japan

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Japan’s Deflation Persistence

It's deflating...

Is it all about the age of the population?

One in four people in Japan will be older than 65 in 2014, compared with 9.6 percent in China and 14.2 percent in the U.S., according to data compiled by the U.S. Census Bureau.

Now, because they have had longer to accrue weal the older people tend to have more savings, or have retired and live in a fixed income, and therefore benefit from deflation But correlation is not causation. Certainly, Japan’s older population loves deflation. But the issue is the love of deflation, not the age of the population, per se. More than 80 percent of respondents in a Bank of Japan (8301) survey released this month who noticed rising prices last year said it was bad. Deflation-loving Japanese voters are the main stumbling block to Abe and Kuroda’s desire to reflate the Japanese economy back to inflation (to incentivise borrowing) and growth.

One of the peculiarities of state-backed fiat money is that it is a medium of exchange that the people of a state are expected to share. Clearly, individuals existing in a state will by definition have different motivations, different time preferences, and different conceptions of what constitutes good money. Different individuals have different preferences for inflation and deflation — while deflation helps savers, younger generations without savings are hit by stagnant wages and diminished incentives for borrowing. Inflation incentivises borrowing, and deflation incentivises saving, but these things are both to a great degree two sides of the same coin — deposited savings are lent out by banks. So when a population comes to love deflation and savings soar — and about 56 percent of household assets were in cash or bank deposits in 2012, according to a Bank of Japan report — the glut of savings depresses interests rates. With the value of savings rising, savers have little incentive to spend. This, ceteris paribus, constrains spending.

Abe and Kuroda are fighting to break Japan out of the liquidity trap. They have specific growth and inflation targets — 1% inflation, and 3% income growth — and have a clear plan to hit those targets. But fighting against the widely-desired status quo — that is, deflation — in a democratic state is difficult. If Japanese people love deflation, they will vote for it at the polls. If Abe and Kuroda are to succeed in reigniting inflation, they need to convince Japanese savers to change their minds about inflation, and challenge the idea that saving in Yen is a desirable thing. After all, saving is not confined solely to the state-backed fiat currency. In a more inflationary environment, savers often choose to save through ownership of assets whose prices are increasing — land, real estate, commodities and currencies other than the state-backed fiat currency. In principle, there is no reason why Japan’s ageing population may not prove capable of moving its desire for savings into different media, and letting the Yen inflate. In practice, deflation and saving in Yen is cemented as a norm. That may prove extremely difficult to overcome.

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Abenomics & Rooseveltian Resolve

The new Bank of Japan chief Haruhiko Kuroda today unveiled an aggressive new round of monetary easing, the latest step in the policy of recently-elected Japanese Prime Minister Shinzo Abe.

As part of a promise to do “whatever it takes” to return Japan to growth, Kuroda promised a level of quantitative easing unseen before in Japan, intended to discourage saving and encourage spending. Kuroda promised to print 50 trillion yen ($520bn; £350bn) per year.That is the equivalent of almost 10% of Japan’s annual gross domestic product, and over double the level of what the Federal Reserve is currently experimenting with.

Many are hailing this as an attempt to put into practice the advice of Ben Bernanke to Japan in the 1990s — what Bernanke called “Rooseveltian resolve“. In fact, Ben Bernanke has provided a practical as well as a theoretical template through the unconventional policies adopted in the last five years by the Federal Reserve. Although some economic commentators believe that Shinzo Abe was more interested in reviving Japanese mercantilism and drive exports through a cheap currency, it is fairly clear that even if that is Abe’s ultimate intent, Abe is certainly harnessing Bernankean monetary policies (as well as Keynesian fiscal stimulus policies) in that pursuit.

So, will Abe’s policies return Japan to growth, as Bernanke might have intended?

Well, this diagnostic pathway sees deflation as the great central ill. The rising value of a currency acts as a disincentive to economic action and the encouragement of hoarding, because economic participants may tend to offset projects and purchases to get a greater bang for their buck. (This, of course, would be the great problem with Bitcoin becoming the sole currency as its inherent deflationary nature encourages inactivity and not activity, but that is a topic for another day). During deflation, delayed projects and subdued consumer spending are reflected in weak or nonexistent growth. More expected inflation encourages businesses and individuals to consume and start projects rather than save. At least, that’s the theory.

In theory, there’s no difference between theory and practice. In practice, there is. So in practice, what other effects are at play here?

