Don't Shoot the Messenger

Reading the Writing on the Japanese Wall

The recent decision by Fitch Ratings to downgrade the Japanese sovereign by one notch, from AA minus to A plus, has all the outward appearance of being a predictable non-event. As the Reuters article reporting the decision puts it,  Credit downgrades usually do not have a lasting impact on markets in Japanbecause its government bonds are mostly held by domestic investors”.

Yet something somewhere fails to convince me that this nonchalance is really justified . Something tells me that this process of rising debt and falling credit ratings  cannot go on and on forever, and that at some point we will reach what Variant Perception’s Claus Vistesen calls “the end of the road”. In which case, we could start 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, unless I am mistaken.

On one hand, Japan seems to have invented what seems to be some kind of economic perpetual motion machine. Since the country has an external surplus, and can print its own money, 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.

But somehow or other this view fails to convince, in particular it fails to get to grips with why Japan has gotten into this ridiculous 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 are we all destined to slowly drift towards the financial equivalent of the world that was so ably described in Ridley Scott’s cult film Blade Runner?

But if there is no longer hope of exit, and we are now evolving towards what could be considered a brave new financial world, we could at least spare the time to ask ourselves why this is happening. Certainly from a macroeconomic point of view the explanation “that’s just how it is” feels far from satisfactory, while the argument that we just need to continue long enough and hard enough along the current path before  the Japanese economy somehow “rights itself”  - after more than two decades – appears to be based more on belief and hope than any thorough empirical analysis of the situation. As I keep repeating, we are entering terrain which was never really contemplated by neoclassical theory, in either its Keynesian or its Austrian variants.

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 has to constitute negligence” –  and we seem to be all set to have a third one in front of us, as long markets and weather permitting, always assuming the Japanese government remains able to finance its debt.

The Deflation Issue

The argument that Japan’s economic and financial system is simply undergoing a much needed correction after the unwinding of the excesses of a stock market boom (1989) and property bust (1992) as we enter the third decade of the problem doesn’t, as far as I am concerned, seem credible. The heart of the problem has been the deflation issue. The Japanese economy first fell into some kind of deflation trap in the mid 1990s. Following a sharp reduction in interest rates and a massive injection of capital into the banking system in 1997 inflation briefly recovered, only to fall back into negative territory again at the turn of the century. The problem has persisted ever since, with the exception of a brief spell of inflation during the oil price surge in 2008 (see CPI chart below). However, even this timid inflation disappears if we look at the core (ex energy, ex fresh food) index, which never really left negative territory, and which was still registering a minus 0.5% annual rate in March (the latest month for which we have data).

At the heart of the deflation problem in Japan has been the ongoing slump in land prices, which are now still stuck around early 1980s levels (watch out Spain). Land prices did briefly rise for the first time in 16 years in 2007 as a wave of speculative activity saw external investors flocking in to what they were promised would be a new boom (shades of Germany 2012), but then slumped back again in the “risk off” environment which accompanied the onset of the Global Financial Crisis. Prices have continued to fall, and if the metric of golf club membership fees used by Bloomberg reporters is anything to go by, 2012 looks set to be another bad year.

The result of all this deflation is that nominal GDP has fallen substantially in Japan since the 1997 high. In real terms, Japan’s GDP grew just just 25 percent between 1990 and 2007 while the contraction experienced during the recent crisis has sent 2011 real GDP back to its 2005 level (while nominal GDP slumped to 1991 levels

Naturally, it is this fall in nominal GDP values which lies behind the massive surge in the government debt to GDP ratio, although as the IMF points out, the constant budget deficits and ongoing low growth have played their part.

The steady increase in primary deficits, from an average 1.7 percent of GDP in the 1990s to an average 5 percent of GDP in 2000–07, is reflected in the evolution of the net debt ratio, which rose from 12 percent of GDP in 1991 to 81 percent in 2007 (67 to 188 percent in gross  terms). Following the global financial crisis, net debt escalated sharply, to  117 percent in 2010.  - IMF report to the G20 “Japan Sustainability“.

Now all these fiscal deficits are interesting, since the one thing they have not produced is growth. Japan’s long term growth rate has been falling since it peaked in the late 1960s, and it continues to fall. The ten year moving average, after hovering round 1% in the mid 2000s hit 0.75% in 2011. This raises the more than the hypothetical possibility that it will soon fall into negative territory.

Now, on one account, this situation is not as dire as it seems, since Japan’s falling population means that real GDP could fall and GDP per capita actually rise. This argument seems very attractive at first sight, but when you come to think about debt, it is not quite so appealing, since even if GDP per capita stabilises, debt per capita continues to rise as population falls, and this impact is even more accentuated if we consider that the fall in working age population will be even greater. Fewer people paying more doesn’t sound like a positive trend, and especially not from the viewpoint of domestic consumption.

