The land of the rising sun seems more like the land of the setting sun. Several market commentators like Chris Martenson have stated that they thought Japan was going to be the next stick that snaps but why? Japan has been facing a multitude of challenges including a natural and man-made (bad policy infused) disaster in 2011 which crippled the nation and added an unseen problem hidden being the angst of the politician's actions or inactions to the 2011 crisis. It now faces an energy crisis on top of burgeoning problems of a rapidly aging population, overly expensive Yen, increasing budget deficits, and stratospheric public debt levels. This section aims to drill deeper into all of these issues on the quest to see if Japan is indeed the next stick that would snap.
As most already know, absent Tokyo, the outskirts of Japan mostly inhabited by old and prudent (they deserve some respect) people. My anecdotes tell me that the Japanese are hard working people because unlike in most western countries, it seems that the ballpark age of retirement in Japan is around 62-67 years old. As astonishing as it may be, the outlook is gloomy. I've scoured through historical data from the Japanese statutory boards and managed to dig out good demographics data. Presented below is a time series (2000-2010 in 5 year intervals) infogram of the spectrum of Japan's population according to their ages.
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In 2000, the median age of the populous was 43 years. This rose to 47 in 2005 and 54 in 2010. So in about 5 years, when the next population census is carried out, most of the baby boomers would be preparing for retirement. There is no question why the savings of these folks would be expected to steadily increase over time as they have past their gleaming days of peak productivity and income. Notice the twin spikes in the distribution where the mode of the aggregate distribution was circa 62 years old in 2010. This should be a cause for concern. To further appreciate the severity of the conundrum, I would have to delve deeper on to the other issues Japan faces. It is also important to note that the pop-culture influenced young adults of Japan are giving birth to less and less babies, as evident in the decreases seen in the first 5% percentile of the distributions. Japanese are also living longer (as known to be very healthy people benefiting from a relative clean environment and technological advances in medicine and health supplements); the last 5% percentile of the distributions are getting fatter, especially for the females. This places greater emphasis on healthcare expenses and a general rise in health related expenses. Pensioners and savers who fail to accumulate enough savings risk needing to seek financial help from the government. Infact, the government might be pressured to increase the payouts of its social welfare system for the elderly and retired citizens.
Another issue with an aging population and son retiring baby boomers is that organic growth will be hard to achieve. Japanese productivity has already peaked back in the late 80s before the burst of the housing bubble which sent the Nikkei and the economy into a head first tail spin. Japan has never seen a full recovery of GDP growth due to its aging population amongst others. Post the housing market crash, the Japanese started to save more and spend less. This natural tendency extended into the new millennium. Private investments in residential property have slumped and seen serious follow through; also pulling down non-residential investments. Foreign investments have come fourth not as FDI but flows into Japanese equity market and the Yen ithrough the foreign exchange market. Government spending makes up a sizable portion of GDP. The the chart below, I visualize Japan's GDP, disaggregated into its components via the expenditures approach. The lower pane of the diagram breaks down the budget and also plots the deficit.
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Private consumption undeniably remains the single largest portion of GDP but notice how it has virtual remained flat throughout the past decade? This is my case on the problem an aging population brings to an economy mired in debt and still reeling from the placebo shock of the 2011 Tsunami antecedent to the nuclear incident. If the population doesn't start to pick up, the late-middle aged civilians will retire and the remaining fuel takes their place. If Japan's demographics doesn't see radical change towards more spending and domestic investments to further boost all-factor productivity, this will indeed be a land of the setting sun.
Stigmatization of the Yen and Trade
Absolutely nothing obfuscates us more then the Yen's strength over the last 2 decades. How can a country that has suffered a total catastrophe of a housing market implosion and weak organic growth see its currency appreciate against almost all other developed economy currencies? The Yen, Deutsche Mark, French Franc, and Sterling Pound was artificially made expensive against the Dollar post 1971 under the Nixon administration. The Yen was hit the hardest; it saw of appreciation of more than 20% in a few months if those import taxes were factored in, and a rough 10% appreciation solely on n exchange rate basis. Yet strangely, exports surged, Japan grew while America stumbled 3 years into unhinging from the Gold Standard. But the question still remains: How could a surging Yen and rising exports commingle? This was in part due to demand for Japanese exports of electronics and industrial machinery in the 70s and 80s. China was still in a state of transition and had not become an industrial and mass production power house. Japan was still king of production in Asia and perhaps the world. Global demand offset the Yen's strength so exports rose. The second reason can be better illustrated by the following trade diagrams (first 2 panes breakdown Japanese trade according to geography and commodity from 2004 through 2010; the last pane breaks down trade from Jan '11 through Jan'12).