First of all, the Japanese in general (or a substantial and influential proportion of them) seem to really dislike inflation. Why? Well, since the initial housing and stocks bubble burst in the 1990s, they have become a nation of capital accumulators with a low private debt level. This is at least partially a demographic phenomenon. Older people tend to have a much higher net worth than younger people who have had less time to amass capital, and they need places to park it — places like government and corporate debt. This has driven Japanese interest rates to the lowest in the world:

bernanke-exhibit-20130301a1

The other side of the coin here is that this has made it very easy, almost inevitable, for the government to run massive budget deficits and run up huge levels of debt (which has to be rolled). Higher inflation would mean that those elderly creditors (who have up until now voted-in politicians who have kept the deflationary status quo) will very likely experience a negative real interest rate. Many may find this a painful experience, having grown used to deflation (which ensures a positive real interest rate even at a very low nominal interest rate, as has been the case in Japan since the 1990s):

JapanRealInterestRate

Every time Japan’s real interest rate has touched zero, it has shot back up. Japan has an aversion to negative real interest rates, it seems. And this is in stark contrast to countries like the UK and USA which have experienced much lower real interest rates since the 2008 crisis. A negative real interest rate in Japan would be a shock to the system, and a huge change for Japan’s capital-rich elderly who have happily ridden out the deflationary years in Japanese government bonds. (Of course, if reversing deflation revived real GDP growth then they would have more places to park their capital — like lending to or purchasing equity in growing business — but the question is whether or not the Japanese people at large have an appetite for such a shift).

Another challenge to growth is the existence of Japan’s zombie corporations and banks — inefficient, uncompetitive entities kept alive by government subsidies. Although some zombie banks left on life-support from the 1990s were terminated during the Koizumi years, it is fairly clear from total factor productivity figures of both Japanese manufacturing productivity and non-manufacturing productivity are still very uncompetitive. How can a burst of spending as a result of inflation turn that around? Without removing the subsidies — something that Abe, as a leader of the establishment Liberal Democratic Party, the party that has ruled Japan for the overwhelming majority of the postwar years, and is deeply interwoven with the crony industries is very unlikely to do — it may prove very difficult to return Japan to growth. And of course, these industries own the bulk of Japanese debt, so attempts to reduce the real interest rate is likely to prove deeply unpopular with them, too. (On the other hand, Japanese banks will profit from these open-market operations through flipping bonds at a profit, so the new policies may have their supporters as well as opposers among Japan’s zombie financiers).

This doesn’t necessarily mean that the Bank of Japan’s new programs are doomed to fail, or that they are likely to trigger severely adverse outcomes, but if serious attempts are not made to tackle the systemic challenges and entrenched interests, then it is hard to see how much can come out of this other than a transitory inflationary and devaluationary blip followed by a retreat to more of what Japan has become used to, and what much of Japanese society seems to like — low growth, a strong yen, and low inflation or deflation. And if Abe’s gameplan is really to grow by boosting the exports of the crony industries, then hope of desubsidisation of the crony industries seems almost entirely lost.

Certainly, more fiscal stimulus will eat up slack capital resources. And certainly, this is an interesting experiment on the fringes of Monetarism and monetary policy in general. If Japan goes through with this experiment, hits its inflation target and triggers sustained nominal GDP growth this will be a decent empirical test of whether or not such policies can lead to sustained real GDP growth. But there is no guarantee that Japan has the Rooseveltian resolve to follow through with these policies, and even if it does there is no guarantee that they will lead to a significantly higher trend in real GDP growth. The underlying system is deeply entrenched.

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Do Wages Benefit From A Shrinking Labour Force?

Dean Baker says yes:

The retirement of the baby boom cohorts means that the country’s labor force is likely to be growing far more slowly in the decades ahead than it did in prior decades. The United States is not alone in facing this situation. The rate of growth of the workforce has slowed or even turned negative in almost every wealthy country. Japan leads the way, with a workforce that has been shrinking in size for more than a decade.

Baker concludes:

With a stagnant or declining labor force, workers will have their choice of jobs. It is unlikely that they will want to work as custodians or dishwashers for $7.25 an hour. They will either take jobs that offer higher pay or these jobs will have to substantially increase their pay in order to compete.

This means that the people who hire low-paid workers to clean their houses, serve their meals, or tend their lawns and gardens will likely have to pay higher wages. That prospect may sound like a disaster scenario for this small group of affluent people, but it sounds like great news for the tens of millions of people who hold these sorts of jobs. It should mean rapidly rising living standards for those who have been left behind over the last three decades.

