LONGREAD: Is Japan a boiling frog?

Obviously, this is a metaphor for under-reaction to threats that occur gradually. Does the metaphor have any relevance to Japan’s economic situation and outlook? My fear is it does.

"[Japan] should get worried about a likely 2020 event now – but it probably won’t until much closer to then."
Dr David Morgan, MD, JC Flowers & Co

Japan’s main economic problems are well known: massively excessive public debt and entrenched very low inflation expectations. Below is some finer detail.

Public debt: Th general government primary fiscal deficit (that is, the fiscal deficit before public debt interest expense) is still very high. It was around 6 per cent of Japan’s GDP in 2015 (the equivalent figure for the USA was 2 per cent).

Also, gross public debt is huge at around 245 per cent of GDP (estimated at end 2015). This is unprecedented among advanced economies and has risen by 50 percentage points in the last five years.

Inflation expectations: Japan’s core-core Consumer Price Index inflation rate has lingered around 1 per cent since the beginning of 2013 (Prime Minister Abe’s mandate started in late December 2012). It is still short of the 2 per cent target.

In terms of GDP, Japan is doing well. However, this performance is fuelled by a fiscal stance that will ultimately prove unsustainable, in view of the burden of Japan’s public debt. The main underlying problem is that private demand is not strong enough.

Given this diagnosis, the required economic policy package is one that will increase inflation and curtail public debt. Japan needs inflation for two reasons: first and foremost, to stimulate private consumption and private investment through a reduction in the real interest rate; and, second, to erode the stock of public debt in real terms.

But there is no agreement on the policy approach to achieve these two outcomes.

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ILLUSTRATION: Okitsu-gawa, New York Public Library Digital Collections, 1832.

ECONOMIC POLICY APPROACHES

For Japan, there are a number of actual or potential economic policy approaches:

• Abenomics (the three pronged economic strategy of prime minister Shinzo Abe) 
• Income policy and medium-term fiscal consolidation
• Helicopter money
• Default/debt restructuring/debt write off

Here is how each stack up.

ABENOMICS

The three arms of Abenomics are (ultra-loose) monetary policy, structural policy and fiscal policy.

The classic transmission mechanisms of ultra-loose monetary policy are very low long-term interest rates, rising asset prices and currency depreciation. Japan has seen all three of these mechanisms at work.

The Bank of Japan recently moved to its Negative Interest Rate Policy (NIRP). Its initial effects were not encouraging : some asset prices (notably bank equity prices) declined and the yen actually appreciated. More intensive NIRP runs the risks of a further negative impact on bank profitability while inducing conversion of bank deposits in currency notes, thereby undoing the stimulus effect.

As the Peterson Institute’s Olivier Blanchard recently remarked: “Everything works a little. What worries me is you get perverse effects on the banking system. At some stage, you are screwing up banks so badly bank credit is affected”. The NIRP appears (so far at least) to have backfired.

Mervyn King (the former Governor of the Bank of England) has also pointed out (in his excellent recently-released book The End of Alchemy: “when interest rates at all maturities, from one month right out to 30 years or more, have fallen to zero, then money and long-term government bonds become perfect substitutes (they are both government promises to pay which offer zero interest), and the creation of one by buying the other makes no difference.”

In brief, monetary policy in Japan (as well as in other parts of the global economy, including notably the Eurozone) is well and truly into the area of severely diminishing returns. With the possible exception to be noted below, the Bank of Japan appears to be effectively out of ammunition.

Their actions have had only a very limited impact on increasing inflationary expectations. Inflationary expectations in Japan appear to be formed in an adaptive rather than leading fashion. Moreover, the Japanese conjuncture is not a purely monetary phenomenon but faces severe supply side constraints (of which more below).

STRUCTURAL POLICY

Abenomics gets high marks for committing Japan to the Trans-Pacific Partnership project. Beyond that, most independent observers conclude the structural policy ‘arrow’ deployed to date is probably better described as a ‘dart’.

On the structural front, Japan faces some truly formidable headwinds, including:

• A dramatic future reduction in population (absent a major liberalisation of Japan’s immigration policy, Japan’s population is due to fall from around 127 million at present to around 87 million by 2060);
• Rapid ageing of its population;
• Significant offshoring of production;
• Corporates with significant cash reserves; and
• A labour market characterised by duality and weak bargaining power.

The IMF Fiscal Monitor calculates Japan would need to turn today’s primary deficit (that is, its fiscal deficit before interest expense) of 6 per cent of GDP into a surplus of 6 per cent by 2020 and to maintain surplus for an entire decade to reduce net public debt to 80 per cent of GDP by 2030.25.

This will simply not occur - and if attempted would push Japan into a deep deflationary depression in which public debt leverage, far from falling, would almost certainly rise. Japanese government debt will simply not be repaid in the normal sense of the word.

Therefore it is hard to avoid the conclusion while Abenomics is directionally correct it seems highly unlikely on current trends to resolve Japan’s debt and deflation problems.

