Japan’s Quantitative Easing (QE), the Yen Carry Trade and QE in the US

I have recently seen two short essays comparing QE in Japan with that in the US:

"Quantitative easing in US and Japan".

Paul Krugman, “Way off Base”.

The monetary base in Japan rose by 70% from 2001–2006 and by 140% in the US from 2008–2010.

The Bank of Japan increased the base money from about 65 trillion yen in March 2001 to 110 trillion yen by 2006.

In the article above, Paul Krugman points out that, just because the monetary base rises rapidly, this does not necessarily mean that higher inflation must occur or is likely to occur – and Japan’s case proves it, as Japan continued to experience deflation down to 2006 despite its QE.

Needless to say, when QE was adopted in the UK and the US in 2009, we had many predicting hyperinflation for 2009 or the near future.

To take one example, the investment analyst and entrepreneur Marc Faber was interviewed by Glenn Beck on 28th May, 2009, and predicted that hyperinflation would happen in the US and that this was 100% certain.

It is obvious that there was no hyperinflation in 2009 and no signs of it now.
Many have correctly pointed out that Japan engaged in QE in the early 2000s, and no hyperinflation ever resulted. One response to this is that much of the money created by the Bank of Japan during QE was simply lent out for the yen carry trade.

The blogger Cynicus Economicus, for example, has argued that Japan did not experience high inflation because the printed money (that is, the excess bank reserves) went to the West via the carry trade (See “Getting carried away…” Trade & Forfaiting Review, 3 Dec 2009; "Easy money?" Trade & Forfaiting Review, 9 April 2009).

However, the view that all or most of the excess reserves created by Japan's QE were simply lent out in the carry trade is actually false.

First, the initial phase of the yen carry trade occurred from 1995 to October 1998 – before Japanese QE even began.

In addition, the second phase of the yen carry trade went from 1999 (again before Japanese QE began) to 2008:

despite the carry trade’s importance, no one knows for sure how large it really is. Mr. Kanno [an economist for JPMorgan Securities] estimates that about 7 trillion yen, or about $58.39 billion, flowed overseas last year [2006] alone. Another way to measure the trade is by the amount of assets now held overseas by all those involved in the trade since it began in 1999, when the Bank of Japan first cut rates to near zero. Mr. Kanno estimates those holdings are worth about 40 trillion yen, or around $330 billion …. Policy makers also seem aware that the carry trade is mostly driven by Japanese individuals trying to improve the return on their savings. Mr. Kanno of JPMorgan estimates that these individuals’ holdings overseas have grown to about 30 trillion yen since 1999, making up about three-quarters of all carry-trade-related investments. Most of the rest is held by foreign investors, he said.
Martin Fackler, “Bank of Japan Raises Short-Term Interest Rates,” New York Times, February 22, 2007.

So in fact that vast majority of all yen carry trade investors were Japanese savers, who were investing their own money that they had saved, not newly created money from QE.

Furthermore, the Bank of Japan rapidly drained the excess reserves and ended QE in March 2006, yet the yen carry trade continued. With the end of QE the Bank of Japan also ended its zero-interest-rate policy, and lifted interest rates slightly, though again the yen carry trade simply continued.

Tadashi Nakamae, in a 2007 article in the International Economy magazine, explains what happened:

The Bank of Japan undertook drastic steps to lower interest rates to save domestic banks and non-financial companies after Japan’s bubble burst. Easing the interest payment burdens of [banks] … was the most effective measure to rescue them. The victim of this policy was the household sector. Their interest income was wiped out. After peaking in 1991 at 39 trillion yen in returns from 600 trillion yen in interest-bearing financial assets (mostly bank deposits), households’ interest income has nose-dived to less than 5 trillion yen from 860 trillion yen in interest-bearing assets …. Zero interest rates also triggered a significant change among Japanese savers. An increasing number, who had traditionally favoured domestic bank deposits, are now looking abroad for better returns …. Japanese households have some 1,500 trillion yen—triple the size of Japan’s GDP—in financial assets (including the 860 trillion in interest-bearing instruments). The 15 trillion yen flowing overseas is just 1 percent of the total.

Tadashi Nakamae, “Weak Yen Conundrum: Why Japanese households love foreign financial assets,” International Economy, Winter 2007.

Thus there was more than enough money in Japanese household savings to fund most of the yen carry trade (and in 2010 Japanese savers still have about $15 trillion US in savings).

Even foreign investors probably could have borrowed yen for their carry trade operations from the Japanese money markets and the banks' own deposit base rather than massively drawing on excess reserves.

As an aside, the carry trade also caused significant depreciation in the exchange rate of the yen, as you can see in this graph of the trade weighted value of the yen (1980–2009). The fall was very steep.

It is likely that the fall in the yen’s value had a major role in the recovery of Japan’s economy in the 2000s by making its exports much cheaper on international markets. This factor was no doubt important, given that Japan is an export-led growth economy (Lok Sang Ho, “The Moral of Japan's Lost Decade”).

So the yen depreciation was actually beneficial.

With respect to the carry trade and the fall in the yen's value, the relevant policy instrument was the interest rate, which was driven down to zero by the Bank of Japan through QE. The expanding monetary base did this, but those reserves were not all suddenly lent out. When QE ended in 2006, the short term interest rate rose from nearly 0% to 0.25% – which was still a very low rate.

But, during the time of QE, the monetary base had been increased to 110 trillion yen by 2006, so the banks had more than enough money to lend into Japan’s domestic economy if they wanted to, yet domestic Japanese bank loans actually fell during most of the time in which QE was conducted and the broad money supply growth was slow.

The claim that the yen carry trade prevented the injection of the newly created bank reserves into Japan’s economy is obviously false. There were other factors that prevented a rise in bank loans.

Hyperinflation never resulted because bank lending is determined not simply by reserves, but by the number of creditworthy businesses and individuals and the willingness of banks to lend. In the uncertain environment of the lost decade and the slow recovery that followed it, Japanese business confidence was not that high, so borrowing and lending was not either.

Much the same thing has happened in the US. As of February 2010, the US banks were still not lending much:

David Rosenberg from Gluskin Sheff said lending has fallen by over $100bn (£63.8bn) since January, plummeting at an annual rate of 16pc. "Since the credit crisis began, $740bn of bank credit has evaporated. This is a record 10pc decline," he said ... The M3 broad money supply – watched by monetarists as a leading indicator of trouble a year ahead – has been contracting at a rate of 5.6pc over the last three months. This signals future deflation.

Ambrose Evans-Pritchard, “US bank lending falls at fastest rate in history,” The Telegraph, 17 February 2010.

In other words, the situation is similar to what happened in Japan during their experiment with QE.

You can get excellent graphs of the various US money supply measures and growth rates at Shadowstats.com (Monetary Base and Money Supply).

These confirm that the broadest US money supply measure (M3) is falling.

The most recent data from Forbes.com suggest that “for the three weeks between Feb. 24 and March 10, outstanding loan balances were flat. That represents the first three-week period without a decline since early 2008.”

But this doesn’t mean that lending will significantly increase any time soon, as there is still a lack of creditworthy borrowers and non-performing loans are a serious issue, as pointed out in the Forbes article.

One can also point out that even in an upturn banks are likely to return to conservative lending principles – and even if they did increase lending greatly they still only have a limited demand for credit from over-indebted borrowers, not enough to cause hyperinflation.