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For the purposes of this discussion, we focus on the upper pane. In maroon, trade with Asia overshadowed exports and to a lesser extend, imports. Exports to Asia (East Asia includes China) increased steadily from 2004 through 2009 despite Yen strength. This was because since 2000, most Asian currencies also saw massive appreciation due to growth and global recognition that Asia was where the next debacle of growth would come from. To them, Japanese exports were relatively stable in prices and Japan was still a big exporter in machinery and electronic goods (see middle pane for specific breakdown). NAFTA which includes America, Canada and Mexico only made up a small portion of exports, contrary to popular believe so Yen strength doesn't matter all that much. Demand from this region was latent, able to offset Yen strength and remained fairly consistent until 2009, but recovered in 2010. Europe made also made up a small portion of Japan's exports. Brazil remains a relatively large importer of Japanese goods, probably due to growth and a surging Real. However, note that the western economies make up almost 40% of Japan's exports. Although not all European nations adopt the Euro, recent weakness in both the Dollar and Euro against the Yen has indeed hurt exports to these nations. However, the Dollar and Euro are in a paradoxical struggle to see who is worse off, hence the huge range of the EUR/USD between 1.5 and 1.2 within the last 2 years of trading. Unless the Yen sees further absolute appreciation, I do not see exports to these regions falling as a sole result of Yen strength (but one should question the integrity of the economic health in both America and Europe, especially the former where I feel risk is under priced).
Since we are at this trade diagram, let us now take a look at Japanese imports by region (refer again to the upper pane). Asia remains Japan's largest supplier of raw materials like industrial metals and agriculture produce. Australia is a major exporter of industrial metals to Japan (hence Oceania doesn't appear as a blip). Imports from NAFTA nations are much lower compared to exports to them. One region stands out in bright yellow: Middle East (read oil). Not shown is trade data for 2011 (which I cannot locate on the referenced data base) but imports from this region have surged. Please look at how above $100/bbl oil prices have caused imports to surge even in the midst of a looming financial crisis. Please bear with me as I will get to this point later on.
For the sake of it, please refer to the middle pane. As said earlier, Japan exports alot of electronics and industrial machinery. Add manufactured goods to the list too. The 2008 recession saw demand for durable goods to plunge and is reflected in the fall in machinery exports across the board. On the imports, textiles (raw materials) and energy are the largest components. Again, look what peak oil in 2008 did to that specific portion. I feel that Japan has alot of downside risk in regards to falling exports or a spike in imports (all in nominal terms per se) than it has upside risk in which its trade balances improves. This is one concern that has manifested itself in 2011.
Refer to the bottom pane where this time, we saw the trade balance tipping into the red and plunging in Jan '12. Cyclically, January has been a weaker month for exports of Machinery (capital equipment as per the chart). This could be attributed to exogenous factors. This time, it was also a function of the Yen and a European slump (weak sentiment). To make matters worse, imports have been steadily increasing throughout 2011. The deficit seen in April to June was a result of industrial disruptions caused by the disaster. Exports recovered rather promptly. The quiet killer here doesn't seem to be exports but rather imports, which after all that was said and done, really rests on 2 things: 1) Price of the Yen; 2) Oil prices. In late 2011, the Yen was surging despite multiple interventions by the BoJ. This made imports cheaper (to those not yet believing the positive correlation between imports and the Yen, I will humble you with another chart later on). Oil price also surged. This was the concoction for disaster which appeared to as a record trade deficit in history in Feb '12. What else is there left to say? We shall move on.
Another Energy Crisis
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As seen, high oil prices have remained sticky post the start of the Arab Spring. The panic leading up to the surge to $113 was on an unsustainable dose of testosterone. This time, the structure of the trend leads me to believe oil could very well take out those highs. With tensions building between Iran and Israel and with America on the edge of the seat waiting for any moment to intervene (it now has 2 aircraft carriers pin position and one more, the USS Enterprise sailing towards position)... why the heck would anyone need 3 nuclear powered aircraft carriers with more than 5000 men onbaord each if there was no intentions to start an act of war?
