Japan is not Greece, but it is in trouble.
Willem Buiter, LSE Professor of European Political Economy, quoted in the Financial Times, October 29, 2010
[A word of warning: I’m not an economist, although I play one on television. Finance industry types—and I know there are a couple of you out there—need read no further, as nothing much in what follows is original, but just intended to explain Japan’s circumstances to people who would rather entrust the care of their teeth to an eighteenth century dentist than wade through an IMF report.]
A plunge into the icy waters of debt
Sometimes you come across a visual so arresting it gives you pause for thought. Here’s one that I disgracefully stole from The Economist here (they do such excellent charts), complete with part of the preamble.
The chart below shows OECD calculations of what it would take governments to reduce gross debt to 60% of GDP by 2026. This is around the level considered healthy and is also the ratio set by the widely ignored Maastricht agreement, which is meant to govern debt in the European Union. It is not pretty.
The first and cowardly thought I would have, were I a Japanese man or woman in my early twenties fresh out of college who understood at least some of the implications of the graph, would be emigration, preferably to one of the countries ranking near the bottom—they say Australia is nice at this time of year. But what does the graph actually imply?
For Japan, it implies that the current primary deficit (the gap between government spending and revenue as a percentage of GDP, excluding debt interest payments), which was around 8.4% in 2010 (according to the IMF’s April 2011 Fiscal Monitor), needs to be turned into a fiscal surplus of around 23% of GDP between now and (I believe) 2020 to meet the Maastricht criteria for sustainability by 2026, which in a Y475trn economy, would mean a Y110trn budget surplus—a tad problematic, as the entire initial budget for the current fiscal year, FY3/12 (the year to end-March 2012), was only Y92.4trn.
If we pinch, tweak, and prod the numbers by pushing out the deadline to 2030 and easing the sustainability criterion to a less rigorous 80% of GDP, then, says the IMF, Japan would only need an adjustment of 13.3% of GDP and a primary surplus of 6.6% from 2020 on. Assuming heroically for the sake of simplicity that all things are equal and will be equal in a decade’s time, a budget surplus of Y31trn or so would be needed for the decade from 2020 to 2030 to get to the IMF goal.
This might mean, for instance, permanent spending cuts of around 50%, which on a very rough back-of-the-envelope calculation, would cut annual discretionary government outlays from Y92trn to Y52trn, and an increase in the tax take, through the doubling of all forms of taxation, from around Y42trn now to around Y85trn. In turn, this might mean, for instance, that the basic state pension would tumble to around Y32,500 ($400) a month from around Y65,000 ($800)—more, in all likelihood, as there is scant meat left on the bone of discretionary, non-social security spending to cut—and that marginal income tax rates would rise to 40%-46% from 20%-23% for middle-income earners, the corporation tax would rise to 80% from 40%, and the consumption tax to 10% from 5%. Another way of arriving at the goal would be to place the entire burden on the narrow shoulders of the consumption tax, which would have to rise from 5% now to, ooh, 40% should do it.
Never fear though, none of this will happen, as the government has no intention of reaching for the heavens of conventional fiscal sustainability anytime soon. Why should it, after all, when it is able to borrow so cheaply at such levels of indebtedness? The current plan is to halve the primary deficit by FY3/16 and to achieve a primary surplus by FY3/21. Even this would not be enough to balance the budget and stop the debt-to-GDP ratio from rising, as it excludes interest payments on debt. The plan also rests on some rose-tinted GDP growth assumptions and a nebulous “fiscal consolidation” that relies more on perspiration (“make every effort to steadily decrease the amount of new government bond issuance after FY3/12”, as the Ministry of Finance puts it) than concrete proposals. It’s not just me that takes a dim view of the wooliness of the plan: In answer to the question, “How detailed is the medium-term fiscal framework?” The Bertelsmann Foundation’s Sustainable Governance Indicators award Japan a lowly 4/10.
The Japanese state reminds me of nothing as much as an operator of one of the country’s myriad rural rail lines that are awash and drowning in a roiling sea of red ink. Take the Sanriku Railway, for instance, the subject of a great profile recently in the Financial Times, which has been loss-making since 1994, around the time the government debt pile began to grow from a hillock into a Himalaya, which was in deep trouble even before the tsunami swept away its southern line and most of its northern one, and which in FY3/10 took in Y377mn ($4.6mn) in revenue (taxes) and needed Y432mn ($5.3mn) in subsidies (bonds) to keep its creaking lights on. The critical difference is that these subsidies never have to be repaid, whereas government debt is a bill that always comes due.
Why then are there riots on the streets of Athens and not on the streets of Tokyo and Washington? How do Japan and the US, the world’s third-largest and largest economies, get away with their extreme fiscal denial and avoid the onslaught of the bond market vigilantes? Part of the answer is buried in the question; in the case of the US, it helps also that it has in the dollar the world’s reserve currency and in Treasuries the world’s deepest and most liquid financial market. The case of Japan is more curious.
Japan, the fiscal ostrich
Japan’s mounting government debt and low interest rates incense all sorts of people: orthodox economists of many a stripe, who cannot reconcile the decline in the 10-year Japan government bond (JGB) yield with mounting public indebtedness (see chart above), the traders on the Tokyo trading floors of foreign banks, who have tried and failed to bet against Japanese sovereign debt for years and years, and the bug-eyed gold-bug professional prophets of doom who make their living from alarmism.
In a January 2010 IMF paper by Kiichi Tokuoka, The Outlook for Financing Japan’s Public Debt, the author conducts a cross-country regression analysis and finds that in Japan, there is no statistically significant relationship between the primary fiscal deficit and the government bond yield, whereas the relationship is highly statistically significant for the US and the UK and significant for France and Germany, if less so. To paraphrase, the state can stack up debt and not suffer the consequences of having to pay a higher rate of interest. What might explain this?
First and foremost—and most fascinating to me—is what in the literature is delicately referred to as “home bias”. Decoded, this means the willingness of key buyers in the JGB market, primarily Japanese financial institutions, to act in patriotic, mercantilist, and non-economic ways that do not in theory maximize their interest, propping up the Japanese sovereign by accepting internationally uncompetitive interest rates. The clearest manifestation of this is in the fact that some 94% of all JGBs are held by domestic investors, making Japan a huge outlier among major OECD nations—elsewhere at least a quarter of national debt is held by foreigners. In essence, this should be seen as a species of tacitly agreed financial repression, one of the phrases of the hour and one originally applied to what were once called poor developing nations:
Under financial repression, banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payments system, not simply currency. Governments force local residents to save in banks by giving them few, if any, other options. They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate: financial repression therefore constitutes a form of taxation. Citizens put money into banks because there are few other safe places for their savings. Governments, in turn, pass regulations and restrictions to force the banks to relend the money to fund public debt.