Euro Look-alikes?

The curious thing about Japan is in fact how much it seems to resemble a more extreme version of what we have been seeing in Europe –  in countries like Portugal and Italy – over the last decade. Certainly the growth picture is quite similar.

As is the chronic dependence on fiscal deficits to achieve any semblance of growth.

Really it is hard to continue to call this ongoing dependence on fiscal life support “stimulus”, clearly something new is happening here. What separates Japan from these two Euro look-alikes is in the first place they have been suffering from excess inflation, not deflation (so the debt has not ballooned the way the Japan’s has) and secondly Japan used to be able to boast a significant trade surplus. I say used to, because this is no longer the case, with the post tsunami energy dependence  exacerbating a tendency which had already started to take root following the sharp rise in the value of the yen we saw in the wake of the Global Financial Crisis.

This means that 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.

The real issue is how long can Japan maintain its current account surplus, given its declining household saving rate, and the need of its growing elderly population to draw down savings. 

Savings Imbalances

As the IMF points out, Japan’s high aggregate private saving rate masks a deep imbalance between sectors. “In particular, the aggregate rate reflects a high corporate saving rate, which trended up from 13 percent of GDP in 1981 to 21 percent in 2009, and a very low household saving rate, which declined from 10 percent of GDP to less than 3 percent over this  period”.

The falling household saving rate is undoubtedly demographically linked (as populations age they tend to draw down on savings), although the downward pressure on wage income resulting from globalization also plays a part. The key issue though is for how long will corporate saving, and the resulting income flow, keep the country’s debt afloat.

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. In Japan, two scenarios are possible. In one, private demand would pick up, which would lead the BOJ to increase policy rates, in which case the interest rate growth differential may not change much. The other is more worrisome. Market concerns about fiscal sustainability could result in a sudden spike in the risk premium on JGBs, without a contemporaneous increase in private demand. An increase in yields could be triggered by delayed fiscal reforms; a decline in private savings (e.g., if corporate profits decline); a protracted slump in growth (e.g., related to the March earthquake); or unexpected shifts in the portfolio preferences of Japanese investors. 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”.

In other words, a wrong combination of circumstances at an inopportune moment in time could easily send Japan spiraling to where Italy and Portugal are now, even without being in the Euro. In a recent in-depth research report on Japan Variant Perception’s Claus Vistesen put it thus:

“Japan will run out of savings to buy JGBs by 2016, but 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”.

Demographic Drift

Japan’s population – in median age terms – is the oldest on the planet. Median age is around 45, and it continues to rise. There is no real prospect of it coming back down again, since the process appears to be totally irreversible.

A large chunk of the debt problem is demographically related (see chart below). Since the early 2000s, Japan’s non-social security spending has been well contained and, at about 16 percent of GDP in 2010, was the lowest among G-20 advanced economies. Meanwhile, social security benefits have risen steadily due to population aging. Social security spending rose 60 percent in 1990–2010, 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, which has  rapidly deteriorated the social security balance.

Unorthodox Policies

In an article published in the late 1990s and entitled “Japan: What Went Wrong?, Paul Krugman starts to wrestle with a problem which had evidently been bugging him for some time, as the title of the piece shows. The whole text is worth reading, as it gives important background over how the modern debate about what to do with countries who fall into a liquidity trap came into existence. In many ways it was Krugman himself who brought it back kicking and screaming into the current discourse. In fact, he asked himself a question which many others could have asked, but few have chose to do so.

“How could a wealthy, productive, sophisticated country have gone from enviable growth in the 1980s to stagnation in the ’90s, and now be slipping into a downward spiral of recession and deflation?”

In order to do this he looked at a number of the explanations that had been offered for the particular nature of the Japanese “malaise”:

Explanation 1 is that it is mainly a financial problem. Japan’s corporations are too burdened with debt, its banks too burdened with bad loans that have never been acknowledged. On this view, what Japan needs is a long, painful financial housecleaning.

Explanation 2 is that the problem is mainly psychological. When the “bubble economy” of the 1980s (remember when the square mile under the Imperial Palace was supposedly worth more than all California?) burst, goes the story, consumers and investors went into a funk that has depressed the economy, and the depressed economy has perpetuated the funk.

Well, of course, both of these explanations are immediately contextualise-able in the context of housing boom/bust societies like Spain or Ireland. The financial system got broken and credit dried up, at the same time consumers got frightened by continually falling property prices and started to keep their wallets wide shut. But leaving aside the issue of whether a “jump start” which was large enough and sustainable enough would be sufficient to return Ireland and Spain to a regular growth path, there was obviously something “funny” going on in Japan, which is why Krugman started to consider Explanation 3.

