Gruber: Japan Foreshadows Next Global Crisis

[Beet]

Before anyone accuses me of "forecasting doom", I am merely linking to this article for the sake of discussion.

http://www.forbes.com/sites/jamesgruber/2013/06/01/japan-foreshadows-next-crisis/

Particularly, I was struck by the following assertion by James Gruber:

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This makes Japan very different from the United States as well as the Eurozone. The fact that the United States, for instance, pays a very small amount of its revenues as interest payments (around 10%), it one of the critical reasons why our governmental debt level is sustainable. Otherwise, the tea partiers would be right and it would be imperative to balance the budget immediately. If the need for Keynesian stimulus can be illustrated historically, so does history, going back to the Middle Ages, illustrate that the share of government revenues going to interest payments is precisely what precipitates default.

Now the BOJ has stated that its policy goal is 2% inflation. Nominally, this is a worthy goal. When consumers expect inflation they will spend more, and this will stimulate demand, and in turn, economic activity. Further, the depreciation of the yen will tend to push this stimulated demand into domestic production, rather than demand for imports.

However, if a 2% annual inflation rate is achieved, then JGB bond investors would rationally be able to demand a higher than 2% return. That means if the market expects the BOJ successfully increases the average 10-year inflation rate to 2%, then 10 year JGB yields would have to rise to 2%, then over 2% to (assuming investors expect no default risk) the risk-free rate of return, denominated in yen. So if 10-year inflation is 2%, and Japanese assets can be expected to return 1% risk-free (which would not be a surprise if you expect Japanese real GDP growth to pick up), then the 10-year JGB yield should be 3%.

Here is where Gruber's assertion comes in. There is no way the Japanese government would be able to meet its obligations when the 10-year JGB yield is 3%, because of the massive volume of previous debt built up. If investors see this, and begin to fear default, this risks a Japanese bond market dislocation.

In such a scenario, the Japanese authorities would only have two options, (1) default, and (2) outright monetization. Option (1) is unthinkable. For most JGB holders are not foreigners, so they would not be pulling a 'Rafael Correa' or 'Nestor Kirchner'. Japan's own banking system holds large amounts of JGBs, so essentially the domestic banking sector would completely collapse, triggering a massive depression. Option (2) would require the BOJ to essentially stop demanding that the Japanese government pay it any interest on the bonds it holds; while at the same time intervening in the market to soak up the entire offering. Thereafter the yen would continue to depreciate as the BOJ was forced to buy up the entire issue to cover Japan's public deficit every year, until the bond market reached a new equilibrium. The problem with this is that the BOJ would conducting a thinly veiled monetization of Japan's public debt. The question is whether it can sacrifice its 'respectability' and go through with this step.

Either way, if markets become convinced that the BOJ is determined to push through 2% inflation, there is no question that JGB yields will have to rise significantly, well above the 1% level that currently seems high. And that means Japan's banks will have to take capital losses on the JGB holdings. The Japanese government and the BOJ would have to coordinate with the banks to ensure that they remain well capitalized, and then are able to make up their JGB capital losses with higher returns in a more inflationary environment.

If they can't handle a 1% yield, a 2.8%, or heck, a 4% yield, then the BOJ will be forced to U-turn. This is uncharted waters.

[Beet]

http://www.bloomberg.com/news/2012-12-21/boj-holdings-of-jgbs-exceed-100-trillion-yen-for-first-time.html

Well that's one question answered. The BOJ's holdings on JGBs accounted for only 11 percent of the total outstanding as of December. That suggests they would have to massively expand their role in the market in order to dominate it.

It also raises the possibility in my mind of a "price gap." Basically, we're used to thinking about price curves on a free market; that's become demand is considered to be a smooth. There are a certain number of people for which popsicles are worth 5 utils, some for which it is worth 6, and 7, and so on.

But if the ice cream man comes around, and a high roller comes in and buys half the truck for $50 a popsicle, that doesn't mean you or I are going to buy the next popsicle for $49. We're still only going to pay $2 or however much popsicles are sold for these days.

Similarly, even if the BOJ buys up 80% of the issue at a 1% yield, the first private sector buyer is only going to offer a price that puts the yield much higher. Of course, the BOJ would still be affecting the effective interest rate over the total issue, but it would be a bizarre situation. How would the yield be quoted in that situation? We're used to seeing news organizations calculate such that, "The government [X] sold $10 billion in securities at a [Y]% yield," is that Y% a simple average? Presumably the private sector yield rate would be quoted since that reflects the price on the secondary market, not the central bank's price.

[Beet]

Sorry for the third consecutive post. I'll admit this situation is quite worrying to me.

I just wanted to point out that one additional reason why Japan's situation is different from the one addressed by Keynes is that Japan's problem is not low capacity utilization or unemployment. Japan's official unemployment rate is only 4.1%; its capacity utilization is at around 85%, although it is lower than it was before 2008. In contrast, during the U.S. 2008-09 financial crisis, the capacity utilization rate plunged from over 80 percent to around 67 percent, and unemployment surged. More than a tenth of the economy simply went idle.

One of Keynes' great insights was that when you get past all of the obfuscating numbers and financial concepts (such as "savings" and "deficits") at the end of the day all economies come down to real world things and people engaged in the act of production. His insight was actually a very pragmatic and traditional one: that if you work hard, you become wealthy, and if you're not working, you become poor. By leaving millions of unemployed people and idle factories, the root source of the depression economy's problem is that people are not working and factories are not being put to use. Hence his reply to austerity policies in Greece would be that they are not 'responsible' because the government is cutting spending, but they're irresponsible because Greeks are not physically working; in this way they're actually even less responsible than they were during the bubble era.

