Is Japan the Canary in the Keynesian Coal Mine?
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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