Here are some figures from Japan:
- Budget deficit over 7% of GDP
- Public debt in excess of 200% of GDP
- Two supposedly 'lost' economic decades
- Aging, and hence shrinking population
- Declining current account surplus
Normally one would think this is a disaster looming, especially in the present, very uncertain economic climate. In fact, you might be at a loss in trying to understand that a disaster hasn't already happened.
However, we think you would be wrong. Go to Japan and you'll see a surprisingly prosperous country, with relatively low unemployment. It's nothing like some of the eurozone periphery, even though it is, in many respects, still suffering from the hangover of the collapse of an asset price bubble of rather momentous proportions, all the way back in 1990.
That asset price bubble, and its subsequent deflation, was three times the size of the bubbles and collapses of similar events in the US in the 1930s and 2008-9, to put things in perspective. To put things further into perspective, Japanese banks, which ended up with mountains of bad debt, are way more important in the credit provision to firms (and households) compared to the US, so Japan not only suffered from a bubble and collapse that was three times as large, it was severely handicapped in other ways as well.
The monetary transmission mechanism virtually stopped, with firms and banks hell-bent on repairing balance sheets even at zero interest rates. Credit demand collapsed, yet the Japanese economy didn't, due to massive fiscal expansion, which is responsible for that 200%+ public debt/GDP ratio.
We have already argued that the Japanese did the sensible thing, but critics argue that Japan's day of reckoning will surely come, and what they did is merely postpone things. We have several answers to that.
Two decades and counting
The first thing to note is that Japan has, well, been pretty good at kicking that proverbial can. Twenty-two years to be precise. If there is a day of reckoning, they've managed to, well, push that further and further out. Not for much longer, people keep saying. Well, perhaps, but that's certainly not the impression one gets from looking back.
Indeed, looking forward doesn't increase the rate of alarm a whole lot, if at all. The Japanese bond market is remarkably relaxed about this coming collapse, still lending the Japanese government at ridiculously low interest rates for decades into the future. We simply conclude that, while many side-line pundits are worried, actual market participants with a stake in the game are not. Despite several downgrades from rating agencies, the Japanese yields have come down steadily
(click to enlarge)
Fiscal expansion and the Japanese non-depression
It is an under-appreciated fact that the fiscal expansion has kept the Japanese economy afloat, and what's also often overlooked is that the public debt/GDP ratio has a numerator and a denominator. Here is what the pre-eminent specialist on those Japanese 'lost' decades has to say about that:
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]
And while many cling to the mantra that "you can't solve debt with more debt," the reality in a balance sheet recession suggests otherwise. This is the type of recession that is caused by private sector delevaraging, paying off debt in order to repair balance sheets, saving more and borrowing and spending less.
If central banks bring interest rates down to almost zero and nothing happens then it is not an ordinary world. [FT]
Indeed it isn't. Just like the actor Bruno Ganz explained a tank (he just thought to have invented) as a vehicle that brings along its own road (in the film "Der Erfinder," if you really must know), a balance sheet recession is a recession that brings along its own savings. These are simply the product of the private sector deleveraging process.
Now, some (like us) argue that under such conditions, the public sector has to pick up the slack and borrow at record low interest rates to build bridges, roads, and hospitals, and a whole lot more, like the Japanese did. Others are alarmed by that and worry about ballooning public sector deficits and debts.
Hence the importance of Japan, as it is simply a decade and a half more advanced in this process. We would argue that the evidence is conclusive. Whenever the public sector cut back, it simply compounded the private sector reduction in spending, creating a downward spiral that is especially dangerous with so much debt outstanding, risking a Fisherian debt-deflationary spiral.
This happened in the early 1930s, until Roosevelt. It happened again in 1937, when Roosevelt prematurely pushed the brakes (by a whopping 5.8% of GDP, resulting in an economic contraction of 11%, no less). It happened in 1931 in Weimar (with rather ominous consequences). It happened in 1997 in Japan, when Hashimoto did a 'Roosevelt 1937.' It is happening in much of the eurozone periphery, and it is even happening in the UK, according to the IMF.
Actually, the only place that has suffered from the deflation of a credit infused asset bubble which hasn't suffered from a severe economic contraction (not even a mild one, apart from 1997, when they pushed on the brakes) is Japan post 1990. And keep in mind that:
- The asset bubble, and subsequent deflation, was three times bigger than those of the US post 1929 or 2008
- Japanese monetary policy was very slow to react
- Japanese banks did virtually nothing for over a decade to address their bad debt problem.
