- No need to panic, a lot of analysts tell us, since far from that constant upwards surge in Japan government debt meaning we are on the verge of some earth shattering event, the country has in fact finally invented the economic equivalent of a mechanical perpetual motion machine. Or as Nobel economist Paul Krugman once put it, “while there is much shaking of heads about Japanese debt, the ill-effects if any of that debt are by no means obvious”. Maybe there is just one word missing here - yet.
It's hard not to feel that the rise and rise of Japanese government debt is far from benign. Not that any kind of doom is just around the corner. The current dynamic can probably be sustained for some considerable time to come, but at some point or another further on down the road the BoJ defensive wall will surely break, and the debt will become unsustainable. Unfortunately by the time we reach that point it will be too late to correct course, and some sort of disorderly and disruptive event could well occur. Indeed, if the underlying cause of Japan’s malaise is, a Krugman notes, demographic, then after several decades of ultra-low fertility in all probability it already is too late to find a neat and straightforward solution in the classic sense, since the root of the problem is, as he says - wait for it - that there is "a shortage of Japanese".
Japan has, as will be outlined here, a major problem in that it has become stuck in an almost permanent state of deflation. Not that deflation is in all respects something terrible. Consumers obviously enjoy the price reductions, and when we come to look at the outcomes of many of the attempts to return the country to inflation it is often hard to see the benefit.
But deflation does create a very large problem for one section of society - the financial sector. Not only are ultra low interest rates and falling prices hard to manage, they produce secular increases in debt levels, associated either with perpetual problems with non performing loans or rising and unsustainable levels of sovereign debt (banks, pension funds and insurance companies tend to be large holders of government bonds).
- But what if all our best attempts to generate inflation come to nought, what if the costs of trying outweigh the benefits which come from having done so and failed?
Far from following in the footsteps of that woeful economist so tellingly characterised by Keynes, the one who through many travails and pages and pages of equations is only able to tell you that when the storm is long past the ocean is flat again, the argument used here will have more akin to that advanced bythe character so ably played by Mike Shannon in the Jeff Nichols’ film “Take Shelter” - "there’s a storm comin, one like none of you have ever seen before…."
The Recovery That Wasn't
Japan's economy has been in some kind of limbo since the government raised the consumption tax from 5% to 8% in April 2014. The tax hike was followed by a strong slump in domestic demand, which produced two quarters of economic contraction. From October last year the economy has been slowly recovering, but the recovery has been weak and tepid. GDP grew by a quarterly 0.6% in the first three months of 2015, but that number is largely illusory since 0.5% of that was due to a build up in inventories.
- So the GDP breakdown reveals that the country's recovery after the 2014 recession is weaker than anticipated. This impression is also re-inforced by the results of the most recent Tankan survey on capital expenditure expectations, which was strongly negative.
- If the root of Japan's problem is secular stagnation caused by weak demographics then this constant investment shortfall is what you would expect to see. In his post, Demography and the Bicycle Effect Paul Krugman describes the situation as follows:
"To have more or less full employment, we need sufficient spending to make use of the economy’s potential. But one important component of spending, investment, is subject to the accelerator effect: the demand for new capital depends on the economy’s rate of growth, rather than the current level of output. So if growth slows due to a falloff in population growth, investment demand falls — potentially pushing the economy into a semi-permanent slump."
- What all these conflicting signals underline is the lack of clarity about just what the principal objective of Abenomics actually is. Simply creating inflation cannot be the goal. If it is achievable on a sustained basis this inflation has to be a means to something else. For Paul Krugman that something else would be a lowering of the real interest rate via rising medium term inflation expectations. This lower real rate would - so the theory goes - stimulate investment in capital goods and hence provoke an ongoing (and self sustaining) recovery in the Japanese economy after years of sub-par growth.
And what if Alvin Hansen was right, and in economies suffering from structurally weak consumer demand linked to ongoing demographic dynamics (and not simply a balance sheet recession) the principal determinant of productive investment decisions is not the cost of capital but corporate profitability and the anticipated size of the future market? In this case even success on the inflation expectations front would probably not deliver the expected recovery.
And there are downside costs. While financial markets boom, the living standards of the majority of Japanese families continues to fall as real wages drop month after month. It's hard to see consumption booming in this case. Then there is the debt: gross government debt current stands at around 245% of GDP.
Deflation Hasn't Been Beaten
Is Japan about to fall back into deflation just 2 years after starting the boldest monetary experiment ever? That is the unfortunate question we now need to ask after watching the ups and downs of the Japanese economy over the last 24 months.
Certainly the most recent inflation numbers suggest that in April - after the impact of last years 3% tax hike falls out of the calculations - Japanese annual inflation will once more turn negative. Even if it doesn't fully succumb the price level will be surely be hitting directly up against the boundary line. In February core inflation (stripped of the central bank's estimate of the tax effect) hit zero, after dropping steadily month by month. The figure popped up to 0.2% in March, but the outlook for the coming months suggests the respite is temporary before an eventual relapse.
- Unless the Bank of Japan does more monetary easing to force the value of the yen lower it is hard to see inflation returning in any significant way in the near term. And in any event, if if they should do some more easing the short term boost given to inflation soon wears off - as we have seen time and again over the last two years.
Even Though There's Been No Shortage of BoJ Bond Buying
Certainly there is little doubt that the Bank of Japan has already printed a lot of yen.
- And the central bank is fast becoming the "customer of first and last resort" in the government bond market.
- The bank of Japan now holds around 35% of all JGB's and the proportion is rising steadily.