This is the first issue of a new series of weekly letters I will be writing on a regular basis to share my thoughts and impressions on the global economy and financial markets. They will all be posted on Seeking Alpha so that anyone can just jump in to post a comment, share their own views, correct me when I write utter nonsense or even just to say hi. I hope this will be an entertaining journey that may also help us climb the never-ending learning curve of macroeconomics.
These thoughts and delusions I will write about will generally evolve around a few core dynamics I believe are likely to shape and shake economies in the coming years. As some of these secular trends reach their tipping points, there might also be some very interesting financial rewards to grab from the crowd if we can get our trades and timing right. Here are a few I will often refer to and that I hope we can debate:
- Over indebtedness of developed economies and how Keynesian fiscal policies will force unexpected adjustments
- Plutonomy and the elasticity of wealth disparity
- The Chinese elephant on a bicycle and its flawed business model
- Lost in deflation, or how monetary policy fails in a fractional reserve system
- Demographics, natural resources, and the illusions of perpetual growth
Each week I will add a small stone to the edifice, dig deeper into these concepts, and with your help, try to connect the dots between the daily noise of the financial markets and the core secular shifts above that may profoundly change this complicated world we live in.
So to kick off this first article, I will share a few thoughts on Japan that happens to have had its credit outlook cut to negative. I will often refer to Japan, as I believe it is an interesting situation to follow on many aspects and it may offer much insight on what to expect in many developed economies in the coming decade.
One aspect is Japan’s record public debt level. While its never ending lost decade of deflation may appear to have no end in sight, the gigantic government debt load it has induced in an effort to avoid negative growth could very well be reaching a tipping point. We may well be living the last inning before a game-changing event. Rest assured, I don’t believe we will see a failed bond issuance or a sudden rise in interest rates leading to default. As I explained in “Government Debt and Inflation: A Fallacy of Composition, sovereign countries with sovereign currencies issuing sovereign debt in their own currency don’t go bankrupt. Central banks may issue whatever amount of government bonds at whatever interest rate they wish. Interest rates are not the force that creates an adjustment on excessive debt levels. The adjustment factor is the exchange rate. Interest rate volatility there may be, but an involuntary default caused by rising rates there can not.
But let’s go back to the current Japanese debt situation. Even though Japan is paying less than 1.5% on its bonds, their 200% debt to GDP level is so elevated that interest payments amount to 27% of tax revenues. If you include the roll of maturing debt needed to service it, the share rises to 57%. Think of that, 57%. Over half of every single yen received in taxes and revenue is used solely to service the existing debt load. Just as a matter of perspective, if rates were to move only to the level of the US, existing debt servicing would equal all tax revenues leaving absolutely nothing for any public service. No schools, no public transport, no social security, no defence spending, nothing at all, a libertarian dream come true.
No wonder Japan is flooding the back of taxicabs with pamphlets and advertisements on the wonders of holding government bonds. If one adds the basic necessities of social security and education to the weight of debt servicing at current record low rates, these basic expenditures are not even covered by tax revenues anymore. Only the issuance of more debt can enable the basic functions of the state.
We all know that there are only three venues that can remedy excessive indebtedness – debt restructuring, inflating it away, paying it off. Debt restructuring is not only unnecessary for Japan, as it benefits from dual sovereignty (sovereign nation with a sovereign currency), it is also not in its interest. Indeed, domestic banks hold about 45% of outstanding debt, insurance companies 20%, public pensions 15%, the Bank of Japan about 8%, households 5% and finally foreigners 5%. Clearly, when 95% of your debt is held domestically, a restructuring is not even a remote political option. As for paying it off, given its current level and the debt servicing to tax revenue ratio, it appears for the least, a herculean task. This is not to say that it is impossible, and any input or comments on this question are most welcome.
The way I see it is that there are way too many structural headwinds to hope for such an outcome. The most common arguments I have read implying that Japan may still stir the ship is that their debt level is much lower if one looks at net debt versus gross debt (excluding the social security trust fund surpluses), and that the government has significant other financial assets. On this front, my view is the same for the US and will simply refer to my article “In Debt We Trust: How Much Public Debt? A Dissenting View on US Sovereign Debt”. Although I wrote in reference to US intra-governmental debt, it applies just the same to Japan. Intra-governmental debt is issued irrespective of the government’s financial position. This implies that when the government is running fiscal surpluses, publicly held debt will be paid back, but the government will need to continue to issue intra-governmental debt because these trusts have no other choice than to be invested in them.
If these surpluses persist, the intra-governmental debt will continue to grow, giving a misleading indication that the government is more and more forced into debt. But this is a whole different story when the government is running deficits. By investing the trusts’ balances in nonmarketable debt, the government needs to borrow less from the public; the debt held by the public alone therefore fails to reflect the worsening overall fiscal position of the government. Intra-governmental debt should therefore be viewed in times of surplus as excess “savings” that allow Social Security taxes collected in the past to reduce the need for taxes in the future as the debt is forced onto the government balance sheet. In times of deficit they should be considered as a current unfunded liability. This is clearly the case in Japan.