Regardless, the energy crisis in Japan is far more serious than it is in America because it involves a major shift from using relatively cheap nuclear power to using fossil based fuels for inefficient power generation. Post the Fukushima scare, Japan has been (rather nonsensically) shutting down its nuclear plants. I feel this has to be one of the dumbest moves Japan has taken in a while. Let me explain myself. Nuclear power has claimed less lives than other forms of power generation. Take thermal coal for instance. To get coal one must mine. Coal mining has claimed the lives of many thousand miners either from hydrogen explosions or collapsing caverns. Take oil for another instance. How many oil spills have we had in the past 5 decades? That huge spill from that tanker and the deepwater horizon bullcrap? Why hasn't America shut down its oil fired plants post the deepwater horizon accident? Probably because it is too reliant but also because it is a very profitable business. To wit, it is the errors of policies, and not the commodity or the matter at hand which is to blame. The Japanese were stupid enough so that they never thought building a nuclear plan beside the sea in an earthquake prone region was asking for eventual trouble? Like know Gold took the vicarious beating for causing the Great Depression, Nuclear energy has been the surrogate of poor policy. Smart guys understand that Gold did nothing wrong, it was the FED that erred by pricing Gold at $30. There is nothing Uranium did, it was it falling into the evil hands of warlords who decided that it was fun to create atomic bombs for mass destruction... nuclear and nukes are probably the two most emotion string words out there.
Now that Japan has almost no nuclear power to live on, it has to restore power output gap by running on more oil. Oil isn't going to be cheap anymore because global excess inventories (not just at Cushing) have run low, and oil demand isn't at all price elastic. Thanks to the non-forward thinking central planners of our cosmos, the world and Japan is trapped in this oil bubble.
Relating this to Japan's situation, if the Yen weakens, oil imports will be a ton more expensive on top of already being more expensive. Although a cheaper Yen might boost exports marginally, any gains would be offset by higher nominal imports of energy. In other words, Japan is screwed because it has bitten its own tail and the politicians don't seem to realize it until the pain comes. Whether or not this is the turning point for the Yen remains unknown. Your guess is as good as mine. But the ramifications of a weaker Yen could trigger another chain of events, also known as the debt (read JGBs) avalanche. I leave you with this chart, which shows the marginal impact of rising oil prices have on GDP. What this chart fails to depict is the psychological blow high energy prices have on consumers. Global gasoline demand is waning thanks to a jobless 'recovery' in America and what not. I believe this will be a gaping wound for Japan's economy for an extended period of time.
While high oil prices is the oddball, Japan's national debt remains the juggernaut. The Japanese government has eschewed to the inconvenient fact that they have the largest public debt to GDP of any developed economy with a figure of 202% (according to CIA's estimates). ¥969,630,370mn of public debt overhangs from its public accounts. I have written about how more than 90% of this debt is held domestically because of Japan's relatively high savings rate and patriotism. This large pool of savings is recycled back into the economy by way of deficit fiscal spending. Taxes are marginally recycled in the form of coupon payments to JGB holders. All seems well and the debt carousel can continue spinning, right? Wrong. Japan's budget deficit is around the ballpark of 9%-9.5% in 2011 and it has been in a sleepy liquidity trap for almost 2 decades now. A liquidity trap occurs when ZIRP doesn't spur economic growth through increases in consumption or domestic investments and as such, the fresh liquidity is trapped in the banking system and not released into the productive economy where wealth is created rendering monetary policy useless. As another anecdote, American and Europeans banks seem to be following this path. the FED has had ZIRP on for almost 3 years but growth hasn't exploded whilst inflation (as per the official CPI) has remained relatively tamed (although $3.85/gal gas tells a different tale). In Europe, record amounts of fresh LTRO funds are being parked at the ECB for another rainy day. A liquidity trap requires fiscal spending and for Japan's case, it has always been on a credit basis. Juxtaposed to America, the BoJ holds a relatively small amount of JGBs because Japan has relied private sector demand for most of this time. Their risk temperament being low, equities proved too much for them so JGBs were the next obvious thing. Pensions funds have invested heavily in JGBs but the tide seems to be turning as I read somewhere. How much longer before demand wanes? The BoJ will eventually follow the path of the FED, buying up JGBs because if not, the Government will bankrupt itself.