Of course, Baker could just look at the data from Japan. Real wages there have been depressed in recent years, even while the labour force has shrunk:

Japanwages

Even more damningly, labour’s share of income in Japan has declined even more considerably than the United States, and other nations with a growing working-age population:

ShareofLabourincome

Matthew C. Klein asks an important question:

Perhaps Mr Baker was thinking of an older example: the Black Death, which killed about half the people in Europe. Many (including me until I looked it up) believe that the resulting shortage in agricultural labour led to soaring real wages for peasants and a redistribution of economic power away from landowners. Recent evidence, however, casts doubt on this hypothesis. While nominal peasant wages did indeed increase in the aftermath of the Black Death, real wages may have actually fallen for decades. That may have helped heavily indebted peasants, but everyone else had to endure punishing declines in their standard of living, not to mention the psychological trauma of surviving such a devastating plague.

And the evidence on the Black Death seems conclusive:

In southern England, real wages of building craftsmen (rural and urban), having plummeted with the natural disaster of the Great Famine (1315-21), thereafter rose to a new peak in 1336-40. But then their real wages fell during the 1340s, and continued their decline after the onslaught of the Black Death, indeed into the 1360s. Not until the later 1370s – almost thirty years after the Black Death – did real wages finally recover and then rapidly surpass the peak achieved in the late 1330s.

And if we look at China — a country which has seen stunning real wage growth in recent years — it is clear that that growth has come in the context of a growth in the working-age population. China’s working-age population hit one billion for the first time in 2011.

To me at least, this seems to suggest that while all else being equal, a shrinking working age population might lead to a more competitive labour market, all else is not equal. Employers invest in more capital-intensive processes like automation and robots to compensate for a lack of workers, or in our globalised world they shift operations to somewhere with a stronger labour force (like China today, or perhaps like Africa further into the future). Even more simply, a falling population as a result of a natural disaster like the Black Death, or even just as a result of demographic trends like Japan, may lead to an economic depression due to falling demand.

This suggests that Baker’s conclusions are extremely optimistic for labour, and that shrinking populations may be bad news for wages.

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Do Creditors Exploit Debtors, or Vice Versa?

I’m asking this question because I think a proper understanding of the answer is a giant leap toward grasping the geopolitical realities of the relationship between America and China.

This discussion was triggered by Noah Smith’s discussion of David Graeber’s ideas on debt, and particularly his idea that debt is a means to “extract wealth” out of others.

Noah Smith on David Graeber:

“Debt,” says Graeber, “is how the rich extract wealth from the rest of us.” But sometimes he seems to claim that creditors are extracting wealth from debtors, and sometimes he seems to claim that debtors extract wealth from creditors.

For example, in the Nation article, Graeber tells that The 1% are creditors. We, the people, have had our wealth extracted from us by the lenders. But in his book, Graeber writes that empires extract tribute from less powerful nations by forcing them to lend the empires money. In the last chapter of Debt, Graeber gives the example of the U.S. and China, and claims that the vast sums owed to China by America are, in fact, China’s wealth being extracted as tribute. And in this Businessweek article, Graeber explains that “throughout history, debt has served as a way for states to control their subjects and extract resources from them (usually to finance wars).”

But in both of these latter cases, the “extractor” is the debtor, not the creditor. Governments do not lend to finance wars; they borrow. And the U.S. does not lend to China; we borrow.

So is debt a means by which creditors extract wealth from debtors? Or a means by which debtors extract wealth from creditors? (Can it be both? Does it depend? If so, what does it depend on? How do we look at a debtor-creditor-relationship and decide who extracted wealth from whom?) Graeber seems to view the debtor/creditor relationship as clearly, obviously skewed toward the lender in some sentences, and then clearly, obviously skewed toward the borrower in other sentences.

But these can’t both be clear and obvious.

What Graeber means by “extracting wealth” in the context of a relationship between, say a mortgager and a mortgagee seems to mean the net transfer of interest. It is certainly true on the surface that there is a transfer of wealth from the debtor to the creditor (or from the creditor to the debtor if the debtor defaults).

However, between nations Graeber sees the relationship reversed — that China is being heavily and forcefully encouraged to reinvest its newly-amassed wealth in American debt (something that some Chinese government sources have suggested to be true). But if the flow of interest payments — i.e. from America to China — is the same debtor-to-creditor direction as between any creditor and debtor, then is the relationship really reversed? If China is being forced to amass American debt by the American government, is America effectively forcing China into “extracting its wealth”?

