Reading The Writing On The Japanese Wall

The recent decision by Fitch Ratings to downgrade the Japanese sovereign by one notch, from 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 Japan because 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 forseen, anywhere, unless I am mistaken.


On one view, 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 Scott Ridely’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 we 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, Japans 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 point 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 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 one 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 for how long Japan can 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 is though, 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. Ifthe 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 so to do.

“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 contextualiseable 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 sustained enough would be big 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 an 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 countryshould 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 contempories. 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.

 This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

This entry was posted in A Fistful Of Euros, Economics, Economics and demography, Economics: Country briefings by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo' is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

9 thoughts on “Reading The Writing On The Japanese Wall

  1. The problem with Krugman is that he’s very good at telling us what the Keynes of 1930 would say about a superficially analogous situation, but incapable of making the intellectual leap required to imagine what a Keynes of 2012 would suggest.

    Attributing the fiscal problems of all these different economies to failures to implement sufficiently “pure” Keynesian policies just doesn’t seem credible.

    Your post really gets at the nub of the problem. The solution is likely to be something fairly revolutionary. Where are the new thinkers among economists?

  2. Pingback: Japanese debt-The end of the road? |

  3. Bob in MA,

    Really, I agree absolutely. I am trying to identify problems, not suggesting I have all the answers. New things are happening, but we are trying to address these new things with old theories. Most of the responses represent some kind of denial of the “this just isn’t happening” type. The argument needs to be tipped over into “yes it is” mode, then we will get the debate which will produce the revolutionary solutions all those bright young thinkers will come up with. At the moment all we are getting is “more of the same”. Actually, the Spanish “mas de lo mismo” is even better here, as it incorporates a rather negative feeling about the process of simply recycling old arguments.

  4. Seeing Ambrose Evans-Pritchard mention you in his Telegraph piece of May 27 I thought perhaps he would have an epiphany beyond his monetarist fixation as to what the problem is but, like Krugman and his fiscal stimulus obsession, he pays no mind to demographic issues.

    Why this is perplexes me as it seems to stare you in the face when you look at countries like Spain or Japan. There is a demographic bulge of protected aging workers heading into an increasingly insecure retirement who must save and a smaller cohort of, in the case of Spain, unemployed or underemployed young people whose ability to consume or access credit is greatly reduced. If Japanese
    youth unemployment is not at the catastrophic levels of Southern Europe their earning power is , through globalization, also reduced in comparison to what their parents enjoyed. If you are a fan of Ricardo, even the most successful young people are going to be cowed by the mountain of debt their governments have built and the prospect of heavy future taxation to service it as well.

    If this inverted demographic pyramid weren’t problem enough there is also the issue that the blogger Charles Hugh Smith brings up and that is the increased complexity and economic “friction” that exists and impedes economic growth in the so called ‘advanced economies’. Ridiculously complex tax and legal systems that employ vast numbers but produce nothing other than ‘compliance’. Crony capitalism that stifles innovation and crushes competition and, of course financialization that employs the best minds from our universities to create nothing more useful than complex computer models and trading programs that work until they don’t and blow up.

    Unless these issues are resolved ( and how do you resolve an inverted demographic pyramid in a democracy?) the economic theories of the past are simply irrelevant in this new era we seem to be in.

  5. This is a very imprecise observation, but I just wonder if we have overlooked the importance of leaving the gold standard. What I mean is, if the government can print it’s own currency and the citizens have little other realistic choice (or reason) to abandon their local currency then essentially the government can do what it likes in terms of spending and it will only be the global currency markets that have the potential to punish them. But in the current economic situation where major central banks are actively engaging in QE and others are actively trying to weaken their currency, this discipline via the currency leg disappears. Without a gold standard paperless currency does not have to be earned before it is spent – actually the printing press gaurantees return of your money and in this sense government bonds are the new form of ‘cash’ in todays economy.

