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Sunday, March 02, 2014

The Growing Mess Which Will Be Left Behind By The Abenomics Experiment

According to wikipedia, "overdetermination is a phenomenon whereby a single observed effect is determined by multiple causes at once, any one of which alone might be enough to account for ("determine") the effect.That is, there are more causes present than are necessary to generate the effect".  In this strictly technical sense Japan's deflation problem is overdetermined - there are multiple causes at work, any one of which could account for the observed phenomenon. Those who have been following the debate can simply choose their favourite - balance sheet recession, liquidity trap, fertility trap - each one, taken alone, could be sufficient as a cause. The problem this situation presents is simply epistemological - in a scientific environment the conundrum could be resolved by devising the requisite, consensually grounded, tests.

But I would here like to use the term "overdetermination" in another, less technical, sense, since it seems to me Japan's problem set is overdetermined in that we always seem to be facing at least one more problem than we have remedies at hand.

The case of the country's ongoing energy dependency which is producing a growing trade and current account deficit would be a good example. Notionally the problem forms part of the legacy of the tragic tsunami which hit the country in March 2011 and lead to the decision to phase out  nuclear energy capacity.  But now  that decision has been reversed, and starting this summer nuclear generating capacity is once more to be "phased up". The issue is, from a strictly economic point of view would that be good news? Well, it would certainly help with the deteriorating trade balance:

But what about deflation? Would having cheaper domestically produced energy help here? Wasn't generating inflation supposed to be the whole point of the Abenomics exercise? Don't rising energy costs constitute the lions share of the country's recent, much heralded, inflation? Damned if I do, and damned if I don't would seem to be the only conclusion to draw. A win-win policy which both closes the trade deficit and foments inflation (if that's what you think Japan needs) doesn't seem to be on the table. The trade deficit could also be corrected by reducing the fiscal deficit, but that would lower domestic demand, possibly send the economy back towards recession and almost certainly ignite deflation yet one more time.

Falling Real Wages

In this very context Takashi Nakamichi had a timely post on the WSJ blog last week. What is going to happen to Japanese inflation, he asks, if the yen does not undergo another significant depreciation? "Barring another major drop in the yen", he points out,  the earlier "exchange-rate effects will start to fade from this spring. Friday morning, the yen was trading around Y102 to the U.S. dollar – about the same level it was last May".

In fact - leaving aside the  possible impact of next April's consumption tax increase - the inflationary wave which followed the yen's sharp depreciation (around 20% in the months between October 2012 and May 2013) may well already be waning. Annual inflation as measured by Japan's general price index fell in January from 1.6% to 1.4%, while it remained the same on both the core (1.3%, ex fresh food) and the core-core (0.7% ex fresh food and energy).

As Nakamichi points out, roughly half of the current inflation in consumer products is due to the dramatic drop in the value of the yen. The drop has sharply inflated the costs of imports, especially energy imports, and these have partly been passed on to consumers. While many consumers in developed countries have been benefiting from lower energy costs, in Japan the costs of liquid natural gas — now a main source of power generation — were up 17% over a year earlier. In addition, "the Japanese also saw sharp rises in prices of foreign-made home electronics, which they increasingly import: Prices of washing machines were up 13%, while prices of audio equipment and refrigerators both rose 16%".

Even the 0.7% annual rise in core-core inflation isn't all it seems to be, since some 40% of the increase is accounted for by a one-off rise last year in charges for accident insurance and public services. The key point to grasp in all this is that the rise is due to what we could call "cost push" rather than "demand pull". As Takeshi Minami, chief economist at the Norinchukin Research Institute put it,“Those increases had little to do with demand and supply.”

Initially private consumption surged in Japan on the back of the sharp rise in stock values which went hand in glove with the yen devaluation, rising by  an annual 5.2% in March 2013. Subsequently it has fallen back and the rate of increase was just 1.1% in January, despite the "consume now" stimulus of a looming tax hike. In recent quarters what has most driven domestic demand has been private residential investment (in the anticipation that prices might finally start rising) and public spending on infrastructure projects as part of the "second arrow" stimulus programme (see chart below which comes from Deutshe Bank's Michael Spencer).

 The basic reason for the weakness in domestic consumption is obvious. Japanese real wages keep falling.

"Over the past 15 years, wages have dropped 15 percent. In the 11 months through November 2013, pay for the average worker rose only 0.2 percent. Households’ real income fell 1.7 percent in December from the previous year. Base wages, excluding overtime and bonuses, fell 0.2 percent in December, the 19th consecutive month they’ve dropped. The issue of wages, says Martin Schulz, an economist at Fujitsu Research Institute, “is a litmus test for whether Abenomics works or falls apart.”" 
Japan, Land of the Falling Wage By Bruce Einhorn, Jason Clenfield, and Yuko Takeo, Bloomberg 
Naturally  with so many different measures of wages and earnings to choose from, not everyone is convinced this is such a problem. FT Alphaville's Cardiff Garcia, for example, has a good try at rescuing some sort of wheat from all the chaff in order to demonstrate that things aren't as bad as they seem to be. Latching onto an argument presented by Capital Economics, he suggests that even with falling real hourly wages during an economic expansion if bonuses and employment growth mean that total earnings increase, so can consumption:
"The silver lining is that rising employment may partly offset the drag on aggregate incomes from falling real wages. Firms are happy to recruit more staff even if they are not yet ready to boost individual pay. Indeed, the total number of people in work has risen by around 1.5% in the last year. However, many of the new jobs are part-time, leaving most households still worse off."
Capital Economics research report.
But is there really empirical evidence to back up the idea earnings are in fact increasing? And what about the forthcoming rise in consumer tax, that will surely add to inflation. In this sense it must be good for the economy, musn't it? Not so fast say the editors at Japan Consuming, who in their February bulletin make the following very reasonable point:
Retailers are bracing themselves for consumer reaction to the increase in Consumption Tax. Retailers may be worried, but some consumers are looking at a serious change to their spending patterns if incomes don’t increase soon. Although the last tax rise in 1997 caused relatively minor sales disruption in the end, it came at a time when deflation was lowering prices and incomes were high – the highest on record in fact. This time around, incomes are falling just when prices are rising, making a sudden, doubling in direct taxes a potential disaster for the average Japanese household. But the situation is already bad: in the past year there has been a 24% fall in cumulative net annual disposable income, with the average family finishing with a [saving] surplus of less than half that of 2007. The surplus will be wiped out by the tax increase.

In 1997 an earlier LDP government increased the consumption tax to 5%, plunging the economy into recession. As now, in the year before the increase, consumers pushed up spending, but incomes on that occasion incomes were on  the rise supporting consumption. The household saving surplus also hit a peak of ¥142,000 during the 12 months following the rise.

Fasting-forward to 2014, real average incomes are now 12% below the 1997 level. Expenditure too has fallen, if by slightly less: down 8.6%.  On the other hand household saving for 2013 was 14.3% down on 1997 at just ¥106,962 per household, a fifth of one month’s income or just ¥8,900 a month on average. According to Japan consuming calculations, everything else being equal, a 3% rise in consumption tax will raise average monthly expenditure by ¥12,500 leaving a typical household ¥3,600 in arrears.

As they point out, these figures involve using a second average of the monthly averages of the past 12 months. So..........
"Taking the month to month cumulative totals of consumption expenditure and household disposable income, in 2007 total net disposable income exceeded expenditure by ¥393,493 for a typical two-person working household. This figure fell with the Lehmann Shock, but then rose slightly to ¥272,432 in 2011, still 30% down on 2007. It has since dropped further. In 2013, the generally increased levels of consumption were coupled with further falls in overall average disposable income. With a net short-fall of around ¥130,000 per household as of November, double the same month in 2012, more optimistic observers expected large end of year bonuses to turn this deficit around. These did not materialize – bonuses did rise in December 2013 but by only 2.8%, way down on the 6.4% rise in the summer. The result was an astonishing fall in cumulative net annual disposable income of 24% in the past year, with the average family finishing with a surplus of just ¥160,418, less than half that of 2007 on this basis."

Ergo, even allowing for the impact of bonus payments and and increased part time employment net annual disposable income fell. Hardly a strong support for rising consumption.

Monetary Policy Impotence

So what about credit? Isn't that the mechanism which allows consumer spending to rise despite falling net incomes in countries like the US and the UK? Well not in Japan, as this Bloomberg chart of the day from February 20 makes plain.

The loan to deposit ratio in Japan's banking system - at around 70% - is one of the lowest on record and the money multiplier fell in January to the lowest since 2003, when data became available, signaling the amount of money in the economy dropped relative to funds provided by the BOJ. Naturally, according to your preferred theory explaining what the problem is in Japan you will read this data one way or the other, but personally I see it as a clear sign of the decline in demand for loans which you could expect to see in a country with an ever older population.

Whichever way you look at it, it is clear that the preferred mechanism for overcoming deflation - using monetary policy to generate inflation expectations and increased "demand pull" inflation - simply isn't working:  the increase in base money isn't passing through to broader money in the economy.