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Refer to the first pane of the above set of tapestry. Base money has sky rocketed, highlighting that the BoJ has been printing Yen. Notice how base money expansion accelerated to a parabolic state when the discount rate was lowered to 0.1% starting 2001 and ending 2005, then subsequently fell as JGBs were sold to the private and corporate sector? With the BoJ's surprise announcement of 1 quadrillion Yen of additional asset purchases earlier this year, expect base money to expand further. The regression curve indicates the BoJ might be on the verge of an all out printfest, the likes of the FED and ECB. Refer now to the third pane where M2 and M3 are charted. Notice that despite the surge in base money when the discount rate was at 0.1%, broad money never really exploded? This proves that since 1995, Japan has been mired in a liquidity trap and this has unfortunately become the new normal, hence deficit spending had to come into place to avoid a depression. The rebuilding efforts after the Fukushima tragedy will unfortunately worsen the country's deficit in 2012. The clean up has yet to be fully completed while towns in the radiation total exclusion zone (20km radius from the stricken plant) will be a ghost town for years. This should give you an idea of how much spending the government needs to do just for restoration purposes.
Referring to the fourth pane, one can conclude that foreign investments will not be Japan's next mustard seed in which it dearly needs. Capital flows have been mixed with a surge in 2011 attributed to repatriation of foreign assets into Yen when the crisis struck. I reckon we could start to see Japan's BOP position worsen in earnest. Would this be the combination that will cause the Yen to plunge? Again, I don't know but it could since markets are complex systems. The Yen is terribly overvalued. I mean years of ZIRP and a terrible fiscal position would destroy most currencies. And I think the tail risk to JGBs is that a plunging Yen would somehow cause the TIBOR to spike. If a falling Yen, amidst a myriad of other things can turely bring Japan out of its deflation and liquidity trap, that is when we will see the JGB bubble start to unravel in grotesque fashion. The BoJ will be forced to counter any demand pulled inflation buy selling JGBs but who will be buying them? The BoJ will also have to take a loss if the sold JGBs and so will everyone who holds JGBs. Some will be tempted to sell prior to maturity so we could see collateral problems and solvency issues especially for smaller firms. Please note that all this is theoretical and how I could envisage the popping of Japanese debt bubble.
I mentioned in the previous section that I would humble those who didn't believe the Yen was tightly correlated to imports. Take a look at the second pane where I highlighted in orange lines how imports surged with a stronger Yen. But apart from this, I think i've addressed Japan's biggest problems. I don't think there can be a solution for Japan. Either the market leaves Japan alone or the Yen starts its plunge... which ever the case, a 100 kiloton time bomb is waiting to crater the ground beneath, so watch out. Watch Japanese interbank and repo rates as well as broad Yen performance (and against Gold). Savvier participants and observers can also monitor Japan's CDS basis package, something I wish I could do but lack access to.
Before I conclude my piece, I really need to address the topic of austerity. I think this term is very misunderstood by people in general and most certainly the muppets ruling pulling the invisible strings of their countries. We have come into an era of austerity per se where the private and corporate sectors deleverage while the public sectors takes on more debt to offset (so basically a transference of risk?). The motive for austerity is to reduce budget deficits and ultimately to cut down aggregate public debt levels. Deleveraging has nothing to do with austerity. Let's be clear: Austerity is reducing public expenditures relative to revenues. Most people wrongly perceive this to be a cut in government spending and tax hikes, and with the MSM and even the muppets broadcasting such information, I'm not surprised that most wrongly believe so.
Depending on interest rates, aggregate debt levels, and specific dispositions of an economy, cutting government spending could actually increase a budget deficit and so is raising taxes. I've mentioned previously about the Laffer curve whereby tax revenues are a simple function of the composite tax rate and the amount of tax payers. There is the corporate tax rate; the personal income tax rate; and the sales (VAT) tax rate. All three taxes have very different dynamics. Government spending could come in a myriad of ways: government consumption; public investments; transfers (unemployment benefits ect...). Again, all three forms of government spending have different dynamics. The misconception here is that governments need to cut spending and/or raise taxes to reduce the deficit. That is untrue. I do not have dexterity to mathematically explain the mechanism and the interlinks between each vector of expenditure and taxation but I could try provider readers with a quantitative understanding of how austerity should work.