This Time is Different: Eight Centuries of Financial Folly, Reinhart and Rogoff, p143
The coercion is less overt in Japan, of course, and some parts of the mechanism do not apply, but the results are similar.
Some observers who should perhaps know better are fond of leaning on the statistic that more than 90% of JGBs are domestically owned—and owed—as proof that Japan has rewritten the rule-book on government debt—this is money owed by the government to its own people, they cry, it’s a family affair, as if this somehow absolved the sovereign from its obligations. In any ultimate default, it is true, home bias should bestow two blessings: the debt resolution and burden-sharing process should be simpler and less painful, as it would largely involve domestic actors, and the global contagion would be less severe than it would if the debt was more internationally held, although the upheavals of a Japan default would still in all probability make Greece look like a Sunday school walk in the park.
The corollary to that, though, would be a mighty concentration of pain in one place—Japan. Above all though, in its irrational way home bias may just prove to be the Achilles’ heel of otherwise inviolable Japanese warriors, as it exorcizes the discipline of the rational and permits the pile of debt to grow into a more unmanageable mound than otherwise. Indeed, Reinhart and Rogoff conclude (provisionally but worryingly) in their magisterial feast of folly that domestic defaults occur at levels of greater economic distress than external ones—it’s a blood thing, I suppose. This may close off—until in extremis—one way out of the debt maze for the state.
It’s more than a little amusing to watch master-of-the-universe hedge-fund managers, who may know a lot about high finance but who seem to know next to nothing about Japan, awaken to the home bias phenomenon without being able to articulate it precisely. Here’s an excerpt from a March 2011 letter to shareholders by Kyle Bass of Hayman “we hate us some dollar and we hate us some yen even more” Advisors, a Dallas-based macroeconomic hedge fund (bolding mine):
Investing with the expectations of rising rates in Japan has been dubbed “the widow maker” by some of the world’s most talented macro investors over the past 15-20 years. It is our belief that these investors missed a crucial piece to the puzzle that might have saved them untold millions (and maybe billions). They operated under the assumption that Japanese investors would simply grow tired of financing the government–directly or indirectly–with such a low return on capital. However, we believe that the absence of attractive domestic investment alternatives and the preponderance of new domestic savings generated each year enabled the Japanese government to “self-finance” by selling government bonds (JGBs) to its households and corporations.
There’s a second crucial advantage Japan has on its side—of the top ten fiscal sinners in the hall of shame in the first chart above, it’s the only one that runs a current account surplus (a forecast +2.6% of 2011 GDP, according to The Economist). The others are all deficit states: US (-3.4%), Ireland (-2.7%), Greece (-4.5%), Britain (-2.0%), Iceland (-0.9%), Portugal (-9.9%), France (-2.0%), Poland (-4.0%), Italy (-3.4%), Canada (-2.2%). These are part of the “global economic imbalances” about which world leaders have been routinely sounding off at their talkfests for more than a decade to no particular avail.
The composition of Japan’s current account surplus, which has been around almost without interruption since the late 1960s, is striking: there is a modest and shrinking deficit in services, and a larger, but shrinking surplus in merchandise, as Japan is not much of an exporter—exports per capita are far lower than those of that notorious export powerhouse, the UK (cue gasps of reader disbelief). Key to the overall surplus is the sizeable income surplus, which reflects prior decades of high saving rates and unbridled mercantilism, with some of the savings channeled abroad and now earning interest income and dividends—a gift that keeps on giving, even as the household saving rate has tumbled over the last decade.
Japan taken as a whole remains a net creditor and saver, with government indebtedness outweighed by the creditor status of households and corporations. The question is then, whither the surplus? The nuclear crisis adds a new and unforeseen dimension to the issue, as a prolonged shutdown of all nuclear plants would slash the merchandise surplus because of the cost of substitute fuel imports. Most observers agree that the current account is headed for a deficit; the Nikkei had this to say on July 4 as to when:
With the income balance safely in positive territory, trade deficits will not instantly push the current account over the edge. Yet there appears to be a consensus among economists that a current account deficit is inevitable in the not too distant future.
That is not to say economists agree on exactly when the current account will cross the threshold. Masaaki Kanno, chief economist at JPMorgan Securities, is among those expecting it to do so in 2014 or 2015. Others look into their crystal balls and see the 2020s.
The Japan Center for Economic Research used to say a dive into the red would not happen before fiscal 2020. But in view of the increased thirst for oil and gas imports since the nuclear disaster, as well as the decrease in exports due to restrictions on power usage by manufacturers, the institute recently brought its forecast forward to fiscal 2017 or 2018.
The demise of the current account surplus is likely to have negative implications for the ability of the state to fund itself as cheaply as it does. What might the marginal foreign buyer of JGBs look like in the future? One clue might be provided by the Japanese stock market, where foreigners have come to own a quarter of all shares, up from less than 5% in the late 1980s, and account for two-thirds of all trading activity, while over the last couple of decades, valuations—the prices investors are prepared to pay for shares—have shriveled. Stodgy old domestic telephone monopoly NTT once famously traded at 100 times earnings (it was the Bubble, after all); it now trades at 10. Correlation is not causation, of course, and other factors have undoubtedly been at work in the great valuation compression, but this does at least hint that foreigners would demand much higher yields and much lower prices (as the Wall Street Journal loves to point out, bond yields have an inverse relationship with prices) to hold JGBs.
“A bug in search of a windshield”: The case for the bears
The three bears with the most menacing growls—no Goldilocks dare venture near their lair—are Kyle Bass (of Hayman Advisors, quoted above), John Mauldin (self-proclaimed “renowned financial expert” and proud coiner of the “bug in search of a windshield” bon mot to describe Japan), and Dylan Grice (a global strategist at French bank Société Générale). It’s worth noting at the outset that the trio all have some serious skin in this game: Bass is wagering his money and his clients’ money on a Japan collapse, Mauldin is a purveyor of apocalyptic prophecies, and Grice earns his humble crust in cahoots with one of the most celebrated perma-bears of them all, Albert Edwards.