But it's worse, the monetary expansion has driven down the value of the yen but in the context of the second arrow - a double digit fiscal deficit - this drop in value is leading to a growing not a declining trade deficit. The FT's Tokyo bureau chief, Jonathan Soble, has an enlightening recent piece on this.
‘J-curve’ recovery eludes Shinzo Abe as trade deficit balloons

The widening of Japan’s trade deficit to an unprecedented Y2.79tn ($27.4bn) in January, more than Y1tn larger than the previous record, highlights a painful structural shift for an economy that has long relied on exports to drive its growth. For economists who follow Japan, the phenomenon might be called the case of the missing J-curve.

When the yen began falling sharply in late 2012, menaced by the threat of devaluation from Shinzo Abe, the soon-to-be prime minister, it made imports more expensive and dragged an already sizeable trade deficit more deeply into negative territory. That is exactly what economic textbooks predict would happen.

But theory, and past experience in Japan, suggested things would quickly turn round: consumers would respond to the rising cost of foreign goods by buying fewer of them, while Japan’s exports would become more competitive. Before long, the initial deterioration would be followed by an even more pronounced improvement: economists’ “J”-shaped curve. Yet that has not happened. Instead, imports have continued to bound ahead of exports, creating ever-widening trade deficits and leaving Japan’s Abenomics recovery, the roughly year-old spurt of economic growth that has coincided with Mr Abe’s expansionary policies, reliant on domestic spending.

Stimulating the Unstimulatable?

But where is this domestic spending coming from? Not from earnings, nor from credit, as we have seen. It is coming from the government stimulus programme, which is, in an economy near its output potential, simply ballooning the trade deficit. "Sorry, what was that you just said?" "Run that past me again?" "In an economy running at near its potential output level?????" Yup, I think this is the heart of the problem. Most of the theories people are working on assume that the Japanese economy is running at way below potential, and that something extraordinary needs to be done to change this dynamic. As Larry Summers put it in his IMF speech, "we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity holding our economies back below their potential".

But what if that view is wrong, and the aforementioned economies are not operating at below their potential.? What if their trend growth rates are systematically falling as populations age and working age populations fall?

And what if Japan's deflation is a product of this process, rather than being a simple liquidity trap? In the words of former Bank of Japan governor Masaaki Shirakawa, "Seemingly, there would be no linkage between demography and deflation. But it may not be the case. A cross-country comparison among advanced economies reveals intriguing evidence: Over the decade of the 2000s, the population growth rate and inflation correlate positively across 24 advanced economies. That finding shows a sharp contrast with the recently waning correlation between money growth and inflation."

If Shirakawa is right all the ongoing attempts to reflate the Japanese economy may be simply working against history, with the central bank governors sitting there, like modern Canutes, trying to order back the waves. Maybe the theoretical debate is far from over, but the evidence is mounting that Abenomics may lead Japan's economy to shipwreck, tossed between the Charybdis of a growing external imbalance and the Scylla of a deflation driven monetary black hole.

In the meantime, and while we decide, that government debt mountain simply grows and grows.

See Also

A Simple Chart Illustrating Why Japan Style Deflation Is Now More Or Less Inevitable In Spain

The Real Experiment That Is Being Carried Out In Japan

The A-b-e Of Economics


Monday, May 13, 2013

The Real Experiment That Is Being Carried Out In Japan

The future never resembles the past - as we well know. But, generally speaking, our imagination and our knowledge are too weak to tell us what particular changes to expect. We do not know what the future holds. Nevertheless, as living and moving beings, we are forced to act. - John Maynard Keynes

Discussions of the population problem have always had the capacity to stir up public sentiment much more than most other problems. - Gunnar Myrdal

Last Thursday the yen broke through the psychological threshold of 100 to the US dollar. On Friday the slide continued (see chart), even dropping very close to 102 to the USD at one point before strengthening slightly on the run in to the G7 finance ministers meeting.

The ostensible source of the sudden shift was a news release from the Japanese Ministry of Finance detailing the fact that Japanese investors bought a net total of 514 billion yen ($5.2 billion) in foreign bonds during the two weeks to May 3. Speculation had been rife that Japanese money funds would start to respond to continuing yen weakness and low Japanese yields by investing abroad. It is still far from clear that this is really going to happen in the short term, but nonetheless the news was sufficient to spark bets on more yen weakness.

Naturally the fall has drawn comment, especially during the run up to last weekend's G7 meeting. US Treasury Secretary Jack Lew told CNBC that while Japan had "growth issues" that needed to be dealt with its attempts to stimulate its economy needed to stay within the bounds of international agreements to avoid competitive devaluations."I'm just going to refer back to the ground rules and the fact that we've made clear that we'll keep an eye on that," he said in a comment that was widely seen as drawing a red line in the sand.

But really, what else do external observers expect? On 4 April Bank of Japan governor Haruhiko Kuroda announced he was going to increase the money base by 1% of GDP per month for the next two years. That is to say Japan's monetary expansion will be incremental and continuous. Kuroda has even stated he will continue to increase the money base beyond the initial 24 months if the targeted inflation doesn't come. It was always clear that the country was going to have a difficult time trying to generate inflation and that one of the knock-on consequences would be to continually weaken the yen. So you can't realistically expect him to turn round and say now, "sorry, we didn't know it would offend you so,  I'm cancelling the policy". Anyway, that move would throw financial markets straight into turmoil. Didn't they understand what they were signing up to when they accepted "Abenomics" at the last meeting?

Obviously there is still a considerable amount of confusion around about what exactly Japan's problem is, and what the policy is trying to achieve. I have tried to examine the more theoretical background to the problem in my  A-b-e of economics post, but looking through the comments to that piece I realised that I was very tightly focused on one, examining only one aspect of what has come to be known as Abenomics, the inflation targeting component and its theoretical justification. Since ideas about what exactly it is the Japanese government is trying to achieve seem to be many and various, I thought it might be worth coming back and taking a second look at the experiment.

Three Arrows Into The Sunset

The aim of Abenomics is obviously to shake Japan out of its deflationary lethargy and return the country's economy to a more pronounced growth path. In order to achieve this Japan's Prime Minister has notoriously identified three policy arrows, or transmission mechanisms:

1) Aggressive monetary easing
2) Strong fiscal stimulus
3) An extensive programme of growth enhancing structural reforms

Achieving the inflation target is effectively the key objective of the first arrow, and weakening the yen is basically the transmission mechanism which achieves the objective. In fact while we have heard a good deal concerning the first two arrows, there is still relatively little on the table regarding the third one, as some commentators have started to wryly note.

Since there are many possible pathways along which these arrows may pass, it is probably worth taking a look at the big picture story in all its glory. To do that the following chart from Ritchie King at Quartz (who adapted it from a piece by Nomura economists) should serve as a very handy visual aid.

Central to the model is naturally the idea that generating inflation expectations can kick-start the economy. To help us think a little more about what that involves let's take a quick look at a non-Japan-related chart - the Spanish retail sales one.

Notice the sharp spike in August 2012? Just what happened to cause that to happen? Essentially the Spanish government decided to raise consumption tax by 3 percentage points from September, so many consumers decided to advance their purchases to avoid the perfectly foreseeable coming inflation. The tax increase pushed up Spain's CPI a couple of percentage points, and this effect will stay in the data till September 2013, when - guess what - the country might even fall into (irony of ironies) deflation. The reason the rise in the CPI may be followed by a slump into deflation is because the move was a deficit reduction one in an economy which is in ongoing deep recessionary mode, and evidently failed to restart the economy (no one thought it would) since retail sales then fell back onto their previous downward path. Hey, and guess what, Spain's population just started to shrink. No possible connection I suppose?

A chart like this could be produced for a whole range of different economies on Europe's periphery, but the point here is this, generating inflation expectations only advances sales, and doesn't generate new ones, unless you implant the idea  that the inflation will be permanent and ongoing, and will be followed by more inflation and so on, leading people to the conclusion that it is better to get rid of their money by spending it rather than holding on to it for their old age. Whoops!

The most important arrow to leave Shinzo Abe's bow to date was fired by the steady hand of his helmsman, Bank of Japan governor Huruhiko Kuroda, and this has been the massive monetary easing one. According to the plan announced following their April 4 meeting the BoJ will conduct monetary market operations which will increase the monetary base on a monthly basis at the rate of about 5 trillion yen a month. In this way the base will be raised from 138 trillion yen at the end of 2012 to 200 trillion yen at end of 2013 and 270 trillion yen by the end of 2014.

This amounts to a massive increase in base money to around 50% of GDP (see chart from Citi analysts below), but what is important is to note the incremental and continuing character of the ramping up - by about 1% of GDP a month. And if this isn't enough Bank of Japan governor Kuroda has already said he is willing to continue the easing process beyond the initial two years. In effect the policy will continue for as long as it takes. I think this is called a "the sky's the limit" approach.