That only leaves fiscal policy as the explanation. But yes, apart from keeping the economy from collapsing into a Fisherian debt-deflationary spiral and producing a lot of shining new infrastructure, there is that public debt that keeps on accumulating..
Day of reckoning unavoidable? Well..
The end game
The Bank of Japan (BoJ) could simply retire a considerable chunk of the outstanding debt. Ho, some readers might react, isn't that monetary financing of public spending? Well, and yet. Isn't that supposed to be inflationary? Well, really not always and everywhere. It isn't very likely in an economy where the private sector is deleveraging.
The BoJ bought government bonds for six years, between 2001 and 2006. What happened? Nothing. No inflation, the economy couldn't even get out of deflation, as it happens.
In the UK, the Bank of England [BOE] has bought a whopping 375 billion pounds worth of government bonds in the last couple of years. That's a good 20% of GDP's worth of QE. What happened? Inflation is falling, not rising, and certainly not accelerating. And in fact, according to Martin Wolf, the FT's most authoritative commentator, inflation is just what the Japanese need:
All the country needs to do is generate, say, expectations of 3 per cent inflation and the public debt problem should melt away like snow. [Martin Wolf, FT]
His 'recipe' for getting to that 3% inflation rate is to:
hire a central bank governor who knows how to create inflation - an Argentine, for example
We find it difficult to imagine what this Argentine would do to create such inflation, besides massive purchase of government bonds, given that interest rates are already effectively zero. So if the retiring of government debt by the BoJ creates some inflation in the process, not only is a substantial part of the public debt retired (before you get confused, the debt retirement by the BoJ is our suggestion, not that of Wolf), the real value of the remaining part is reduced as well.
Yes, the only problem we can foresee is that it might be difficult to keep inflation at 3%. We suggest that they would simply stop the operation if that happens, sell back some bonds should that happen. But perhaps that's not necessary. QE, at least so far, hasn't been able to create inflation. Not in Japan, not in the UK, and not in the US.
And there would be another obvious way to keep inflation from accelerating, should that even become a danger. Fix the budget deficit. With 3% inflation, Japan would be well and truly out of its deflationary period, and money balances would decline, not increase in value. That would generate spending on real assets, giving the Japanese economy a boost.
That would change the balance sheet recession dynamic, and make inflation a more serious threat, at which time the public sector should curtail spending and hike taxes. This would keep inflation in check, and further reduce the public debt problem. Pretty neat, as it happens.
The consequences for Japanese bond holders are not good, needless to say:
let us suppose inflation indeed goes to 3 per cent. That should raise the interest rate on JGBs to 5 per cent. Other things equal, the market value of the outstanding net government debt would fall by 40 per cent. [Martin Wolf, FT]
That would only happen if the average maturity of the Japanese outstanding public debt was a lot longer. Wolf urges the Japanese to considerably lengthen the maturity, to 15 years from the average of 5.2 years (2010 figures). With shorter maturity, the fall in bond values would be less dramatic, but it would be less interesting for the Japanese authorities to embark on this process.
One might conclude that it's not terribly realistic, the BoJ is far too conservative to deliberately create inflation (Wolf's suggestion) or simply retire debt (our suggestion). Perhaps. But if anyone has any better idea of getting rid of 200%+ of public debt/GDP, you have our ear..
Another consequence would be a considerable fall in the Japanese yen (if others not simultaneously copy this grand scheme), boosting the economy further and adding to the inflationary risk.
So the process has limits, these limits are inflation getting off. But since that hasn't happened in countries with their own currency and under some kind of balance sheet recession, it isn't likely to happen in Japan anytime soon. Japan is the country suffering from deflation, and it's about time they got out of that hole. Deflation, after all, increases the real value of outstanding debt.
What the Japanese did was to amortize what can only be called the mother of all asset bubble collapses, and prevent it from turning into a 1930s style depression. They did this through public sector borrowing. Borrowing at 1% or less and build hospitals and roads and bridges. No, perhaps not all of these roads or bridges were necessary, but go to Japan and you can see for yourself that they have first rate infrastructure.
Infrastructure building has kept the economy from collapsing, and the existence of which has strengthened the supply side of the economy. And the bill for this, at sub 1% interest rates, has been particularly low and could very well be a whole lot lower still if the BoJ simply retires a substantial part of the public debt and/or creates moderate inflation to reduce its real value and fosters a more vigorous economic recovery by getting Japan out of its deflationary rot.
Now, we agree, this is not how things are supposed to work. But given the bubble, and its massive collapse, we think we can make a pretty good case that, rather than having suffered from two lost decades, they've actually done a pretty good job, given the circumstances. They could do a better job still if only the BoJ would play game.