The thing Graeber seems to miss is that the transfer of interest is the payment for a service. That is, the money upfront, with the risk of non-repayment, the risk that the borrower will run off with the money. That risk has existed for eternity. In this context, the debtor-creditor relationship is a double-edged sword. Potentially, a debtor-creditor relationship could be a vehicle for both parties to get something that benefits them — in the case of the debtor, access to capital, and in the case of the creditor, a return on capital.

In the case of China and America, America may choose to pay off the debt in massively devalued currency, or repudiate the debt outright. That’s the risk China takes for the interest payments. (And the counter-risk of course being that if America chooses to repudiate its debt, it risks a war, which could be called the interstate equivalent of debtors’ prison).

Of course, the early signs are that China’s lending will be worth it. Why? Because sustained American demand provided by Chinese liquidity has allowed China to grow into the world’s greatest industrial base, and the world’s biggest trading nation. And it can’t be said that these benefits are not trickling down to the Chinese working class — China’s industrial strength has fuelled serious wage growth in the last few years. Yes — the Chinese central bank is worried about their American dollar holdings being devalued. But I think an inevitable devaluation of their dollar-denominated assets is a small price for the Chinese to pay for becoming a global trading hub, and the world’s greatest industrial base. Similarly, if American firms and governments use cheap Chinese liquidity to strengthen America, for example funding a transition to energy independence, then the cost of interest payments to China are probably worth it. And that is a principle that extends to other debtors — if the credit funds something productive that otherwise could not have been funded, then that is hardly “wealth extraction”. There is the potential for both parties to benefit from the relationship, and the opportunity costs of a world without debt-based funding would seem to be massive.

But what if tensions over debt lead to conflict? It would be foolish to rule out those kinds of possibilities, given the superficial similarities in the relationship between China-America and that of Britain-Germany prior to World War I. It is more than possible for an international creditor-debtor relationship to lead to conflict, perhaps beginning with a trade war, and escalating —  in fact, it has happened multiple times in history.

It is certainly true that devious creditors and debtors can extract wealth from each other, but so can any devious economic agent — used car salesmen, stockbrokers, etc. The actual danger of creditor-debtor relationships, is not so much wealth extraction as it is conflict arising from the competition inherent to a creditor-debtor relationship. Creditors want their pound of flesh plus interest. Debtors often prefer to be able to shirk their debts, and monetary sovereign debtors have the ability to subtly shirk their debts via the printing press. That is potentially a recipe for instability and conflict.

There is also the problem of counter-party risk. The more interconnected different parties become financially, the greater the systemic risks from a default. As we saw in 2008 following the breakdown of Lehman Brothers, systemic interconnectivity can potentially lead to default cascades. In that case, debt can be seen as a mutual incendiary device. 

So the debtor-creditor relationship is very much a double-edged sword. On the one hand, if all parties act honestly and responsibly debt can be beneficial, allowing debtors access to capital, and allowing creditors a return on capital — a mutual benefit. In the real world things are often a lot messier than that.

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Currency Wars Are Trade Wars

Paul Krugman is all for currency wars, but not trade wars:

First of all, what people think they know about past currency wars isn’t actually true. Everyone uses some combination phrase like “protectionism and competitive devaluation” to describe the supposed vicious circle of the 1930s, but as Barry Eichengreen has pointed out many times, these really don’t go together. If country A and country B engage in a tit-for-tat of tariffs, the end result is restricted trade; if they each try to push their currency down, the end result is at worst to leave everyone back where they started.

And in reality the stuff that’s now being called “currency wars” is almost surely a net plus for the world economy. In the 1930s this was because countries threw off their golden fetters — they left the gold standard and this freed them to pursue expansionary monetary policies. Today that’s not the issue; but what Japan, the US, and the UK are doing is in fact trying to pursue expansionary monetary policy, with currency depreciation as a byproduct.

There is a serious intellectual error here, typical of much of the recent discussion of this issue. A currency war is by definition a low-level form of a trade war because currencies are internationally traded commodities. The intent (and there is much circumstantial evidence to suggest that Japan at least is acting with mercantilist intent, but that is another story for another day) is not relevant — currency depreciation is currency depreciation and still has the same effects on creditors and trade partners, whatever the claimed intent.