Yen Devaluation Means Exports Are Up

Anticipation of the move (which was announced by Abe in the autumn of last year) has been successful in driving down the yen, which has now fallen by around 30% against the euro since last summer (see chart below), and by around 25% against the dollar. Naturally, as we have been seeing at the end of last week, we should expect more of the same to come. Plenty of it. As much as it takes.

This reduction in the value of the yen has evidently helped exports, but not by that much so far. They were up 1.1% over a year earlier in March.

But Deflation Stubbornly Continues

Naturally the sharp rise in the cost of imports this produces is generating cost pressure, but not enough to kick the country off the deflation path so far.

Indeed the Bank of Japan's favoured index, which includes energy but not the cost of  fresh food, saw deflation accelerate in March to an annual price fall of 0.5%, the fastest rate in two years. And what inflation there is in the pipeline - electricity tariff hikes to cover mounting losses among the producers as energy import costs rise - was described by Bloomberg journalists Tsuyoshi Inajima and Brian Swint as the "wrong kind", a statement which highlights the amount of confusion there is abroad about just what it is that the BoJ is supposed to be achieving.

To back their point they cite Klaus Baader, chief Asia Pacific economist for Societe Generale in Hong Kong to the effect that “this isn’t the kind of inflation we want in Japan to break the deflation mindset. We’d like inflation that is a reflection of higher wages, whereas this is pure cost inflation that decreases purchasing power.”

Maybe this cost push inflation is the "wrong kind" for some adherents of Abenomics, but it is the only kind they are going to get. Those who have gone through the structural lack of demand argument I advance in other posts will have realised that there is permanent downward pressure on costs in an environment of constant oversupply (this is why there is deflation in the first place)  making inflationary wage increases difficult to envision. Indeed, as reported by another group of Bloomberg journalists (Masaki Kondo, Mariko Ishikawa and Yumi Ikeda), reality itself belies such expectations, since Japan's wage index hit a post 1992 low in January, even if it has bounced back a little since.

Hardy evidence for looming wage pressure. Indeed the wage-increase-driven inflation argument in Japan curiously resembles a similar one advanced for Germany - in both cases adherents tend to forget that market economies are not centrally planned, even by central bankers, and while you can possibly target equities in a long term deflationary economy caught in a liquidity trap you can't target wages. Put another way, it simply isn't clear what the mechanism which fuels the extra wages that some people are expecting actually is, or why company CEO's should be influenced by massive liquidity in precisely this way.

The central problem in Japan is constant oversupply, given technical change and a stagnant market, and hence there is permanent price pressure on companies to maintain their share of what market there is. Thus it isn't surprising to find the following statement in the latest Japan manufacturing PMI report:

"While supporting a rise in exports, a further impact of a weaker currency was to raise the price of imported raw materials. Latest data showed that average input costs rose for the fourth month in succession, and at the sharpest rate in over a year- and-a-half. Margins subsequently remained under pressure as a net fall in output charges was recorded for the twenty-first month in a row."

So raw material prices rose for the fourth month in succession, while the final product (output) price fell for the twenty fourth successive month. If the demand isn't there you simply can't raise prices, or wages. That there isn't a basic understanding of this reality after so many years of deflation simply astounds me. You could argue that making money cheap and plentiful might encourage people to borrow a bit more and consume more, but borrowing to give some more away in wages, under market economy conditions I simply don't follow the logic.

In fact Japan's banking system is awash with deposits, deposits which simply can't find enough loans to finance, even at interest rates on long term loans which are under 1%. Deposits in the banking system exceeded loans by 186 Trillion yen in March (around 30% of GDP), and the situation is unlikely to change. Much more likely than handing out money to wagearners is that banks who are awash with cash invest in one the country's private equity funds, for which Bloomberg reports there is growing interest. Those who have been around long enough to remember the Bull-Dog Sauce Co affair may be forgiven if they roll their eyes at this point.

If the idea is to put more money in peoples pockets so that they can spend more, then this is exactly what fiscal policy is there for. But Japan is already running a 10% deficit, and has sizeable deficits running back as far as the eye can see, and that approach hasn't worked to date, so there is no reason to expect it will start doing so now.

Here Comes My Umpteenth Economic Recovery?

Later this week we will surely open our newspapers (on Thursday to be exact)  to discover that the Japanese economy "bounced back to life" in the first three months of this year. Certainly it would be a huge surprise if it hadn't. But much as any good news will be welcome we should never forget that Japan has been struggling with its problems since the property bubble burst over 20 years ago. So there has been more than one disappointment along the way.

The sad truth about the Japanese economy is that the demand just isn't there. Indeed, despite a number of bullish "bravado type" articles ("Japan household spending surges as "Abenomics" gains momentum" -Stanley White and Kaori Kaneko, Reuters, or "Older shoppers lead Japan’s surge in consumer spending" - Ben McLannahan, Financial Times) nothing which has happened of late really changes that assessment.  What consumption indicators we do have are often contradictory. Thus, despite the fact that household spending "soared" 5.2 percent in March from a year earlier in price-adjusted real terms (clearly very good news), in the same month overall  retail sales actually fell 0.3 percent from a year earlier. The key point is that neither of these pieces of data is any way conclusive of anything, and especially since the policy itself didn't come into operation till April. To be convincing the consumption data would need to improve on a sustainable basis over months and even years.

Looking into the situation a bit further, though, it becomes clear that most of the positive dynamic in consumption is coming from big ticket and  luxury items, and the reason for this isn't hard to discern - Japan's Topix stock index is up 65 per cent over the last six months, its strongest rally in decades. But it is important to bear in mind that four-fifths of Japanese households have never held any securities at all and 88 per cent have never invested in a mutual fund, according to a survey carried out last year by the Japan Securities Dealers Association. So while those who do hold shares will benefit from a "wealth effect" (another of the channels in the diagram above, monetary policy puts spending power in the hands of the top 20%) it's always going to be a fairly minority affair.

But I would stress, since the BoJ measures were only announced on April 4 it is still far too early to be drawing any firm conclusions one way or the other.

It should also be borne in mind that Abe's second arrow is a boost to fiscal stimulus, and naturally we would expect to see some positive impact on spending coming from that. When you couple this spending with the boost to exports which comes from the weak yen then  it is quite clear the economy should be expected to perform better in 2013 than it did in 2012. But at the end of the day this isn't really what this experiment is about, since no one doubts extra fiscal spending adds to growth, and Japan isn't simply trying to emerge from a garden variety recession.

What matters is that the country needs to convincingly demonstrate its ability to "turn the corner" so as to start paying down all the sovereign debt it has been accumulating. Or at the very least it needs to generate sufficient inflation and growth as to reduce the size of the debt as a proportion of GDP. Maybe the economy can get a bit of "bang for the yen" from the various measures, but with the labour force set to decline for decades to come ongoing economic contraction becomes inevitable at some point.  What matters then is the debt and the deflation tandem and how this can be put on a more stable dynamic without resorting to draconian spending cuts which will surely reduce the size of the economy even further. This is what the Abe experiment is about, and this is why the economy needs inflation, but on that front we are still very much in "wait and see" mode.

Domestic Critics Await The Day Of Reckoning

One of the issues facing Abenomics is that while the approach has become highly fashionable abroad (and especially among Hedge Fund managers), back home there are a growing number of critics raising doubts it will actually work. Doubts about the ability to reach the inflation target even start with the current board of the central bank itself. Board members are divided over the outlook for inflation, with some anticipating that consumer prices won’t even be rising at half the targeted rate two years from now. Former investment-bank economists like Takahide Kiuchi and Takehiro Sato, themselves recently appointed to the board, voted against the statement which set down that the bank believes inflation is likely to reach 2 percent in the latter half of the three-year BOJ forecast horizon. Governor Kuroda, however, is more optimistic and thinks the goal will be achieved in the 2015 fiscal year.

If the current board members have their doubts, those from the outgoing one tend to be even more scathing. Masaaki Kanno, now chief Japan economist at JPMorgan Chase in Tokyo put it bluntly to Bloomberg journalists, "It’s unrealistic -- they won’t be able to reach their target in two years, or even in five." Kuroda's predecessor at the bank, Masaaki Shirakawa, is another who is far from convinced. Shirakawa sees deflation more as a symptom than a cause of Japan's problems which, he argues, have important demographic roots. "If there was a single thing that would have cleared the fog and solved all problems, Japan wouldn't have been in this situation for 15 years," he said in a speech on March 19, his last day in office. Journalists covering the Japan story might like to bear this in mind.

It is hard to disagree with Shirakawa, even though the former central bank board is being widely trashed. If demography is at the heart of the problem, it's far from clear how massive monetary easing is going to solve it. In fact even Paul Krugman, intellectual godfather to Abenomics, sometimes seem to have his doubts. At one point he even said: “Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be there”. (Monetary Policy in a Liquidity Trap – NYT April 11 2013).