The essence of the Grice case is that with debt servicing costs already at 35% of government revenue and tax revenue no longer covering even non-discretionary spending (social security, education, and debt servicing), the most politically expedient way to keep debt yields low enough to be affordable would for the Bank of Japan (BoJ) to emerge as a buyer of last resort, triggering horrendous hyperinflation (“Japan, our Weimar-in-waiting”, as another big grizzled bear, Ambrose Evans-Pritchard, once snarled). En route to this most heinous destination he makes some solid points, taking potshots against the complacencies of those who would argue that because the debt markets have been tranquil for so long, they will remain so (“recency bias”), and arguing against a focus on net debt rather than gross debt (we’ve been dealing with gross debt up to now) because of the fuzziness and illiquidity of the asset side of the government balance sheet.
Unfortunately he spoils his thesis with some unreliable charts, one of which claims that “Japan goes over the demographic peak in 1995” (too early by a decade or more) and some unreliable assertions—the Government Pension Investment Fund (GPIF) is not the biggest holder of JGBs, as he wrote here in March 2010 (Y80trn at end-2010) on the planet, the Japan Post Bank (Y146.5trn at end-March 2011) is—which make me wonder how accurate the other numbers that buttress his position are, numbers that—not personally being a global investment bank myself—I lack the resources to collate and crunch.
The BoJ may not be as willing a participant in the hyperinflationary endgame as Grice imagines, either. BoJ Governor Masaaki Shirakawa went on record as recently as March in defense of the “banknote rule”, whereby BoJ purchases of long-term government debt must be kept below the value of banknotes in circulation, and the larger issue of which this is a subset, central bank independence, is not one that looks likely to be wished away any time soon, however wobbly the BoJ seems in the face of political pressure on occasion.
John Mauldin sets out his stall for the Cassandras thus:
Japan’s population is shrinking, and the number of workers per retiree is rising [sic—if only]. Japan has the highest ratio of debt to GDP in the developed world. And that debt is growing by 7%-8% a year, and does not include local debt. Interest rates cannot go lower. Savings are falling rapidly and will not be able to cover the need for new debt issuance, by a long shot. Within a few years, because of the aging of the population, savings will go negative. Social security payments are rising.
If rates were to go up by 1%, let alone 2%, over time Japan’s percentage of tax revenue dedicated to interest payments would double to 18% and then to 40% and then just keep going up. It is conceivable that it will take 100% of tax revenues in less than ten years, at the current trajectory. Why? Because Japan is going to have to start to compete with the rest of the world to sell its bonds. Who but the Japanese would buy a Japanese bond at 1.3%? From a country that is rapidly going to 200% of debt-to-GDP? Doesn’t really seem like a smart trade to me. And as the data shows, the ability of the Japanese consumer to buy more debt is rapidly waning.
The Japanese government is coming to a crossroads with no good exits. Cut the budget drastically in the face of a deflationary recession? Monetize the debt and let the yen go the way of all fiat currencies? Can someone say Zimbabwe? Increase already high taxes in a very weak economy?
While hot-headed and oversimplistic, much of this is indisputable, except the conclusion. Essentially, there are four ways out of the dire fiscal holes that Japan and many other advanced economies have dug for themselves. The first is growth, which is what saved Western Europe and the US after World War II, during which they ran up liabilities so astronomical they make today’s debt mountains look like molehills in comparison. Sadly, as practitioners of the dismal science like to remind us, growth is not a policy option, and no one respectable expects Japan of the future to limp along at much more than 1% trend GDP growth. The second, as Mauldin says, is to monetize the debt, to unleash the power of the printing presses—and not all fiat currencies have yet trodden the same path to hyperinflationary Hades, as he seemingly believes. The third, and best, is to try for fiscal consolidation—taxes are not “already very high”, they are relatively low: Japan ranked 25th out of 33 OECD countries by general government revenue as a percentage of GDP in 2009. Relatively low tax rates and relatively high rates of tax compliance, as shown by the modest underground economy (smaller by some calculations than in any major economy except Switzerland and the US) raise hope for consolidation, as does the general lack of corruption: according to Transparency International’s Corruption Perceptions Index 2010, Japan ranks 17th out of 179 countries, above the UK (20th) and US (22nd), while Italy is 67th, just below Rwanda, and Greece is 78th, equal with Colombia. The fourth way out, of course, is default.
Kyle Bass made oodles of spondoolicks for himself and his firm by taking the contrarian approach in the subprime fiasco, and is determined to enrich himself further astraddle the twitching corpse of Japan:
We focus on incremental sales or “flow” versus the “stock” of aggregated debt. To simplify, the available pools of capital are comprised of two accounts—household and corporate sector. The former is the incremental personal savings of the Japanese population, and the latter is the after-tax corporate profits of Japanese corporations. These two pieces of the puzzle are the incremental pools of capital to which the government can sell bonds. As reflected in the chart below, as long as the sum of these two numbers exceeds the running government fiscal deficit, the Japanese government (in theory) has the ability to self-finance or sell additional government bonds into the domestic pool of capital. As long as the blue line stays above the red line, the Japanese government can continue to self-finance. This is the key relationship the macro investors have missed for the last decade—it is not a question of willingness, but one of capacity. As the Japanese government’s structural deficit grows wider (driven by the increasing cost of an ageing population, higher debt service, and secularly declining revenues) the divergence between savings and the deficit will increase. … When the available incremental pool of capital becomes smaller than the incremental financing needs of the government or a Ponzi scheme, the rubber finally meets the road.
