NEW YORK \u2014 In October 2016, Japan tried a new riff on an old economic strategy to mask the severity of mushrooming government debt: prodding the central bank to write Tokyo a blank check.<\/p>\n
It was the first time since World War II that the Bank of Japan\u2019s bond purchases would be \u201cdirectly linked to the government\u2019s issuance of debt,\u201d observed analyst Mark Fleming-Williams at Stratfor. In many ways, he added, \u201cthis could be the biggest economic development Japan has seen since the 1985 Plaza Accord.\u201d<\/p>\n
Nearly nine years on, it\u2019s an even bigger development. US President Donald Trump wants the\u00a0Federal Reserve<\/a>\u00a0to issue a blank check to a White House that\u2019s rapidly making runaway debt issuance great again.<\/p>\n Japan, the third-largest economy, dabbling in de facto debt-monetization is one thing. The globe\u2019s biggest economy by far and protector of the reserve currency, angling for \u201cfiscal dominance\u201d, is quite another.<\/p>\n The reference here is to a practice common in developing nations where monetary policies serve the political whims of the national leader of the moment. Trump\u2019s threats to fire Fed Chair Jerome Powell and Governor\u00a0Lisa Cook<\/a>, revamp how district Fed banks are run and load the Fed Board with #MAGA economists suggest the US is veering in the same direction.<\/p>\n \u201cWhat we hear is, we need lower interest rates because interest payments are exploding,\u201d former Fed\u00a0economist Eric Leeper told Bloomberg. Now at the University of Virginia, Leeper says this ploy is effectively \u201cadmitting that fiscal policy is not going to take care of itself, and so they\u2019re trying to find some other way out. This is fiscal dominance.\u201d<\/p>\n George Saravelos, global research head at Deutsche Bank AG, noted that \u201cthe Fed is now subject to intensifying fiscal dominance risks. What is a bigger surprise to us is that the market is not more concerned.\u201d<\/p>\n Last month, Powell tiptoed up to the issue, telling reporters that it \u201cwouldn\u2019t be good\u201d to set policy to accommodate the government\u2019s fiscal needs. He stressed that \u201cno advanced-economy central bank does that.\u201d<\/p>\n With the\u00a0national debt<\/a>\u00a0well above US$37 trillion and Trump\u2019s recent mega-spending tax cut bill adding trillions more, Washington\u2019s debt-servicing challenge is growing. The US has also passed the precarious point where spending on government debt interest is now more than it spends on national defense.<\/p>\n The answer, of course, is less debt. Throughout the rest of Trump\u2019s term, which ends in 2029, S&P predicts budget shortfalls of around 6% of the gross domestic product. That\u2019s well above historical standards and two times the 3% target laid out by Treasury Secretary Scott Bessent. That would push Washington\u2019s debt ratio to a peacetime record of greater than 100% of GDP.\u00a0<\/p>\n Yet, tell that to Trump\u2019s inner circle, which clearly seems to have learned the wrong lessons from Japan by betting on the Fed to take the problem off its hands.<\/p>\n In Japan\u2019s case, we need to go back to the 1920s and 1930s, back to the days of\u00a0Korekiyo Takahashi<\/a>, who\u2019s often called the John Maynard Keynes of Japan. The economist served as finance minister, Bank of Japan governor and, eventually, prime minister.<\/p>\n Takahashi is best remembered for a hyper-aggressive mix of monetary easing and aggressive fiscal expansion, along with efforts that modern economists would call debt monetization. Central banks buying ginormous blocks of debt directly from the government is as radical as any Group of Seven nation can get.<\/p>\n Many would say Takahashi ran the 20th century\u2019s most audacious experiment in so-called \u201cModern Monetary Theory.\u201d All the debating over so-called MMT ignores that Takahashi effectively pioneered it. MMT holds that a country issuing debt in its own currency can borrow aggressively with little financial fallout or risk of default.<\/p>\n Ben Bernanke, the former Fed chair, once told an audience that \u201cTakahashi brilliantly rescued Japan from the Great Depression through reflationary policies.