Marshall Auerback is a Denver, Colorado-based global portfolio strategist for RAB Capital plc and a Fellow with the Economists for Peace and Security (http://www.epsusa.org/). He is a frequent contributor to the blog, Credit Writedowns, and the Japan Policy Research Institute (www.jpri.org) and a new contributor to The Big Picture.

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It has been a few months since an electoral tsunami threw the Liberal Democrats out of office and replaced them with the Democratic Party of Japan – only the second non-LDP government in Japan in the past half-century. Not much has changed so far, but it is the first time since the 1940s that a party has been elected on a specific pledge that it would renew Japan’s foreign policy to give it more independence in dealing with Asia and the rest of the international community, and more decision-making power within the U.S.-Japan security alliance. Although the DPJ has emphasized repeatedly that the U.S.-Japan alliance remains the foundation of Japanese foreign policy, it has garnered attention by calling to review the status of U.S. forces in Japan, another hot-button issue in Washington. Other reviews which must be causing some gnashing of teeth in the US include discontinuing the Japanese Self-Defense Forces’ refueling mission to assist with NATO operations in Afghanistan and creating an East Asia economic community — excluding the United States.

None of this has come to pass yet and it is possible that the DPJ administration will ultimately prove as ineffectual as the Hosokawa government of the early 1990s, in effect providing the Japanese electorate with a nice bit of kabuki whilst changing little of substance. Still, the threat is there. Equally interesting (and perhaps not uncoincidentally), the election of this new government has occasioned much renewed discussion about the state of Japan’s public finances and the possibility that the nation’s solvency is a subject worthy of serious debate. It is indeed ironic that a country which has done so much to subsidize Washington’s growing militarism across the globe (by assuming so much of the costs of bases in Japan unwanted by the vast majority of the population), and has slavishly followed so much of Wall Street’s neo-liberal agenda should find itself in this position. But fortunately, the claims of “national insolvency” are as bogus as the idea that Tokyo should continue to subcontract so much of its country to the US as a launching pad for American adventurism in Asia and beyond.

At first glance, the state of Japan’s public finances paints a dire picture: Japan has about 190% debt-to-GDP financed at an average cost of less than 2%, according to the IMF (Goldman Sachs estimates the figure at 216% of GDP). Even with the benefit of cheap financing the Japanese budget deficit is expected to be 10% of GDP this year. Prominent fund managers such as David Einhorn (whose forensic accounting skills helped to expose the capital deficiencies of Lehman Brothers last summer, months before its bankruptcy), has remarked that were “the market to re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.” Carl Weinberg of “High Frequency Economics breathlessly suggested: “A catastrophic breakdown of Japan’s public-sector finances will be the biggest story ever to hit the world economy in our times, eclipsing the current financial crisis.”

Similarly, market analyst Jim Bianco recently penned a report entitled, “Japan Sovereign Credit Risk Rising” (Nov. 5, 2009, Bianco Research LLC), in which he argues that Japan’s “sovereign credit is questionable, printing press or no printing press” and that it was only a matter of time before the debt was downgraded.

Last year, not only did Japan’s economy fall in percentage terms by three times that of the U.S.; it fell in percentage terms in a year by more than the U.S. economy fell from cyclical peak to cyclical trough in all of its recessions and depressions over the last two hundred years with the exception of 1837-1841, 1929-1933, and perhaps the panic of 1907. Japan’s business expansion in this past decade was driven almost entirely by the growth in exports and an increase in business fixed investment which was itself driven for the most part by the growth in exports. If one looks at the peak to trough decline in Japanese GDP over the last year or so, almost three quarters of it was due to the collapse in exports.

On the face of it, it appears that Japan has a severe domestic demand problem. Even though its share of exports in GDP is not especially high, its economy seems to be very export dependent, which implies a huge deficiency in pro-active fiscal stimulus, although the latest data just released from the Cabinet Office suggests a somewhat better picture: the third-quarter Japanese national accounts data showed that the economy has posted positive growth for the second consecutive quarter and is now motoring along at an annualized rate of 4.8 per cent (1.2 per cent in the September quarter). In the June quarter growth resumed at 0.7 per cent (2.8 per cent annualized) and so the recovery is getting stronger. Given they did not allow labor underutilization of labor to rise very much (a large increase by Japanese standards but relatively small compared to countries such as the UK and the US, they should be able to absorb the jobless fairly quickly. But this will only strengthen the growing call for the government to cut back net spending, ironically, even though the country still has a long way to go to even get back to the level of output that it was producing before its 4 dramatic quarters of contraction began. During the downturn, Japan returned to its 2003 output levels. Industrial production is still at about 80 per cent of where it was in early 2008. The capacity utilization data also shows that around 33 per cent of Japan’s factories are not producing and there is little new demand for labor as yet.