The problem with the chart is that it suggests there should already be ructions in the bond market—but there aren’t—and that the rubber should already have met the road and we should be careening off down the hyperinflationary highway—but we’re not. Could Bass have simply got his sums wrong? One admittedly very crude way of looking at the debt picture is this: the MoF projects that there will be Y668trn in JGBs outstanding at end-FY3/12, while household financial assets in cash and deposits amount to approximately Y825trn. With bond issuance running at around Y44trn annually, household reserves look set to be depleted in three to four years’ time, a conclusion which chimes with that of Tokuoka, who writes in the circumspect tones of an economist:
The author’s simulation indicates that based on current trends, gross public debt…in 2015 could exceed gross households’ financial assets, assuming the household saving rate remains at 2.2%. … Although these results do not imply any specific turning point for public debt financing, they suggest that if current trends continue, domestic financing could become more difficult toward the mid-2010s, placing a premium on other sources of funding, including from overseas. (Tokuoka, p17)
Ultimately though, it’s Japan’s bickering, twittering, and dithering politicians, rather than this motley horde of foreign hucksters, pundits, and financiers, that make the case for the doomsday scenario most powerfully, for it is they, absent a coup d’état by the Ministry of Finance, who will be responsible for steadying the fiscal ship, and with interest payments in the general account in FY3/12 running at Y9.9trn a year, Y27.2bn a day, Y19mn a minute, Y315,000 ($3,900) a second, there’s not a moment to lose.
The latest government fiscal consolidation proposal, more than a year in the making, is the unified social security and tax reform plan unveiled on June 30, which goes so far as to test the choppy waters for a rise in the consumption tax, for so long the “third-rail” issue of Japanese politics, to 10% from 5%. Due to fierce opposition within the government for even this modest increase, however, the timeframe has been watered down to “by the mid-2010s” instead of FY3/16, the initial target, and would only happen on the get-out clause proviso that the economy improves. The plan even calls for more spending, on an expanded safety net, estimated to cost Y2.7trn by 2015, which together with the annual Y1trn plus increase in the social security bill, means that the Y12trn-Y13trn in revenue the doubling of the consumption tax could be expected to bring in would be eaten up by 2020 or thereabouts. A doubling of the consumption tax is nowhere near enough: a recent IMF note estimates that even a tripling, to 15%, would only “provide roughly half of the fiscal adjustment needed to put the public debt ratio on a downward path within the next several years”.
All of this is academic, though: as a scathing editorial in the hawkish Sankei Shimbun put it, the stillborn plan doesn’t even amount to a sticky rice cake painting (Japanese for “pie in the sky”). There’s no guarantee that the plan, drawn up under a now lame-duck prime minister, will be taken on by his successors and so strident is the internal opposition that it was not even put to a cabinet resolution. No wonder that an outside observer like Carl Weinberg, founder of High Frequency Economics, can lament:
We presently have no plausible scenario in which the ratio of debt to GDP ever declines…We doubt that any government in Japan has the political moxie to introduce fiscal spending cuts or tax hikes on that order of magnitude…not one that plans to survive, anyway.
British Prime Minister Harold Wilson’s greatest contribution to the English language was the unsourced aphorism “A week is a long time in politics”. The Japanese equivalent, “An inch ahead is utter darkness” (一寸先は闇), suggests uncertainty lurks even closer at hand. Only a fool would try and chart the political calendar over the next few years, but fiscal consolidation seems to be going nowhere fast until, at the earliest, after the next lower house election in the late summer of 2013—unless insanity really does prevail and PM Kan calls a snap nuclear election. In the meantime, who knows what will happen? Perhaps Japan’s very own Tea Party movement, Genzei Nippon, which embeds its sole cause, tax cuts, in its very name, will break out of its bastion in Nagoya and become a national force to be reckoned with—in which event someone will need to get on the phone pronto to bring in the IMF straightaway.
Politicians’ nervousness about fiscal consolidation is grounded in a well founded fear of retribution at the callous hands of the electorate, which would like the comforts of a Nordic welfare state coupled with the tax regime of the Turks and Caicos Islands. There have been signs in recent post-quake opinion polls that a fickle public is coming around to embracing pain—a June 29 Nikkei BP poll found nearly 60% of respondents willing to countenance an increase in the consumption tax to 10% in five years’ time—but this support could well melt away faster than shaved ice in summer at the ballot box, as the DPJ found out to its cost in last year’s upper house elections.
One of the most striking things about the nuclear crisis to me has been the reluctance of many living in the vicinity of Fukushima Daiichi to evacuate in the face of stern official advisories and carcinogenic radiation levels. Taken to task by a TV crew, one elderly farmer defended his recalcitrance: “I’ve got a herd of cows and a mother-in-law to look after”. Like radiation, debt is colorless and odorless, invisible and toxic. It exists only in digital form in the server farms of data centers in half-remembered suburbs, but it can’t be willed out of this existence by a collective wish. Until voters fully wake up—or more plausibly are fully awakened, sad to say—to the precariousness of the fiscal predicament, the prospects for an orderly resolution are grim indeed.
Muddling through: The case for the bulls
Few bother to make the case for the bulls, as it sells far fewer newspapers, books, and lucrative lecture tours than scaremongering does, thus failing (as George W. Bush might have said) to keep the wolf on the table and the food from the door. The shifting quicksands of Japanese politics can ensnare even the most illustrious of the professionally upbeat but unwary, luminaries such as Goldman Sachs chief economist Jim O’Neill, writing in June 2010 (bolding mine):
Recent developments [in Japan] paint a less gloomy picture. First, the cyclical recovery of the economy is on a par with that in the US and Europe—and possibly even better. Second, following another change in the Prime Minister, the conditions for Japan to make progress on its taxation system and its fiscal challenges now appear to be in place.
Here then are a few counterconsensual tidbits from those in the bull camp, inadvertently or otherwise (bolding mine), with commentary:
Public gross debt has not increased over the past 10 years, if government liabilities under the Fiscal Investment and Loan Program (FILP liabilities) are included (Tokuoka)
The FILP is a huge (about Y194trn in liabilities at end-FY3/11) parallel shadow budget system that funnels funds raised through its own bonds to an array of quasi-governmental agencies with a bewildering variety of acronyms—JFC, JOGMEC, JDB, and JBIC for starters—and is generally excluded from debt calculations because it is not tax dependent. This raises the vexing question of whether anyone truly knows how large Japan’s fiscal debt is, as manifested in the spread of 2010 gross debt-to-GDP estimates: 171% claims the Cabinet Office, but the IMF begs to differ, putting it at 220%, while Fitch offers a range from 161% to 201% at end-2009, depending on whether intra-government debt holdings are consolidated out and FILP debt is excluded or not.