Incomes policy and medium-term fiscal consolidation

An alternative policy package could include two main components: income policy and medium-term fiscal consolidation.

Historically around the world, we have seen many attempts at incomes policies aimed at reducing inflation. The current idea is to introduce an incomes policy which would increase inflation.

Direct government action is proposed to increase wages in Japan. This could take the form of moral suasion, requiring an annual increase of, say, 3 per cent per annum in nominal wages. Companies would need to either ‘comply or explain’.

An alternative would be some subsidy delivered via the tax system to incentivise wage increases.

I understand the relevant Japanese authorities are very reluctant to interfere so directly with the operation of the Japanese labour market. I support the views of the Japanese authorities. This would represent a very large extent of the interference in the economy.

For medium-term fiscal consolidation, there could be a gradual increase in the rate of VAT; one percentage point a year increase for many years, taking the rate from 8 per cent at present to around 20 per cent.

They might provide a credible medium term anchor for fiscal consolidation and reduce uncertainty. While something like this might be favoured by Japan’s Ministry of Finance (MOF), the relationships between the MOF and the Cabinet Office are reportedly weak at present.

HELICOPTER MONEY: BREAKING THE TABOO

Some economists, including Adair Turner(the former Chairman of the Financial Services Authority in the UK), advocate for Japan to turn to so-called ‘helicopter money’. There are many variants of helicopter money.

For present purposes, it is assumed the government’s budget deficit be financed directly by the Bank of Japan, creating fiat money. This could take the form of zero coupon perpetual bonds.

In this way, no current or future debt servicing burden would be created to imply future taxes. Hence, it is argued, financing say a tax cut in this way should ensure at least some of this windfall gain is spent.

In brief, it is argued countries can always stimulate nominal demand by printing fiat money. If they print too much, they will generate harmful inflation.

Using central bank money to finance fiscal deficits or to write-off past public debts remains a taboo policy. Many central bank mandates, including the ECB’s, make it illegal. Helicopter money tears down the wall between politicians and the central bank.

The taboo serves a good purpose. As summarised in a recent speech by the Governor of the Reserve Bank of Australia, Glenn Stevens: “The main complication is surely that it would be a lot easier to start doing helicopter money than to stop, if history is any guide. Governments have found that a difficult decision to get right. That is, after all, how we got to the point where direct central bank financing of governments is frowned upon, or actually contrary to statute, in so many countries.

“It would be a very large step to overturn those taboos, which exist for good reason. The governance requirements in doing so would be, if not intractable, at least very complex. Desperate times call for desperate measures, perhaps. Are we that desperate?”

Japan used helicopter money in the early 1930s, under Finance Minister Takahashi, without producing harmful inflation. But it was also used by Weimar Germany and modern-day Zimbabwe, both producing hyperinflations.

DEFAULT/DEBT RESTRUCTURING/DEBT WRITE-OFF

One option would be for the Bank of Japan to convert part of its existing holdings of Japanese Government Bonds (JGBs) to zero coupon perpetual bonds.

The view attributed privately to Japanese finance officials was any resort to issuing zero coupon perpetual bonds was tantamount to saying JGBs are essentially worthless.

Another option would be for the Government to make a debt restructuring offer on JGBs to all holders but that only the Bank of Japan accepted. This would almost certainly destroy the independence and credibility of the Bank of Japan.

A broad-ranging debt restructuring/default would require everyone to take a hit: including pension funds, shareholders, and the Postal Savings Bank. JGB’s are overwhelmingly held domestically.

Historically, while external public debt defaults are common, outright defaults on domestic public debt are extremely rare. The usual way for governments to reduce excessive domestic public debt is via rapidly increasing domestic inflation.

We have discussed above the problems involved in lifting inflation substantially and rapidly in Japan.

CAN THE SETTING SUN RISE AGAIN?

It seems clear Japanese public debt will not be reduced substantially through a normal process of economic growth (Japan’s potential real growth rate is estimated at around one half of a per cent per annum) and fiscal consolidation.

By around 2020, on current trends, the stock of JGBs will be equivalent to the entire stock of Japanese private sector savings. Beyond then, who will take up incremental JGBs? It seems likely to be foreigners, the Bank of Japan, or some combination of the two.

Japan may manage to muddle through this, but expectations would be high for either very deep recession, or high and very difficult to control inflation.

As foreign investors impose stronger market discipline on government debt, they might require a yield increase of up to around 1.6 percentage points on the Japanese 10 year government bond to align its estimated risk-adjusted real returns with the OECD average. This will be a very delicate phase for Japan’s economy.

If investors in Japanese government bonds lose faith in the administration’s ability to control its debt, rising yields will increase the already onerous burden of servicing the borrowings, the bond market will go into a tailspin and, most likely, drag the equity market with it.

To avoid drowning in debt this way, the administration will have to show resolve in taking the necessary policy action that will make public debt sustainable. If a crisis developed, Japan would most probably significantly lifts its government revenue to GDP ratio, which is among the lowest in the OECD.