Krugman cites Barry Eichengreen as evidence that competitive devaluation does not necessarily mean a trade war, but Eichengreen does not address the issue of a trade war directly, much less denying the possibility of one.  Indeed, while broadly supportive of competitive devaluation Eichengreen notes that the process was “disorderly and disruptive”.

And the risks of disorder and disruption are still very real today.

As Mark Thoma noted in 2010:

While the positive effects a currency war produced in the 1930s are unlikely to reappear, there is a chance of large negative effects such as a simultaneous trade war or the breakdown of the international monetary system, so let’s hope a currency war can be avoided.

The mechanism here is very simple. Some countries — those with a lower domestic rate of inflation, like Japan — have a natural advantage in a currency war against countries with a higher domestic rate of inflation like Brazil and China. If one side runs out of leverage to debase their currency because of heightened domestic inflation, their next recourse is to resort to direction trade measures like quotas and tariffs.

And actually, the United States and China in particular have been engaging in a low-level trade and currency war for a long time.

As I noted last year:

China and Russia and Brazil have all recently expressed deep unease at America’s can-kicking and money-printing mentality. This is partly because American money printing has exported inflation to the world, as a result of the dollar’s role as the global reserve currency, and partly because these states already own a lot of American debt, and do not want to be paid off in hugely-debased money.

Since I made that statement, there has been a great lot of debasement without any great spiral of damaging trade measures. But with the world locked into ever greater monetary and trade interdependency, and with fiery trade rhetoric continuing to spew forth from the BRIC nations, who by-and-large seem to continue to believe that American money-printing is damaging their interests, and who in the past two years have put together a new global reserve currency framework, it would be deeply complacent to believe that the risks of a severe trade war have gone away.

(Unfortunately, Krugman and Eichengreen both seem to discount the reality that Okun’s law has broken down, and that monetary expansion today is supporting crony industries, and exacerbating income inequality, but those are another story for another day)

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Is War Coming Between China And Japan?

Last month, I looked at the legal implications of a conflict between China and Japan, concluding that the likelihood remains low, and that America would not be legally bound to defend Japan:

First of all, it is critical to note that the United States is not legally obligated under its with Japan treaty to intercede on Japan’s behalf. The treaty states that the United States is required to report any such event to the UN Security Council, instead:

Each Party recognizes that an armed attack against either Party in the territories under the administration of Japan would be dangerous to its own peace and safety and declares that it would act to meet the common danger in accordance with its constitutional provisions and processes. Any such armed attack and all measures taken as a result thereof shall be immediately reported to the Security Council of the United Nations in accordance with the provisions of Article 51 of the Charter. Such measures shall be terminated when the Security Council has taken the measures necessary to restore and maintain international peace and security.

Very simply, this means that China can attack Japan without fearing an inevitable American retaliation. That fact alone makes a small skirmish fairly likely.

So what if China successfully captured the islands — and perhaps even more Japanese territory — as we can perhaps assume given China’s overwhelming size and military-spending advantages? Well, the United States and presumably the international community other than China’s allies would seek to diplomatically pressure China to stand down and reach a peaceful arbitrated resolution via the UN.

If China refused to stand down and accept a diplomatic solution — that is, if China was absolutely set on staring down the United States — then the United States would be forced to choose between providing military support to Japan — and possibly ultimately escalating up to a global war between China and her allies and the United States and her allies — or facing a humiliating climbdown, and accepting both Chinese sovereignty over the islands, as well as any other Japanese territory that China might have captured, as well as face the possibility of further Chinese incursions and expansionism in the Pacific in the future.

In the last day it has been reported that Chinese forces have been mobilising.

Mobilising

A report out of China by NTDTV (in very broken English) notes:

February 3, Nan’an, Fujian Highway 308, artillery units practical exercise for several days.

February 3 to 6, Fujian, Xiamen, Zhangzhou, Huzhou, a large troop movements, nearly 100 vehicles of various types of military vehicles, armored vehicles, artillery filled the entire road, endless, Xiamen and even the scene of a traffic jam 10 kilometers.

In addition, on February 3 in Shiyan, Hubei, a large number of tanks, wheeled military base from Shiyan room counties is delivered to the coastal areas. Many local residents of the tense situation of some concern.

Prior to this allegation, January 15 and 30, the Chinese navy guided missile frigate, twice the fire control radar lock frigates and ship-borne helicopters of the Japanese Maritime Self-Defense Force, is also considered to enter a combat state.

According to mainland media quoted the “People’s Daily” front-page article claiming that China will not change in point of view on the issue of the Diaoyu Islands , and have to prepare to win the war.