Washington, meanwhile, has been conspicuously quiet. Perhaps the Obama Administration has enough on its plate right now, but the silence is very telling. Could it be that this lack of public support of a longstanding ally is the administration’s subtle way of telling the new Japanese government that political independence will incur a significant cost? Certainly, judging from their bullying behavior during the Asian financial crisis in 1997, it is clear that Obama’s chief economic advisors, Tim Geithner and Lawrence Summers – both members of the so-called “Committee to Save the World” back in the late 1990s– are no real friends of the Japanese.

Of course, the implied “cost” to Japan’s credit rating and the threat of a sovereign credit downgrade is more apparent than real. Remember, the very same groups which would issue the downgrades – S&P, Moody’s and Fitch – are the ones responsible for rating the toxic subprime mortgage structures which occasioned the current credit crisis as “AAA” only 3 years ago.

And to paraphrase the famous baseball Hall of Famer, Yogi Berra, we have a sense of “déjà vu all over again”. In November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody’s Investors Service began the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. The next major Moody’s downgrade occurred on September 8, 2000.

Then, in December 2001, Moody’s further downgraded the Japan Governments yen-denominated bond rating to Aa3 from Aa2. On May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana, Chile and Hungary.

In a statement at the time, Moody’s said that its decision “reflects the conclusion that the Japanese government’s current and anticipated economic policies will be insufficient to prevent continued deterioration in Japan’s domestic debt position … Japan’s general government indebtedness, however measured, will approach levels unprecedented in the postwar era in the developed world, and as such Japan will be entering ‘uncharted territory’.”

“Uncharted” it may well have been, but none of these downgrades had any impact at all in terms of adversely affecting the Japanese Government’s ability to find buyers for its debt, which is all yen-denominated and sold mainly to domestic investors. Quite the contrary: Japan proved that when the ratings agencies played their games on them some years ago and significantly “downgraded” their public debt. It did not stop Japan running huge deficits, selling huge amounts of debt into the markets and keeping interest rates at zero and inflation negative or zero.

In the New York Times, the logic of the rating was questioned:

“How … could a country that receives foreign aid from Japan have a better rating than Japan itself? Japan, with an economy almost 1,000 times the size of Botswana’s, has the world’s largest foreign reserves, $446 billion; the world’s largest domestic savings, $11.4 trillion; and about $1 trillion in overseas investments. And 95 percent of the debt is held by Japanese people. . . “

With a straight face, former Moody’s President, John Bohn Jr. had in 1995 claimed that: “We’re in the integrity business: People pay us to be objective, to be independent and to forcefully tell it like it is.” (Reference: Ratings Trouble, Institutional Investor, October 1995: 245).

Rating sovereign debt according to default risk is nonsensical. While Japan’s economy was struggling at the time, the default risk on yen-denominated sovereign debt was nil given that the yen is a floating exchange rate, and that the country was issuing the debt in its own currency (unlike, for example, Iceland or Latvia, both of which had huge foreign debt components, and therefore had an external constraint, which does raise solvency issues).
Once we understand how a sovereign government operates with respect to the monetary system this point become obvious.

First, when a particular government bond matures (that is, becomes due for repayment) the Government of Japan would simply credit the bank account of the holder with the principal and interest and cancel the accounting record of that debt instrument. Simple as that. The banking reserves would rise by that amount and the wealth of the private investor would change in mix from bond to bank deposit.

Second, the massive fiscal deficits that the Japanese Government has run since the 1990s work in the same way – adding reserves on a daily basis to the banking system (as people spend the yen and deposit them back into bank accounts etc). The bond issues are designed to give the private sector an interest-bearing financial asset to replace the non-interest earning bank reserves. The way the Bank of Japan (BOJ) has kept the interest rate in Japan at virtually zero for years now is that they do not issue debt volume of debt to match the reserve-add of the deficit spending (which they have to do by law in the US). That is, they leave just enough excess reserves in the cash system overnight each day to force the interbank market to compete the rate down to zero. This is a very clever way of ensuring that the longer rates (the so-called investment rates) are as low as they can be.

