Edward Hugh, who has written some interesting analyses of the European debt crisis, recently joined the ranks of those tying themselves into pretzel knots over Japan's government debt.
He's not alone, of course. In certain corners of the financial punditry, there has been a steady drumbeat for Japan's imminent-or at least 'any decade now'-demise.** In fact, it's a theme that many Japanese policymakers have been seduced by over the past two decades plus. Is there a connection? You bet.
The key problem with these types of arguments is that their proponents are mired in macro frameworks that might have made sense in the 19th century, but get the current workings of national monetary economies precisely backwards.
According to Hugh (emphasis added):
The recent decision by Fitch Ratings to downgrade the Japanese sovereign by one notch, from AA minus to A plus, has all the outward appearance of being a predictable non-event. As the Reuters article reporting the decision puts it, Credit downgrades usually do not have a lasting impact on markets in Japan because its government bonds are mostly held by domestic investors".
Yet something somewhere fails to convince me that this nonchalance is really justified . Something tells me that this process of rising debt and falling credit ratings cannot go on and on forever, and that at some point...we could start to ask ourselves, what then gets to happen next? Certainly there is nothing in conventional economic theory which can help us anticipate the answer, since this kind of end of the road point has not been foreseen, anywhere, unless I am mistaken.
On one hand, Japan seems to have invented what seems to be some kind of economic perpetual motion machine. Since the country has an external surplus, and can print its own money, there is a savings surplus, and no problem selling government debt, even at ridiculously low interest rates. And since the interest paid remains ridiculously low, then there is no problem servicing the debt, and if there ever was, why then the Bank of Japan could just buy even more of its own government bonds, effectively driving the interest rate even lower. In theory there is no good reason why it couldn't even follow the lead being currently set in Germany, and push the rate into negative territory. Heck, the government would then be even earning income on its debt.
This passage illustrates the glaring gap between thought and reality that pervades the ratings agencies, much of the economics profession, and Wall Street.
Let's examine and dismantle some of the key points made:
High domestic savings help finance sovereign budget deficits. When a government is the monopoly supplier of a currency (i.e., monetarily sovereign), its deficits supply savings, not the other way around. And whether those deficit-created monies end up in domestic or international hands, a government debt security is essentially just an interest-bearing alternative to it. An analogy offered by Warren Mosler (pdf) is helpful-a sovereign currency is to sovereign debt as your checking account is to your savings account. The resulting mix of government liabilities (currency, reserves, and debt) is simply a function of market demands and central bank management of an interest rate target.
"There is nothing in conventional economic theory" that lets us predict what happens at the point Japan is approaching, because no country has ever been there. First, the claim that no country has been here is highly suspect. And second, conventional theory's failings have little to do with Japan's allegedly uncharted territory, and everything to do with gross mischaracterizations of modern monetary systems, or ignorance of money, credit, and financial institutions altogether. Call it inertia, laziness, or even professional malfeasance, but don't lay blame at the feet of insufficient evidence. That's a copout, and a rather pathetic one.
"Japan seems to have invented what seems to be some kind of economic perpetual motion machine." Only to those who don't understand the workings of a monetarily sovereign government and central bank. It makes more sense to argue that, thanks to the pervasive influence of "conventional economic theory," that Japan has invented a perpetual economic drag machine, where the net supply of Yen-denominated financial assets runs continuously short of demand.
"Heck, the government would then be even earning income on its debt." And while in "conventional economic theory" that might sound like a good thing, in reality, it's not. Once you realize that only the Japanese government can provide the Yen-denominated savings desired by the rest of the Japanese and global economies, you realize that this is simply a way to suck yet more air out of Japan's economy.
The bottom line is that the Japanese government debt Cassandras (Japandras?) are still wrong, and will be until Japan adopts an external currency peg or commodity standard. We continue to argue that Japanese equities are ridiculously cheap-due in no small part to the policy advice provided by Hugh's peers-but its demographic internals are more positive than a naive measure such as median age would indicate. If Japan's economy and stock markets perform as we expect in the coming decade, then interest rates could well rise, causing the ranks of Japandras to become even more shrill (to be fair, Hugh is not of the shrill variety). But the financial implosion will not come, however long they wait. Instead, we'll get more of the same stop-go economic cycles of the past twenty years, as policymakers react inappropriately to government deficits and debt loads by, for example, doubling the national sales tax.
** While doing research for this post, we came across an excellent refutation of one well-known Japandra by Joe Weisenthal:http://www.businessinsider.com/japan-is-never-going-to-default-2012-5
Additional disclosure: Some of the firm's clients hold long positions in Japanese exchange-traded equity funds and/or stocks of Japanese companies.
Disclaimer: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. SCM is not affiliated with or related to Symmetry Partners, LLC. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment. We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.