Abeconomics, Japan and market failure; the anatomy of crisis

by George Hatjoullis

Humpty Dumpty

Humpty Dumpty (Photo credit: merlinprincesse)

The 2-in-2 policy announced by the Bank of Japan seems to have broken the Japan government bond market (JGB). There is a serious risk of market failure. All other market crises ultimately come down to market failure. Usually it takes the form that nobody wants to buy and everyone wants to sell. Those making prices continuously move the price so that sellers are discouraged. Very little trading volume actually arises.

Market failure can become systemic and this tendency has been exacerbated by the requirement to mark-to-market. Posted market prices are used to mark inventory, value assets and so on. Very large notional gains and losses can arise and if these lead to economic decisions systemic problems can arise. The distribution of notional gains and losses are unknown so all agents become wary of trading because of counterparty risk. Even if you are trading something apparently unaffected by the market failure, you may still avoid doing so with an institution that might be affected adversely by the market failure. The problem thus spreads along product lines and becomes systemic.

This general description will be familiar to anyone that has been trading since the 1970s. It has happened all too often and much more often than statistical models would predict. It is essentially the mechanism behind the 2007/2008 bank crash.  It was the mechanism that lay behind the October 1987 equity market crash. It was the mechanism that lay behind the 1994 bond market crash.There were several other less dramatic but no less painful crashes for those involved. I have experienced them all and have the scars to prove it.

The JGB market is a worry. There are a lot of JGBs in Japan financial institutions. The intention of Abe was flagged last December. Yet there appears to have been little reaction until some time after the BoJ decision was made. Indeed the first reaction was for JGB prices to rise which was just as odd. The problem is no one is quite sure what to do and the government has not thought through the market response.

The government plans to achieve inflation in two years of 2%. It will do so by doubling the stock of fiat money. This will, in part, be achieved by greater purchases of long dated JGBs. The question is at what price will the purchases be made? If you hold JGBs and you believe that the BoJ policy will be successful then you do not want to be holding long dated JGBs at present yields. Japan financial institutions are huge in terms of assets but not fleet-of-foot. Moreover, they have a strong tendency to all move together (in my experience). The BoJ really needed to think through the market response of its policy announcement and buld it into the strategy. It appears not to have done so.

If the JGB market fails then prices could fall precipitously with little actual volume exchanging hands (see 1994 for a case study). Mark-to-market losses could be substantial and raise questions of counterparty risk and so on. The BoJ would do well to act to circumvent this immediately. Markets are a bit like Humpty Dumpty and everyone gets egg on their face.