The international media alleged that China has purchased from Russia 239 engine, used in the manufacture of the H-6K. Combat covering the Diaoyu Islands, in this model, the engine can also be used to manufacture transported -20 transport aircraft purchased.

If the engine assembled, will greatly enhance China’s military power.

This may turn out to be much ado about nothing, propaganda released to make a hullabaloo. With China gradually growing relatively stronger, and the United States and her allies growing relatively weaker, China on the surface may seem to have very little incentive to do much other than wait. But with global economic conditions worsening, and both China and Japan becoming more fierce in their rhetoric, it becomes likelier and likelier that China may choose to project its economic problems outward by starting a hot war. Most importantly, with the United States not committed to materially defend Japan, it appears to me like China may see this as a golden opportunity to impose itself on the region, to humiliate the already overstretched United States, and make a statement by pushing Japan out of the islands, or perhaps even by going postal and invading other Japanese islands or even Taiwan. With the world dependent on goods and components produced and assembled in China, China already has a lot of leverage to push the rest of the world into accepting a Chinese-dominated regional order.

Still I would say that by far the most rational course for China is to not start a war. But if China starts, it becomes increasingly likely that the United States will respond.

Governments around the globe are advised to remember that while war may increase GDP, and while it may lower unemployment, it destroys an unquantifiably larger amount of real wealth — lives, businesses, physical capital, social capital.

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Why China is Holding All That Debt

What does it mean that China are making a lot of noise about the Federal Reserve’s loose monetary policy?

 Via Reuters:

A senior Chinese official said on Friday that the United States should cut back on printing money to stimulate its economy if the world is to have confidence in the dollar.

Asked whether he was worried about the dollar, the chairman of China’s sovereign wealth fund, the China Investment Corporation, Jin Liqun, told the World Economic Forum in Davos: “I am a little bit worried.”

“There will be no winners in currency wars. But it is important for a central bank that the money goes to the right place,” Li said.

At first glance, this seems like pretty absurd stuff. Are we really expected to believe that China didn’t know that the Federal Reserve could just print up a shit-tonne of money for whatever reason it likes? Are we really expected to believe that China didn’t know that given a severe economic recession that Ben Bernanke would throw trillions and trillions of dollars new money at the problem? On the surface, it would seem like the Chinese government has shot itself in the foot by holding trillions and trillions of dollars and debt instruments denominated in a currency that can be easily depreciated. If they wanted hard assets, they should have bought hard assets.

As John Maynard Keynes famously said:

The old saying holds. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.

But I think Keynes is wrong. I don’t think China’s goal in the international currency game was ever to accumulate a Scrooge McDuck-style hoard of American currency. I think that that was a side-effect of their bigger Mercantilist geopolitical strategy. So China’s big pile of cash is not really the issue.

Scrooge-McDuck

It is often said that China is a currency manipulator. But it is too often assumed that China’s sole goal in its currency operations is to create growth and employment for China’s huge population. There is a greater phenomenon — by becoming the key global manufacturing hub for a huge array of resources, components and finished goods, China has really rendered the rest of the world that dependent on the flow of goods out of China. If for any reason any nation decided to attack China, they would in effect be attacking themselves, as they would be cutting off the free flow of goods and components essential to the function of a modern economy. China as a global trade hub — now producing 20% of global manufacturing output, and having a monopoly in key resources and components — has become, in a way, too big to fail. This means that at least in the near future China has a lot of leverage.

So we must correct Keynes’ statement. Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed; owe him £1 trillion, and become dependent on his manufacturing output, and the position is reversed again.

The currency war, of course, started a long time ago, and the trajectory for the Asian economies and particularly China is now diversifying out of holding predominantly dollar-denominated assets. The BRICs and particularly China have gone to great length to set up the basis of a new reserve currency system.

But getting out of the old reserve currency system and setting up a new one is really a side story to China’s real goal, which appears to have always been that of becoming a global trade hub, and gaining a monopoly on critical resources and components.

Whether China can successfully consolidate its newfound power base, or whether the Chinese system will soon collapse due to overcentralisation and mismanagement remains to be seen.

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Soaring Debt Precedes Financial Crises…

Things don’t look so good for China:

Screen-shot-2013-01-23-at-5.25.43-AM

Will we see a Chinese financial meltdown in 2013? Or 2014? Or 2015? With global GDP growth on a definite trend downward, with such a tepid Western recovery, and with global geopolitical tensions still high, the last thing the global economy needs is a financial crisis at the heart of the BRIC growth engine. But the data implies that that may just be what we get.

