Richard Koo
 
EQUITY RESEARCH
.
 
Potential benefits and dangersof “quantitative and qualitative”easing
 April 16, 2013
The Kuroda BOJ’s bold program of “quantitative and qualitative” easing shocked thefinancial world when it was announced two weeks ago. Attention also focused on the hugeannouncement effect of the policy as Japanese equity prices surged and Europeangovernment bond yields slid.In this report I would like to discuss the potential benefits and dangers of the BOJ’s newpolicy, which has been labeled “easing of a different dimension” in Japan and whichelsewhere has been described as a revolution in monetary policy.
BOJ to double monetary base in two years
The newly announced easing program, which seeks to double the monetary base in twoyears’ time, appears at first glance to be very aggressive. Japan already has a much larger monetary base (relative to GDP) than western economies, and it comes as little surprisethat overseas analysts were shocked to hear it would be doubled again.However, the relationship between base money and GDP depends to a great extent on (1)the economy’s reliance on cash and (2) whether individuals and businesses prefer to placetheir savings in bank deposits or invest them in other financial assets, such as stocks, or real assets.
Japan’s monetary base already larger than that of US or UK
Japan’s monetary base already amounted to 12% of GDP in 2000, compared with figuresof just 6.9% for the eurozone and 5.9% for the US. After Lehman Brothers collapsed and the global financial crisis took hold, the Fedexpanded the monetary base by 250%, the ECB by 57%, and the BOE by 335%, butJapan, where the Shirakawa BOJ had already been increasing the supply of base money,still had a larger monetary base relative to GDP.Inasmuch as the quantitative easing programs undertaken by the US and the UK failed tobring the monetary bases in those countries to Japan-like levels when Masaaki Shirakawawas at the helm of the BOJ, Haruhiko Kuroda’s plan to increase the monetary base byanother 100% naturally came as a surprise to observers outside the country.
Richard Koo is chief economist at Nomura Research Institute. This is his personal view.
Richard Koo
r-koo@nri.co.jp
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See Appendix A-1 forimportantdisclosures and the status of non-US analysts.
Japanese version published on 15 April, 2013
 
Nomura | JPNRichard Koo April 16, 2013 
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Statutory reserve system links base money and money supply
Fig. 1: Kuroda BOJ seeks to overtake Fed and BOE
Notes: (1) The estimate is based on the assumption that required reserves will increase by 3% a year and bank reserves constitute 88.8% of financial institution's current depositholdings with the BOJ. (2) The BOE has suspended reserve requirement in March 2009. The post-March 2009 figures are based on the assumption that the original reserverequirement is applicable.Source: Nomura, based on BOJ, FRB, ECB, EOB data
Simplistic comparisons should be avoided, however, since the size of the monetary base relative to GDP is greatly affected bypeople’s propensity to keep their savings in bank accounts. Perhaps more importantly, a distinction must be drawn between themonetary base and the money supply, which represents money actually available for use by the general public. Only when basemoney flows out into the real economy and becomes part of the money supply can it be spent, boosting economic activity andinflation.The statutory reserve requirement plays a key role in the transformation of base money into money supply. When the BOJ buysJGBs from private financial institutions, it deposits the money in their accounts at the BOJ, thereby expanding the monetarybase. In Japan, the monetary base consists of currency and coins in circulation and current accounts at the BOJ, but as thelatter also includes deposits from securities firms and money market dealers that are not required to hold reserves, thediscussion below will focus only on reserve component of the deposits.Commercial banks seek to earn money by lending out those reserves, but they must keep a certain portion on deposit at thecentral bank in the form of statutory reserves. A statutory reserve ratio of 10%, for example, means banks can lend out 90% of their current account balances at the BOJ.When someone spends the money lent by a bank and the party receiving that money then deposits it somewhere else, thereceiving institution can then lend out 90% of the new deposit to earn interest income (10% must be kept with the central bankas statutory reserves).This process comes to a halt only when all the base money supplied by the BOJ has been lent and spent to become statutoryreserves. At that point in time, commercial banks have on their books deposits and loans equal to ten times the reserve depositsinjected by the BOJ (this multiple is the reciprocal of the 10% statutory reserve ratio and is referred to as the money multiplier).Private-sector deposits at commercial banks represent money available for use by the private sector and are referred to as themoney supply. The money supply also includes banknotes and coins, but in all modern economies bank deposits represent thelion’s share. Changes in the money supply have a major influence on economic activity and inflation.
051015202599 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14BOJBOJ: estimateFRBECBBOE(x)
Bank reserves
÷
statutory reserves
16.0x4.8x3.8x11.8x18.7x21.6x9.7x
 