Third, what if the Japanese Government decided it didn’t want to issue any more debt but still ran the deficits? The net spending would still occur – day by day – and provide stimulus to the economy. But the liquidity effects would just remain in the excess banking reserves and force the private sector to hold the new net financial assets pouring in each day via the deficits in the form of reserves rather than interest-bearing bonds.
The other angle on this that is often overlooked is that the bond holdings of the private sector also constitute an income source – that is, the government interest payments on its outstanding debt constitute another avenue for stimulus. So when the Government retires debt it reduces private incomes.

None of this appears to be understood by Wall Street financial practitioners, such as David Einhorn, who likened Japan’s debt to a giant Ponzi scheme (which has no applicability, as a Ponzi scheme implies an external constraint, which doesn’t exist here, as an individual, unlike the government, does not have the power to tax and issue currency to sustain deficit spending).

Einhorn ridiculed claims that the US “made a great mistake by withdrawing stimulus in 1937″ and said:

“Just to review, in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew another 14.3%. Over the period unemployment fell by 30%. That is three years of progress.”

These figures are wrong because the BLS didn’t incorporate FDR’s ‘workfare’ laborers – adjust for those and you get unemployment going from 25% in 1933 to 9.6% in 1936, according to Michael R. Darby, “Three-and-a-Half Million U.S. Employees Have Been Mislaid: Or, an Explanation of Unemployment, 1934-1941,” Journal of Political Economy 84, no. 1 (February 1976): 1-16).

But the point Einhorn is attempting to make contains a more important flaw. He concludes:

“An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.”

This clearly misses the point of the deficits in the first place. There is nothing artificial about growth and job creation. This is the essence of the fallacy at the heart of the neo-liberal thought that pervades Wall Street (and has consigned Japan to decades of economic misery). We might dispute the composition of the growth and the type of jobs and consider the distribution of spending could have been better but the dollars spent are real (irrespective of where the spending is coming from) and the output response is not fictional.

The reason the US economy double-dipped in 1938 was that private saving had begun to recover from the 1932 and 1933 negative rates. At that time, US households were running down saving to maintain living standards as unemployment rose. The point is that if the stimulus is removed before the private sector recovery is evident then, of-course, the spending gap will widen and you will get “significant economic fallout”.

So the only choice is to maintain the deficit or adopt “fiscal discipline” which equates with falling GDP and rising unemployment and further dents in confidence. Deficits are an inevitable outcome of this. The key is whether additional government spending REDUCES future unemployment, or simply is a reactive consequence of it (which appears to be the case in Japan today, with its ongoing stop-start fiscal policy for the past 15 years).
In addition, Einhorn doesn’t hesitate to introduce the “refusal-of-bond-markets-to-finance” problem. This sounds like some evil threat in Batman or Get Smart, but it too is nonsense, because a country issuing debt which it creates does not depend on bond holders to “fund” anything. The issuance of debt is just an offer to provide an interest-bearing asset in place of non-interest bearing (or low bearing) bank reserves. Exactly the same outcome would occur if the government just paid a return on overnight (excess reserves). This would accomplish all the central bank operational requirements to stop competition in the interbank market from driving the overnight interest rate away from that targeted by the central bank.

And this strategy would have absolutely no implications for the government spending which created the reserves in the first place. The government doesn’t need to borrow remember and isn’t “funded” by taxes. There is not a “finite pool of savings” to “fund” the government as implied under a “loanable funds” theory, or a “government budget constraint” (GBC)

Similarly, the notion of the government “monetizing” debt is based on an old style gold standard construct, whereby gold used to be monetized when the government issued new gold certificates to purchase gold. (Monetizing does occur when the central bank buys foreign currency. Purchasing foreign currency converts, or monetizes, the foreign currency to the currency of issue.)

But today, debt monetization is usually referred to as a process whereby the central bank buys government bonds directly from the treasury. In other words, the federal government borrows money from the central bank rather than the public. Fear of debt monetization of this sort, however, is unfounded, not only because the government doesn’t need money in order to spend but also because the central bank does not have the option to monetize any of the outstanding government debt or newly issued government debt.
Bonds, then, are simply a savings alternative to cash offered by the monetary authorities. Einhorn then quotes the right-wing American Enterprise Institute for Public Policy Research which said that:

“… by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.
It hinges of what are “relevant” debt indicators. From a perspective of modern monetary theory (MMT), the sort of indicators used by the mainstream economists (including the AEI) is not relevant. Clearly, there is no risk of sovereign debt default in Japan unless for perverse political reasons the Japanese government chose this course of action. So if there is no risk … then the indicators that the conservatives wheel out must be signaling circumstances other than default.”

