Japan's monetary alchemy may not yield gold

by Richard Duncan 

Financial Times

10 February 2004

The most aggressive experiment in monetary policy ever conducted is now
under way. Japan is printing yen in order to buy dollars in such
extraordinary amounts that global interest rates are being held at much
lower levels than would have prevailed otherwise. In essence, the Bank of
Japan is carrying out the unorthodox monetary policy that the US Federal
Reserve intimated it was considering in mid-2003. In other words, the BoJ is
creating money and buying US Treasury bonds, which is helping to drive down
US interest rates and underwrite US economic growth - and, by extension,
global growth.

It is inconceivable that economic policymakers in Tokyo and Washington do
not understand the impact that this unprecedented act of money creation is
having on global interest rates and economic output. The amounts involved
are staggering. Since the beginning of 2003, monetary authorities in Japan
have created Y27,000bn with which they have acquired approximately $250bn -
that amount is equivalent to more than 4 per cent of Japan's gross domestic
product. It also represents $2,000 for every person in Japan. In fact, it
would amount to $40 per person if divided among the entire population of the
world. Most importantly, it is also enough to finance almost half of
America's $520bn budget deficit this year.

The amount of new yen that Japan "printed" and converted into dollars during
January 2004 alone was enough to finance 13 per cent of the US budget
deficit. The investment of those dollars into dollar-denominated debt
instruments clearly explains why the yield on the 10-year US Treasury bond
fell last month in spite of the 10 per cent upward revision in the Bush
administration's budget deficit projections.

By accident or by design, Japan is carrying out the most audacious endeavour
to conjure wealth out of nothing since John Law sold shares in the
Mississippi Company in 1720. So far, the results have been impressive.
Japan's monetary alchemy has been the most important factor in allowing the
US government to finance a $700bn deterioration in its budget over the past
three years without pushing up US interest rates to levels that would pop
the wealth-creating property bubble there.

US tax cuts have fuelled domestic consumption. In turn, growing US
consumption has shifted Asia's export-oriented economies into overdrive.
China has played an important part in this process. With a trade surplus
vis-à-vis the US of $125bn, equivalent to 9 per cent of its 2003 GDP, China
has become a regional economic growth engine in its own right. China has
used its large trade surpluses with the US to pay for its trade deficits
with most of its Asian neighbours, including Japan. This recycling of
China's US dollar export earnings explains the incredibly rapid "reflation"
now under way across Asia. Even Japan's moribund economy has begun to show
signs of export-oriented growth.

These developments highlight a fundamental question that has been debated
over centuries: can governments create money and make the population richer
without setting in motion a chain of events that ultimately ends in monetary
chaos? We may be about to find out as Japan tests the hypothesis on an
unprecedented and global scale. If this experiment in unorthodox monetary
policy succeeds, then we have arrived at a new international monetary
paradigm. Governments will have discovered how to finance limitless deficits
through the creation of paper money, and we all can look forward to an age
of great prosperity. If it fails - as have all past attempts to create
wealth from thin air - then the world may not be able to avoid a severe and
protracted economic slump as the extraordinary imbalances in the global
economy ( caused by the explosion of fiat money in recent years ) begin to
unwind.

In mid-2003, economists at the US Federal Reserve published a paper
explaining why the Fed was not "out of bullets" despite having cut
short-term interest rates to 1 per cent. That paper stated that "the Fed
could even implement what is essentially the classic textbook policy of
dropping freshly printed money from a helicopter," if necessary, to
stimulate the economy.

Today, that helicopter is in the air. But, strangely, it is not the Stars
and Stripes that is painted on its side, but rather the Rising Sun. That
much is clear. What still is not quite discernible, however, is who is
actually in the pilot's seat.