We recently wrote an article about the economic plight of Japan, efforts to get out of it, the narrow margins of error, and hedge funds like Kyle Bass's Hayman Capital betting against these. This created quite a discussion, with heated comments galore. However, some clarification is in order as the article also created some confusion, apparently.
The article is mainly about the role of finance in modern economies, and as such, a follow up on an earlier article in which we describe how much of modern finance deviates from positive sum-game capitalism in which transactions create benefits for both parties and are aligned with social benefits.
That goes to the heart of the rationale for capitalism, and we argued that many financial transactions are either of a zero-sum game nature ("my win is your loss") and some are even negative sum-game transactions where private gains come at a social loss. Some examples of the latter are the securitization of sub-prime mortgages and high-frequency trading.
That is where Kyle Bass's bet against Japan enters the discussion, as for us it basically serves as a metaphor for transactions that, if successful, produces enormous private gains, at possible horrendous social cost. Kyle Bass bets against Japan were taken as an example because we couldn't really construct any social gains from these, and neither could any of the (often angry) commentators.
But the discussion got distracted by a lack of focus in the article, for which we are solely responsible. Let us clear up some of the mist.
Kyle Bass influence on JGB yields
Many commentators zoomed in on this and argued that Bass wouldn't be able to shift the JGB market, but this isn't actually all that relevant to the argument, the article isn't really about Kyle Bass, he only serves as an example of transactions that generate huge private gains at the possible catastrophic social losses.
However, having said this, at some point market participants like Bass will start to influence prices, so the question is far from hypothetical. Also, there is a fair amount of research (starting with the work of Doyne Farmer) out there that indicates that it doesn't take a whole lot of volume to influence prices in financial markets.
We don't blame Kyle Bass for Japan's troubles
Of course Bass, or any other hedge fund, isn't responsible for Japan's plight even if a number of people thought we were suggesting that. Japan fell victim to the implosion of what still is the biggest bubble in history (relative to GDP), and policy was too slow to react. As a result, deflation set in and Japanese nominal GDP hasn't grown in 20 years.
The stagnant nominal GDP (real growth is basically cancelled out by deflation) makes the Japanese debt problem so intractable. We have pleaded for the BoJ to embark on large scale bond purchases even before Abe came to power, as only a combination of real economic growth and mild inflation can deal with a public debt overhang exceeding 200% of GDP, as historical examples show.
The alternative is a default, which will have truly terrible consequences, as we set out in the article. Policy should have been way more expansionary 15 years ago, then deflation would have had no chance to ingrain itself in the Japanese economy and psyche.
The only reasonable argument to be made for this kind of trade is that bond yields provide a signaling function to governments. Rising bond yields are often the cause for a change of government policy. A notorious recent case is the Spanish and Italian bond markets cajoling the European Central Bank (ECB) into action last year.
We don't see any possible signal function from rising bond yields in Japan. Policy makers really are on their last gambit here, there isn't anything else they can do, which makes the market disciplining function devoid of meaning. Yes, they can embark on structural reforms, but the pay-off of that is very gradual and it takes time while the initial effects are often adverse, it's not something they can do to stem a crisis in the bond market.
This is going to the heart of the matter, rising yields can spell disaster in Japan, and by extension, the world economy (for some details, see our previous article). So, essentially, betting against JGB's is a zero-sum game, if bonds fall and yields go up, the bet wins, and the counter-party loses. Nothing is wrong with that, this is how much of the financial markets work. However, should many bet against JGB's, rates could go up a lot, and fairly soon, debt dynamics will become untenable in Japan, a possible disastrous event.
In that case, it turns out to be a negative-sum game, and we wanted people to reflect on that.
Many people sort of argued to hell with that, Kyle Bass isn't responsible for Japanese economic mismanagement. That point we have already conceded, but to some (who were rooting for Bass to succeed), it seems that markets are always right, always the solution, and government is always wrong.
To us, free markets are a means to an end, not an end in itself, as they seem to be for many of the critics to the previous article. Markets are good when they create gains from trade and align private and social benefits. In the article about Bass versus Japan, and the previous one about zero-sum capitalism, we wanted to show that we have created a financial system, which doesn't always generate these social benefits, and in quite a few cases even generates large private gains at large social losses.
Where does Japan go from here?
Whomever you blame for Japan's current predicament, we all have a stake in them managing to get out of it, and the margins for error are rather small. What Japan is trying to achieve is a complex balancing act. As we explained in the previous article, Japan tries to engender both economic growth and enough inflation (2%) to get nominal GDP growing in order to reduce the real burden of the outstanding public debt.
But as Bass himself observed, higher inflation normally leads to higher bond yields. If bond yields rise enough, it could trigger a catastrophe, or, more likely, trigger the BoJ to double down on bond purchases, but this in itself could trigger higher inflation. Quite a difficult balancing act indeed, which is why we look with some trepidation to hedge funds piling in and potentially make it even more difficult, and we have left out possible currency effects.
Can the BoJ hold the line in the Japanese bond market? Well, one example is what the Swiss did with the currency. The Swiss national bank drew a line in the sand at a specific euro/Swiss franc exchange rate, and since they have virtually unlimited ammunition to defend that line, they've been successful.
The BoJ could do something similar, although the JGB market is quite a bit bigger than the market for Swiss francs, and they're buying already a lot. The excellent Ambrose-Pritchard from the English Telegraph thinks that the BoJ will succeed in holding the line:
I stick with my view that the BoJ has the means to crush all resistance, and should do so. This may require financial repression. Rutaro Kono and Makoto Watanabe from BNP Paribas have an excellent note out this morning arguing that Kuroda will have to copy the "pegging operations" of the Fed in the 1940s.
In effect, the Fed became part of the Treasury's debt management team as the budget deficit hit 25pc of GDP in WW2. It capped one-year notes at 0.875pc and 30-year bonds at 2.5pc. The markets knew that all necessary means would be used to hold the line...
But all this is clearly "doable", and if the alternative is a spiral into mayhem and debt default, you can hardly blame Mr. Abe for wanting to try.
Many at the BoJ even seem to doubt whether the BoJ will be able to get inflation to 2%, but we all have a stake in Japan succeeding, the alternative could easily become too ugly to contemplate. We've seen what Thailand (1990s Asian crisis) or Greece can do to the world economy, we really don't want to see what the biggest bond market crash in the third biggest economy would do to the international economy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.