Rising interest rates are good thing for Japan

Richard A. Werner, The Daily Yomiuri, Asia News Network, Tokyo

Japan's nominal gross domestic product grew by 2.6 percent in the first quarter this year, compared to the same quarter in the previous year. This was the highest year-on-year growth rate in nominal GDP since 1997. But instead of rejoicing about this news, many investors have been worried by it: If Japan's recession and deflation are about to end, then interest rates should rise.

The Bank of Japan may soon have to end its policy of almost zero short-term interest rates. Such fears coincide with the rise in U.S. interest rates. And all commentators agree: If interest rates rise, this will be bad for growth.

Japanese corporations and banks have benefited for so long from ultralow interest rates, the argument goes, they will now be hurt by higher costs of borrowing. Thus, is it time to get bearish on the Japanese economy and its equity market?

The logic of the argument is compelling, and that is why world equity and bond markets were rattled so much in May. Newspapers and economic commentators are telling us virtually on a daily basis that high interest rates are bad for growth, and hence also for equities. Likewise, low interest rates are good, it is said. This is the faithfully regurgitated story central banks have been drumming into our heads for years.

But what is the evidence for this argument? If higher interest rates are bad for growth, then this suggests that causation runs from interest rates to growth. However, is there any evidence, either in Japan or in the United States, that interest rates drive economic growth or equity markets?

During much of the 1990s in the United States, interest rates were on the rise. Yet the economy accelerated and the equity market was in the biggest speculative boom in years. Likewise, the stagnation of the Japanese economy over the past decade was accompanied by falling interest rates.

Indeed, a closer examination of the data shows that interest rates do not lead growth, they follow it. And their correlation with economic growth is not a negative one, but a positive one.

Every bond trader will concur: Whenever news about stronger- than-expected economic growth appears, bonds do badly, and interest rates tend to rise.

Thus there seems to be a fundamental flaw in the economic logic that we are being told on a daily basis in the media and the "official" textbooks. This has far-reaching implications. For one, we do not need to worry too much about rising interest rates in Japan or the United States. When Japan was growing over 3 percent in the 1980s, and there also was no inflation, interest rates were far higher. Likewise in the United States in the 1990s. Just because rates are going up, we do not have to fear that economies will slow down.

The other major issue raised by our finding is the question of what actually determines economic growth. The party line is that interest rates do the job. But this is simply not true. Since interest rates are the result of growth, they cannot also cause it, and therefore there must be other explanations.

The main reason why the economics textbooks focus so much on interest rates lies in the fixation of economists on the simple demand-and-supply model. This says that prices will move so that demand will equal supply--and the market will be in balance (equilibrium). Since prices are the adjustment mechanism, they are the most important variable.

This simple model is the foundation of most economics textbooks and underlies the thinking of the economic journalists. For financial or macroeconomic matters, where money is important, it is the price of money that determines matters: hence the emphasis on interest rates.

But we are usually not told the full story: The notion that demand equals supply, thanks to the movement of prices depends on a number of crucial assumptions, which are highly unrealistic, including the assumption that everyone has perfect knowledge of all there is to know.

The upshot is clear for Japan and the United States: We do not have to worry about rising interest rates. To the contrary, rising interest rates are a good sign, as they tell us that economic growth is accelerating. And that has been due to an increase in the amount of transactions, which in turn was fueled by an increasing number of chips in the game that we call the economy: The amount of money in circulation has been increased. The Austrian economist Alois Schumpeter called it the amount of tickets for the game.

As long as the U.S. Federal Reserve Board and the Bank of Japan keep the supply of tickets high, there is no worry about economic growth. This of course does mean that we must scrutinize the central banks much closer in order to figure out whether they are increasing purchasing power in the economy or not. Mere interest rates will not tell us anything about that, as the past decade in Japan has proved: While rates were zero, the economy remained mired in recession, because the amount of money circulating actually shrank.

Little known to the public, the Bank of Japan has not actually increased the amount of money circulating in the economy over the past year. Most of the foreign exchange intervention was sterilized so that it did not increase the amount of money in circulation (this is also why the yen rose, instead of depreciating).

The Bank of Japan's tight credit policy is a far bigger worry than interest rate rises. But besides the central bank, money is also created by private-sector banks through the process of bank lending.

Fortunately for Japan, there have been signs that bank lending, especially to the household sector and to small firms, is through the worst and has been improving. As long as that continues, and the Bank of Japan also increases its own credit creation, Japan's economy will do well. That means higher interest rates. And that is something we should be happy about.

The writer is an investment strategist and fund manager. He is author of Princes of the Yen: Japan's Central Bankers and the Transformation of the Economy.