This week in horrible economic policy news, we learned that the central bank of Japan is top 10 shareholder in fully 90% of Japan’s leading public companies. Admittedly, this probably sounds like an exceedingly mundane and boring fact if you aren’t too familiar with how central banking works. But once you understand what’s going here, you will recognize it for what it is–a scandalous economic policy that is destined to go down in flames, and take many innocent bystanders with it. In this post, we’ll explain what this policy is, why it matters, and why this is another sign that the global economy is well on its way to the next collapse.
Central Banking and Monetary Policy*
The central bank can be thought of as the bank for banks. It is the institution where commercial and consumer banks store their extra cash, and it is well-known for serving as the lender of last resort to prevent bank runs. Individual banks never have enough money on hand to fulfill all the deposits that have been made with them. The reason for this is that some of the money stored by individual depositors has been given out in loans to other customers. This is where the name fractional-reserve banking comes from. At any given time, each bank only has a fraction of their total deposits on hand and ready to meet deposits. Though this fact is not commonly understood, there’s actually nothing inherently underhanded or shady about it; it’s just how the modern banking system works. And because modern banking works this way, all banks are always technically at risk for a bank run where many of their depositors come knocking all at once and demand more cash than the bank can provide. This can probably be viewed as the main reason that central banks came into being–to lend banks money when they are faced with a bank run.
In the aftermath of the Great Depression and with the steady rise of Keynesian economics, however, the US central bank, the Federal Reserve, eventually adopted a broader role. Now the Fed’s mission is not only to serve as the lender of last resort, but to also manage the money supply (which is precisely what it sounds like, the amount of money in existence) in order to ensure a healthy economy. And in particular, the Fed’s goal was to ensure both low inflation and low unemployment, often referred to as the dual mandate. And the basic way they go about pursuing this goal is by adding money to the economy (by lowering interest rates and/or directly injecting money into the system) when it is in a slump, and reducing money in the economy when it looks like it is overheating. In practice, the first part of that process, injecting more money, happens frequently, but the second part rarely does.
For our present purposes, the key thing to understand is that the central bank, in the US and elsewhere, literally has the power to create money out of nothing. When it wants to inject new money into the system, it will frequently buy US Treasury Bonds. And when it makes these purchases, it usually does so with money that, prior to the purchase, did not exist. It sounds strange, but it’s the truth. The only difference between a counterfeiter and a central bank creating money is that it’s illegal for the counterfeiter; if they were both using the money to purchase Treasury Bonds, the impact on the actual economy would be the same. Obviously, this is a very significant (and dangerous) power.
If the central bank does too much money creation, there’s a risk of having massive inflation. In the current situation, however, with consumer spending down and oil prices down as well, most consumer prices are basically flat. Thus, most central banks have judged that the risk of inflation is limited, and that we might actually need more of it. You see, most mainstream economists view deflation (generally falling prices) as the supreme evil that must be avoided at all costs.** And to prevent this from occurring, they are pulling out all the stops to get more money into the economy and cause inflation.
What to Buy
We mentioned above that the Fed typically buys Treasury Bonds (US Government debt) when it wants to inject money into the economy. There’s a good reason for this. Treasury Bonds are very heavily traded, which means they are easily bought and sold. It also means that the Fed’s purchases or sales on any given day probably won’t have a huge impact on the broader market; they’re still a large player, but their presence is diluted by the actions of so many other investors. Another benefit is that the value of Treasury Bonds is relatively stable. And to the extent that the Fed profits off of the interest on US Government debt, that gets remitted back to the US Government at the end of the year anyway, just like all of the Fed’s net profits. So, viewed in the most optimistic sense, this is sort of like one arm of the US government lending to another arm. (Yes, people pretend the Fed is independent, but we’ve previously explained how deeply silly this belief is.) In effect, the Fed’s demand for US government debt, subsidizes the government’s borrowing costs. And given that it’s inevitable that the Fed’s efforts to inject money will subsidize something, this is probably about the least distortionary effect. That doesn’t mean it’s a good thing, but it’s probably the least bad.
So to revisit, if a central bank is going to buy financial assets (and most, if not all, of them do it), the things it buys should have the following characteristics:
- Highly liquid
- Highly traded market (so the central bank doesn’t make a big dent in the price)
- Stable value
- Limited subsidy impact
- Neutral ownership interest (owning other government assets)
- Less liquid and less heavily traded – While the BoJ owns shares of large, highly traded companies, the fact is that stocks are much more prone to panic sell-offs than government debt. If the BoJ tried to sell off its stake, the value would likely decline rapidly.
- Unstable value – Obviously, stocks are not known for having a stable value over time
- Subsidy – The BoJ is now effectively subsidizing the shareholders of individual companies
- Ownership – The BoJ, which is to say the Japanese government, has now accidentally gained a large ownership share of major companies.
*Before we get started, note that none of what follows should be taken as an endorsement of central banking. I share the view common among the Austrian School of economics that the net impact of central banks on the economy is decidedly negative. But that larger issue is not the subject of the present post. Thus, we’re going to describe the central bank in a neutral way and describe the role that more conventional economists believe it should play in the economy.
**There are compelling reasons to reject this idea in general, but for our present purposes, we’ll just stick with the mainstream view.