Until recently I was more sympathetic to Explanation 2. But lately I have started to wonder whether the stubborn unwillingness of Japan’s economic engine to catch is, as many foreigners seem to think, merely because the jump-start hasn’t been big enough or sustained enough. And so (like a small but growing number of people, including at least one influential Japanese economist and I have started paying attention to Explanation 3–that Japan’s troubles really stem from a subtle but deadly interaction between demography and ideology.

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.

Well, all this sounds familiar, doesn’t it? It sounds vaguely related to things you will find scattered across  my blog posts, and in fact this is not surprising, since it was reading this piece, and another one entitled “It’s Baaack! Japan’s Slump And The Return Of The Liquidity Trap” (see the appendix to my 2008 post “Did (or Didn’t) Japan Just Re-introduce Quantitative Easing?” for the relevant excerpt), that really started me thinking that what was going on in Japan might have some sort of demographic connection.

But, as I argued in e-mail communication with Krugman at the time, 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 problem, then it means the problem is a deep structural one which won’t be resolved by any kind of “kick start”, however large. It isn’t a question of a planet which has slipped off its orbit, and just needs a nudge to get it back on, it is a planet which has veered off onto a whole new trajectory, which leads who knows where. As I say, 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. Curiously, while you will find these kind of reflections spread out all through my work, it has been many years since I have seen Krugman come back to the issue.

I think that Krugman’s work at the time was truly innovative. He identified a problem, a country with an ageing and declining workforce, and he looked for a solution to that problem. This put him head and shoulders above the majority of his contemporaries. But he stopped short of digging deeper, and allowed his spade to be turned too soon. He could see that the problem was one of demand deficiency due to the changing balance between saving and borrowing, but he didn’t follow this through and see that the problem was not simply temporary (even if decades long) but more or less permanent, and he didn’t see that this demand deficiency results in export dependency (leveraging the global rather than the local economy in the search for customers), and that the only consequence of having permanent fiscal injections would be not to give stimulus, but rather an accumulation of debt that will be increasingly harder for those smaller and poorer (deflation) workforces to pay down in the future.

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. Which brings us back to Fitch Ratings and the Japanese downgrade. The core issue of the moment is the attempt by Japanese Prime Minister Yoshihiko Noda to raise the country’s consumption tax from 5% to 10%. As Paul Krugman would tell you, such a move would bring in revenue, but would weaken internal demand even further. Effectively it amounts to austerity in a country which is “growth challenged” and just as in Portugal and Italy, austerity is not popular with voters. In a recent poll only 40% of those questioned were in favour of the measure, while 50% were opposed. As a result, and attempt to push through the increase could split the governing Democratic Party and bring down the government.

Meantime Former Japanese Finance Minister Hirohisa Fujii has warned that failure to pass the legislation will inevitably spark ratings agencies to implement further downgrades and yet more downgrades of the kind  which might eventually force banks to sell off their government bond holdings, making one of the IMFs nightmare scenarios come true. However, as Bloomberg’s Isabel Reynolds points out:

Fujii’s warning is at odds with previous credit rating downgrades that have failed to result in higher interest rates. Japanese banks face a total of 6.4 trillion yen ($80.4 billion) in valuation losses on their holdings of government bonds if interest rates increased one percentage point, the Bank of Japan (8301) said in a report last month.
Domestic deposit-taking institutions hold about 39 percent of JGBs, while about 8.5 percent are held by foreigners.
Japanese government bond prices have so far been unaffected by the country’s ballooning debt. The country’s credit rating has been downgraded by Standard and Poor’s four times since 2001, and over that period yields have fallen more than 52 basis points.

Unfortunately, just because it hasn’t happened yet doesn’t mean it never will, as we saw with house prices that only went up. If the downgrades pile on fast enough, and junk bond status approaches, expect markets and banks to react. As Claus Vistesen says, they have four or five more years, and the clock is ticking away.

22 Responses to “Reading the Writing on the Japanese Wall”

burkbraunMay 25th, 2012 at 8:44 pm

Forgive me for reading superficially, but the whole doom loop proposition seems unconvincing. At some point, demographically, savings will be net withdrawn and consumption increase, at which point the economy will re-enter a normal trajectory, with inflation pressures and a shortage of real resources to all the old drawing down their savings. Then the government may have the unpleasant task of reigning in consumption, but at least it won't be issuing much more debt. (And, one could add that inflation will wear away at the accumulated debt as well.)