As for the rest of the financial assets, I have doubts they can monetize any of them and doubt even more they wish to do so (there are many interesting articles on the Japanese culture that are convincing in explaining why asset sales are pretty unlikely). Finally, it is important to remember that the debt ratio always converges to a level that depends just on the nominal growth rate of the economy and on the level of the deficit. All structural trends in Japan, and demographics in particular, are weighing heavily against growth. Considering the amount of deficits that were necessary only to barely prevent the growth rate from turning negative, it's unlikely this ratio will be improved with higher growth rates.
Japan is becoming a textbook example of what happens when you try to fiscally stimulate yourself out of a demographic compression. Revenues keep falling as the working age population is reduced and expenses increase as the dependency ratio rises. A perfect storm.
Given the demographic picture of the voting pool, one can be pretty sure that future fiscal policy measures are going to be nothing else than more of the same. The political disasters that followed the 1989 and 1997 consumption tax hikes are still fresh memories for any ruling party.
Now, Richard Koo is well known for arguing that fiscal stimulus enabled Japanese GDP to remain above bubble peak levels despite the loss of corporate demand worth 20% of GDP and a national wealth loss worth 1.5 trillion JPY. Absent this transfer of loss from the private sector to the public sector, Japan would have fallen into a depression which would have left its GDP at a fraction of its peak (land prices fell 87% and the stock market fell by 80%). That this avoided a huge amount of pain and suffering to Japanese households is absolutely clear. That this was the only responsible answer, historians will tell us in due time.
I would say, however, that the “debt burden” argument on future generations by “austerians” tends to dismiss the great tragedy of a whole generation losing educational and vocational opportunities in the name of budget austerity. Not to mention that many historians agree that it’s this same faith in balanced budgets that pushed the US and Germany into depression in the early 30’s, laying the foundation for the rise of Hitler.
But even if they chose the right path, this path has some unavoidable consequences that denial will not make less painful. As I will address in future articles, I believe that Japan’s fate is actually a useful roadmap for a number of other countries.
Japan’s GDP has grown from about 450 trillion in 1990 to about 477 trillion today. Koo argues that without the stimulus, Japanese output would have fallen back to its pre-bubble state of 1985 at 330 trillion JPY and would have remained there for 15 years, resulting in a cumulative loss of 2 trillion JPY. The government’s “supplementary” deficit over the period was only 315 trillion JPY. A pretty efficient use of stimulus, he says.
One could, of course, question the figures and should we not always question them? The 2 trillion is based on the assumption that the contraction would have been similar to the US Great Depression. Maybe, but given the level of globalization democratic economies have reached and the large differences between the gold standard and our fiat flexible exchange rate regimes, one could suppose that the yen would have fallen like a rock, triggering a massive rise in exports. Also, the 315 “supplementary” surplus, and please correct me if I am wrong, excludes the pre-existing fiscal gap. Sure, excluding the gap gives a better idea of the stimulus spent to sustain the output at 1991 levels, but it fails to bring to light that these deficits are compounded and that the country was already on a sick fiscal path to begin with.
In fact, gross debt has grown from a little under 270 trillion in 1991 to 920 trillion at the end of last year, a rise of 650 trillion. In an effort to bring some perspective to these gigantic numbers, the Japanese Ministry of Finance makes an interesting comparison on what the revenue/expenditure picture looks like if the situation is likened to that of a household (keep in mind that it is considering only net debt and not gross debt so the numbers are actually even higher when one considers gross debt). The household would be earning 400k yen a year and spending 770k yen, of which 170k would only serve to service existing debt. The household would therefore have an annual shortfall of 370k (almost all its income), which is added at year-end to an existing amount of accumulated debt of 64 million yen (159 times his annual income). I can’t think of anyone who would lend money to such a household, would you?
The main problem with Richard Koo’s truly brilliant analysis, in my opinion, is that it suggests that a Keynesian approach of throwing endless stimulus against a wall of overcapacity will ultimately lead to an unwind of the excesses and the return to a “normal” state of growth. What Japan is maybe teaching us instead is that governments can only maintain the excesses until the only remaining adjustment factor of our modern monetary system finally adjusts and tears down the state of denial.
So what happens when a country saddled with such a gigantic debt load avoids defaulting at all costs? The answer is in simple accounting identities. If the government can’t save because it’s in a vicious spiral of rising debt servicing costs and lower receipts, only a current account surplus can balance the books. The only way Japan can swing to a significant surplus that will finally trigger sufficient growth is through a sizable devaluation of the yen. Sizable could be an understatement and happens to be the “inflate it away” option. In coming articles, I will discuss the triggers for such a devaluation. For those who are looking for the next Big Short, this could well be an exceptionally rewarding trade if implemented correctly. Interestingly, these triggers are nearing their ugly heads.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.