Consumer price index-basis real yields on JGBs have exceeded real yields on US Treasuries since November 2009. This may imply that the terms on which the Japanese sovereign can finance itself are not so abnormal, leaving less scope for a blowout in yields and consequent damage to debt sustainability than might otherwise be thought. (Fitch)
This is the rejoinder to the rhetorical question of the hotheads: “Who but the Japanese would buy a Japanese bond at 1.3%?” Deflation—widely regarded as being underestimated in official statistics—means that the real yield is very roughly double the nominal yield and may be concealing a stealthily rising fiscal risk premium in its very stability, although this in itself is not bright news for the longer-term prospects of the Japanese sovereign.
At just 5%, the rate of the consumption tax is among the lowest in the world and because it is broad based, by international standards, there is ample scope for raising additional revenue by raising the rate. (Keen et al.)
Japan’s consumption tax (aka general sales tax and VAT) is the equal lowest, with Canada, of the 30 out of the 31 OECD countries (as of end-2009) that levy one (the US is the exception), and far below the unweighted OECD average of 18%—the only other country in single digits is Switzerland, at 7.6%. A hike in the rate to the OECD average, coupled with the closure of some of the numerous loopholes in the personal income tax, which the IMF politely describes as “porous”, would largely put Japan on the path to fiscal sustainability.
The relative ease with which consumption taxes have been introduced and/or raised across the OECD over the last few decades suggests that there is no good reason Japan should be such an outlier, if a government can muster the cojones to face down the electorate after the requisite consensus has been built. We are starting to see glimmers of this consensus-building exercise, too, with the Kansai Economic Forum, a business body, coming out in favor of a 15% consumption tax within a decade in a July 13 report.
And as presently formulated, the consumption tax in Japan offers one huge advantage: it’s one of a minority across the OECD to allow no exemptions or reduced rates, making it efficient and easy to administer—superior in this regard to all but three OECD economies, says the IMF.
The growth effect of fiscal consolidation is a concern in the short run. The growth impact of such a large scale adjustment would depend on the composition of the measures adopted and will change over time. In the absence of any offsetting policies, growth is likely to slow in the short run due to the withdrawal of demand. However, over the medium run, the benefits of fiscal consolidation are likely to dominate. (Berkmen)
The disastrous, government-destroying history of the consumption tax in Japan argues for a very gradual phasing-in of increases, perhaps at no more than 1% increments annually. While even this could well drag down growth, positives are likely to come into play over longer horizons, as a credible plan for fiscal sustainability could reduce precautionary saving among the young, who have lost their last shards of confidence in the prospects for the pension system (the premium payment rate for the national pension dropped to an all-time low of 59.3% in FY3/11, the Nikkei reported on July 14), and boost business confidence and hence investment.
How hideous would default be? That is naturally impossible to foretell with any precision, but some of the consequences might include the bankruptcy of much of the banking system, the collapse of the yen, flirtation with hyperinflation, and a wrenching recession that swiftly steals away 10%-20% of GDP and takes half a generation to recover from—a consummation devoutly to be avoided, with the greatest indignity of all to be Michael Lewis jetting in to pen a long article on the meltdown for Vanity Fair, titled Sushinomics: Further Adventures in the New Third World. But even this would not rob Japan of developed nation standing and would barely undo any of the extraordinary catch-up of the last half-century or so shown in the chart above. Only Argentina and (arguably) Venezuela, after all, have ever surrendered their standings as developed nations (although Greece looks to be giving it the old college try), and that took decade upon decade of grotesque mismanagement to achieve. As Adam Smith once counseled a worrywart acquaintance fretting about British reversals in the American War of Independence, “Be assured, my young friend, that there is a great deal of ruin in a nation.”
If not apocalypse now, exactly, then when? My hunch was once that the crunch would come in the mid-2020s. Now I suspect that if nothing is done, if smugness and deadlock remain the order of the day, the crisis will descend in the late 2010s, as swarms of salarymen samurai finally sheathe their swords (the first baby boomers will hit 69, the average male retirement age, in 2015, having labored on a full decade longer than their French counterparts), and debt, demographics, and dissaving conspire to take their sapping toll.
Foreign bears like to see Japan as the unwitting sacrificial canary in the US fiscal mine, keeling over on its perch at the noxious fumes of debt to warn the reckless collier away. Personally, I feel—when I’m feeling optimistic—that the reverse scenario is more likely, with tornados rattling the US government bond market before the typhoon makes landfall in Japan and serving as a wake-up call to those responsible here for battening down the hatches.
As so often, everything hinges on timing: whether in this silent disaster movie, our politician heroes can reach the train tracks of debt on which the damsel of Japan has been tied in the nick of time before the vigilantes of the bond market steam in and roll over her to mete out their lynch-mob justice. But timing is hostage to confidence, and there’s no magic number, no infallible debt-to-GDP ratio or any other metric, that might warn when confidence will evaporate:
Economic theory tells us that it is precisely the fickle nature of confidence … that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to “multiple equilibria” in which the debt level might be sustained—or might not be. Economists do not have a terribly good idea of what kind of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply in debt, they are headed for trouble. (Reinhart and Rogoff, Preamble xliii)
Sometimes it seems as if the Japanese state and its people are huddled coconspirators in one last suicidal act of exceptionalism: this time we’ve cracked it, they whisper in each other’s ears, it really, really will be different this time.
It never is.
The Outlook for Financing Japan’s Public Debt, Tokuoka, IMF Working Paper (2010)
The Impact of Fiscal Consolidation and Structural Reforms on Growth in Japan, Berkmen, IMF Working Paper (2011)
Raising the Consumption Tax in Japan: Why, When, How? Keen, Pradhan, Kang, and de Mooij, IMF Staff Discussion Note (2011)
Shifting Gears: Tackling Challenges on the Road to Fiscal Adjustment, IMF Fiscal Monitor (2011)
Household Savings in Japan (Edison) and Home Bias in Japan (Walker), in Japan: Selected Issues, IMF (2005)
2011 Article IV Consultation with Japan: Concluding Statement of the IMF Mission
Restoring Public Finances, OECD Working Party of Senior Budget Officials (2011)
Government at a Glance, Public Governance Committee, OECD (2011)
Shadow Economies and Corruption All Over the World: Revised Estimates for 120 Countries, Buehn and Schneider (2007)
Shakai Hosho Zei Ittai Kaikaku Seian (Final Draft of Unified Social Security and Tax Reforms), Democratic Party of Japan (2011)
Zeizaisei Bappon Kaikaku to Seicho Senryaku no Kyoryoku ba Suishin ni yoru Zasei Sakiken wo Nozomu (Fiscal Consolidation through Fundamental Tax and Fiscal Reform and the Powerful Promotion of a Growth Strategy), Kansai Economic Forum (2011)
Economic and Fiscal Projections for Medium to Long Term Analysis, Cabinet Office (2010)
Japan’s Fiscal Condition, Ministry of Finance (2010)
Just how Indebted is the Japanese Government? Fitch Ratings (2010)
Japan’s Debt-ridden Economy: Crisis in Slow Motion, The Economist (2010)
This Time is Different: Eight Centuries of Financial Folly, Reinhart and Rogoff (2009)
Endgame: The End of the Debt Supercycle and how it Changes Everything, Mauldin and Tepper (2011)
“they say Australia is nice at this time of year. ”
‘s winter and yuk in the southern states, though Queensland is probably quite nice.
