Remember back last year when the predictions were coming in daily that Japan was heading for insolvency and the thirst for Japanese government bonds would soon disappear as the public debt to GDP ratio headed towards 200 per cent? Remember the likes of David Einhorn – see my earlier blog – On writing fiction – who was predicting that Japan was about to collapse – having probably gone past the point of no return. This has been a common theme wheeled out by the deficit terrorists intent on bullying governments into cutting net spending in the name of fiscal responsibility. Well once again the empirical world is moving against the deficit terrorists as it does with every macroeconomic data release that comes out each day. I haven’t seen one piece of evidence that supports their view that austerity will improve things. I see daily evidence to support the position represented by Modern Monetary Theory (MMT). Anyway, there was more evidence overnight that I thought should be mentioned and relates to the idea that “the government is the last borrower left standing”. Einhorn gave a speech to the Value Investing Conference on October 19, 2009. I note he is a keynote again this year so the organisers obviously haven’t been keeping track of events to realise that this guy’s predictions have been way off the mark.
Einhorn’s speech was entitled – Liquor before Beer … In the Clear – and he began by outlining what he thought were the “macro risks we face” in the investment context.
He rehearses all the known arguments of the deficit terrorists – inflation, debt-default etc. Then he gets to Japan and says:
Japan appears even more vulnerable, because it is even more indebted and its poor demographics are a decade ahead of ours. Japan may already be past the point of no return. When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts. Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year. At some point, as American homeowners with teaser interest rates have learned, when the market refuses to refinance at cheap rates, problems quickly emerge. Imagine the fiscal impact of the market resetting Japanese borrowing costs to 5%.
Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan's population aging, it's likely that the domestic savers will begin using those savings to fund their retirements. The newly elected DPJ party that favors domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.
Greenlight – Einhorn’s investment company – is known to have bought long-dated options on much higher interest rates in Japan which if rates rise significantly over the next four odd years will give it large profits. The counterparty was the major banks and I expect them to make the money.
When people are talking big like this we need to look at the data.
The first graph shows the national debt to GDP ratio since early 1990 to March quarter 2010 (left-panel) and the 10-year Japanese government bond yield since December 1998 (there was a break in the official series in November 1998). You can get Bank of Japan data for 10 year government bond yields back to October 1985. The choice of sample is immaterial.
So I wouldn’t be betting against rates rising anytime soon in Japan.
And what about the relationship between the debt ratio and the bond yields? The following graph plots the volume of outstanding national government debt (100 millions) (horizontal axis) against the 10-year JGB yield. The black line is a linear regression (sloping down!).
Short-term rates have also been very low in Japan for a very long time. This graph is from the Bank of Japan database and the red line is the overnight call rate and the blue line is the basic discount rate. The grey bars are official (GDP) recessions.
The conclusion is obvious. The BOJ controls short-term rates and has kept them at around zero for years. I could have plotted inflation rates which would have shown low and stable inflation for many years bordering on a deflationary problem arising from deficient economic activity.
Anyway, I will close my blog down immediately and apologise profusely for being a dingbat if JGB yields skyrocket in the next five years.
I also wonder how the Einhorn’s take in the regular news on the latest JGB auction results.
The Japanese JiJi financial news service carried an item overnight that caught my attention this morning and was the source of a few E-mails (thanks Marshall!):
Tokyo, Aug. 4 (Jiji Press)–Japanese government bonds rose sharply in Tokyo Wednesday amid growing uncertainties about the U.S. economy, with the yield on the benchmark 10-year issue slipping through the one pct threshold for the first time in seven years. In late interdealer cash trading, the yield on the latest 309th 10-year JGB with a 1.1 pct coupon stood at 0.995 pct, a level unseen since early August in 2003 and down from 1.020 pct late Tuesday.
So the demand for JGB rose for this issue as the total stock of bonds (absolutely and relative to GDP) continued to rise.
A bit later Nikkei reported that Long-Term Rates Climb Back Above 1%. Heavens I thought – bond yields are nearly going through the roof!
TOKYO (Nikkei)–The benchmark 10-year government bond yield rose to 1.015% Thursday morning as eased worries over the U.S. economic slowdown prompted investors to sell the safe-haven asset.
On Wednesday, the bond yield fell below the 1% line for the first time in about seven years, hitting 0.995%.
Read carefully: this is saying that financial market investors got less nervous and decided a bit more risk was tolerable so they sold the “safe-haven asset” (the Japanese government debt) and rates rose just a tad.
