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Forget Cyprus, Japan Is The Real Crisis
Asia Confidential on 03/23/2013 12:00 -0400
Forget Cyprus. A much bigger story in the coming weeks and months will be in Japan, where one of the greatest economic experiments in the modern era is about to begin. A country where government debt even dwarfs those of Europe's crisis-ridden nations, Japan will attempt to inflate its way out of a 23-year deflationary spiral.
The overwhelming consensus among the world's economists is that quantitative easing (QE) has saved the day in the U.S. and that Japan needs to follow suit, on a larger scale. I beg to differ and suggest this policy will almost certainly lead to a hyperinflationary disaster in Japan. If that's right, it will have serious ramifications for other countries, dragged down by an acceleration of the so-called currency wars. More broadly though, it is likely to destroy the myth pushed by today's economists that QE is a cure-all for downtrodden economies. It isn't and Japan will become the template to prove it.
Monster stimulus on the way
The new Bank of Japan (BoJ) Governor, Haruhiko Kuroda, started work on Thursday and his first day on the job disappointed investors. At a press conference, Kuroda pledged to do whatever it takes to defeat deflation and reiterated the government's target of 2% inflation. But he provided little in the way of specifics and investors promptly bought the yen and sold stocks.
More concrete measurers will almost certainly come by the central bank meeting on April 3-4. There are good odds that they may come even earlier via an emergency meeting of the bank.
It's widely expected that the BoJ will expand its 101 trillion yen (US$1.06 trillion) asset buying program by more than 10 million yen. Also, it will start buying Japanese government bonds with remaining maturities of up to five years by scrapping the upper limit of three years by the end of April.
The idea behind the strategy is that you create money out of thin air, use that money to buy government bonds off private institutions and others, thereby increasing money supply and possibly inflation. Also, the institutions will start lending the money out, thereby kick-starting spending and the economy. That's the theory anyhow.
What was fascinating to watch was the verbal sparring between the outgoing and incoming BoJ governors. In Japan, where group consensus rules, this was almost an outright brawl.
Outgoing Governor Masaaki Shirakawa has never been a believer in the inflationist policies of the new government and he didn't mince his words in his final days in office:
"Even if prices rise 2% and wages do the same, that won't mean an improvement in people's living standards ... what we want to achieve is an increase in real economic growth...
... Past figures in Japan as well as in Europe and the U.S. show that the link between monetary base and prices has been broken."
The latter refers to the fact that printed money in the U.S. and Europe hasn't flowed through to economies as banks have sat on the money rather than lent it out.
And if Shirakawa wasn't clear with the above, he was with the following:
"If there was one single measure that would have resolved the problem, just like clearing a fog, then we wouldn't have been in this state for the past 15 years."
The new BoJ chief, Haruhiko Kuroda, wasted little time trampling on his predecessor's legacy. Though couched in economic jargon, his statements were clear enough: Shirakawa was part of a failed era of central banking and something new needed to be done:
"It's very important for the BoJ to make itself responsible for the 2% [inflation] target by a certain period ... We should not make excuses that it wasn't our responsibility if we fail to achieve it."
"In the long term, the correlation between money supply and inflation is high."
In other words, if we print enough money, inflation will come. And we'll do whatever it takes to get the job done.
Is it the right path?
The sparring between the two central bankers isn't just an arcane discussion. It's part of a much larger debate about the effectiveness of stimulus policies. And it matters because Japan is the world's third-largest economy and it's about to pursue these policies on a grander scale.
What's amazing is the extent to which those advocating stimulus in the slow-growth developed world now dominate public debate. Consider a recent article by Financial Times columnist Martin Wolf, entitled "The sad record of fiscal austerity". In it, Wolf takes Europe to task for enforcing spending cuts while their economies were in dismal shape:
"By adopting [outright monetary transactions], the [European Central Bank] could have prevented the panic which drove the [credit] spreads that justified the austerity. It did not do so. Tens of millions of people are suffering unnecessary hardship. It is tragic."
He goes on to recommend a mix of stimulus, increased public spend and structural reforms to help Europe's plight. And he finishes with this:
"In the long run, the fiscal deficit must close. In the short run, the UK has the chance to pursue growth. It should take it. So should the US."