The use of that little word “might” is striking for such a bold experiment. In fact once you look into it the Nobel economist seems to be hedging his bets all over the place. In the same article he says: “So, at this point America and Japan (and core Europe) are all in liquidity traps: private demand is so weak that even at a zero short-term interest rate spending falls far short of what would be needed for full employment”. So its not just one problem, it's at least three. But are all these liquidity traps the result of low fertility, or only some of them?

In an earlier article - The Japan Story (NYT February 5 2013)  –  he threw a bit more light on this, since he commented: “Oh, and what about the US relevance?............ What I think you can argue is that because we don’t share Japan’s demographic challenge, our liquidity trap is probably temporary, the product of an episode of deleveraging”.

Temporary????  Doesn’t that imply Japan’s may be permanent, which it is why he says it only “might” escape. And what about Europe, which is half US half Japan in demographic terms, will Europe's liquidity trap be "semi-permanent"?

The thing is this, given all the doubt about the real roots of Japan's problem, and the fact that it may well be permanent - as working age population slides there might be a permanent, structural excess of supply over demand - is it really justified to run such a high risk, all-or-nothing experiment?  What makes people nervous is the thought that if the central bank can't deliver on its promise then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

Seki Obata, a Keio University business school professor who in January published a book "Reflation is Dangerous," argues exactly this, that "Abenomics" is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by young workers with only entry-level wages. Japan's overall consumer spending power will therefore fall, rather than rise as Abe hopes. "Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages," says Obata. "On the contrary, that amount will shrink."

Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As is clear from all I am saying here, the gist of the criticism which is leveled at Abenomics is related to the the idea that the country's problems have strong demographic roots. With this in view, many members of the central bank "old guard" feel they are being unjustly held responsible for not finding a solution to a problem which it may not be within the capacity of monetary policy to solve. In a 2012 speech - Demographic Changes and Macroeconomic Performance - former BoJ governor Masaaki Shirakawa argues the following:

"Japan’s economic growth gradually slowed during the past two decades mainly for two reasons. In the former half of the period, the Japanese economy was hobbled by the crippling effect of the burst of the bubble. In the latter half, the rapid population aging hampered the Japanese economy through a variety of channels."
Regarding inflation, he continues:
Seemingly, there would be no linkage between demography and deflation. But it may not be the case. A cross-country comparison among advanced economies reveals intriguing evidence: Over the decade of the 2000s, the population growth rate and inflation correlate positively across 24 advanced economies. That finding shows a sharp contrast with the recently waning correlation between money growth and inflation. How could we square those facts with each other?

Another former board member Takahiro Sekido, now a strategist at the Bank of Tokyo-Mitsubishi UFJ is even more direct:“The BOJ’s bond buying can’t resolve the shrinking population or aging of society. Because Japan’s productivity has only marginal room to rise, it’s necessary to prevent a decrease in population or to encourage more participation of female workers for economic growth.”

A comment which points to one evident conclusion, that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shizo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through.

Managed Population Decline

Perhaps the most important thing which the whole Abenomics episode has brought to light is the urgent need to bring the existing corpus of economic theory somehow up to date with our modern realities. Despite all the talk of policies for "growth, growth, growth" a simple look at the population outlook in OECD countries, and especially the potential work force numbers means at some point or another economic growth will turn broadly negative. Valter Martins wrote about this in a post examining the Portuguese case I put up at the weekend, but former Bank of Japan governor Masaaki Shirakawa makes exactly the same point in the speech I mentioned earlier.

"Neoclassical growth theories normally do not distinguish the overall population from the working-age population for reasons of analytical simplicity. However, without taking into account the distinction between the two variables explicitly, the very challenges that Japan is currently faced with will be outside the scope of analysis."
The key point is that when labour forces are growing, the extra employment adds positively to productivity to generate growth, when they are stationary labour is neutral and economic growth is equivalent to productivity growth, but when they are contracting then you have to subtract the rate of contraction from the rate of productivity growth to get your final GDP growth number.
"The [neo-classical] economic growth model supposes that everyone works at a given intensity. With a labor-augmenting technological change, in the long run steady state, per capita variables grow at the rate of technological change, and aggregate variables grow at the rate equal to the sum of population growth and technological change. In aging economies, including Japan, where the working-age population has started decreasing, the labor force also declines, given the participation rate being held constant. Because the scarce labor force imposes a natural constraint on labor supply, the marginal product of capital declines accordingly. As a result, macroeconomic growth would be impeded. With this idea in mind, the Japanese economic data in the past decade indicates that the workforce declined by 0.3 percent point, labor productivity increased by 0.8 percent point, and they add up to real GDP growth rate increase by 0.6 percent".
Many of those who want to argue that miracle productivity performances make the demographic issue irrelevant normally simply fail to understand growth accounting dynamics or little about the productivity performance of developed economies over the last 20 years. Getting productivity growth of over 1% per annum  is hard, very hard, and will become even more so with an increasingly elderly workforce. A point which isn't lost on US growth theory expert Robert Gordon.

So the real point is there is an experiment being conducted in Japan, but the experiment isn't Abenomics (which I suspect won't work, and could end very badly). No, the experiment is about learning to grow old with dignity, not as individuals, but as societies. It is about managing debt in a time of deflation, about giving opportunities to the young, even while the force of the ballot box rides with the old, and about finding ways to ease that rate of work force decline to give some additional room to allow productivity to help, which means again helping the young, since they are the ones who start families.

I will close with a quote from Keynes, one which comes from the same talk from which I drew an extract to start this piece. Population decline has been seen coming for decades, there are few things about the future we can know with a higher level of probability, and yet we find the reality and its consequences hard to accept. Rather like our own finitude I suspect. Yet accept we must, since otherwise it will be hard to find the energy to act, and to make the changes we must make if we don't want a difficult process to become an extraordinarily painful one.
"Perhaps the most outstanding example of a case where we have a considerable power of seeing into the future is the prospective trend of population. We know much more securely than we know almost any other social or economic factor relating to the future that, in the place of steady and indeed steeply rising level of population we have experienced for a great number of decades,we shall be faced in a very short time with a stationary or declining level. The rate of decline is doubtful but it is virtually certain that the changeover, compared to what we have been used to, will be substantial. We have this unusual degree of knowledge concerning the future because of the long but definite time-lag in the effects of vital statistics. Nevertheless the idea of the future being different from the present is so repugnant to our conventional modes of thought and behaviour that we, most of us, offer a great resistance to acting on it in practice".

Wednesday, May 01, 2013

The A-b-e Of Economics

And the world said "Let Shinzo Abe be", and all was light.

“The point is not that I have an uncanny ability to be right; it’s that the other guys have an intense desire to be wrong. And they’ve achieved their goal.” Paul Krugman

A new craze is sweeping the planet. The image I have in mind isn't exactly that of the community of central bankers all dancing the Harlem Shake in unison, but for all the economic sense it has it might as well be. In fact the craze is called "Abenomics" and it is gathering adepts in financial markets across the globe. A precursor in Japanese history has already been found for the movement, Korekiyo Takahashi, who was the country's finance minister during the key years of the 1930s depression. Even a book has been written to extol his virtues entitled “From Foot Soldier to FinanceMinister: Takahashi Korekiyo, Japan’s Keynes." Unsurprisingly it was an immediate hit with Japanese academics when it came out in 2010.

While the creation of the Takahashi lineage may be important for home consumption in order to make the Japanese themselves more comfortable with the adoption of a set of radical and even unprecedented measures - Japan isn't exactly the country you would expect to be in the vanguard of a major economic experiment with extensive global implications - the resonance of Abenomics outside the country among those with little knowledge of economics and even less of the specificities of the Japan problem is perhaps rather more surprising. Mariano Rajoy, for example, told journalists recently that the recent BoJ decision represented a "very important change in its monetary policies." The Spanish PM argued in a clear reference to what is going on in Japan that Europe needed to decide which kind of powers its central bank should have, those it has now or "the ones other central banks across the globe have". "We are in a decisive moment," he said.

Despite the fact Abe's move fits comfortably on the austerity vs growth policy axis, at the heart of the new approach lies not a strategy to directly create growth per se, but rather one to try to induce inflation. The idea, which may have some understandably scratching their heads in confusion, is to see whether by this rather circuitous route it is possible to tease the country back on to what advocates of the policy consider would be a more normal growth trajectory of the kind from which it has been exiled for the best part of two decades now. The inflation-inducing monetary injection could be thought of as something like the kind of sharp jolt given to a twisted spine (or a dislocated shoulder) by the firm hand of an experienced osteopath. Once the shock has been administered, so the story goes, the patient should once more be able to walk - and develop - normally.