However, this is not the case in Japan; the Japanese problem is not idle people or resources. People and resources are being put to full use. The problem is that their productivity has stopped growing or is growing too slowly. Furthermore, an aging population is causing massive fiscal imbalances. That suggests that structural reforms, and not further stimulus, either fiscal or monetary, are the long term solutions to Japan's problems.

[Ban my account ffs!]

The biggest reform Japan could undertake for growth would be to have more babies.  In the meantime, the idea is to inflate their way out of debt.  Unfortunately their energy portfolio is being ripped to shreds by the reaction to Fukushima.

But I'm cautiously optimistic about Japan.. not predicting doom and gloom.  They can always go back to slow death by a thousand cuts like they've been doing for 20 years.  It's much too soon to call Abenomics broken.

[Beet]

And structural reform. That's the key right now. Structural reform is a lot more difficult than monetary easing. You need the participation of the ministries, and political interest groups. The resistance of ministries that want to focus on subsidies, and some of the traditional political special interests, and the political pressures from the upcoming Senate elections, are the main resistance to Abenomics. Abenomics can't succeed if it's based solely on monetary easing without structural reform. There are more parties involved in the drafting of a comprehensive strategy, which is why Abe's speech yesterday was such a convoluted disappointment.

Japan ironically actually has the highest birth rate among the Confucian Tigers (South Korea, Taiwan, Singapore, Hong Kong). While some Western European nations and the U.S. has sustained a higher total fertility rate (TFR) than Japan, all of these countries tolerate a substantial  proportion of births out of wedlock. There does seem to be a correlation between proportion of births out of wedlock and the TFR in the OECD. The problem is that Confucian values strongly state that one should not bring children into the world outside the bounds of a stable family. So if Japan were to try to restore its TFR to replacement level, it would be going into unknown territory... where no country has gone before.

[opebo]

'Structural reform' is usually just a code-word for increasing inequality and/or lowering of standards of living.

I think before Japanese should accept that they should try to create an empire in East Asia via conquest.  This time I think we might support them!

[Beet]

'Structural reform' is usually just a code-word for increasing inequality and/or lowering of standards of living.

I think before Japanese should accept that they should try to create an empire in East Asia via conquest.  This time I think we might support them!

Disgusting! This is why I voted for Margaret Thatcher over you. And yes, Japan needs structural reform to shake up the private sector. Its companies have not been innovative since the 1980s and that is at the root of its economic problems.

[opebo]

'Structural reform' is usually just a code-word for increasing inequality and/or lowering of standards of living.

I think before Japanese should accept that they should try to create an empire in East Asia via conquest.  This time I think we might support them!

Disgusting! This is why I voted for Margaret Thatcher over you. And yes, Japan needs structural reform to shake up the private sector. Its companies have not been innovative since the 1980s and that is at the root of its economic problems.

Buddy, all the 'innovation' since the 1980s has been just more oppression.  'Technological innovation' is just a nonsense distraction from the real issue - profits are made from political power.

But don't be too disgusted at my advocacy of militarism - it was a facetious way to point out that anything is better than accepting neoliberalism.

[Torie]

Just because Japan is in more serious trouble than the US (Beet makes an excellent point about potential capacity utilization), does not mean that the US is not itself in serious trouble, if there is not a course correction, and interest rates pop up. On current course, and given all the unfunded public employee pension liabilities, and if say real interest rates pop up from zero or negative to say 3%, what percentage will debt carry be of government expenditures in say 10 years in the US? 

And then there is the issue of overall productivity. Those who do work in Japan, I suspect have higher skill levels overall than in the US, given the sad state of the US's public secondary school educational system. The Asians are on course to eat the US alive if things don't change over the decades, pushing down even further, US low skilled wages.

[Beet]

Buddy, all the 'innovation' since the 1980s has been just more oppression.  'Technological innovation' is just a nonsense distraction from the real issue - profits are made from political power.

This is where the hard left departs from the reasonable left. Technological and business innovation drive productivity, which in turn drives growth, which in turn drives jobs and wages. The primary reason why the current U.S. economy recovery has been so slow jobs-wise, is that GDP growth has been well below average for your typical recovery. So these capitalist processes ultimately have a place in benefitting the working class.

[opebo]

Buddy, all the 'innovation' since the 1980s has been just more oppression.  'Technological innovation' is just a nonsense distraction from the real issue - profits are made from political power.

This is where the hard left departs from the reasonable left. Technological and business innovation drive productivity, which in turn drives growth, which in turn drives jobs and wages. The primary reason why the current U.S. economy recovery has been so slow jobs-wise, is that GDP growth has been well below average for your typical recovery. So these capitalist processes ultimately have a place in benefitting the working class.

Depends on what you consider a 'benefit', obviously.  A slave is a slave, regardless of the state of his victuals and shanty.

[Torie]

Buddy, all the 'innovation' since the 1980s has been just more oppression.  'Technological innovation' is just a nonsense distraction from the real issue - profits are made from political power.

This is where the hard left departs from the reasonable left. Technological and business innovation drive productivity, which in turn drives growth, which in turn drives jobs and wages. The primary reason why the current U.S. economy recovery has been so slow jobs-wise, is that GDP growth has been well below average for your typical recovery. So these capitalist processes ultimately have a place in benefitting the working class.

Depends on what you consider a 'benefit', obviously.  A slave is a slave, regardless of the state of his victuals and shanty.

If you cease worrying about growing the size of the pie, in due course, politics will be mostly about who to off who is the least politically correct, so that there is one mouth less to feed.

[opebo]

If you cease worrying about growing the size of the pie, in due course, politics will be mostly about who to off who is the least politically correct, so that there is one mouth less to feed.

The argument that slavery is necessary to 'grow the pie'.