D M SmithMay 26th, 2012 at 1:26 am

"At some point" seems to be the operative phrase. How much impoverishment and/or demographic aging will it take to force a sufficient reduction in the rate of savings to establish a net withdrawal? And would this not impel more and more young people to overcome the language and cultural barriers to exit the country?

barfMay 26th, 2012 at 2:31 am

i would argue the Yen has become a textbook "carry trade" currency (again)…not necessarily a condition a nation wants to find itself in as it wrestles with tremendous issues of "economic sovereignty." i also think the International Community will shortly start demanding answers relative to the ongoing Fukushima nuclear catastrophe. The silence relative to the West Coast political class has been deafening indeed. And rather odd i might add. Obviously "there are implications for France" in this matter as they get i believe 70 plus percent of their electricity from nuclear power. "sounds expensive" as they say.

Edward_HughMay 26th, 2012 at 6:16 am

Hi Burkbraun and Barf,

"Forgive me for reading superficially, but the whole doom loop proposition seems unconvincing. At some point, demographically, savings will be net withdrawn and consumption increase",

Well, I think some sort of variant of this is what most people are assuming, otherwise they would be more worried than they evidently are. I think I would just point out a number of things here.

Firstly, I am trying to use Japan to show that the Euro problems are not unique, that Japan arguably has similar low growth problems to some Euro area countries, and despite the fact it has its own currency, and its own central bank, it never seems able to achieve escape velocity. You should I think accept this point, that empirical reality backs this argument, as there is no evidence to back a counter thesis. Just hoping isn't evidence.

I think Barf is absolutely right that the safe haven and carry trade aspects are very important in understanding why Japan has deteriorated so quickly (Switzerland has similar issues, although they have managed to peg the CHF to the Euro for the time being). Basically you need to read through quite a bit of my material to get a feel for the whole argument I am advancing. Part of it is to do with growing export dependency as median ages rise. Again, there is empirical backing for this sort of argument (and no counter evidence to falsify) if we look at countries like Germany and Italy who are also around the 45 mark.

Now what has happened to Japan is that between 2005 and 2008 Japan was able to get very near to what seemed to be "escape velocity" because with interest rates pinned near to zero they became the main funding currency, and the yen was at ridiculously low levels. The bank of Japan even made timid moves to exit QE. Then came the GFC, and carry unwound, sending the yen to very high levels, where it has stayed. It has stayed at these levels since near zero interest rates have become a general phenomenon in the developed world (why is this I wonder, can neoclassical theory explain??), so the US, the UK and even the Euro have become carry currencies of reference.

This meant that Japanese exports NEVER (ie nothing to do with the Tsunami) recovered anything like their pre crisis highs, and as a result Japan has struggled to find growth.

In broad brushstroke terms economic growth comes from either very high rates of export expansion, or from growth in credit feeding domestic demand and property and asset prices. Ability to take on credit is an age related phenomenon, and again we don't see credit driven booms among elderly societies like Germany, Italy and Japan, we see them in societies with much lower median ages – the US, the UK, Spain. Again, I would argue more empirical backing for my view.

Now your argument would be OK up to a point if people did start drawing down their savings on aggregate in sufficient quantities, since this would be equivalent to an expansion in domestic credit, but think about it, you have a finite stock of savings, median ages continue to rise, not fall, so once the stock of household savings starts to contract eventually it gets to zero in finite time. What happens then? Naturally this point is only a theoretical limit, since there is no evidence old people anywhere are comfortable as their savings reach zero.

And think about what happens as savings are drawn down to the financing of government debt. Either the drawdown comes from the domestic system, in which case the institutions that hold them need to sell off some of the government bonds they have accumulated, or they realise external assets they have, in which case the income flow on the current account weakens, and this latter is like life blood to Japan.

The only way I don't see a doom scenario here is if trends in median ages were to reverse, and I see no evidence at all of this happening.

Edward_HughMay 26th, 2012 at 6:18 am

Just summarizing my argument, one of the key points I am trying to make is that many of the simplistic arguments about the Euro don't work if you look at Japan, and this is a point I try to get across in my Wolfson essay. What is the solution for Japan, default devalue and exit the Euro? Whoops.

rodeneugenMay 26th, 2012 at 9:14 am

Lets try to create a short balance sheet to Japan liquid assets. (Japans GDP at 2011 in current prices- 5,855 mill.US$)
mill. US$
Assets value – Net value of Stock of direct foreign investment – abroad: 733
Reserves of foreign exchange and gold:1,063
Market value of publicly traded shares: 4,100
- Debt – external: (2,719)
Net liquid equity3,177

The internal public debts are compensated by equivalent private credit holdings.

This figures doesn't include the net value of the real estate holdings and the value of the foreign shares holdings by the Japanese entities. While the real estate is not liquid, the foreign shares holdings are. All this means that the net liquid equity of Japan is probably something above 100% of its GDP.