To those who believe that China is immune to such a thing, recall that America suffered the Great Depression immediately previous to becoming a global superpower. China’s economy has undergone a rapid transformation in recent years:

china-economy-12-4

Such a transformation is sure to necessitate some dislocation and fallout — just as America’s transformation from an agricultural to a manufacturing economy did. America ended that process as the global superpower. It remains to be seen if the same will happen for China, but controlling the world’s largest productive industrial base certainly suggests so. The other factor, of course, that presaged America’s rise was a global war…

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Could America Get Sucked Into a China-Japan Conflict?

So China and Japan are both threatening conflict in their fairly brutal ongoing argument over a few tiny disputed islands (and their mineral rights):

Senkaku islands

With global growth slowing, both countries’ leaders might look to a war as a way to distract from economic woe. While a limited war between China and Japan over the islands — perhaps of the scale of the Falkland War between Britain and Argentina in the 1980s — would be unsettling for the global economy, the real question is whether or not such a conflict could spiral into something bigger. 

The first critical point to note is that both countries’ leadership are increasingly hawkish in tone and character. China is in many ways seeking to establish itself on the world stage as a global military and economic powerhouse. Countries seeking to establish themselves on the global stage have traditionally sought out conflict. Japan is an ideal candidate for Chinese hostility. There is a lot of resentment — Japan’s invasion and occupation of Manchuria was brutal, and filled with war crimes (war crimes that the Japanese continue to deny). But more than that, Japan is an American protectorate, dotted with American bases, and subject to a mutual defence treaty. If China is to eclipse the United States as a global superpower, China must be able to show that she can impose her will on America.

And Shinzo Abe, Japan’s new Prime Minister has made it his life’s work to change Japan’s pacifistic constitution. Japan is faced with a twenty year economic depression, falling birthrates, a population of “herbivore” males with an aversion to sexuality. Abe may see hostility against China as a gateway to greater nationalism, and greater nationalistic fervour as a gateway to a national recovery.

First of all, it is critical to note that the United States is not legally obligated under its with Japan treaty to intercede on Japan’s behalf. The treaty states that the United States is required to report any such event to the UN Security Council, instead:

Each Party recognizes that an armed attack against either Party in the territories under the administration of Japan would be dangerous to its own peace and safety and declares that it would act to meet the common danger in accordance with its constitutional provisions and processes. Any such armed attack and all measures taken as a result thereof shall be immediately reported to the Security Council of the United Nations in accordance with the provisions of Article 51 of the Charter. Such measures shall be terminated when the Security Council has taken the measures necessary to restore and maintain international peace and security.

Very simply, this means that China can attack Japan without fearing an inevitable American retaliation. That fact alone makes a small skirmish fairly likely.

So what if China successfully captured the islands — and perhaps even more Japanese territory — as we can perhaps assume given China’s overwhelming size and military-spending advantages? Well, the United States and presumably the international community other than China’s allies would seek to diplomatically pressure China to stand down and reach a peaceful arbitrated resolution via the UN.

If China refused to stand down and accept a diplomatic solution — that is, if China was absolutely set on staring down the United States — then the United States would be forced to choose between providing military support to Japan — and possibly ultimately escalating up to a global war between China and her allies and the United States and her allies — or facing a humiliating climbdown, and accepting both Chinese sovereignty over the islands, as well as any other Japanese territory that China might have captured, as well as face the possibility of further Chinese incursions and expansionism in the Pacific in the future.

Who will blink first is uncertain. Only the Chinese really know how strong they are, how far they are willing to push, and how much of their threats are a bluff.

On the other hand, as I wrote last year:

The relationship between China and the United States today is superficially similar to that between Great Britain and Germany in 1914. Germany and China — the rising industrial behemoths, fiercely nationalistic and determined to establish themselves and their currencies on the world stage. Great Britain and the United States  — the overstretched global superpowers intent on retaining their primacy and reserve currency status even in spite of huge and growing debt and military overstretch.

Mutually assured destruction can only act as a check on expansionism if it is credible. So far, no nation has really tested this credibility.

Nuclear-armed powers have already engaged in proxy wars, such as Vietnam. How far can the limits be pushed? Would the United States launch a first-strike on China if China were to invade and occupy Taiwan or Japan, for example? Would the United States try to launch a counter-invasion? Or would they back down? Launching a first-strike is highly unlikely in all cases — mutually assured destruction will remain an effective deterrent to nuclear war. But perhaps not to conventional war and territorial expansionism.