Inflation? Not likely at present with continued deflation being the issue.
Rising interest rates? The Bank of Japan is keeping short rates at zero (and it has demonstrated that it can do this indefinitely). Furthermore, if things got that dire and no-one wanted the debt then the Government could just modify its debt-issuance policy and allow the deficits to sit in the banking system as increasing reserves. As long as the domestic saving ratio is high and net exports weak, the deficits will continue to support aggregate spending and output without being inflationary.

One could perhaps query the manner in which government money was spent under the LDP in terms of maximizing the economic benefits, and in that regard, there are some promising things in the new DPJ program.

The Post-War World II growth strategy has been to focus public spending on corporations via national infrastructure projects. The DPJ say they will change this and stimulate domestic consumption by putting more income into the hands of consumers and welfare groups. Japan has very high household saving rates significantly driven by the lack of a national superannuation scheme. So the government needs to accommodate that desired savings, via greater government fiscal deficits. Perhaps this will be done via tax cuts rather than more boondoggle projects which act as political gifts to the construction companies. Such tax cuts will enable Japan to consume more of its economic output, rather than exporting it.

The new government also intends to introduce a meaningful social safety net to divert funds to the poor. They want to reform the dysfunctional social security system and increase pensions for households in poverty.

These initiatives will have the immediate effect of stimulating domestic demand and increasing employment. So the progressive agenda includes addressing the increasing insecurity of employment and stimulating wages growth now at record lows. It also means addressing the highest unemployment rates since Labor Force data was first published in 1960. Official unemployment is now at 5.7 per cent.

They have promised free secondary education, free medical care for expectant mothers and generous child support allowances, all aimed at addressing the declining population. The large deficits that the Japanese government runs are symptomatic of the huge saving desire of the domestic population. Not even the traditionally strong net export performance can offset the high saving ratio. The rising unemployment rate in the country is de facto proof that the country’s fiscal policy is insufficient to accommodate the net desired savings of Japanese households. For if the desired net nominal savings rate was lower, the population would be spending more and creating more jobs for the unemployed. In Japan, as elsewhere, this has undoubtedly been the largest economic crisis since the 1930s Great Depression and required all the tools that the neo-liberals hate to stop the world economy from slipping as far as it did in those days.

Still, with no shortage of irony, the Washington Consensus whiz kids, whose advice helped to destroy Japan’s stable financial system (by forcing the MOF to deregulate the capital account and banking system, setting the stage for the subsequent credit bubble) and eradicate the country’s generous social safety net (because of alleged “inefficiencies”) can still raise their heads in public and lecture us on the benefits of the free market and the futility and evil of government intervention. Intervention that is, which benefits the broader population rather than the corporate welfare that the top-end-of-town have become used to receiving and to which they would claim is their right.

The neo-liberal period in Japan has devastated the security of the middle class which accounted for more than two-thirds of the population. The constant obsession with “fiscal consolidation” over the past two decades has led to persistent stop-start economic policies, which has left the country mired in economic stagnation. Combine this with external shocks (the Asian financial crisis in 1997, the end of the “dot.com boom” in 2001, and the current credit crisis) – none of which were the fault of the Japanese – and one can see why the country has done so poorly. The obsession with deregulation under the neo-liberal helm of the Koizumi Administration exacerbated the population’s pervading sense of economic insecurity.

One should applaud the DPJ’s decision to shift spending priorities to welfare away from national infrastructure and do hope that the government follows through on its promise of a more independent foreign policy course (since entanglement with Washington’s military agenda does nothing to serve the interests of Tokyo). Hopefully, the new government in Tokyo will dismiss the doom mongering emanating from Wall Street for the bogus nonsense that it is, and free the country from a destructive course of action that has done little to serve the interests of Japan, but much to fatten the pockets of certain rent seeking monopolists. Even though Japan is now poking its GDP head above water the damage done to the real sector by the worst crisis since the Great Depression will take some quarters to repair. They haven’t even started to work on reforming the financial sector yet and unemployment is still at unacceptably high levels.The DPJ can make a difference if it wants to. The only constraints it faces are self-imposed. The sooner it understands that, the better off will be the people of Japan.

