Practical analysis for investment professionals
06 February 2013

Is Japan the Canary in the Keynesian Coal Mine?

Posted In: Economics

When it comes to discussions on the economy, it’s easy to get lost in the jargon of finance. Oftentimes, highbrow statements can sound very plausible until you stop and think about them, or better yet, analyze them for yourself. What continues to amaze me is the chorus of opinions emanating from academics, central bankers, and politicians in support of certain policies that are, at best, debatable — and at worst, highly destructive. Ralph Waldo Emerson is often misquoted as having coined the phrase, “What you do speaks so loudly I cannot hear what you say.” Nonetheless, it’s a wise statement. To get to the heart of economic policy, one must tune out what the puppet masters say and tune into what they actually do. In other words, let the data speak.

As many of you know, I have been following the events in Japan with great interest. This is partly out of the desire to understand how a large, modern economy can be moribund for 23 years and counting. But I’m also interested because the policies that Japan has utilized for so long are now being emulated by many countries around the world. Japanese policy is the avant-garde of economics — or, perhaps, the canary in the coal mine. And since the financial crisis of 2008, the United States and Europe are following a very similar path.

Of course, every country has unique characteristics and is comprised of its own social customs, values, demographics, and history. However, the approach these countries are using — and which Japan is using with gusto — can generally be traced back to the same philosophical source: John Maynard Keynes. Moreover, because Japan has been using these policies and approaches for so long — and because it has a very insular culture — we have a rich laboratory with which to make observations about the efficacy of monetary policy, fiscal stimulus, debt issuance, monetization of debt, and so forth.

According to the World Bank, from the peak of the Japanese bubble in 1990 to the latest estimates for 2012, the Japanese population grew slightly from 123.5 mm people to 126.9 mm (with the population now in decline since 2009). Over this same span of time, nominal GDP in Japan was ¥442 trillion in 1990 and registered at approximately ¥475 trillion in 2012. (Note that these figures are not adjusted for inflation of the money supply, which obviously can inflate reported figures in more recent years, thereby exaggerating the difference.) The difference is ¥32 trillion over a period of 23 years.

As discussed in “Government Debt: a Gentleman’s Wager” and “Latest Debt and GDP Figures Indicate US Economy is Still Unwell,” GDP growth must be financed somehow. Obviously, such growth can be financed with either debt or equity. And while we don’t have data on equity to estimate total investment, we do have the data on debt. The change in total debt over this same 1990–2012 time frame is ¥761 trillion. Had the entirety of this ¥761 trillion been put toward long-term investment, then GDP would be ¥761 trillion higher. Had it all gone toward consumption, then GDP would not have changed (materially) in 22 years, assuming the money supply was held constant.

So, dividing the change in GDP by the change in total debt gives us an indication as to how much of the additional debt went toward investment and how much went toward consumption. Shockingly, the ratio yields an answer of only 4.2%. In essence, it means that 4.2% of this additional debt created long-term growth in the economy — and, in essence, 96% of it was wasted. So, there was no long-term benefit to the economy, yet the debt remains, creating an ever-increasing burden on the working-age population of Japan.

Here’s what that means: First, it means that the total investment into the Japanese economy was almost certainly much greater than what we captured, because we only used debt and excluded equity investment, which further pushes the ratio downward. Second, if we had factored inflation into the analysis, then the change in GDP would have been even smaller. (We didn’t because comparing the debt and GDP calculations create a timing mismatch either way.) Lastly, it means that huge amounts of money were spent very poorly.

The central risk to Japan is the possibility that their current account balance shifts from a persistent surplus to a persistent deficit. It is this surplus that has been chiefly responsible for Japan’s ability to maintain low interest rates for so long. In essence, Japan’s funding mechanism works as follows: The central government runs large deficits, and the Ministry of Finance issues government bonds (JGBs) to make up for shortfalls in tax revenues. The Bank of Japan, as well as commercial banks (with a regulatory push from the BOJ), purchase JGBs and keep rates low, and the total debt of the economy (mostly government debt) grows, keeping the country afloat. Should the current account balance turn negative, then the inflow of yen will be inadequate. JGB prices will fall, yields will rise, and the government financing mechanism that Japan has used for so long will categorically fail.

Yesterday, Masaaki Shirakawa, the current governor of the Bank of Japan, announced that he will step down early. His replacement will be selected by the recently elected Prime Minister Shinzō Abe, and this person is widely expected to accelerate and amplify previous policies in the interest of producing inflation of 2–3%. In order to produce inflation, Japan must undermine the value of the yen.

What happens to the current account balance when the yen declines? Already, Japan has lost leadership positions in many industries, so their trade problems are deeper than the relative price of their exports. As the yen falls in value, imports are more expensive, and exports are cheaper. In 2012, Japan reported a trade deficit of ¥6.93 trillion. Part of this is structural, and perhaps part is cyclical (or temporary). However, Japan’s imports are skewed toward necessities like raw materials, food, and energy. In contrast, their export industries are losing leadership positions where the discounted yen is far from the only variable for buyers to consider. So, the burgeoning trade deficit will be difficult to offset via monetary policy and should continue to widen. The trade balance is more inelastic than one might suspect.

