and go put your funds in. And there really aren't any other comparable banks in the world. The US is the main banker to the world, and for better for worse, China has to face that reality.

Bird: Absolutely. As does everyone else. And I think in the case of ... This is a historical interest of mine, but when you saw the collapse of the sterling system in the 1920s, 1930s and after the Second World War II, it was only possible because the dollar was there as a potential alternative. It was only possible because of that. If you can't transfer into something else, it doesn't work. Yeah, absolutely.

Beckworth: All right. Well our time is up. Our guest today has been Mike Bird. Mike, thanks so much for coming back on the show.

Bird: Thanks very much David. Great to be here.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast APP. And while you're there, please consider rating this and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

Photo credit: Jaison Lin/Unsplash.

David Beckworth
Calendar Date: 
Jun 4, 2019
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A Macro Musings Transcript