On the other hand Japan economy, as you mentioned has no growth and probably will even start to shrink in the near future, while still it has enough liquid assets to finance trade deficit if needed (not very probable in the foreseen future).

The public deficit problem is at annual level of about 8% of the GDP, means about 40 billion US$. On the other hand it taxes and other public revenues are about 34% of the GDP which is compared to Germany lower by about 10% and of France even 15%. So Japan if wanted, it could level its annual deficit. But rightly asked aren't there limits to such a public deficit, accumulating to frightening 200% of the GDP? To where it can develop?:

1. Let us say, the holders of the Japan public debts decide one day to stop their savings and doing it by increasing investment or consumption. Then the GDP in Japan will finally grow again, or if it wouldn't have enough production capacity (very improbable) the reduction of savings will cause reduction of the net equity value, and it would bring more balance to the world economy.
2. The other alternative is that the savings are reduced due to reduction in the production level (again very improbable) the effect will be the same, just the supplement to the reduced production will come from aboard and its net equity will shrink. All this is good for the world economy.
3. And now the last scenario, Japan continues to be balanced in its trade balance, and its private entities continue to create surpluses, without investing it in Japan or consuming it, and will stop purchase government bonds. What will they do with their surplus? They will have to invest it aboard and export the economic growth abroad. The result is same.
All the alternatives are bringing us to more balanced world economy. Do not forget Japan holds about 1 trillion US$ US Government bonds, the same as China.

As to economic growth, is it really necessary for a country with declining and aging population and with no immigration, out of cultural choice? Probably we have to get used to this phenomena of economic decline, that goes hand to hand with the demographic developments.

William HalversonMay 27th, 2012 at 12:42 am

Good grief … in Japan's case the answer is simple: they no longer want to buy more toys. So if
1) not enough young people exist to form new households to buy things
2) the old people don't need to buy more things either

Demand just isn't there. QED. Your more interesting question, which none of your commentators has taken up is the fundamental question:

"As I keep repeating, we are entering terrain which was never really contemplated by neoclassical theory, in either its Keynesian or its Austrian variants."

What economic theory explains how economies work if people believe they own enough stuff already? There aren't enough Africans to buy all the stuff coming out of the factories of Japan etc., and most people I know don't need or want a third iPhone. In spite of themselves, at some point consumers just become satiated.

Norman F. SimensonMay 27th, 2012 at 10:55 pm

1. One problem is that we can no longer 'examine'/analyse one country in isolation from the reswt of the world.

2. If we were simply to redistribute all of the world's resources/products across everyone in the globe– hardly anyone's income (except, perhaps, those living at barely subsistence levels) would increase. So, the real problem is that we simply lack enough resources/products to materially increase the standard of living of most people on this planet– except for limited numbers of people for relatively brief periods of time (and then, generally at the expense of some other group, e.g., the American economy boomed after WWI and WWII while the rest of the world's economies were prostrate).

3. The basic problem of declining GNP and an aging demographic is thus nature's way of rationing the planet's resources and mankind's value added. The only effective solution would be a greatly increased productivity and a better distribution mechanism for the ensuing wealth. There is some optimal distribution between all of the wealth going to a few rich and all of the wealth being equatably distributed (which would hardly benefit anyone).

lottinMay 27th, 2012 at 11:24 pm

I don't believe that a non-growing economy is a problem per se. How about the standards of living? Have they deteriorated at all? Looking at unemployment data, it looks like the unemployment rate peaked in 2002… at 5.5 percent! Debt might be a problem, but I think is the sort of problem that mitigates itself. Anyway, interesting article. It makes me want to know more about the Japanese economy.

Clive JonesMay 27th, 2012 at 11:30 pm

This is my first comment, so let me start out with kudos to Edward Hugh. I've benefited from his earlier discussions on Spain and Italy, and now find this on Japan.

My background is in the electronics industry, and with respect to this industry it is impossible to avoid the linkage between Japanese investment and lower growth rates and China. Japanese investment since about 1990 has bled off into China. The result is Japanese electronics on the islands themselves may have become somewhat ossified, while the aggressive money in Japan has been pitched into production in China.

But I think the facts of demographics – the aging of the Japanese population as well as its lack of immigation – now function as big intermediate factors.

Anyway, thanks for this piece on Japan.

buzzMay 28th, 2012 at 12:52 am

Thanks Edward for a very interesting blog. I completely agree with your view of Japan as the bellwether and frontier-pusher of a global movement into uncharted and unanticipated macro-economics territory. Krugman by the way has changed his mind and decided Japan's post-bubble policies were relatively successful. Japan is being held up as an inspiration to the backlash against austerity.