An interesting and enjoyable (in the abstract – I live in Japan) read; thank you for putting this together. While reading it though, I had hoped that there would be a section devoted to some consideration of just where the debt came from in the first place. Nation ‘G’ – with a vast debt – may look around and ask themselves “Where did the money go?” while Nation ‘J’ – with an even more stupendous debt – can look around and answer the question fairly easily. Vast portions of it went into infrastructure: highways, trains, fibre optic networks, ports, schools, etc. and etc. Surely the ‘investment’ aspect of the debt has to be taken into consideration when discussion scenarios of repayment/default/etc., no?
“Nation ‘G’ – with a vast debt – may look around and ask themselves “Where did the money go?” while Nation ‘J’ – with an even more stupendous debt – can look around and answer the question fairly easily. Vast portions of it went into infrastructure: highways, trains, fibre optic networks, ports, schools, etc. and etc.”
Are you saying this was a good thing? You’re not one of the “roads to nowhere” bashers of Japanese public sector investment, then? I only ask.
Funnily enough, though, this isn’t where the spending/debt went, really. Yes, Japan got an excellent infrastructure, albeit excessively excellent in some places. But the debt crisis has overwhelmingly been driven by boring old pensions (and increasingly debt servicing). See slides 7 and 8 here. (The trains were largely privately financed, BTW, and the schools, well, they’re not something to be proud of infrastructurally.)
“Surely the ‘investment’ aspect of the debt has to be taken into consideration when discussion scenarios of repayment/default/etc., no?”
In as much as it makes a nation more competitive, yes. A lot of it, though, especially in the 1990s, was wasted. Spending $100mn+ to build a tunnel so that a village of 1,000 mostly elderly farmers can get to an expressway in 30 minutes instead of 2 hours previously (a future case study for these pages) is not a great allocation of resources. And we’ll probably find out eventually that the international financial markets will be blankly indifferent to anything other than repayment.
I think it is an often overlooked point that there is a fundamental difference between a deficit that leaves no assets (if, for example, the money is blown on battleships and foreign wars), and one that leaves solid assets behind, such as a great public infrastructure. This is why many Keynesians would say that in a recession, pumping money into railways and roads is still better than tax cuts or handouts in welfare, even if it is superficially less efficient.
So in this sense, whatever happens with Japans macroeconomic economy in the short to medium term, it still has a superb infrastructure, unlike say, what happened to Argentina in its most recent collapse. The money was blown on different things.
Its not just with public goods – private sector irrationality can result in a big stockpile of very nice but worthless tulip bulbs, or it can result in an amazing network of railways (as it did in the mid-1890’s railway boom in Europe and the US). It has been argued that the DotCom boom actually left a good infrastructure of behind, allowing for the final victory of Google, etc.
So I would take from this that whatever woes Japan faces, it will not slip back to a truly wretched state. It still has great companies and and an infrastructure that allows them to make things the rest of the world needs/wants. Although it obviously has an enormous amount of countryside and coast covered with concrete for no obvious reason.
I think the main question is that if and when a crisis hits, the pain is spread equally among all Japanese, or whether you have a situation whereby those Japanese with assets and are associated with successful companies manage to create a bubble around themselves, and cut the old, poor, and outer regions adrift.
I’ve read all of your posts, and I found this one to be among the most insightful (though I enjoy your trips through ruins as well). Excellent read.
Now I must start by saying that some of your observations are insightful and the taking the contrarian, devils advocate position, in defence of hope for the Japanese budget, is an admirable task indeed. However having read your earlier blogs, concerning for example the current prospects of some leading Japanese companies and the system of political nepotism – the inflexibility of both the business sector and political world – I was surprised of your almost insistent optimism that you displayed here concerning the fiscal situation.
What you have actually made is a very good case of why the debt is so insurmountable. The few reasons for optimist you manage to drag out are like exceptions which prove the rule – and the few favorable comparisons to the U.S and E.U are more like saying: “oh, but Japan isn’t hemorrhaging from every limb like they are”. Sure there are ‘bulls’ and ‘bugs’ calling for Japan to fall for all kinds of reasons, having all kinds interests – but that itself doesn’t convince one that there is any more hope hidden somewhere. The cold hard economic facts of fiscal situation are still there no matter how convenient/inconvenient they are for some interests.
However I would agree that it is the U.S who is going to experience some sort of ‘restructuring’ (but essentially default) of its debt sooner than anyone else. Would the Japanese, having perhaps a ‘different’ attitude towards the ‘yankees’ then other the ‘outside-world’ react accordingly?
Also, it is not only a fiscal crisis that the western governments are experiencing. The monetary systems themselves are failing because of the global contraction of real growth – and the simultaneous explosion of all kinds of financial instruments and printing presses. Central banks have demonstrated very little power over the fiat currencies they are supposedly using to control economic activity. The money supply in every major currency is out of sync with real world economic activity.
And finally there is the Peak Oil which looms over all the recent financial crisis – with prices reaching and staying at all time highs. With Japan now seriously short of nuclear generating capacity, some analyst say it will need to double its oil consumption to regain long term prospects for growth, what chance is there for the ‘optimistic outlook’ of ceteris paribus GDP growth?
“I was surprised of your almost insistent optimism”
Well, that’s the first time anyone has called me optimistic around here! I think if you read what I wrote again, fragmentary though it was, I am only arguing that there IS a way out and not saying that I have any confidence it will be pursued before a crisis erupts.