No Einhorn scenario is likely yet. When? Answer: never!
So why do the commentators and the insiders like Einhorn get it so wrong?
First, they don’t fully understand how the macroeconomy works. Most of their knowledge would come from either mainstream macroeconomics course at universities which worthless (actually damaging) or around lunch tables sipping cups of tea sharing “knowledge” with similarly blighted individuals.
Second, they therefore do not understand the nature of the problem at present. They think the problem is the “size” of the public deficits and the growing ratio of public debt to GDP but a considered reflection leads one to conclude these are not problems at all. The movements in these aggregates tells us about other problems – pertaining to the real economy – but in and of themselves they present no issue that is worth a moment’s thought.
The problem for the public debate though – in terms of moving it in a direction that will address the actual underlying issues such as weak aggregate demand and persistently high unemployment and rising long-term unemployment – is that these commentators are stuck in mindless obsessive warp about these financial ratios. They cannot see beyond them and they cannot see how meaningless their daily obsessions are.
Which brings me to the hearings that were conducted last week by the US Committee on Financial Services, which is a committee of the US House of Representatives.
On July 22, 2010, Richard Koo appeared before the Committee and presented his testimony – How to Avoid a Third Depression. I have previously considered Koo’s ideas in this blog – Balance sheet recessions and democracy.
Essentially, his views have resonance with the main perspectives offered by MMT although he does get some things wrong.
His recent testimony is one of the better commentaries on the current economic problems but probably fell on deaf (or dumb) ears at the hearing.
Koo told the hearing that there are recessions and then there are depressions. The correct policy response must differentiate correctly between these two economic episodes. He said:
The key difference between an ordinary recession and those that can lead to a depression is that in the latter, a large portion of the private sector is actually minimizing debt instead of maximizing profits following the bursting of a nation-wide asset price bubble. When a debt-financed bubble bursts, asset prices collapse while liabilities remain, leaving millions of private sector balance sheets underwater. In order to regain their financial health and credit ratings, households and businesses in the private sector are forced to repair their balance sheets by increasing savings or paying down debt, thus reducing aggregate demand.
So while the ultimate problem remains a deficiency of aggregate demand (total spending) the balance sheet dynamics in the private sector are also important to understand.
When we talk about deficient aggregate demand we are considering spending in relation to the capacity of the economy to produce real goods and services. This can also be viewed of as the capacity to employ workers at current productivity rates. So deficiency is a shortfall in spending which provokes firms to reduce output (so that they do not accumulate unsold inventories) and lay off workers.
All recessions have this dynamic. Private spending falls perhaps because firms feel negative about the future growth in sales. Perhaps the fall in private spending originates as reduced consumption. Either way, overall aggregate demand falls.
The normal inventory-cycle view of what happens next notes that output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.
The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.
Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.
At that point, the economy is heading for a recession.
So the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur. This could come from an expanding public deficit or an expansion in net exports. It is possible that at the same time that the households and firms are reducing their consumption net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).
So it is possible that the public budget balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.
However, what Koo calls the depression-route is also associated with huge levels of private indebtedness that has to be cleared before private spending growth can occur. The balance sheet urgency complicates the recovery process and make the policy intervention even more critical because private saving has to be supported to allow the balance sheet corrections to occur.
Koo notes that in these circumstances (private debt minimisation) monetary policy becomes ineffective:
… because people with negative equity are not interested in increasing borrowing at any interest rate. Nor will there be many lenders for those with impaired balance sheets, especially when the lenders themselves have balance sheet problems.
From a MMT perspective, monetary policy has dubious effectiveness anyway because it is highly dependent on the reactions of creditors (facing low incomes) and debtors (facing higher incomes). The timing and magnitude of these spending reactions are unclear. Further, monetary policy is a blunt instrument and cannot be targetted at all.
But Koo’s insight remains interesting and relates to what Keynesian economists have called a “liquidity trap” – where all people form the view that interest rates can only rise and so hold their speculative wealth balances as cash rather than bonds (because they fear the bond prices will fall). At that point credit creation stalls and interest rate manipulation is futile.
But Koo’s point should also be extended to note that the claims by central bankers and others that their quantitative easing policies would expand credit were always misleading if not plain wrong. Please read my blog – Quantitative easing 101 – for more discussion on this point.
You might also like to review the blogs – Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion of the way in which monetary policy changes in recent years have been seriously misunderstood by commentators (for example, Einhorn and his ilk).
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