My feeling is that Japan will stick to its model longer than you imagine possible. Big Japanese institutions just don't have an incentive to dump their holdings of government bonds. There's a gradual pressure from the dropping personal savings rate, but that can be handled with further repression and/or central bank purchases. So I'm not looking for when Japan will break down.

My interest in Japan is how it demonstrates the effects of persistent high deficits and of a high proportion of savings being held in the form of public debt. When households save in public debt they buy a non-specific claim on the future output of the national economy, of which a small portion is invested (in public investments) and the rest is consumed (in public operating costs) or transferred through the welfare system to less well off households who mostly consume them. This is a less risky way of saving for retirement than betting on specific activities in the private sector. But it is by nature a piggy-back on investment in the private sector, which drives growth. Japan demonstrates what happens when the piggy-backer weighs more than his carrier. Leaving aside the merits or demerits of Keynesian stimulus during recovery of recession, there is a definite downside to maintaining persistent high deficits, even if you have a culture like Japan's that can sustain them seeming indefinitely.

Peter ItohMay 29th, 2012 at 8:50 am

You correctly point out that economic growth comes from either or both very high rates of export expansion, or from growth in credit feeding domestic demand. Japan failed on both fronts. As for the latter, Krugman's explanation 1. of financial problem in the 90s that prevented credit expansion. As for the former, a very high rate of export grwoth did not allow the Japanese economy to boost domestic demand, but rather induced a deflationary spiral both in price and demand. On this I defer to Gunther Scnabl paper "Weak Economy and Strong Currency – the Origin of the strong Yen in the 1990s". He argued that the any spike in the Yen caused Japanse exporters to maintain export volume at the expens of profit margins. Consequently, Japanese exporters, major source of corporate profits, continuously suffered low margins and never made sufficient investments domestically to boost demand.

DamienMay 30th, 2012 at 1:27 pm

Japan net international investment position is approximately 50% of GDP and the government is strongly encouraging Japanese companies to invest/buy foreign companies. The diet is also in the process of approving an almost USD 700 bio. fund to invest outside of Japan.

What about Japan taking advantage of the highly valued Yen to increase its NIIP and then devaluing massively its currency (and by massively I mean a move above 200 against the USD) by having the BOJ embarking into a massive round of QE. They will then repatriate some of their foreign assets to pay back their domestic debt.

With little debt left, high corporate saving and an undervalued currencies, it will then be easier to sell debt to foreigners.

The fact that the nuclear energy complex has been shut down and hence the high energy import bill would talk against a massive devaluation as is the fact that real interest on deposit will be highly negative hence hurting cash and fixed income rich elderly (which happen to hold the keys during election…) but…

A SinclairMay 30th, 2012 at 3:57 pm

Large JGB buyers are now net sellers. GPIF (Second largest holder) is liquidating $80 billion of JGB's per year to pay retirement benefits. Japan Post Holdings, the largest financial institution in the world, holds over 70% of its assets in JGB's (largest holder) is trying to diversify and is a net seller of JGB's. The Banks hold over 20% of assets in JGB's and no longer are growing. Savings rate is down to 2% from a peak of 25% and is projected to go negative. Government Deficit is over 50% of spending and may hit 60% with supplemental budgets. Japan can no longer fund its debt on an ongoing basis and is guaranteed to have more credit downgrades..

KansasCommonSenseMay 30th, 2012 at 4:53 pm

Kansas is an interesting counter point to your Japan article proposing aging of population as the issue versus Keynes and followers like Krugman, the famous writer and Nobel Prize winning professor.  

Like Japan, Kansas population is aging.  We are not a young thriving economy with citizens that need to consume, and we are not huge exporters. 

When a nation or state faces a liquidity trap, is there another way forward?  Does  a Keynesian Japan model to escape a liquidity trap offer the only solution?

When our current governor took over some 3.5 years ago, the State of Kansas had a $500M deficit, out of control spending, and a declining economy with businesses leaving.  3.5 years ago,  we sent our previous Govenor to Washington to set up Obama Care.

The new Republican governor reduced the size of the state government in both spending and employees, cut income taxes, cut business taxes, and raised sales taxes.  This year's budget was the largest reduction of Kansas state government spending ever.  Today, we have a $500M state government surplus, higher income per family, and a growing economy with declining unemployment.  Businesses are moving into the state.

One way to look at all this:  Obama Care has been a huge plus for Kansas (so far) because it helped us dispose of an out of control Democtatic governor and dispose of a Federal Congressional House Democrat who refused to meet with Voters during the Obama Care debates.  For the first time in almost a century, all major post held in the State of Kansas moved to Republican control.  

The economics of the Republicans have shifted from a government controlling "the voters" (and their hard work) to Voters controlling the government.  If this experiment works for the long term, then it may be a good national model for Japan or any nation facing aging and liquidity problems.  If the Kansas model fails, then Dr. Krugman can report the failure in the New York Times, and the Republicans will be thrown out.