Naturally, the very existence of the this other, alternative, path for Japan remains at this point a mere theoretical postulate since with so many bouts of fiscal and monetary stimulus having been administered over the years, just exactly what a normal growth pattern would be for the country, or even what exactly "normal" means in this context, is at this point very difficult to discern. The fact that the population and workforce are now both ageing and shrinking in ways for which we have no historical precedent means that you wouldn't necessarily expect to see that much growth in the economy anyway. Indeed, in order to make allowance for this new phenomenon some have started to claim that Japan is not doing so badly after all (or here), since GDP per capita has been performing tolerably well in comparison with the US or Europe, so in some ways it is hard to see what all the fuss is about, except... except..... except for that nasty, nagging little detail of all the government debt that has been being run up in the meanwhile.


For those who have not been following the Japan saga as it has developed over the last twenty odd years this whole debate may seem like a strange way of thinking about things, after all isn't inflation supposed to be a bad thing, one central banks are supposed to combat? And how can a country become more competitive by force feeding inflation? The fact of the matter is, however, that during all that time the country and the Bank of Japan have been continually fighting and losing an ongoing battle with falling prices. And it is this battle with falling prices which means that the "tolerably good" economic performance becomes a serious problem, a serious debt problem.

Of course, falling prices are not necessarily in-and-of themselves a bad thing - as any old consumer will tell you -since products get cheaper and cheaper with each passing day. So the run of the mill consumer might find life in Japan quite a pleasing and desirable thing, especially if that particular consumer happens to be retired and living on a fixed income from savings as many contemporary Japanese actually are. Falling prices only really become a problem in a more general macroeconomic sense if they lead people to postpone consumption, and if this postponement becomes self perpetuating in a way which leads prices to continually fall, as the combination of constant productivity increases and stagnant demand produce perpetual oversupply. Falling prices also constitute a nasty headache for policymakers since while prices go down the value of accumulated debt doesn't, and herein lies the rub. So additional "stimulus" which doesn't lead to increasing nominal GDP simply pushes the sovereign debt even farther along an unsustainable trajectory.

The problem Japan has is one of a perpetual shortfall in domestic consumer demand and the core issue is whether this shortfall is simply being generated by consumption postponement, or whether there are deeper structural factors at work.

It's The Demography Stupid!

As everyone now recognizes and accepts Japan has a rapidly ageing population and an ageing and shrinking workforce. This situation, which has really been obvious for years has only lately come to be regarded as a significant component in the "Japan problem". This neglect has most probably been due to the influence of a deep seated predisposition among adherents of neoclassical growth theory to think that population dynamics don't fundamentally influence economic performance in the long run.

However, and as I think is now clear to all, one result of the "demographic transition" that is going on in Japan (and which will be replicated in one country after another as the century advances) is that while GDP per working Japanese continues to perform tolerably well, and, as I said, GDP per-capita growth bears comparison with many other countries in the developed world, government debt to GDP levels now bear no such comparison and have started to surge off the known register. Obviously something has to be done.

In 2012 Japan gross government debt stood at 235% of GDP and naturally with falling nominal GDP the burden of the debt would still continue to rise even if there were no further fiscal deficits. But fiscal deficits there are and there will continue to be since without such "stimulus" it is apparent that even real GDP would be perpetually negative. The country has been running a fiscal deficit of close to 10% annually and Shinzo Abe has promised even more fiscal stimulus in 2013 as one of his three key "economic arrows".

You don't have to be an economic or mathematical genius to see that this can't simply go on and on. Japan has now passed some sort of tipping point. GDP per working Japanese may continue to rise nicely, but as the working population steadily shrinks a the 21st century advances then surely total GDP will eventually start to fall. If in addition prices continue to drop then government debt to GDP would start to rise almost asymptotically even without any more government borrowing. And naturally Japan is not a unique case, since during the course of the 20th century one country after another will be faced with the same sort of problems. That is why the country is now so important.

What is going on in Japan is a huge collective experiment on all our behalf's. And we have also passed a tipping point in another sense, since if what Abe is doing doesn't work there is now no realistic possibility of turning back. Relative prices and values across the whole global economy are currently being distorted to such an extent that any sudden loss of faith in the experiment would surely have consequences which reached far afield and far from benign. Austerity reins are now being loosened all over Southern Europe (a region where population ageing is not far behind Japan) and debt levels are surging. If Japan can't pull it off then neither can Southern Europe, meaning all those bond yields which are coming down simply shouldn't be doing so. Japan is simply the pioneer.

What Went Wrong In Japan?

Basically, in terms of our classical understanding of economic problems there are two straightforward solutions to the Japan debt problem: either the economy achieves more growth (which as we have seen will prove difficult given the shifting demographics) or it generates continuing inflation, since inflation pushes nominal GDP into positive territory and hence eases the scale of the debt burden. But, we need to ask ourselves, what if something important has changed and Japan now faces the worst of both worlds, getting virtually no growth while at the same time remaining stuck in deflation. While few are yet willing to contemplate either the possibility or the consequences of this eventuality this does not mean that it is an outcome which can't happen.

But before examining that possibility a bit further, let's dig a little deeper into the intellectual backdrop that lies behind Abenomics.

"Japan: what went wrong?" is the title of a 1998 article by Paul Krugman (you can find it on this site under "Japan"). Krugman's work at this time has some significance for the current policy approach since in many ways he can rightly claim to be the intellectual father of the Japanese experiment. He was the first economist of note to see that something important was happening in the country, and the first to see that some sort of major initiative was going to be needed to address the emerging problems. In particular the whole idea of trying to correct the Japanese imbalance by targeting inflation can be traced, for good or ill, back to his door.

The "what went wrong" article is useful, since there he tried to set out in simple layman's terms his version of the Japan story. For a number of reasons it is worth going back to these old arguments since they help make sense of recent events, and offer us the opportunity of glimpsing the initial justification for the Bank of Japan policy initiative that Mariano Rajoy and others find so interesting in all its full glory.

Krugman's starting point is population ageing. The details could be changed, and the argument fleshed out a lot, but this is basically the picture he paints to explain why the country fell into deflation - the Japanese don't spend more because, on aggregate, they are trying to hang onto their savings.

Here's the story: Japan, like the United States only much more so, is an aging society. Thanks to a declining birth rate and negligible immigration, it faces a steady decline in its working-age population for at least the next several decades while retirees increase. Given this prospect, the country should save heavily to make provision for the future--and lacking the kind of pay-as-you-go Social Security system that allows Americans to ignore such realities, it does. But investment opportunities in Japan are limited, so that businesses will not invest all those savings even at a zero interest rate. And as anyone who has read John Maynard Keynes can tell you, when desired savings consistently exceed willing investment, the result is a permanent recession.

Actually more than saving, the problem is really that the Japanese won't commit to borrowing (again on aggregate). Hence some people locate the problem as a monetary transmission mechanism one - the normal credit cycle simply won't start because the economy is suffering the after-effects of a "balance sheet recession".

But another approach to the problem would be to try and understand whether the failure of both Japanese households and corporates to harness themselves to what is considered to be a "normal" credit cycle might not be associated with the age structure of the country's population. In fact the Japanese household saving rate has been falling steadily over recent years, and it is Japanese corporates who are doing the saving, but the latter won't invest in the domestic market for the reason Krugman identified - the lack of consumer demand for end products - and indeed perhaps this reluctance is fortunate since with final demand limited more supply would only push prices down even further. The idea that further investment would in and off itself produce enough incremental demand to soak up the capacity expansion sounds very much like the Spanish housing and immigration story - Spain was, on this account, bringing in immigrants to build houses for which they themselves would be the customers. This kind of investment-lead demand simply doesn't work, as we are also seeing in China.

Investment has to some extent to be driven by autonomous demand, if it isn't imbalances are inevitably generated, even if, in a well-oiled economic machine the investment generated by that autonomous demand is what drives the business cycle forward. But in Japan this kind of demand-lead investment process isn't working (outside the export sector) for reasons which have demographic roots and not due to malfunctioning of the monetary transmission mechanism. Thus the key difference between the world of contemporary Japan and the world Keynes contemplated is that the shortage of demand in his model was simply conjunctural (due to the presence of a liquidity trap) and not structural and permanent, as in the case of demographic decline.

Although one of his contemporaries, the Swedish Nobel prize winner Gunar Myrdal, did go into this demographic possibility (fertility in Sweden had already dipped below the 2.1 child per woman replacement level in the 1903s) and Keynes did read Myrdal's Godkin Lectures where the ensuing process is examined, the author of the General Theory never really contemplated the kind of problem Japan is facing. This is a pity since it only really makes sense to use the expression "liquidity trap" if you are making the kind of assumption Keynes was - that there is some sort of "normality" (the normal credit cycle, for example) to return to, so that the damage that was being caused to the normal functioning of the economy could be put right by some kind of self-correcting mechanism. If what you are faced with is an economy that is becoming extremely dysfunctional following almost four decades of ultra-low fertility then it is not at all clear that this self-correcting solution is available. Hence Japan's dilemma.

Promising the Unachieveable?

But to return to the Krugman story, after many years of deflation people simply hang on to cash instead of spending it in the expectation of price rises in the future, even if the demand shortage itself is being caused by a lack of investment which results from a shifting population structure.

