Monday, February 20, 2012

Japan Can't be Greece if it Tried

I recently read this piece and I feel it would be perfect to write a response on it.  Yes I disagree on a lot of the parts, but it is wonderfully written with deep insights and contain many of the Japan is unsustainable arguments I have been hearing for years now.

Greece is not alone; Japan has also dug itself a bottomless debt pit. In a perspective view: the United States currently has a debt to GDP ratio around 98%. Greece has a debt to GDP ratio of 160%. Japan, on the other hand, has an incredible 235% debt to GDP ratio.

Japan should never be lumped in with Greece.  Greece is in dire straits because it is not a currency issuer.  It is on the hook for a lot of euros yet it lacks the printing press to meet that obligation.  Japan's debts are in yen, which its government has unlimited supplies of.  Thus its problems are of an entirely different nature, mainly productivity and population growth.

The Bank of Japan has consistently attempted to control yen appreciation by repurchasing government bonds, also known as quantitative easing. A bond repurchase inflates the monetary supply of an economy and effectively depreciates national currencies. In fact, over the last year alone, the Bank of Japan engaged in three rounds of quantitative easing to no avail...   Finally, according to Goldman Sachs, "foreign ownership of Japanese debt is on the rise, going from 5% last year to around 8%. The share of short-term debt held by foreigners has now doubled in the last decade to just below 20%." Foreign ownership means Wall Street, and when Wall Street enters the picture, Japan is no longer a contained debt-fueled economy. It is a deficit bubble about to explode.

Repurchasing long term government bonds from banks (which is where we got the QE idea from) does not increase the effective private sector money supply and does not devalue the currency.  However I do admit the perception of currency devaluation is incredibly important in the fiat world and thus I am not blind to real-world effects of QE.  In fact, the BOJ might be banking on that fact as it begins another round of QE.  QE does not increase total assets in the private sector because it is an exchange of of two assets in equal amounts.  From the bank's perspective this is actually a negative draw on liquidity as they lose out on potential coupon payment.  Does money supply technically grow?  Yes, but the money sits as extra reserves at the central bank and for all intents and purposes never touches the private sector.  I have long assumed that it is potentially inflationary if it gets lent out, but I have recently realized that reserves do not quite work that way.  This will be explained in another piece.

This is purely an interest rate exercise trying to stir up demand for credit rather than a yen depreciation move, which is why the yen continued to strengthen even with QE x 1000.  This is sustainable because the government bond market is not a free market.  Government bonds are a tool for the central bank to target interest rates.  Sometimes, the private sector can get a good deal on them, sometimes not.  The government and central bank do not consider that to be high on their list of priorities.  Because the government never needs funding, it does not really care who ends up holding them.  (See this.)  As long as the banks (in America, the primary dealers) hold enough of them for the Bank of Japan to target interest rates effectively, the job is done.  Once again, the government is only concerned with keeping rates of inflation non-volatile.  This will also be explained in an upcoming piece.

Next, Japan's ills are not because of the large public debt.  In fact, I would argue that the public deficit is single handedly saving them from a deeper depression.  Once again, remember that deficits are just government disbursements minus taxation.  So a big deficit just means that the government is pumping a lot of yen into the private sector.  Yet we look at inflation and it has been at 0 for a while now.  I would argue that if the public debt was smaller, thus less amount of money in the public sector, then Japan would be knee deep in a deflationary spiral.  However, I wonder if a deflationary spiral is exactly what's needed to kill off all unworthy companies and then rebuild from scratch.  It's the case of ripping off the bandaid versus letting it hang on for two decades.

Fourth, Japan seems to be stuck in quicksand because in some ways it is.  The Bank of Japan and the Japanese Ministry of Finance should be seen as a husband and wife where they move toward a similar goal--either increase in money supply/increase in credit demand or decrease in both.  What we have now is essentially domestic violence.  The Ministry has been hellbent on increasing taxes (most recent one in political limbo as of 2/24), which would essentially decrease private sector money supply while BOJ continues to lower interest rates, trying to increase demand for credit.  As an outside observer, this makes no sense.  Combine this with loads of zombie banks/corporations who have no business still being in business and Japan may continue to wallow, but not end up like Greece.

I do agree that the yen should weaken going forward, but that has more to do with Japan's decrease in productivity rather than quantitative easing.  However, there is an equilibrium point to all this.  As an exporter nation, eventually the yen will weaken enough that export companies will start making good profits again.