Our idea of economics is to look around and see what works and then adopt those ideas, no matter which side created them.  In Kansas, we do not look to Japan as a success story because they are on the verge of bankruptcy.  

In Kansas, we still believe a person, a business, a city, a county, a state, and a nation owe it to all to not go bankrupt, to honor contracts, and to pay debts.  We think all should not steal directly or indirectly.  Keynesian (Dr. Krugman's) policies are a form of theft in our opinion because these policies steal from savers, producers, and the most successful.  Further, we do not think high levels of debt to production output is "progressive" for any society because desperate societies, countries and people will eventually do desperate things; And then, the cost will far out weigh the benefit.

May Keynesians be so kind as to permit our little economic experiment to move forward, so we can see how we compete with California, New York, and Illinois.  These states are followers of Keynesian economic ideas and theories in our opinion.  May Dr. Krugman flourish and get rich selling his ideas and theories.

When our Nation and the Progressives talk of "fair", Kansans think "fair"means an equal chance to succeed, not equal out comes.  We have placed our economic bets ….. Kansans are ready to live with the out come.  We hope those choosing a different path will accept their out come.

I could ask for this blog to have their students evaluate the results of the competing States' economic experiments by evaluating the progress or decline  in state educational out come, state level budget deficits or surpluses, increase/decrease money in voters pockets, business formation and attraction of new businesses, money/investment flows, poverty levels, crime, environmental quality, quality of life, and others to these economist choosing, but these would miss what is most important to Kansas Voters.

Kansans want Freedom!  Freedom from a Federal government that is trying to control every aspect of our lives while stealing our savings from hard work.  Freedom to pursue Life, Liberty, and the Pursuit of Happiness, irrespective of the final out come of our efforts.  We want to live in a society where those that succeed help the weaker and poorer because they want to versus being forced to.  As Voters, we would prefer a measurement of our Freedom, and from our freedom to choose and live, we believe we will obtain most of the other metrics of "success" which would be measured.  May be our freedoms could be measured by counting a reduction of Federal Departments, a reduction in Federal employees, a reduction in Presidential czars, or some similar metric.
"May the truth set you free

GuestJune 2nd, 2012 at 6:49 pm

Edward Hugh does not understand that:

1) Japan suffers from "wealth shock" having seen value of it's commercial real estate apartments decline 87% from the peak

2) Public debt is wealth to the private sector

When private sector loses wealth colossal amounts either governments provide that wealth back as a larger public debt or econimies go to the recession, maybe depression

Wealth is the missing link that they do not understand.

Edward_HughJune 3rd, 2012 at 4:00 pm

Hello Guest,

"When private sector loses wealth colossal amounts either governments provide that wealth back as a larger public debt or econimies go to the recession, maybe depression".

Leaving aside for a moment what I do and don't understand, what is the growth model you are using here? On your view what drives growth?

And how long does this negative wealth shock extend. How many decades more should we expect? And why has the impact of the shock been so extended in time in Japan? Or why did land and commercial real estate fall so far, and is that fall a cause of the problem or a result of it?

Finally, I don't suppose you consider that Japan's demographics could have anything to do with all this?

Edward_HughJune 3rd, 2012 at 4:07 pm

Kansas Common Sense

"Like Japan, Kansas population is aging. We are not a young thriving economy with citizens that need to consume, and we are not huge exporters".

Just two questions. Doesn't Kansas form part of the United States of America, and isn't there a Federal system for things like pensions and unemployment benefit?

Secondly, just out of curiosity, just how old is Kansas. What is the median population age? To say it is ageing is not that helpful, since every country which breaks out of the Malthusian population regime then starts to age, as fertility declines and life expectancy rises. The US is quite a young society, with a median age of around 37, obviously those states with younger populations can to some extent compensate – via the pension system – for those who are older. This is not the case, for example, in a country like Latvia, which simply heads for bankruptcy as the young people leave. I don't suppose the US would be willing to incorporate Latvia, as the 53 state, or something.

Edward_HughJune 3rd, 2012 at 4:13 pm

Hi Damien,

I think you see some of the issues with your own question, but…..

"What about Japan taking advantage of the highly valued Yen to increase its NIIP and then devaluing massively its currency (and by massively I mean a move above 200 against the USD) by having the BOJ embarking into a massive round of QE. They will then repatriate some of their foreign assets to pay back their domestic debt".

The problem here is Japan is having a hard time reducing the value of the yen, since, for reasons I try to explain, that is not as easy as it seems.