The idea behind cutting government spending to reduce a deficit is such that the government will spend less. However, there is a good chance that such a clawback causes tax revenues to decrease by more than spending is reduced, mooting the original intent and destroying wealth in the process. Remember the fiscal multiplier? I have had discussions with others about this very ambiguous multiplier because it is impossible to have a single multiplier but rather a fairly wide range, which again is dependent on economic conditions. We assume that the fiscal multiplier is above 1 ($1 of government spending creates more than $1 of wealth through the transfer mechanism). Cutting government spending would in effect reduce output by more than that. Not widely mentioned is the psychological impact of cutting government spending. The riots in Greece; riots in the UK where most of the protestors were the unemployed youths and public sector workers... they all had to do with angst over cuts in government spending be it through transfers (contribution to pensions, subsidies ect...). I read somewhere that the risk of social unrest increases by leaps and bounds once spending cuts exceed 3% of GDP. Most of the cuts governments are proposing involves amounts far greater than that. The psychological impact to the private sector is immense. Such downside risks greatly increases the propensity of employment and hence lowers aggregate income taxes. In many instances, there might be spillover effects to sales tax revenues. I think you get where i'm driving at.
To further this point, most trouble nations (read America; Japan; UK; Eurozone) are in a liquidity trap or in similar conditions where monetary policy has lost most of its efficacy in stimulating economic activity. Government spending then becomes a crucial force in national output. Please do not for one second think that I'm a fiscal spending protagonist. Government spending has been historically proven to be ineffective and unproductive in the long run because governments simply do not have the skills and specific knowledge to property invest and spend in all the areas and sectors they do so in. My premise is simply to not advocate cutting government spending as a means of reducing a deficit, especially if the economy is in a liquidity trap where consumer confidence is fickle. The downside risks far weight the small splash of potential benefits.
The second misconception is that taxes should be raised to generate more revenue. This may be true provided that an economy's taxation elasticity of employment is low. Countries with low income taxes generally have higher elasticities. A hike in personal income taxes will therefore come as a shock to workers. Income taxes are much trickier to meander through because many dynamics are at play.
Sales taxes however, are almost surely a hit or miss type of vector. Raising sales taxes to increase revenues in the backdrop of implementing austerity measures is sure to backfire. The last thing consumers need is higher prices of things they have to spend on like food, clothing, and other necessities. A cut in sales taxes will likely come as a positive shock for the consumer and will raise sales tax revenues. Putting it in layman's terms, a reduction of say 3% in the VAT would easily see a more than 3% increase in the volume in consumption. Hence tax revenues will increase.
The last point about austerity in general is that the muppets who claim to be in the know are myopic, as usual. The whole purpose of reducing a budget deficit is to increase the sustainability of the country's finances by way of reducing public debt levels through time. And the one and only legitimate way to reduce debt to GDP over time is through growth. Growth is such a rare word in today's times because the focus on trying to be thrifty in meaningless ways shaving off a billion or two here and there seems to miss the point about austerity in the first place. In its truest form, austerity should not be deflationary but pro long term growth. I am utterly dismayed by what they are doing over there in Europe where talks about cutting government spending and more importantly tax increases to target seemingly crucial figures of deficit to GDP... it doesn't more ridiculous than that folks. Take Greece for instance. It has lost everything from its private sector, to its sovereignty. How the heck can Greece growth and repay its debts because the one chance for a sold landing through an implicit default was banished after the PSI was successfully implemented. If anything, a depression makes debt more expensive and harder to payoff. I'm done talking about Greece, it has fed me up such that I've given up on the nefarious fat and old Greek muppets who act purely in their own self interest. I genuinely hope that the Greek people rise up and over throw the government. That fat bastard ought to be murdered in public and on global TV.
For those interested, here's a primer by NY FED.
I've come to the end of this rather lengthy deliberation on who will blink first. It seems that Japan has the most downside risks followed by Europe and America. Europe has already blinked by not letting Greece default and leaving the Euro and EMU. It will pay the dear consequences of its pretense that the big problem is solved. America remains the juggernaut of the world. I say this because if it goes to war or initiates an act of war with Iran through its proxy Israel, we will without doubt experience the largest oil price shock on record. Everything will collapse when we see $150 oil. China has to figure out how it wants to land softly and transition to a consumer based economy and not an investment based one. In the process, it has to clean up excess supply of homes far greater than anything America has been through. Any mistake here would send China deep underwater. If China goes under, pretty much half the world is dragged down.
Regardless or who blinks first, I hope you enjoyed reading as much as I have writing. Stay safe in this dangerous world.