Economic and Monetary Policy in Asian Economies

A Macro Musings Transcript

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 [email protected].

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.

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About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.