The arguments of Wolf and others of his ilk can be crudely summarised by three facts, which most of them would regard as beyond dispute.
Fact 1: The U.S. recovery proves stimulus works and the recovery will happen faster if there's more aggressive QE.
Fact 2: Europe remains in the doldrums because it's pursued spending cuts which have failed to repair economies.
Fact 3: Japan has never tried aggressive stimulus to overcome its long-term deflation problem and it needs to follow in U.S. footsteps immediately.
Given these are "facts" beyond dispute, let me dispute them.
Fact 1: It is far too early to tell whether U.S. stimulus policies have worked. They have propped up the economy in the short-term, but whether that's sustainable in the long run is open to question. Even in the short-term though, the recovery has been slow and unimpressive. Consider: 2012 GDP growth of 2.2% vs a post World War Two average of 3.2%, a current unemployment rate at 11.3% if you include that have dropped out of the workforce since 2008, real household incomes are still 10% below levels in 2000 and the velocity of money (M2) is the lowest in more than 50 years (indicating printed money hasn't circulating into the real economy).
Fact 2: Europe hasn't pursued austerity. Anyone who says it has is lying. But it makes for a nice political argument in favour of stimulus. European total debt has kept climbing, now at 390%, as the private sector hasn't paid down any debt, while governments have increased their debt portions. No cutbacks here!
And for the curious, unlike QE, there is some historical evidence that austerity can actually work. In my neighbourhood of Asia, the financial crisis of 1997-1998 brought tremendous pain to many Asian countries, but through austerity and sweeping economic reforms, they recovered relatively quickly and in much better shape.
Fact 3: Those that claim that Japan has never pursued aggressive stimulus are talking rubbish. But again, it's nice propaganda for Keynesian advocates. From 2001-2006, Japan embraced large-scale stimulus, with its monetary base increasing by a mammoth 36% year-on-year at its peak. During the period, the monetary base rose 82% in total. But economic growth was never revived, the currency rose rather than fell and inflation continued to decline. QE in Japan was dropped because it was seen as failing.
So the question must be asked: will the conventional wisdom advocating enormous stimulus be Japan's saviour or its noose?
Why Japan will fail
The subtitle indicates where I stand on the matter. Given its over-indebtedness, Japan has few good options left. But the policies being pursued by Shinzo Abe will fast-forward a major debt and currency crisis. It's a matter of when, not if.
Government debt to GDP in Japan is now 245%, far higher than any other country. Total debt to GDP is 500%. Government expenditure to government revenue is a staggering 2000%. Meanwhile interest costs on government debt equal 25% of government revenue.
There's no way that Japan will ever repay this debt. It has two main options: either go through extraordinary pain by cutting back on government expenditure or print substantial money to inflate some of the debt away.
Japan is choosing the second option, as are most governments around the world. It would rather print money than cut spending and doom the economy to a substantial contraction. The choice to print money though will result in an even more painful and drawn-out outcome.
It's inevitable that the yen will fall further from here, potentially much further. I've previously said that the yen at 200 or 300 on the dollar would not surprise. This could prove optimistic.
It also seems inevitable that Japanese interest rates will rise and bonds will sell off. Yields have to rise to just 2% for interest costs on government debt to take up 80% of government revenue. The jig will be up well before that though.
Those that argue this won't happen as 91% of Japanese government bonds are held by domestic investors are missing some key points. Foreign ownership of bonds is rising as domestic investors need more money to fund their retirements (Japan's rapidly ageing population). Foreigners will demand higher yields for the risks that they're taking on. And even domestic investors aren't going to sit by earning 0.6% on a 10-year bond as hyperinflation takes hold and the currency tanks.
Currency wars to begin in earnest
Talk of currency wars has been on the backburner for a few months. Expect that talk to heat up and become a reality as Japan ramps up stimulus in the next two weeks.
The likes of South Korea and Taiwan are already suffering from the sharp fall of the yen. They, and many others such as Germany and emerging countries, aren't going to sit by and watch their exporters get priced out of the market by the Japanese. They'll retaliate with currency depreciations of their own and the currency wars will be on in earnest. But the question is whether these countries will be able to keep up with a hyper-inflating Japan. I highly doubt it.