"If this is the problem, there is in principle a simple, if unsettling, solution: What Japan needs to do is promise borrowers that there will be inflation in the future! If it can do that, then the effective "real" interest rate on borrowing will be negative: Borrowers will expect to repay less in real terms than the amount they borrow. As a result they will be willing to spend more, which is what Japan needs. In short, this explanation suggests that inflation--or more precisely the promise of future inflation--is the medicine that will cure Japan's ills".

So the idea is this. According to standard macro theory in order to get an economy stuck in a never ending recession being fueled by the expectation of future price falls back onto a dynamic growth path you need to generate negative real interest rates to push people into saving less and borrowing and spending more - basically you need to make it more expensive for people to hold on to money.

Now given the zero limit associated with the conventional application of interest rates it isn't easy to generate negative interest in the here and now, so one proposal is to go for second best and give the impression they will exist in the future and thus change behavioral patterns by changing expectations. This you try to do by generating the expectation of significant inflation in the future.

This expectation is hard to achieve due to the credibility attached to the inflation fighting credentials that developed world central bankers have built up in recent decades. Despite the fears being raised by some monetary hawks that all and every kind of central bank balance sheet expansion will lead to out-of-control inflation, the general opinion is that central bankers are responsible people who will be effectively able to pull the plug on any excessive liquidity easing (or "exit") just as soon as the inflation they are trying to provoke starts to raise its ugly (or should that be beautiful) head. In the liquidity trap situation the result is that you are not able to generate sufficient inflation expectations to be able to achieve even low single digit inflation.

So what you get is a kind of chicken and rooster game between central bankers and the citizen in the street, where the central bankers have to credibly convince the world they have "lost their heads" and become sufficiently frustrated and irresponsible as to be willing to go beyond earlier constraints and really put the pedal once-and-for-all hard down on the metal. Maybe if, instead of limiting themselves exclusively to the verbal registers of communication they broadened out the channels used they would have more success. Instead of wearing suits and ties to their monthly meetings, maybe if they wore swimming costumes or t-shirts and colorfully framed sunglasses that would work.

Now you could say, where's the problem with generating 2% inflation? It doesn't sound that reckless since most central banks in the developed world have inflation targets at or around that level. But simply declaring a 2% inflation target in Japan is not sufficient, partly because people are doubtful after so much time that the bank is capable of doing it, and partly because even if that hurdle could be overcome, the expectation of 2% would not be enough to change behavior sufficiently to unleash the required consumption. So in the Japan case what the Bank of Japan is being asked to do is ramp up the policy approach to such an extent they seem to be flirting with the possibility that they may not be able to stop what they start, and that inflation could easily significantly overshoot the 2% mark. If they can't raise this doubt, so the argument runs, consumers will factor-in the effectiveness of the exit strategy, lower their expectations and adopt behavioral strategies that mean the economy doesn't achieve the required escape velocity to break out of deflation.

All of this naturally assumes that what actually ails Japan is a run of the mill liquidity trap. Now I don't doubt the capacity of the Bank of Japan and the Japanese government, in the last resort, to generate enough concerns about whether or not they know what they are doing to lead people to start to anticipate an "out of control" situation (see more below), but what I do doubt is that even assuming this feeling of things being out of control feeds through to a 2% inflation level (and not say a sudden and dramatic run on the yen) that this inflation will be sustainable. More probable, I think, if the economy is in a demographically driven deflation trap is the economy, following a short-sharp-burst of inflation slumps back yet one more time into long run deflation. The reason I think this is that if the deflation is the result of a savings/investment mismatch brought about by long term demographic changes - rather than by say "garden variety" deleveraging (or a "balance sheet recession") - then I don't see why the supposed "trap" wouldn't come into existence again once the bank started to roll back its balance sheet.

To some extent Krugman himself admits the difficulty:
"This theory is offensive to many people. Deep economic problems are supposed to be a punishment for deep economic sins, not an accidental byproduct of swings in the birth rate. Inflation is supposed to be a deadly poison, not a useful medicine. Above all, it seems implausible that the proposed solution to such severe difficulties could involve so little pain. And while I think logic and evidence are on my side--that demography, not crony capitalism, is the villain, and inflation is the answer--it is certainly possible that I am wrong".

In another article from the same period - "Further Notes On Japan's Liquidity Trap" - Krugman offers us the following curious, but clarificatory, argument:
Japan - like any liquidity trap economy - in effect needs inflation, because it needs a negative real interest rate. The slightly paradoxical conclusion which I believe to be true is that the deflation we actually see is the economy trying to achieve inflation, by reducing the current price level compared with the future. ..........

So, he says, Japan's economy is trying unsuccessfully to achieve the inflation it needs. Leaving aside the implicit animism of the argument, I would counter by saying "No! Japan's economy is in fact desperately trying to deflate, and is only frustrated in doing so by the massive liquidity easing from the central bank and the ongoing fiscal injections it receives". The difference between this deflation and all previous variants known to economists is that this deflationary process is not a simple deleveraging one, but something without end, a way of life, since the economy is seeking an equilibrium point which no longer exists. That is what the deflation is about, the economy is striving to find an equilibrium without being able to locate one.

The "Further Notes" article (again, see the Japan section on this site) also makes one other fundamental point - that his inflation conclusion is not something born "like Athena from the head of Krugman" but is rather the logical outcome of applying universally accepted models based on standard neoclassical assumptions.

"I think I should make it clear that I did not start with this conclusion, then make up a model to justify it. What I did instead was start with a very orthodox model - the same sort of model that is favored by people who are vociferously anti-Keynesian and pro-price stability - and ask under what conditions it could generate the apparent ineffectuality of monetary policy we see in Japan. And the need for inflation pops out - to my own surprise, by the way. If you refuse to accept this conclusion, either you must offer some alternative model, or you are saying that your opposition to inflation comes not from analysis but from gut feelings".

He is right. If Japan's economy is just another planet that has temporarily slipped off its orbit then inflation is what it needs. If something more fundamental is happening then the policy remedy is, to say the least, questionable. Japan's economy may or may not be striving to achieve inflation, but I would no go so far, as Krugman does with those he disagrees with, as to suggest he has some hidden desire to get things wrong. I simply think he is not following his own argument through to its own logical conclusion, he is hovering half way across the rope bridge without finally and decisively striding forward to the other side. He has seen the problem has been produced by a violent fall in the birth rate, but can't really get to grips with whether or not monetary policy can handle this problem.

I can understand his caution, since he is also right that what is needed now is an alternative model to the standard neoclassical growth one, and possibly a whole new way of thinking about macroeconomics, even if - collectively speaking - we don't have either the former or the latter right now. What we do have is an accumulating body of evidence to suggest that Japan, despite all its specificities is not unique, that developed world outcomes are increasingly not in concordance with what conventional theory would lead you to expect, and (at least in my own personal case) a gut feeling that the policy remedy being applied in Japan is a rather dangerous one.

The Black Swan Question
"Since everyone eventually gets through the deleveraging process, the only question is how much pain they endure in the process. Because there have been many deleveragings throughout history to learn from, and because the economic machine is a relatively simple thing, a lot of pain can be avoided if they understand how this process works and how it has played out in past times." Ray Dalio, An In-depth Look At Deleveragings

Those who do not think about what is happening in Japan in demographic terms (a list which would not include Paul Krugman) normally rely on a theory based on the idea of "balance sheet recessions". At the heart of this theory (which is often associated with the name of Nomura economist Richard Koo) is the idea that economies like the Japanese one are essentially deleveraging following a bubble related unsustainable expansion of credit and debt. The demand side deficit can thus be thought of as being produced by this deleveraging process on the part of households and corporates. Most financial market participants assume that some such deleveraging process is what ails the economies of the developed world as a community. I think the kinds of demographically related arguments we have gone over above suggested that use of the deleveraging idea may be a significant over simplification of what is happening.

Japanese households are not borrowing more on aggregate due to the fact that they are still deleveraging from earlier excesses, and corporates are not neglecting to invest more in domestic Japanese activities for similar reasons. Rather, consumers are now borrowing less and less as the age profile and size of the entire consuming community steadily shifts while corporates are hoarding cash as investing in capacity without the necessary expansion in demand makes no economic sense. The structural deficiency in demand which produces the deflation is not an "accidental by-product" of "swings in the birth rate" but an absolutely comprehensible and systematic outcome of fertility dropping well beyond replacement levels and staying there over several decades.

This is not the conclusion drawn by legendary Hedge Fund manager Ray Dalio, who concluded after studying a large number of deleveraging processes that "everyone eventually gets through the deleveraging process" the only real difference being in how much pain is inflicted on participants in executing the operation. Which brings us to "rara avis in terris nigroque simillima cygno", or the phrase from the Latin poet Juvenal recently brought near the headlines by financial affairs writer Nassim Nicholas Taleb which roughly traslated means means "a rare bird in the lands, very much like a black swan". Such a bird was long thought not to exist, since all known swans were white.