On the other hand the issue of encouraging Japanese firms to export yen by investing elsewhere has been raised as one device to devalue. I see only one difficulty here, or maybe two. In the first place once the investment is made, income starts returning, giving a good boost to the current account deficit, but driving the yen back up again.

On the other hand, investing in factories and plant abroad is also investing in jobs. Japan lives from its export sector, not its domestic economy, and if you start sending the export sector abroad, well, and you committing some sort of Harakiri.

GuestJune 18th, 2012 at 12:57 pm

>On your view what drives growth?

My view is that in normal circumstances private sector investments drive growth, but in Japan these have been lacking because companies have been using their earnings to pay down debt. Hence, a growth recession.

>And how long does this negative wealth shock extend. How many decades more should we expect? And why has the impact of the shock been so extended in time in Japan? Or why did land and commercial real estate fall so far, and is that fall a cause of the problem or a result of it?

It takes a long time because asset price bubbles were so astronomically high. It's better to ask why did the real estate and stock market bubbles grow so big? The answer lies in the psychology of every bubble of humankind. 'Growth recession' lasts long because it takes long time for companies to pay down massive debt overhangs from retained earnings, as Richard Koo explains here:

The logic as to why public debt is wealth to the private sector goes as follows: when during a fiscal year government spends more than it receives in taxes there is corresponding increase in monetary holdings in the economy. Government spend by crediting bank account of the recipient and recipients banks reserve account, so that the recipient has received an asset and recipients bank has received an asset that offsets its new deposit liability. When and if bank wants to offer to loan these new reserves to other banks at the interbank market, government sells bonds to help the central bank hit its interest rate target. But only as many bonds as are necessery for this purpose. In a monetary sovereign states such as Japan, government bonds sales are not funding operation. Funding comes from the act of spending itself, and bond sales are part of interest rate maintenance policy.

So for the amount that governments spending into the economy exceeds what it takes away from the economy in taxes, there is corresponding increase in the monetary holdings of the private sector actors, and also corresponding increase in public debt. That is why public debt is wealth to the private sector.

Link to demographics is that big generations, the baby boomers want to save now when they are still in the working age for their retirement years so there is high demand for money as a form of savings, an financial asset. Pension funds usually hold these monetary 'hoards' and prefer to buy government bonds, that are really just an interest-bearing form of money.

Government has deficit spend both money and the bonds into existence and thus enabled these savings. If for some reason government refuses to issue enough money and bonds, financial wealth to the private sector, private sectord saving behavior causes deficient aggregate demand and there is a recession in the economy as economy's productive potentials do not get fully utilized.

Of course baby boomers wanting to hold large amounts savings for their retirement days is big part of the story of economic malaise all over the world right now, but there is difference that where pension chemes are pre-saving, and usually tax-advanced government sanctioned chemes need for financial assets is much larger than elsewhere, for example where government just makes a promise to make pension payments when the time comes due. Either way these achieve the same, but need for government issued financial assets in the pre-saving system is much higher.

Summa summarum, "wealth explanation" for economic malaise and recovery is that after collapse of asset prices, such as housing bust, net wealth position of private sector actors (assets – liabilities) goes below desired level private sector actors want to have. This causes them to start saving out of their income and as spending declines economy usually goes into recession, causing budget deficit to widen. Budged deficit brings financial assets, money and bonds, to the economy enabling private sector actors to have more savings. Once private sector actors have achieved net wealth postition they desire they will stop saving and start to spend out of their incomes again, the need for government deficits will diminish, but the recovery is not because of improving 'confidence' or other psyhological factors mainstream economists explain, but because increase in public debt has brought enough new financial assets to the economy to satisfy saving desires of the population.

Kent WillardJune 19th, 2012 at 3:13 am

A quick aside on Kansas – Kansas, along with most of the Midwest and Southern US, receives more in federal spending than it pays in federal taxes. Those awful liberal states like NY, Mass., and California pay more than they receive. Why? Probably because people make more money there and so pay higher taxes. Either that, or Kansas is full of welfare farmers. Check it out at…. And btw, it usually takes two to make a bad loan: the lender, and the borrower. The higher risk of default is why lenders usually charge higher risk borrowers more.

Japan seems like where the rest of the developed world is heading. And I'm sure demographics has something to do with it, because gov't debt on an aging population means that savings <> investment, but instead savings = generational transfer of consumption. The lack of real growth due to a larger population, or the lack of nominal growth due to inflation, will be our undoing.

But Europe's problems aren't just demographic. It is also distributional, as seen by the differences between member nations. Some younger nations are being sucked into depressions due to an inability to rebalance past trade deficits and mal-investments.
Italy's problem may be demographics, but Spain's is an old fashioned speculative boom that can't find equilibrium because they gave up their sovereign currency for a decade of low interest rates. I guess they'll try deflation before they try default.

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