Are JGBs -- Japanese government bonds -- the ultimate bubble? These are very expensive, hence they have very low yields (around 1% for 10 year maturities). And according to many, that is a bit of a conundrum, considering there are so many of these JGBs.
We described how Japan suffered from a Great Depression-type shock (or actually, an even larger one as a whopping three years of GDP worth of wealth was destroyed) without suffering a Great Depression. They pulled this off by embarking on a rather expansionary fiscal policy (as monetary policy is much less potent under these circumstances). Here is Richard Koo:
Had there been no fiscal stimulus, the Japanese economy today would have contracted by 40-50%, if the U.S. experience during the 1930s is any guide. [Richard Koo]
The eurozone just abdicated from such possibilities, another reason why they should prevent financial crisis from happening in the first place by not letting banks and the private sector overleverage.
However, here we focus on Japan. Some stylized facts:
- Japanese budget deficit is 8.3% of GDP (2011 estimates)
- Japanese public debt is about 200% of GDP
- 95% of public debt is in domestic hands
- Japan is still the world's biggest creditor nation. Even with a 8%+ budget deficit, it still generates excess savings (hence the trade surplus)
These are rather horrendous figures, which lead a lot of people to argue that Japan has merely kicked the can in avoiding a Great Depression.
While Japan's performance over the last couple of decades is quite remarkable (GDP per head growing a tad faster than either in the EU or the US, and having considerably lower unemployment), that doesn't mean they did everything right. For instance, they let deflation get a hold of the economy. Rather than the "drip, drip" of fiscal stimulus over the best part of two decades, they should perhaps have used massive force, the kind of what the Chinese did in 2009. That might have prevented deflation getting a hold.
But then again, this is all wisdom with hindsight, and pretty counter-factual as it is. We don't know with any kind of certainty what would have happened would they have embarked on that. Koo himself isn't terribly worried about the Japanese debt. He argues that people will become adverse to debt after a balance sheet recession, therefore, these are infrequent and this gives the public sector time to pay-off the public debt they produce, like Britain did after WWII.
Also, after two decades, the deleveraging process of the Japanese banks and business sector is nearing completion, the economy would normally be able to withstand some reining in of fiscal stimulus (taxes are rather low in Japan). However, the 2008 financial crisis has thrown some sand in the wheels here.
But there is something else to consider. The Bank of Japan, or BoJ, has embarked on its own version of quantitative easing; that is, large-scale bond purchases. This hasn't led to any notable effect on the economy (indeed, private sector credit demand went down in that period, as you can see in the figure below).
But perhaps the real significance of Japanese QE is that it absorbs some of the outstanding debt. Put into different words, in a land that suffers from (mild) deflation, the central bank can monetize some debt without causing any notable uptick in inflation. Risks of debt monetization causing accelerating (let alone hyper) inflation are exaggerated under the present circumstances anyway, even more so for Japan. It could, in fact, do with a mild uptick in inflation to get it out of its deflationary rut.
If by trying to achieve this it retires any overhang of JGBs from the market, this merely is an additional benefit. In fact, we end up at a position not unlike that of the Modern Monetary Theory position: It's merely a substitution between two public liabilities and the upper limit for public debt isn't any budget constraint, but the onset of accelerating inflation.
So we have the following logic:
- Japan suffered a financial shock bigger even than the US in the 1930s, leading to a collapse in asset prices and a balance sheet recession.
- The private sector embarked on deleveraging, paying off debt. The resulting collapse in demand was counterbalanced by the public sector embarking on a large scale and prolonged fiscal stimulus program.
- That kept the economy afloat, actually to a remarkable extent, as it happens. Japan experienced nothing like a Great Depression.
- However, the public debt has ballooned as a result, now standing at 200% of GDP.
- Since Japan suffers from (mild) deflation, the BoJ has considerable leeway for debt monetization, it merely substitutes one liability for another, and as long as it doesn't set off a considerable acceleration in inflation, it can continue with this process.
- When the deleveraging of the banks and private sector is done and the Japanese economy returns to some form of normalcy, the fiscal stimulus can be wound down and the BoJ can sell some of its JGB holdings.
Combating Great Depressions
We think this is a much better way in dealing with the kind of financial shocks than those who argue for fiscal restraint or outright liquidation. Remember, we also have experiences with the latter solutions (the 1930s, and what's going on in Europe right now).
Yes, Japan's debt is enormous. However, Japan managed to keep its economy afloat as a result. A sinking economy would also have been very bad for public finances, something that is often forgotten in the discussion. We could also point out that in the process of keeping the economy afloat through public expenditure programs, Japan created first rate infrastructure. Some of this, apart from the direct employment it created, also improves the economic structure and productive capacity longer-term.
Financed at what, 1% for 10 year JGBs or so, nobody can convince us that of all these public works, there aren't at least some with a return for the economy higher than that 1%. Not all Japanese bridges go to nowhere.
So for those ready to short JGBs as the bubble of the century, we wouldn't bet on it. It depends on a reading of the future policy actions of the BoJ. That doesn't seem to be as solid a bet as some claim it is.