In fact, the issue of black swans is not exclusively associated with the issues made famous in Taleb's book on the subject (the question of random tail events), but has its origins in a basic flaw in inductive reasoning, long ago highlighted by the philosopher of science Karl Poppper: you simply can't assume something doesn't exist because you have never seen one. Ray Dalio falls into this trap in the exert which opens this section when he asserts that everyone eventually gets through the deleveraging process. It would be more correct to say that everyone had gotten through the process, and then Japan came along. Two decades after the bubble burst, according to the balance sheet recession people, the country has still not gotten through the process, and if the arguments I am presenting here are valid it is highly unlikely it ever will do. In which case the existence of a black swan in the first (simply epistemological) sense of the term may serve to bring one into existence in the second sense in the shape of a very nasty unexpected tail event as expectations are forced to verge violently from one direction to another.

The problem is that almost all investors at this point are assuming that the country will eventually overcome its deflation problem, and indeed markets are positioning as if it were inevitable that it would (producing large and systematic price distortions) even if this inevitability is accompanied by the idea that if at first they don't succeed, then they will try try and try again till they do. Or put another way, that the Bank of Japan will simply keep ramping up its money printing activity until the country obtains escape velocity. In fact Ray Dalio uses his logical fallacy in his inductive argument about deleveragings to justify a change of pricing in European periphery risk assets, as I explain in this post here.

But another possibility exists, one which has already been highlighted by another legendary investor, George Soros. The Japanese currency may be precipitated towards an out of control collapse.

To understand how and why this might happen we need to think about how it could be possible for the Bank of Japan to produce inflation. Since the country's economy has a known structural weakness on the demand side, demand pull inflation is unlikely to occur however much money printing goes on. So it would have to come from the other, or supply, side in the form of cost push inflation. This is not so difficult to generate, since you only need to introduce the expectation that the central bank will use monetary techniques and the currency will, as we have been seeing, fall. The only question here is how far it has to fall to produce a given level of inflation. As of March 2013 the currency had fallen approximately 30% against the euro in 9 months while deflation still remained at a 0.5% annual price decrease rate on the Bank of Japan's targetted measure.

So more will need to be done. But just how much more. But let's imagine for a minute that the yen is devalued such as to produce, say, 1% inflation due to rising import costs. What happens next? Well, as we saw earlier, a lot depends on expectations. If import prices remain unchanged during the following year since the value of the yen remains stable, then the induced inflation simply drops out of the system, as it did in Japan in 2009 following the short price burst produced by the 2008 inflation, or as it does in countries that apply a one off consumer tax hike (Japan itself in 1997, just before deflation really took a tight grip, or many countries on the EU periphery at the present time).

So the issue is, will people anticipate further downward movement in the yen to induce even more inflation? Will the central bank be "responsibly irresponsible" and feed not only those expectations but expectations that the devaluation will continue every year while the 2% target exists? And how will "mum'n pop" Japanese savers react, by spending more, or by moving their money out of the domestic currency to avoid some of the value loss? Soros thinks there is a very real chance that the latter will happen, and I agree with him. What's more, I think it is much more likely that ordinary Japanese savers reach the expectation that the currency value will fall than they do reach the conclusion that ongoing inflation will be induced.

My conclusion then is that there is little evidence or possibility that this policy will work as advertised, largely because it is based on a misunderstanding. It might work if Japan was in a simple liquidity trap as described by Keynes, or a balance sheet recession deleveraging process of the kind Richard Koo talks about. But once you introduce demography into the picture, as Krugman does, the game gets changed and the water incredibly muddied.

Japan is stuck in a shrinking population trap, and neither monetary nor fiscal policy will adequately solve the problem. Continuing to run fiscal deficits in a deflationary environment will only means that government debt is pushed onward and upwards leading to a variety of possible scenarios as to what the end game will finally be. Reining in the deficit, by raising consumption tax, for example, will probably only make deflation worse with a one year time lag, as happened in 1997, and will almost certainly force the economy into more economic shrinkage which in any event makes the debt issue worse.

On the other hand the current BoJ policy while effectively driving down the yen is producing very little in the way of visible inflation. What it is doing is systematically misallocating financial resources across the planet, as those who are convinced that Ray Dalio is right put their money behind their intuition. Italian ten year government bond yields for example hit 3.94% last week, their lowest level since November 2010 based on the idea that at the end of the day, even if the country's debt (currently at 127% of GDP) does continue to rise Japan style, it doesn't matter that much since the ECB will surely one day "go Japanese". Italy is in fact the EU country most similar to Japan in terms of growth and demographic issues.

But if Japan itself cannot go Japanese in the sense of generating the anticipated inflation then the implication will be that neither can anyone else who gets stuck in a similar quandry. Black swans may indeed be very rare birds, but that doesn't mean you may not be able to sight one flying past the bottom of your garden at some point in the not too distant future.

Monday, February 11, 2013

Japan’s Looming Singularity

 by Claus Vistesen and Edward Hugh

According to Wikipedia, in complex analysis an essential singularity of a function is a "severe" singularity near which the function exhibits extreme behavior. The category essential singularity is a "left-over" or default group of singularities that are especially unmanageable: by definition they fit into neither of the other two categories of singularity that may be dealt with in some manner – removable singularities and poles.


No need to panic, a lot of analysts tell us, since far from being on the verge of some earth shattering event Japan  has invented the economic equivalent of a mechanical perpetual motion machine. Or as Nobel economist Paul Krugman put it recently, “while there is much shaking of heads about Japanese debt, the ill-effects if any of that debt are by no means obvious”. Maybe there is just one word missing here - yet.

This, however, will not be the viewpoint taken here. The rise and rise of Japanese debt is far from benign, and the dynamic, we are convinced, will at some point become unsustainable. Unfortunately by the time we reach that point it will be too late. Indeed, given that we agree with Krugman that the underlying cause of Japan’s malaise is demographic, after several decades of ultra-low fertility in all probability it already is too late. The root of the problem is, as he says - wait for it - that there is "a shortage of Japanese".

Far from being like that woeful economist so tellingly characterised by Keynes, the one who through many travails and pages and pages of equations is only able to tell us that when the storm is long past the ocean is flat again, we feel we have more in common with the character so ably played by Mike Shannon in the Jeff Nichols’ film “Take Shelter” - "there’s a storm comin, one like none of you have ever seen before…."

If You Print Your Own Money, And You Run An External Surplus, How Can There Be a Problem?

Japan’s problem is benign, so the argument goes, since the country has an external surplus, and can print its own money. As a result there is a savings surplus, and no problem selling government debt, even at ridiculously low interest rates. And since the interest paid remains ridiculously low, then there is no problem servicing the debt, and if there ever was, why then the Bank of Japan could just buy even more of its own government bonds, effectively driving the interest rate even lower. In theory there is no good reason why it couldn't even follow the lead being currently set in Germany, and push the rate into negative territory. Heck, the government would then be even earning income on its debt. It would be a good investment.

But somehow or other this view fails to convince. In particular it fails to get to grips with why Japan has gotten into this situation. It also doesn't offer any kind of road-map for how the country could ever get back to the sort of monetary regime that was once widely considered to be "normal". Or perhaps, in the world we now live in, as the US novelist Thomas Wolf once put it "you can look homeward angel" but in fact "you can never go home again". Which is just a very poetic way of saying that time has an arrow, and that some processes are irrevocable and irreversible.

So, if this is what you were hoping for, then bad luck, since there is simply going to be no such thing as a return to normality for Japan. That being said, what we have to avoid at all costs is Japan becoming the "new normal", the text book case of a society where the fundamental mismatch between declining demography and appeasing an ever older electorate with populist politics leads to complete dysfuncionality, a dysfunctionality which is then reiterated in one country after another. From this point of view it is fascinating to note just how fast Japan is getting towards "the end of the road". Some investors have even been getting ahead of themselves and frantically shorting Japanese debt in the anticipation of future and continuing credit downgrades, without asking themselves the really awkward question - what happens to the country if it is eventually forced to default on its debt.

If on the other hand we are able to see that something is going on in Japan which is neither normal, nor desirable, nor sustainable, then we just might like to ask ourselves what then gets to happen next? Certainly there is nothing in conventional economic theory which can help us anticipate the answer, since this kind of end of the road point has not been foreseen, anywhere.

It’s equally fascinating that so few people are really talking about this development at the moment. The assumption that things can more or less go on and on is widespread both in and outside Japan. Despite the frequent references to "Japan's lost decade", the country has now lost not one, but two - what was it Oscar Wilde said, losing one child could be an accident, but losing two surely has to constitute negligence - and as things are shaping up we seem to be all set to have a third one in front of us, markets and weather permitting, always assuming the Japanese government remains able to finance its debt.

