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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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.

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.