You really have to do the math and see how much breathing space there is, then fill it with a judicious mix of cautiously incremental tax rises, some spending cuts around the fringes, and a little inflation (if you can get the Bank of Japan to cooperate, which won’t be easy, I admit).
“With Japan now seriously short of nuclear generating capacity, some analyst say it will need to double its oil consumption to regain long term prospects for growth, what chance is there for the ‘optimistic outlook’ of ceteris paribus GDP growth?”
Well, it won’t be oil, will it, it will mostly be natural gas, and I’m reasonably confident that most of our 54 reactors (save Fukushima Daiichi and Daini, ahem) will be back by this time next summer. But do you really believe in Peak Oil? Or rather, Peak Hydrocarbons?
‘But do you really believe in Peak Oil? Or rather, Peak Hydrocarbons?’ Believe is not a word I would use. The US peaked in 71, Indonesia 77, most of Latin America between 97 and 99, the North Sea (UK 99, Norway 01) etc. All indications point to a world peak between 2005 or 2008. That is for crude oil definitely, plus condensate perhaps. As for NG and other hydrocarbons, they are not what the world runs on. They will certainly be important in the future but they cannot replace the flow-rate or the quality factor that crude has in our technological infrastructure (from petrochemical industry to vehicle fuel). In turn I would encourage you to at least glance at the data and analysis available concerning PO and related subjects, and would also ask you: do you really believe that current financial situation of the world isn’t significantly the result of ‘100 dollar oil’?
Funnily enough, I’ve flirted in and out of love with PO for the last few years, even going so far as to write in a piece called “Requiem for a Railway” here:
“It strikes me as sheer folly, in the first decade of the 21st century in the face of the twin threats of global warming and peak oil, to be closing any part of the public transport infrastructure, even one that by the end was barely carrying 2,000 people a day.”
But then I come across a little graphic which claims that the world’s six largest oil reserve-holders each have at least 50 years of supplies left at current rates of production and I have my doubts.
“Do you really believe that current financial situation of the world isn’t significantly the result of ’100 dollar oil’?”
Here we have to part company and I have to answer with an unequivocal affirmative. But thank you for the time you’ve taken in responding and I will investigate theoildrum.com more fully when I have a moment.
Another recommendation here for the Oil Drum blog. It has some odd things in their sometimes, but most of the contributors know their stuff. There is no real doubt anymore that Peak Oil is a reality – it is widely accepted now, and I’m surprised (well, not really), that The Economist is behind the curve with this. Those BP figures shown are based on ‘official’ reserve estimates by OPEC which almost nobody believes (there is an inbuilt incentive to exaggerate reserves to boost voting clout within OPEC).
The fact that the big oil producers were unable to respond to the spike in oil prices in the last few years is pretty much proof (supply actually dropped slightly). The question of whether we are at peak coal too is another one – the world is full of coal, but its been argued that we’ve hit a number of infrastructural bottlenecks which will make it very difficult to meet future demand, even if this was environmentally acceptable. There are also increasing worries about gas. The craze about fracking is increasingly looking like a wild goose chase – non-conventional gas will not replace significantly currently known reserves.
Its good news, btw, for Japan if the nuke plants can be brought online quickly. It is not a simple matter to replace nuclear with oil or gas. There are numerous bottlenecks in production that need to be addressed – you cannot increase imports of LPG without very large, and very expensive facilities. Refining capacity is a major bottleneck for oil. Its not a simple matter of just importing more of it.
Another great piece of writing. With the impending (?) downgrading of US debt, I too wonder whether it is more likely that the US will hit the windshield first, or if Japan will. I sometimes wonder if Japan would entertain monetization of a certain portion of their debt for the double purpose of extinguishing that debt AND to prompt a lowering of the value of the ridiculously high yen. The fact that the yen remains high despite an unmanageable debt burden and ineffective leadership ought to send traders in the opposite direction, and yet the yen remains strong. There are some economists who believe that Japan’s problem is insufficient stimulus: a school of thought (quackery, some might say) known as chartalism. In any event, very though-provoking stuff for those of us who are holding a bit of yen.
Given the essentially unavoidable shit scenario for Japan’s future, are you planning to stay around? Did you ever purchase the home-away-from-home that you blogged about? These are not idle curiosities as the missus and I have always imagined spending at least part of the year back in Japan once we’ve retired. However, if it’s heading unavoidably to Third World status in the next decade or so . . . ?
Beginning to wonder if we should be heading north before Canada wises-up and close the border.
“Given the essentially unavoidable shit scenario for Japan’s future, are you planning to stay around?
I *was* trying to inject a smidgeon of optimism but I guess it’s fallen on stony ground… Yes, I’ll be here for the grisly dénouement, wouldn’t have it any other way. Unless it really does get too grisly–but if it does, there wouldn’t be many safe havens left for a Brit like me.
“Did you ever purchase the home-away-from-home that you blogged about?”
No, but it’s a thought constantly bubbling under.
“However, if it’s heading unavoidably to Third World status in the next decade or so…?”
That might be too premature a conclusion–as I said, quoting Adam Smith, “there’s a great deal of ruin in a nation”.
“Beginning to wonder if we should be heading north before Canada wises-up and close the border.”
Canada looks like an excellent bolt-hole from here.
Be interesting to hear an update on this now we have a new government and a less than independent BofJ.
And, are you leaving Japan? For…where?
A nice meaty post. What to do?
A thought upon the Yen is that it is overvalued, and lots of people either don’t know this or have forgotten it. A visit to Japan in 2005 saw me get about 200 yen to the pound (As in the easy rule of thumb “Knock two zeroes off a price in Yen and divide it by two. Would you pay that at home?”) and so today’s exchange rates are worse than back then and it is not because Japan has gotten more economically competitive – as your website takes the time to illustrate to people – It is that the economy of the rest of the world imploded and the yen has steadily appreciated. Japan can probably get away with printing money provided that it comes up with a nice euphemism for it, because internationally, no-one will really notice. A consumption tax rise, by comparison, just attracts opposition because it is visible, evident and who wants to pay it? – Like gas taxes in America, everyone knows they should go up but who wants to implement it?