The chance of global war in the near-term remains very low. But so long as China and Japan continue their antagonism, the chance of global war in the long-term is rising.

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Why Modern Monetary Theory is Wrong About Government Debt

I’ve taken some criticism — particularly from advocates of modern monetary theory and sectoral balances and all that — for using total debt rather than just private debt in my work.

The modern monetary theory line (in one sentence, and also in video form) is that government debt levels are nothing to worry about, because governments are the issuer of the currency, and can always print more.

This evokes the words of Alan Greenspan:

The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.

Of course, the point I am trying to make in worrying about total debt levels is not the danger of mass default (although certainly default cascades a la Lehman are a concern in any interconnective financial system), but that large debt loads can lead to painful spells of deleveraging and economic depression as has occurred in Japan for most of the last twenty years:

Japan-Debt-Hoisington-27

Of course, before the crisis in America (as was the case in Japan at the beginning of their crisis) government debt was not really a great contributor to the total debt level, meaning that the total debt graph looks far more similar to the private debt line than the public debt line, which means that when I talk about the dangers of growing total debt I am talking much more about private debt than public debt:

010212_2140_TheDebtwatc1

But what Japan empirically illustrates is the fact that all debt matters. Japan’s private debt levels have reset to below the pre-crisis norm, yet the economy remains depressed while public debt continues to climb (both in absolute terms, and as a percentage of GDP). If excessive private debt was the sole factor in Japan’s depression, Japan would have recovered long ago. What we have seen in Japan has been the transfer of the debt load from the private sector to the public, with only a relative small level of net deleveraging.

And high and growing public sector deficits often lead to contractionary tax hikes and spending cuts. This happened time and again during Japan’s lost decades. Peter Tasker of the Financial Times writes:

When Japan’s bubble economy imploded in the early 1990s, public finances were in surplus and government debt was a mere 20 per cent of gross domestic product. Twenty years on, the government is running a yawning deficit and gross public debt has swollen to a sumo-sized 200 per cent of GDP.

How did it get from there to here? Not by lavish public spending, as is sometimes assumed. Japan’s experiment with Keynesian-style public works programmes ended in 1997. True, they had failed to trigger durable economic recovery. But the alternative hypothesis – that fiscal and monetary virtue would be enough – proved woefully mistaken. Economic growth had been positive in the first half of the “lost decade”, but after the government raised consumption tax in 1998 any momentum vanished. Today Japan’s nominal GDP is lower than in 1992.

The real cause of fiscal deterioration was the damage done to tax revenues by this protracted slump. Central government outlays as a percentage of GDP are no higher now than in the early 1980s, but the tax take has fallen by 5 per cent of GDP since 1989, the year that consumption taxes were introduced.

A rise in debt relative to income has historically tended to lead to contractionary deleveraging irrespective of whether the debt is public or private.

The notion at the heart of modern monetary theory that governments that control their own currency do not have to engage in contractionary deleveraging remains largely ignored. Just because nations can (in a worst case scenario) always print money to pay their debt, doesn’t mean that they will always print money to pay their debt. They will often choose to adopt an austerity program (as is often mandated by the IMF), or default outright instead (as happened in Russia in the 1990s).

And what governments cannot guarantee is that the money they print will have value. This is determined by market participants. In the real economy people in general and creditors (and Germans) in particular are very afraid of inflation and increases in the money supply. History is littered with currency collapses, where citizens have lost confidence in the currency (although in truth most hyperinflations have occurred after some great shock to the real economy like a war or famine, and not solely as a result of excessive money printing).

And there has always been a significant danger of currency, trade and political retaliations by creditors and creditor nations, as a result of the perception of “money printing”. Many, many wars have been fought over national debts, and over currencies and their devaluation. One only has to look at China’s frustrated rhetoric regarding America’s various monetary expansions, the fact that many Eurasian creditor nations are moving away from the dollar as a reserve currency, as well as the growth of American-Chinese trade measures and retaliations, to see how policy of a far lesser order than the sort of thing advocated in modern monetary theory can exacerbate frictions in the global currency system (although nothing bad has come to pass yet).

Governments controlling their own currencies are likely to continue to defy the prescriptions of the modern monetary theorists for years to come. And that means that expansionary increases in government debt relative to the underlying economy will continue to be a prelude to contractionary deleveraging, just as is the case with the private sector. All debt matters.