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

7 Responses to “JAPAN: NEW GOVERNMENT, BUT NO INCREASED ‘CREDIT RISK’”

  1. hbl says:

    “Japan has very high household saving rates…”

    The data I’ve seen contradicts this, for example this graph (source: OECD) shows the household savings rate falling from around 15% to under 3% over the last two decades. I’ve assumed the MMT-compatible explanation is that the corporate sector savings rate is what must still be very high in Japan, but haven’t seen it confirmed.

    Anyway, I’m glad to see you sharing your important knowledge on yet another blog.

  2. GBMont says:

    I can claim no expertise here, but having sat through a presentation from Einhorn on this topic, I feel compelled to point out that the author seems to have ignored one of the most important tenets of Einhorn’s argument – demographic challenges. With a rapidly aging population that, via high savings rates (at least historically, see previous comment), has financed much of the debt either directly through bond purchases or indirectly via contributions to excess reserves as suggested by the author beginning to have to draw down its accumulated savings, the built in demand for near-zero interest rate financing will begin to dry up. An extremely leveraged government now planning to increase expenditures via a fleet of new or expanded social welfare programs will need to either retire or refinance debt (at higher rates), sharply increasing the servicing cost of the national debt as income tax revenue potentially falls due to people leaving the workforce for retirement.

  3. haris07 says:

    So, according to the author, the government can simply grow deficits forever and instead of issuing any fiscal debt, just create reserves to finance it (forget savings rate, just create bank reserves)? I guess the only consequence of this action is inflation (if and when these reserves are actually lent out)? As long as disinflationary/deflationary forces are strong, there are NO consequences to QE? Am I reading this right that there is absolutely no limit on governments to incur deficits as long as they are incurred in the local fiat currency and inflation is not on the horizon?

    How does this impact currency levels?

    Of course, US unfortunately doesn’t face the same sitiuation as Japan because it runs a current a/c deficit that has to be funded by foreigners. Or if the author’s proposition is that currency levels are also unaffected by QE, in which case, they don’t care either and US can QE finance deficits far longer than the eye can see as long as inflationary expectations are subdued and the deficit is used to fund “something productive” (of course what the govt deems productive could very well be useless!).

  4. Bob_in_MA says:

    I get the feeling that Auerback remembers a few graphs from his macroeconomics class and can’t see the world except through a prism based on those graphs. He writes these absurdly laborious pieces flogging very simplistic points. Talk about not seeing the forest for the trees…

    On the subject of the aging population and falling savings rate, there was an article a while back on Bloomberg about a large public pension fund in Japan who’s assets had essentially peaked and would need to be a net seller of bonds, or at least allow them to run off. But in the short term, they were borrowing cash to make pension payments so it wouldn’t be necessary to sell bonds.

    It wasn’t clear if this was a done purely for sound fiduciary reasons, or because of the impact on markets.

  5. Simon says:

    I can’t understand this stuff. But I can see how the effort to understand it might cripple one’s ability to think critically on a permanent basis.

  6. jswap says:

    It’s rare that I read an article with so many words in it and am left with the opposite conclusion of what the author purports to be expressing. Is this meant to be some sort of “A modest proposal”-type article? I get the feeling that Auerback believes the Great Depression “just happened”, and it was not the excess borrowing and spending in the roaring 20s that inevitably led to a contraction (or bubble popping). Auerback’s advice reminds me of a movie I saw about a race car driver: if hitting the brakes won’t prevent the upcoming accident, stomp on the gas and hope for the best.

  7. gekkobear says:

    So Japan embarks in huge deficit spending in 1990 due to the slump then, they have no recovery, no economic gains, and their “lost decade” seems to be continuing.

    Clearly if we want our economy to stay right here for the next 20 years we should follow their strategy. Huge debt, 130% expenditure rates, large deficit spending with the promise that we’ll slow/stop it once “things get better”.

    Sadly for Japan in 20 years things haven’t really gotten better; and there’s not a lot of expectations for it in their near future… but I’m sure they just did it wrong. Once we run up huge massive debts to keep the economy on an even keel and fail to move our economy out of a slump while sticking us in more serious debt issues we can show them what a lost decade really looks like.

    Maybe we can make it to a lost century… that would be one for the history books.