\u201d In 2013, then-Prime Minister Abe said the \u201cexample of my forerunner Takahashi\u00a0has emboldened me<\/a>\u201d in the battle against deflation.<\/p>\n That same year, Abe empowered his new BOK Governor Haruhiko Kuroda to grow the BOJ\u2019s balance sheet to a size bigger than Japan\u2019s US$4.2 trillion economy. The Kuroda era pushed the BOJ so deeply into government debt and the stock market that it remains effectively trapped.<\/p>\n And far from shrinking Japan\u2019s debt as a percentage of GDP, the BOJ\u2019s largess has enabled the government to borrow more and more, leading to today\u2019s 260% debt-to-GDP ratio.<\/p>\n Even today,\u00a0Japan<\/a>\u00a0can\u2019t escape the last dozen years of zero-to-negative yields. As Robin Brooks, economist\u00a0at the Brookings Institution, observed, \u201cgovernment bond markets \u2014 given high debt levels also many other places, not just Japan \u2013 are heavily manipulated with the goal of preserving the fiscal status quo. It\u2019s thus important not to see these yields as a market price. They aren\u2019t.\u201d<\/p>\n It\u2019s not like hoarding half the government bond market and dominating the stock market is saving the day. Brooks explained that \u201cde facto central bank yield\u00a0caps<\/a>\u00a0create bad incentives for politicians and make needed debt reduction less likely. Things will get worse before they get better, meaning indebtedness will rise.\u201d<\/p>\n Two-plus decades of being the key\u00a0economic engine<\/a>\u00a0via zero rates in Japan deadened the nation\u2019s annual spirits. Corporate CEOs have been disincentivized to innovate, restructure and take risks. Government officials sat back and let the BOJ\u2019s 24\/7 ATM service take the lead. In the interim, Japanese government bonds have only grown in popularity, leaving everyone exposed.<\/p>\n If JGB yields jumped to 2%, banks, companies, local governments, pension and insurance funds, universities, endowments, the giant postal system and retirees get hurt. It\u2019s created a \u201cmutually assured destruction\u201d dynamic that dissuades virtually anyone from selling debt. <\/p>\n As JGB yields continue to rise, Tokyo will face increasing difficulty in servicing the developed world\u2019s largest debt burden, which is roughly 260% of its gross domestic product.<\/p>\n This unenviable challenge now falls to BOJ Governor Kazuo Ueda. Yet politics will be a bigger variable for Ueda than many investors seem to realize. The BOJ, it\u2019s worth remembering, is less independent than, say, the Fed or European Central Bank. The powerful MOF has a seat in the room when\u00a0BOJ officials<\/a>\u00a0make interest rate decisions.<\/p>\n Trump wants even greater control over the Fed, an arrangement something closer to the\u00a0People\u2019s Bank of China<\/a>. Yet as Japan showed the world in the 1930s, monetizing debt only treats the symptoms of the problem, not the underlying cause.<\/p>\n Takahashi\u2019s policies ended up getting him killed. Around 1934, he figured it was time to trim runaway spending. His moves to cut the defense budget irked military officers so much that they assassinated Takahashi in 1936.<\/p>\n Today, 89 years later, the odds of\u00a0\u201cTakahashinomics\u201d making a comeback are increasing at an alarming rate. In modern-day Tokyo, Ueda is under great pressure to give up on the BOJ\u2019s rate normalization process.<\/p>\n Ueda\u2019s job is a near-impossible one. Though QE has been the law of the land since 2001, it\u2019s been stuck in a very high gear since 2013. That\u2019s when Ueda\u2019s predecessor Kuroda began employing something approximating the \u201chelicopter money\u201d that Nobel laureate\u00a0Milton Friedman wrote of as far back as the late 1960s.<\/p>\n Trump is angling for helicopter Fed money, and then some. This, of course, is not the role the Fed wants to play. Last month, Atlanta Fed President Raphael Bostic warned that\u00a0monetary policy<\/a>\u00a0could become less effective if investors worry about fiscal risk. <\/p>\n \u201cYou could see interest rates move to some extent independent of things that we do,\u201d he said. \u201cThat would be really something that we\u2019d have to think hard about.\u201d<\/p>\n To be sure, the so-called \u201cbond vigilantes\u201d could have the final say over Trump\u2019s campaign to bring the Fed to heel. <\/p>\n