What’s Japan to Do?

The Wall Street Journal reports The World Should Watch Japan’s Attempts to Save Its Struggling Banks.

After 30 years of falling and even negative interest rates, many of Japan’s regional lenders have share prices of 0.2 to 0.3 times their book value—levels that would have been considered catastrophically low even a few years ago.

The Bank of Japan is offering commercial lenders an extra 0.1 percentage point in interest on their deposits with the central bank if they reduce their overhead ratio by certain benchmarks, or merge or integrate their businesses.

A marginal shift in interest rates on accounts held with the central bank might not sound like much, but Moody’s Investors Service rightly notes that given regional banks had an average return on assets of just 0.14% in the last fiscal year, an extra 0.1 percentage point return on large cash balances is nothing to sniff at.

Any institution that relies on interest income is going to be squeezed continually if rates remain low for an extended period, as bond market prices clearly expect them to. With less fee income, similar issues are likely to present themselves in regional lenders around the world.

Low Interest Rates Did Not Promote Grown 

Neither low interest rates, nor QE, nor wasted fiscal stimulus promote growth over the long haul. 

Japan tried all three for decades. The results speak for themselves, recession after recession. 

Zombification

Instead of promoting growth, artificially low interest rates promote zombification. 

Unproductive companies are artificially kept alive at the expense of more productive companies.   

  1. December 16, 2017: Zombie Corporations: 10% of Companies Depend on Cheap Fed Money
  2. July 19, 2019: Zombification Perfected: Negative Yield Junk Bonds Take Hold in Europe
  3. November 18, 2019: China, like Japan in the 1990s, Will Be Dominated by Huge Zombie Banks

Fundamental Strength of Capitalism

A fundamental strength of capitalism is that failed companies go out of business making way for new ideas and better models.

Yet, here we are. The Fed, ECB, Bank of China, etc., all strive to keep failed companies alive. Zombification is still on the rise.

Self-Inflicted Pain

I have been preaching this message for years. Low interest rates are a huge problem.

The ECB faces a worse setup than Japan with hugely negative rates. 

Think of it this way: Negative-yield bonds imply it is better to have 99 cents ten years from now than a dollar today. 

That is of course illogical, and in fact impossible in a free market. We see these things only because of failed manipulation by central banks.

Fed vs ECB

Whereas the Fed pays interest on excess reserves, the ECB charges interest. 

The process slowly bailed out US banks over time in the US but further crippled European banks.

Purposeful Destruction of European Banks?

Policy at the ECB was so questionable, especially given years of study of failed Japanese policy, that I often wonder if it was intentional. 

Here’s the setup:

  • Mario Draghi, head of the Italian Central Bank replaced Jean Claude Trichet as head of the ECB. 
  • Troubled Italian banks were widely understood as crippled and unable to lend because of capital restraints and nonperforming loans.
  • Draghi forced more excess reserves into the system via QE. 
  • Draghi the went down the rabbit hole of negative rates charging crippled banks interest on excess reserves, further weakening the banks, and not just Italian banks. Look at Deutsche Bank for example. 
  • Why? 
  • By any chance was it to so destroy the European banks so that Germany would be forced to commingle debts and bail out Southern Europe?

That’s plausible but against Occam’s Razor that suggests simpler explanation are more likely to be correct.

The simple explanation is that Mario Draghi was just plain stupid. 

Will the Fed Go Down the Rabbit Hole?

Many believe so, but I don’t (as least not that rabbit hole).

The Fed is beholden to the banks. It does not give a damn about consumers as long as it keeps the banks alive. 

Short-term, zombification and QE allows companies who could otherwise not pay back loans to do so. But negative rates that punish banks are another matter. 

The Fed understands this and it can see the problems facing the ECB and BOJ so it is unlikely to go there. 

Bond Bull Lacy Hunt Warns of a Huge Monetary Risk

I commented on the US setup twice. Both are worth a review.

  1. Aug 18, 2020:
    Bond Bull Lacy Hunt Warns of a Huge Monetary Risk
  2. October 22, 2020: Two Inflationary Tail Risks For US Investors

Those links contain observations by Lacy Hunt and me on what the Fed has done and what it might do.

Although the Fed is unlikely to go down the negative rate rabbit hole, there are other rabbit holes the Fed might try. 

One of them is direct printing, making the Fed’s liabilities legal tender or a medium of exchange.

Hunt suggests huge inflation risk if the Fed pursues that path. 

See the above two links for further discussion.

Mish



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