Nomura | JPNRichard Koo April 16, 2013 
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Figure 1 illustrates how much money supply can grow from the present level for leading economies based on the size of monetary base relative to statutory reserves. In other words, it shows how much money supply can grow if the money multiplier reaches its maximum value.
Massive supply of reserve deposits has not sparked inflation
Before Mr. Kuroda was appointed BOJ governor, base money supplied by the Fed under quantitative easing amounted to 16.0xstatutory reserves (Figure 1). The corresponding multiples for other central banks were 9.7x for the BOE, 4.8x for the BOJ, and3.8x for the ECB.If the money multiplier were functioning properly, the money supply would therefore be 16 times larger than it currently is in theUS, 9.7 times larger in the UK, 4.8 times larger in Japan, and 3.8 times larger in the eurozone.If such an expansion in money supply actually took place in a short time, it would normally entail a similar increase in prices,leading to unprecedented inflation rates of 1,600% in the US, 970% in the UK, and 480% in Japan.The reason why this has not happened will be discussed in detail below. In short, however, businesses and households in theseeconomies have stopped borrowing money even though interest rates have fallen to zero. And with no one borrowing moneyand many actually paying down debt, the money multiplier has turned negative at the margin.
BOJ plan not significantly more aggressive than Fed’s QE
Using this concept of the statutory reserve deposit multiple, the BOJ’s new policy would lift potential growth in the moneysupply—and therefore inflation—from 4.8x to 18.7x.The latter number is much higher than the corresponding figures of 9.7x for the UK or 3.8x for the eurozone, but is roughly equalto the US multiple of 16.0x and somewhat less than the 21.6x peak there. In that sense, the BOJ’s easing program can beviewed as an attempt to catch up with (and overtake) the Fed on the easing front.Estimates based on the quantitative easing schedule provided by the BOJ suggest that Japan’s monetary base (as a multiple of statutory reserves) will overtake the UK sometime this autumn and pass the US next summer.
QE did not lead to economic recoveries in US or UK
The next question is what Japan will accomplish once its monetary base reaches the levels of the US or the UK. Inflation in bothof these economies is around 2% and real interest rates are heavily negative, which is what Mr. Kuroda seeks. Yet theunemployment rate remains at 7.8% in the UK and 7.6% in the US. The UK is in the midst of a triple-dip recession, and recentUS consumption and jobs data have not been particularly encouraging.Japan, meanwhile, has an unemployment rate of 4.3%, far below the 6.5% level at which the Fed says it will discontinue its zerointerest rate policy.That suggests Japan’s economy may not necessarily enjoy a resurgence even if the BOJ succeeds in lifting inflation rate to 2%.
Deflation took root in Japan when economy fell off fiscal cliff in 1997
Central bank officials in the US and the UK claim quantitative easing has been a success because it prevented a Japan-likedeflation. But as I noted in my last report (2 April 2021), the rate of Japanese wage growth four to five years after the bubblecollapsed was roughly equal to the levels now being observed in the US.Deflation took root in Japan only after 1997, when the nation fell off the fiscal cliff following the Hashimoto administration’s ill-fated experiment with fiscal consolidation. That was seven to eight years after the bubble burst. It therefore makes no sense tocompare conditions in the US and UK, which are only five years into the post-bubble era, to those in Japan, where more than 20years have passed since the bubble collapsed.
Money supply cannot expand without growth in private credit
Common to all of these countries is the fact that businesses and households are saving in spite of zero interest rates. They aredoing so because of the severe damage caused to balance sheets when the bubble collapse drove asset prices lower whileleaving debts intact. Private savings are running at 8.8% of GDP in Japan, while the corresponding figures are 7.0% for the US,3.3% for the UK, 8.1% for Spain, 8.6% for Ireland, 7.0% for Portugal, and 4.4% for Italy.The fact that businesses and households in these economies are responding to zero interest rates by saving money rather thanborrowing and spending aggressively clearly suggests that lending—and hence the money supply—will not expand no matter how much base money the central bank supplies.Growth in private credit has been severely depressed, as noted here on numerous occasions. Even in the US, where conditionsare said to be relatively healthy, private credit has yet to recover to pre-Lehman levels.Quantitative easing—whether in Japan, the US, or the UK—cannot directly stimulate the economy or raise the rate of inflationso long as businesses and households refuse to borrow money and spend it.
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