Yet at the moment there seems to be no danger of that. Japan has become flavour of the month among investors, following the continuing verbal interventions from prime minister Shinzo Abe. Against all odds, people are buying the story that an inflation target of 2% is attainable, and that the country can permanently devalue its currency by a sufficient amount to produce an ever larger trade surplus, despite the war of words that has already broken out about "currency wars". Or perhaps it has become convenient to believe the impossible will be possible, simply to make money on short term trading positions. Given the quantity of long run uncertainty, this seems to be the main obsession of markets right now,  following the dictum of the 1960s philosophy made famous by Jack Trevor in the film "Live Now, Pay Later."

A Country Growing Short Of People?

But let’s keep the debt issue for later and start with the demography – here Japan is certainly a real global leader, in this case for its advanced population ageing. Japan is not only an ageing society: It’s THE ageing society. Following decades of an ultra low birth rate and negligible immigration, it faces a steady decline in its working-age population and a rising dependency ratio for decades to come. There is no changing this now. Even some "miracle" reversal of the fertility problem would take decades to work through, so whatever happens next, things will get worse before they get better.

Japan's population - in median age terms - is the oldest on the planet. Median age is around 45, and it will continue to rise. There is no real prospect of it coming back down again, since the process it is experiencing appears to be totally irreversible. Forecasts see the median age in Japan rising to more than 50 within the next two decades, and really here we are breaking totally unknown territory – no society in the whole of human history has ever been this old.

Given this prospect, it is natural to expect that the country should save heavily to make provision for the future--and it does. But a country with an ageing and declining workforce gets an additional problem, one of structural demand deficiency due to the changing balance between saving and borrowing. Investment opportunities in Japan are limited, so that businesses will not invest all those savings inside the country itself. The only surprising thing is that people are still surprised by this.

This demand deficiency results in a process we have come to call export dependency (leveraging the global rather than the local economy in the search for customers). Japan has now well passed the threshold at which the economy, as a modern market economy, can rely on domestic demand and domestically oriented investment to grow. The trouble is, that given its export sector cannot grow fast enough to keep pace with the contraction in private internal demand, the country has become increasingly dependent on large fiscal deficits to keep the ship right side up.

However contrary to the expectations of the classic life cycle model, the conclusion we have come to is that rapidly ageing societies will not, in the main, be characterised by aggregate dissaving but rather by the fight against it. In the context of international capital flows this means that rapidly ageing economies will be characterized by an external surplus and not, as theory would predict an external deficit. According to the said life cycle theory, savings by consumers should not affect total aggregate savings in the long run because savings today, by definition and through the idea of consumption smoothing, turns into consumption tomorrow. Yet this might be the wrong way to read the life cycle hypothesis: ageing may be associated with the propensity to run an external surplus and this may lead a country to a state of export dependency.

The conclusion we draw from the above is a simple one – if Japan is going to see a decline in working population over the next several decades (and possibly much longer, since so long as fertility remains below replacement rate each generation will be smaller than the previous one) and if this lies at the heart of the deficient domestic demand deflation problem, then it means the issue is a deep structural one which won't be resolved by any kind of "kick start", however large. The only consequence of having permanent fiscal injections will be not to give stimulus, but rather an accumulation of debt that will be increasingly harder for those smaller and poorer workforces to pay down in the future – especially if the process is associated with ongoing deflation.

To use an analogy - it isn't simply a question of a planet which has slipped off or strayed from its orbit (or “good equilibrium”), and just needs a nudge to get it back on, what we have is a planet which has veered off onto a whole new trajectory, one which leads to who knows where. This situation was never contemplated by the founders of neoclassical theory, and yet, having started in Japan, the phenomenon is now extending itself steadily across all developed economies in one measure or another.

As long as Japan is the only guy in town facing this kind of problem, there is a simple solution - invest national savings abroad, in countries where populations are younger and still growing, and returns on capital are surely higher. These other nations should be able to pay back loans when they are richer and older, supplying some of the funds needed to meet Japan’s pension promises and other obligations.

Up to the arrival of the global financial crisis Japan played this game well because it was the only one playing it. The problem is that now every single OECD economy, one after another, will steadily be looking to do the same. So in similar fashion, those who urge a solution to Europe's imbalances via an increase in German fiscal deficits to stimulate consumption miss the point: arguably what people in these societies need to do is save more, not less, and certainly when it comes to the public sector.

External demand and foreign asset income become crucial elements of growth for ageing societies, and if we end up with every developed country trying to export its way out of the mess it is surely not going to work! The first signs of this can already be seen in the Euro Area, where the sterling attempts of the countries on the periphery to escape from their trap through the ramping up of exports is simply leading to economic stagnation, since the core countries (largely net savers) are unable to take up the demand slack.

What makes the country different is that in Japan the cracks are starting to become visible. The positive external balance which is essentially the only source of growth for the economy is quickly evaporating. The trade balance is now well negative in large part because of the continuing need for energy imports (mainly LNG and oil) and this has started to drag the current account down. Even worse the income balance is also now falling lead the country to recently post its lowest current account surplus since 1985.

Seen in the light of the above, these recent trends in Japan’s external balance are deeply worrying.

To become even more worried, let’s get back to the debt.

A Balloon Which Just Grows And Grows

Amazingly, Japan is the only developed economy still expanding its annual budget deficit even though the economy is saddled with, by far, the biggest debt burden – gross government debt is now around 235% of GDP. Now many make light of Japan's economic growth problem since with the 15 to 65 population falling, output per worker is not performing badly. As Paul Krugman so cogently puts it, "you can argue that demographically adjusted, the whole tale of Japanese stagnation is a myth." You could, that is, if it weren't for the growing debt. Simply thinking about GDP per member of the active population is very misleading, since what you need to thing about is the elderly dependency ratio, how many people, that is, each member of that steadily shrinking workforce has to support. This is where the real action is.

Evidently a large chunk of this growing debt problem is demographically related. In fact, since the early 2000s, Japan’s non-social security spending has been reasonably well contained and, at about 16% of GDP in 2010, it was the lowest among G-20 advanced economies. Meanwhile, social security costs have risen steadily due to the steady attrition from population aging. Social security spending rose by 60% between 1990 and 2010, accounting for about half of consolidated government expenditures in 2010. Moreover, a sustained increase in the old-age dependency ratio has implied larger social security payments supported by a shrinking pool of workers, and again this has rapidly deteriorated the social security balance.

As long as the interest rate is close to zero, even sky-high debt seems to be fine. But, as the IMF puts it: "Should JGB yields rise from current levels, Japanese debt could quickly become unsustainable. Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with unsustainable fiscal imbalances can shift.”

And the IMF draws a scenario, in which a wrong combination of circumstances at an inopportune moment in time could easily send Japan spiralling to where Italy and Portugal are now: “Market concerns about fiscal sustainability could result in a sudden spike in the risk premium on JGBs, without a contemporaneous increase in private demand. Once confidence in sustainability erodes, authorities could face an adverse feedback loop between rising yields, falling market confidence, a more vulnerable financial system, diminishing fiscal policy space and a contracting real economy".

We’re just now seeing the beginning of this scenario. The average rate of maturity on JGBs is being pushed down due to investors buying the short end in combination with the purchasing program from the BOJ. Where have we seen this before ... oh yes, the eurozone periphery. You try to see what yield Japan would need to pay for for a MARKET based 10y or 30y issuance of a decent size. Our best guess is way, way above its nominal growth and herein of course lies the problem. Japan ran a 10% deficit last year and there are no signs of consolidation in 2013. Meanwhile the current account surplus is starting to play the vanishing man act.

Japan will run out of sufficient savings to buy the whole issue of JGBs by 2016, but the possibilities are the market will respond sooner. If the Japanese government continues to issue debt, the Japanese economy is going to run out of savings to buy the new debt. The share of government debt to total currency and deposits will soon reach close to 100%. At this point of the endgame, there is no way out for Japan: either the central bank or foreigners must take up the bid, or Japan must begin to sell off foreign assets. Markets will price in the endgame before it happens.... then it will be game over!

What does game over mean?

How does a country accept its fate of having no other chance of growing other than simply growing old?

How does a country accept its fate of seeing its private savings evaporate? How can a country get along with the discovery that what was seen as a secure source of private wealth and old-age provision, national government bonds, just dematerializes?

Of course, each country is different, especially if it goes through a heavy crisis. And, at least, over the years the Japanese built up a strong net external investment position which leaves the current account strongly positive despite the negative goods trade balance due to the high income flow from investments abroad. This is very different from Italy and Portugal, countries which have long run both trade and current account deficits and have very poor net external investment positions. But these external assets and the internal savings are distributed differently, and in case of heavy losses on the domestic side – will the Japanese Gerard Depardieus and those leading global companies with large foreign assets still be happy to pay the surcharge needed for elderly care of all those elderly people that lost their savings because they trusted the government?

Or Japanese young people, will they still be prepared to stay and work in a country which may well have some of the highest income tax rates on the planet?

No matter how Japan will act in its battle to survive the endgame, it is going to provide us with a fascinating experiment to follow because whether it succeeds or not will tell us a lot about our own future, and of how the rest of the OECD will cope with the rapidly ageing societies they have in their own back yards.