As you point out in your article, “Home Bias” is notable here more than anywhere else. What foreign activities do Japanese industry, banks and government really invest in? I honestly cannot think of any that don’t involve a Japanese corporation operating abroad, and so if you are only writing debts to yourself – effectively – it does explain how they can then have these huge debt levels, completely at odds with the rest of the reality of the place, because the creditors are not going to call it in – That 94% of debt is home owned perhaps means the general population lack the inclination or ability to invest anywhere else competently, so the government can get away with bonds of 1.3% as a result. The debt is enormous but it is all held at home, and the “Vigilantes of the bond market” are not going to show up if rates stay like that. They haven’t so far, after all.
The reason why Japanese economic statistics look so weird is because most Japanese investors probably subscribe to the following logic: It is better to invest money in your own economy than other economies regardless of their stated returns, for the simple reason that that then is money that helps foreign people get rich, but which could have been invested here in the businesses that exist here, so helping us : Why help foreign countries get wealthy, particularly when they then turn up and start competing with you, usually upon the basis of lower labour costs?
Although I don’t have any training in economics, it has always struck me as strange that we should let western investors charge around demanding liberalization of financial markets, free movement of capital and goods, and low taxation, when all that you, I and most people see off of it is the thrilling prospect of competing with Vietnamese people for minimum wage assembly work. The UK government in particular is an epic adherent to this philosophy: It has total liberalization of financial markets and does not hesitate to award contracts to foreign companies, regardless of the chaos it then causes at home….Look where it has gotten them.
Japan can print money because economically speaking, it is “developed” and has nowhere further to go, and now has to settle with simply keeping it’s businesses efficient to avoid what happened to post war Britain. Theoretically, growth IS a policy option if you deliberately undervalue your currency, as in China, and as the German economy now is due to the Euro, which is paying for Europe’s economic recovery via their artifically stimulated exports….Which is something they could try doing.
As it stands Japan has a currency that goes nowhere, does nothing and yet rises steadily over time as western markets crash around making mistakes, because they are not doing the regular “Western” practice of investing money overseas. If you are just 1% less rubbish than your peer group at squandering money, it adds up to people thinking that you’re a genius. Even if all you are doing otherwise is doughnuts on the lawn, which as you illustrate, is what the actual Japanese economy has been doing for years now.
One thing that you don’t see them doing is giving huge chunks of their economy away to the Chinese and telling their population how wonderful that is.
Contra Andrew Mooney above, Japan is in fact moving its productive base to China quite aggressively, as well it should given the weak yuan and the strong yen. Honda workers in China make ~Y800 — a day.
One really can’t talk about the economy of Japan without pinning the direction of the yen — both 50 and 150 make sense to me, depending on what trends I see coming.
shows a $60B trade surplus against the US on $120B of exports — the yen wants to get stronger, subject to the allowances of the Triffin Dilemma I guess.
Having lived in Tokyo for most of the 1990s and having Japanese as my only 2nd language, I do have a strong interest in seeing Japan prosper as it was in my salad days and I do appreciate this effort at looking what’s in the kimono, so to speak.
To get a fuller picture of the debt situation you have to look at private debt, too:
though that doesn’t really do any favors for Japan. Big deal if Japanese have a high savings rate if it’s all in JGBs! Government bonds are just deferred taxation/inflation.
I do wonder who’s more screwed, the US or Japan. Japan’s 2005-2006 recovery seems to me to have been powered by the US’s bubble machine-driven spending, so a screwed US is something of a headwind for Japan.
I took Mandarin 2008-2009 thinking being trilingual there would be a good idea for future life in Japan, but dunno how Japan & China are going to interrelate these next few decades.
A few points to add as clarification.
– Nippon Tel, when it went public in 1987 traded at over 300x trailing earnings.
– The most recent Big Mac index, from the Economist, shows that the yen is a little overvalued, while it had previously been a lot overvalued. See-
– Both the US and Japan have investments abroad that yield more than their government bonds risk-free interest rate. This is a big positive carry.
– Japan is one of the largest markets for life insurance and annuities in the world, and a 20+ year bear market in equities makes for ZERO retail interest in investing in stocks. It wasn’t that way in 1989! There is a TON of private saving in Japan.
– Japan has reduced it’s balance of trade deficit with China such that it’s now nearly neutral. Can’t say that about the US!
Richard Koo at Nomura has written extensively about the Japanese economy. He views the problem as a balance sheet recession. His book- The Holy Grail of Economics- is worth reading to get a better grasp of the effect of a balance sheet recession for both the US and Japan.
Chilling, but a wonderful read as always. Given the scenarios you`ve described, I find it hard to imagine Japan getting out of its own debt trap. And I don`t feel optimistic that America`s debt problems will serve as a wakeup call (at least not for long). I don`t envy the politician who is stuck as prime minster when it all starts to fall apart.
Assuming the worst happens and Japan goes into default, what are the implications for the neighbours and the rest of the world? Not pretty, I`m sure, but what do you think would eventuate? Unlike Greece, there`s no Germany or France able to give a grudging bailout.
Great article, you give some great answers to things that have puzzled me about Japan. I love the way Japan manages to confound economists and investors. Most academic economists react of course by just ignoring its lessons as otherwise they may have to accept their precious models are pretty much useless. But I think the factors showing up in Japan are more general than is frequently recognised.
Richard. If you want to refresh your thinking on peak oil, then you could do worse than read Chapter 3 or the IMF’s April 11 WEO covering oil scarcity:
The report also references some of the new economist literature by economists such as Ayres and Warr that see a slowdown in global energy production growth creating a far larger barrier to economic growth than accepted by the consensus up to now. By chance, Ayres and Warr have just come out with a book on the subject:
The implications of this work are very bad for Japan’s, and in fact the world’s, long-term trend GDP growth rate.
Incidentally, if you don’t want to wade through all the many Oil Drum postings, then it is worth keeping up with Stuart Staniford over at the Early Warning blog:
Staniford has contributed to the Oil Drum and covers the main indicators of peak oil very well.
Finally, if you want to add in some more gloom, then I think you need to take into account that climate change is going to produce increasing expenditure shocks as well as the years roll by. For example, as average precipitation increases, yearly flood damage starts to rise by trillions of yen. You can see some numbers on P53 of this Japanese government report here:
Click to access report_impacts.pdf
And as I write this, I see the Japanese newspapers are carrying articles on extensive flooding. The usual caveat applies that no one event can be linked to global warming, but in probabilistic terms these hits will keep coming with increasing frequency and severity. Not good is you are trying to rein in expenditures in an attempt to stop a debt blow-up.