Another major component of Japan’s historically high current account surplus is their income payments surplus, which runs at about ¥14 trillion per year. Because they had previously run a trade surplus for so long, the Japanese maintain a large foreign asset portfolio that produces a steady stream of income, which is repatriated back to Japan every year. What happens to the yen value of cross-border payments? The yen value of payments abroad increases, and the yen value of payments received increases, thereby widening the income surplus. Because these payment inflows exceed the corresponding outflows by a wide margin, a falling yen will increase the conversion of these income payments in yen. And how about transfers? How sensitive these variables are to changes in the value of the yen is an open question. In any event, these changes are marching forward.

With all this as the backdrop, Japan will almost certainly escalate the aggressiveness of their monetary policy and accelerate their growth and monetization of debt. Because the magnitude of the imports and exports are so much greater than the absolute income payments, there is much greater leverage to changes in the trade deficit than there is to changes in the income surplus. On the margin, the improvements in the income surplus will mollify the adverse movements in the trade deficit.

Nevertheless, the combined impact of Japan’s policies has grown in magnitude over time such that they now have huge fiscal deficits (50% of the annual fiscal budget is financed with debt), a huge debt burden (sovereign debt over 220% of GDP), and a huge reliance on direct or indirect monetization of debt (the BOJ and commercial banks purchase a large and growing percentage of all issues). The United States and Europe began pursuing similar policies in earnest in the aftermath of the financial crisis of 2008, but Japan began these policies in 1990 and is much farther down the path than the others — and thus closer to the end game. But make no mistake, the die is cast.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

6 thoughts on “Is Japan the Canary in the Keynesian Coal Mine?”

  1. Sameer Gupta says:

    Hey Ron, another great analysis. But here’s a question, you mentioned, if Japan’s Current account surplus turns into CAD, yields will rise. I fail to understand that point, since CAS to CAD will depreciate Yen which they are already trying to do. So, its not just CAS to CAD that’s going to cause the yield to rise, its the monetary policy. But they’ve had the same monetary policy for so long, wonder what’s going to change now. Am I missing something big here?

    1. Hi Sameer, thanks for the question. the Current Account Surplus in Japan has enabled the country to operate as a closed system whereby they are able to recylce their money into the purchase of JGB’s. [If and] When this shifts to a Current Account Deficit, the system will spring a leak, so to speak. The magnitude and duration of the deficit will determine how quickly or slowly the leak will happen, but as it happens, a smaller and smaller percentage of the money flowing through Japan can stay in Japan – meaning that demand for JGB’s will almost certainly decline in corresponding amounts. As the BOJ’s money printing leaks into higher inflation, the markets will also seek to raise yields. As yields rise, Japan’s fiscal deficit expands, etc… The virtuous cycle turns vicious if and when the CAS becomes a CAD.

  2. TGM says:

    Most, if not all articles analysing any gloom/doom in Japan seem to conveniently ignore that most of Japan’s debt is owed within the country completely unlike what European sovereigns like Greece etc are suffering from. The net external debt situation of Japan is much better than most developed countries. Any restructuring of debt will be within the nation rather than being at the mercy of creditors abroad and hence will “remain in the family”. In fact a look at the complete balance sheet of Japan shows it’s a major creditor nation ( Would love to hear points for/against this.

    1. Tres Knippa says:

      If you do not mind, I would like to add my 2 cents to this question regarding internal financing. I have heard this argument time and again about how Japan finances from within. Why is this considered a strength? I consider it a very severe weakness. The way I see it, Japanese Government Bonds are held in very few hands. If one of the few owners (life insurance companies, pension plans, etc) turns seller, then who is there to pick up the slack? Everyone who wants to own JGBs already does. Do you think a non Japanese buyer is out there waiting to “buy a dip” in these toxic assets? Not a chance. It is also helpful to look at the math of the “self funding” mechanism of the JGB market. If you run a 1% current account surplus but you have a 10% fiscal deficit, then you have already sailed into the zone of insolvency.

      Think about the position of a money manager in Japan. If the government is set out to hammer the yen and create inflation, then why in the world would those managers want to hold a .75% yielding instrument?

      Bond markets, currencies, and banking systems all need one thing in order to survive……….confidence. When does that confidence get shaken? When it does, since JGBs are in such few hands, the bond market could get very ugly, very quickly.

      1. TGM says:

        On the margin these will cause issues for future issuance of JGBs “IF” they do not find buyers but yet again the buyers have been domestics time and again (thanks as always to QE). The exact same argument could be given every year for the past 10 years. They never did expect and would not expect foreigners to buy JGBs (they are not that naive). Why didn’t asset managers sell JGBs then (when the yen was much weaker and confidence was at it lows compared to the rest of the world) and invest into higher yielding sovereigns elsewhere ? The CAB changing from surplus to deficit will impact the scene on the margin and yields will rise and if it comes to restructuring and write downs, the pain will be absorbed within and reallocated. They will still not be at the mercy of anyone outside. The real problem is with fiat currencies in general and not specific to Japan.

  3. Hi TGM, what you say is true. In fact, I believe 93% of JGB’s are owned internally. Moreover, I agree with your comments about Japan being a creditor nation – which is why they have an income surplus referenced in the article. However, all the interesting things in economics occur on the margin. And the marginal change in the JGB demand will come from a shift in the Current Account from Surplus to Deficit. This is what will place downward pressure on JGB demand and cause yields to rise. Already we have seen a significant shrinking of the Current Account Surplus in the past two years. Should it continue – and I believe it will – Japan’s ability to maintain insular demand for JGB’s is weakened.

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