For most Westerners Japan is synonymous with modern cities, high-speed trains and marvelous new-age technology. I lived in Japan for three years and can attest to the fact that it is in many ways a wondrously modern society, full of innovation and creativity. But there is another Japan that lurks below the surface, mostly unseen by outside eyes. This is the Japan of old shops and tattered awnings, run down buildings with rusting roof-tops, train tracks that have not been replaced in decades and trains and busses almost as old as the citizens that ride them. This is the Japan of two lost decades, the Japan with an aging, shrinking population, and a public debt to GDP ratio of almost 250%. This is the Japan into which 'Abenomics' - the economic policy of Prime Minister Shinzo Abe's government - is being introduced.
In the Western media the problem is usually laid out as follows. Japan was once feared as an economic conqueror - the China of the 1980s. Then, two decades ago, something went wrong. Japan started experiencing deflation and this has wreaked havoc on the economy. Leaders have come and gone, but no one has been able to restart the economic engine. Shinzo Abe, the new prime minister, has a plan to print up a lot of money and restart inflation. If he's able to do this things will turn around in Japan. The only risk is adding more debt to an already deeply indebted economy.
Unfortunately Japan's problems are far more complex than this, and the risks involved with Abenomics quite staggering. To better understand Japan's current predicament we need to consider its recent past. Post World War Two, Japan was a broken country. Major cities had been razed to the ground, the population decimated, and forty percent of its industrial capacity destroyed. During the occupation the US helped Japan in the earliest phases of its reconstruction program, investing money in infrastructure and drafting new economic and political policies. By the start of the 1950s, Japan had rebuilt itself industrially with the newest equipment, giving it an advantage over its competitors in the United States and some parts of Europe. Japan had a weak currency, low labor costs and complete access to the markets of Europe and America, both of whom had committed themselves to free trade. During this time the Japanese made extraordinary amounts of money, and throughout the post-war decades saved on average thirty percent of what they earned. This money channeled back into society contributed to their continued economic ascent. From the 50s right the way through most years in the 70s the Japanese economy grew at close to 10% per annum. Throughout these decades the yen was far weaker than the other major world currencies, trading at around 350 to the dollar. This allowed Japan to flood Western markets with cheaply produced goods.
During the second half of the 80s Japan entered what is commonly referred to inside the country as the 'babburu keiki' or 'bubble economy'. During the first half of the 80s, the US dollar had strengthened enormously against the other major currencies. This strength was damaging to the United States. They convinced Japan, Germany and Britain to sign the Plaza Accord in 1985, in which it was agreed that their reserve banks would aggressively intervene in the currency markets to devalue the dollar. Their plans were successful and from this point onwards the yen began to strengthen rapidly. To try and counter the ever-strengthening yen the central bank, Bank of Japan (BOJ) massively increased the money base, issuing vast quantities of yen. This 'easy money' helped kick start what became the 'bubble economy'. Real estate and stock prices were driven upwards to insane levels. Throughout this time the BOJ kept interest rates extremely low, further encouraging speculation. Money began to flow from the US and Europe into Japan driving up the prices of stocks and real estate even more. Banks started taking on larger risks and it was common for average citizens to have massive stock portfolios and several properties, often largely funded through borrowed money. In the late 80s, on paper, Japan became the richest nation on earth, with total assets valued at over 47 trillion dollars (yen equivalent at the time), over 10 trillion dollars more than the US. This value had doubled in the space of a few short years. The Nikkei peaked at 38, 975. Then in 1989 and again in 1990 the BOJ raised interest rates, ultimately to 6%, fearing that a bubble was forming in some asset classes. This triggered the burst, exposing all the bad debt and leverage in the economy. From this point onwards asset prices tumbled, with some Tokyo real estate losing up to 99% of its value, and the Nikkei over 80%. Tens of trillions of dollars of wealth was ultimately wiped out.
The government and BOJ responded by trying to encourage more lending and spent vast amounts of money on unnecessary public works projects. The government arranged bailouts of banks and insolvent firms, leading to a cycle of stagnation as companies waited for free money instead of reorganizing. Interest rates were lowered again and again, eventually down to 0.1%. Many citizens watched as their pensions and life-savings were wiped out. Others, who at the height of the bubble had three or four houses, now had them repossessed. People had been badly burned and were terrified of taking on risk. The 90s became known as the lost decade, and increasingly the period from 1990 to the present is referred to as 'the lost decades'. The economic and social implications have been enormous and in the course of these 20 odd years of stagnation the government's debt to GDP ratio has gone from 68.3% in 1989 to almost 250% today.
During the post-war years of economic expansion the country had a favorable demographic situation, with only one retiree for every eleven workers. It was during this time that Japan's social policies - including a socialized medical scheme and pension plan - were designed. But by the end of 1980s demographics had shifted, and today Japan has a negative birthrate and less than 3 workers for every retiree. As more people enter into retirement more resources must be set aside to support them. The productive segment of the population is shrinking and with it the productive capacity of the society. A country grows rich by producing more than it consumes. It grows poor by consuming more than it produces. Japan finds itself at the tipping point. In the post-war decades it was a production superpower. But for the past twenty odd years it has been living, to a large degree, off the savings of the past, unwilling - quite understandably - to lower its collective standard of living.
The Japanese government has largely been financing this sustained lifestyle through deficit spending. Almost all of the funding has been sourced internally. This is often used as evidence to support the claim that Japan's economic situation is not as dire as it appears on paper. It has indeed insulated Japan against the kind of bond crises we've seen in Europe where external creditors call time out on indebted governments, but it has also allowed the debt to grow to ludicrous levels.