    Take the UK for example, the Bank’s inflation report does not include tail risks from a messy Eurozone situation. Let’s say Greece leaves the EUR prompting the Bank to mark down their GDP and inflation forecasts leading them to vapourise another X hundred billion of Gilts. Hey presto – no sovereign debt problem in the UK! Wouldn’t you rather own gilts after the govt (- well I mean ‘independent’ central bank -) have chosen to write off a whole chunk of their own debt? If the printing press vapourises a high percentage of outstanding debt stock, if globally everyone else is up to the same game, and if investors (“real money”) are forced to hold long duration government gonds, then pray tell how we are going to have a sovereign debt event? When QE is out and about -as it is now – government bonds are the new cash. This, in my mind, is strongly related to what is happening in Japan & elsewhere.

    In summary: I think the mkt still thiinks as if we are on the gold standard – that for a currency issuer with a printing press money must be first ‘earnt’ before being ‘spent’ – this is simply not true today. It’s like applying money market reserve accounting to the whole economy: what goes into the system always comes back to the govt. They can do what they want and when, collectively, they are all at it there is no mechanism to punish roads to nowhere.

  6. From an amateur viewpoint, the ecologic view is simple. Japan imports most of their energy and much of their resources. The chain of responsibility moves gradually from the stupid lazy borrowers, to the stupid lazy lenders, to the stupid lazy resource exporters who gave away the resources at a fraction of their real value. As scarcity and Hotelling come into play resource importers will be stressed. A smaller population will be a huge benefit eventually, a lower living standard temporarily. They at least kept some of their local farming intact. As long as the stupid lazy exporters continue business as usual the charade continues.
    The ” stupid, lazy” is probably a complete circle but at present it is hard to see beyond the resource exporters. I like the image of a wallah in a mud hut in Calcutta being the ultimate cause of the problem but cannot trace the lineage.

  7. Japans problems are very far from insoluble. It is just that the solutions that would work require substantial cultural upheaval. – Particularily in gender relations. The expectation that mothers should stay at home with their kids is very strong, which in turn results in a dire paucity of accomadations being made for working mothers. The result of which has largely been a heck of a lot of women electing not to become mothers full stop.
    If Japan had the labor force participation and fertility rate of Sweden, the retirement burden would be wastly more managable – but in order to get either of those, Japan would also have to become as feminist as Sweden is. Which seems unlikely.

    Other potential solutions:

    Automation! If you can build your workforce in factories, who cares that not very many workers are being born? This is in very large part what japanese policy is aimed at, but I dont really see how this solves the deflationary problem – Robots arent paid, and dont go shopping so no demand from them . But it does imply that the fundamental productivity of the japanese economy can grow in the face of demograpic decline, in which case government debt might well indeed just keep ticking up for all eternity as an accounting illusion disguising what is really going on – the taxation of automated production to support the population.

    Biomedical breakthroughs, ranging from reduced scenesence to outright eternal youth could also radically alter the dependancy ratio of ageing populations – if a 70 year old in 2039 is as spry as s/he was at forty, there is no particular reason for them to be retired, after all.

  8. “Now all these fiscal deficits are interesting, since the one thing they have not produced is growth.”

    I think you are bit unfair here, because the budget deficits may not have produced growth, they certainly prevented a catastrophic fall in GDP. In Japan there was not enough private demand for money, it is good that the government stepped into the gap so that these funds were not be wasted and a decrease in the money supply avoided.

  9. The Population Neutron Bomb / baby bust after the boom, means that all economic laws (er, temporary quantifiable relations) based on a growing population will be less valid, or even invalid, when population stops growing.

    But if Japan as a society continues to “borrow” too much, what is the real endgame?
    Instead of paying taxes for gov’t services, they are buying gov’t bonds to pay for gov’t services.

    But let’s say Japan ages and eventually even loses population — the excess money the gov’t is spending is being used to prop up consumption and investment. Including with lower rates of return from investment, so the gov’t spending less, and borrowing less, and doing less crowding out of credit, should increase the returns on investment.

    Japan’s endgame … never gets to the end. In any year, Japan can print all the Yen it needs to wipe out, thru monetization, the gov’t debt. That’s why Japan, like the US, will not be like Greece, nor like Argentina 1999-2002 default.
    There is a huge difference in whether your debt, contractual obligations under rule of law, is denominated in currency you can print, or not.

    But as robots take over in production, and imports decline with population, there’s no big reason to expect Japan to collapse, rather than continue drifting for another 2 or 4 or 6 decades.

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