There are also problems in the private sector. Japanese companies are notorious for not paying out dividends to stockholders, or offering wage increases to employees. Instead - despite two relatively stagnant decades - they've managed to amass fairly substantial cash surpluses. With the yen so persistently strong (until very recently), and with limited investments available - they have been happy to stash their cash in the bank. Since the bursting of the bubble, Japanese citizens have also been less willing to borrow money for investment, speculation or consumption. With no other way to earn interest, the banks have been recycling their deposits through the bond market. The Japanese Pension Fund - the largest on earth, with an asset base equivalent to 1.3 Trillion US dollars - has invested almost exclusively in Japanese Government Bonds (NYSEARCA:JGBS). In short, all the massive savings that Japan acquired during the boom years have since been moving through the bond market and earning returns of less than 1 percent per annum.
In times of turmoil investors are willing to accept miniscule returns in exchange for safety. But how - for two decades straight - could anyone accept such consistently awful returns? The answer is simple: deflation. In a country where costs decrease at roughly 2 percent per annum, earning interest of 0.3 percent is not as bad as it sounds. In fact it's a pretty good deal. It's also an excellent reason not to look for alternative investments. Nobody is sure exactly what has caused Japan's persistent deflation. Suffice it to say, individuals and corporations have, for the past two decades, preferred holding onto cash than using it to invest or speculate. Enter Mr. Abe with his plan of inflation targeting. With the help of the central bank Abe is aiming to re-inflate his economy back to life. He's set a target of 2 percent per annum. He wants to get Japanese citizens and companies out of cash and into stocks. He wants them to stop hoarding and start spending. And this is all well and good, except for the small problem that his government still exists, and is completely reliant on extremely low interest rates to finance itself. If Abe does get his inflation, then which banker, fund manager or pension fund is going to accept returns of less than 1 percent per annum?
Does Abe not understand the risks involved? Sure he does. But he has a central banker in his corner. Shirakawa - the previous head of Japan's Central Bank - was not 'accommodative' enough and so was promptly fired and replaced by Kuroda who has assured the world that there will be no spike in interest rates. And if there are, he will step in and purchase any bonds that cannot be sold on the open market. He's doing essentially what central bankers have always done: using smoke and mirrors to convince the world that everything is in order. Central banks have the unique ability to create money out of thin air. And so in theory there should be no risk of interest rate spikes, because in theory there's no limit to how much money the central bank can create. But central banking is a delicate art. People can be convinced of only so much, and no more. If and when it becomes apparent that a government is financing itself mostly - or purely - with freshly printed money, institutional holders of bonds panic and run for the exits. The central bank is unable to suppress interest rates. A bond crisis, currency crisis, or usually a combination of both, ensues.
In recent years Japan's baby boomers known as 'dankai no sedai' have been entering retirement. The Japan Pension Fund has turned from a net buyer of JGBs to a net seller. Moreover as these retirees stop working, they stop saving and start drawing - further drying up an easy source of funding for the government. With or without Abenomics, Japan would have, in the near future, found itself staring a bond crisis square in the face. If Abe is somewhat misguided, he is - at the very least - brave. He's taking extreme measures in the face of extreme circumstances. He's hoping that the central bank can convince the world that everything is fine for long enough to get things ticking again, to the point where the government no longer relies on deficit spending, but is able instead to cover most of its expenses through tax revenue.
It is tempting to believe that tweaking the money supply might be sufficient to fix the deep structural and demographic problems the country faces. Unfortunately no amount of money printing or inflation will be able to revive a population that's in decline. Even if, under the best-case scenario, Abe were able to kick start real growth in the economy, it would be unsustainable without a long-term plan to increase productive capacity. Put differently: with a shrinking population, and no immigration, how can economic growth match monetary expansion? Unless every citizen becomes exponentially more productive, it can't. And when money supply grows faster than real economic growth, one risks inflation of the wrong kind. Prices go up, bubbles develop in various sectors, and consequently the population is left all the poorer. At best Abenomics will keep the stock market running for a while longer and increase the wealth of the financial elite. It will give a boost to consumer spending. Both of these - as has always been the case throughout history - will be followed by slumps. Only then, the days in which the government can borrow money for next to nothing will be over. Already over one quarter of the budget must be set aside for bond and interest repayments. The government has budgeted for an increase of one percent in interest rates. Beyond that however, they will be finished. An increase in borrowing costs of a few percentage points would have them spending their entire budget on debt servicing.
Although the government sources its funding internally, JGB futures are traded on various international exchanges. This means that although foreigners do not own much Japanese public debt they can and do impact on the rate at which the government can borrow. In recent weeks, large hedge funds have been lining up for a very popular new trade - shorting Japanese Government Bonds. And we have recently started seeing short-term spikes in interest rates. The BOJ naturally downplays this and assures the world that everything is fine. But how long can this last? And what could ultimately trigger the collapse?
If yields on bonds continue to rise, and shorting JGBs becomes a profitable trade, we can be sure that international money managers will happily climb on board for a momentum trade, and gleefully profit off Japan's economic collapse. Alternatively - and far more likely - the trigger will come from within. One of the major institutional holders of JGBs (the pension fund or one of the large banks) will conclude that its time to get out. This will trigger a run for the exit, the collapse of the bond market and an even faster - and far more painful - devaluation of the yen.
And what will happen after that? Is Japan doomed forever? I don't think so. The Japanese are a unique, brilliant, and resourceful people, and with time I am confident that they will find a new way. That way however is not the way of money printing.