Will debt derail Abenomics?

It seems to me that one of the automatic, if not always intended, consequences of Abenomics is to force up Japan’s current account surplus, and in fact to force it up substantially. This will have to do at least in part with deciding how to manage the country’s enormous government debt burden, which easily exceeds 200% of the country’s GDP.

If I am right, this should create two concerns. First, in a world struggling with insufficient demand and excess capacity, and in which the growth strategies of too many countries implicitly involve a significant increase in exports relative to imports, a major increase in Japan’s current account surplus could easily derail growth recovery elsewhere. The US for example has to worry that policies aimed at increasing domestic demand don’t simply result in rising debt as US demand bleeds out through the current account, while both China and Europe need strong external sectors to make their own difficult domestic adjustments less painful.

Second, it is not obvious that the world will be able to absorb a significant increase in the Japanese exports, and if Abenomics implicitly forces up the Japanese savings rate relative to investment (which is all that we mean when we say that economic policies force up current account surpluses), these policies can resolve themselves either in the form of high growth and soaring exports, or much lower growth and slowing imports. The former implies that Abenomics will be successful, while the latter that it will fail. It is not obvious, in other words, that Abenomics can succeed in a world of weak demand, and its failure is likely to make Japan’s domestic imbalances worse, not better.

It may seem a little quixotic to worry about a surging Japanese current account surplus just now when in fact Japan’s external balance has declined substantially and is surprising analysts on the downside. According to an article in last week’s Financial Times:

Japan’s current account balance plummeted by nearly two-thirds in August from a year ago, surprising forecasters that had assumed it would grow nearly a fifth. The current account is a broad measure of trade. A fall indicates Japan is receiving less income from overseas investments, despite help from the falling yen.

The current account surplus fell nearly 64 per cent in August, versus forecasts expecting an 18 per cent gain. The unadjusted balance in the month was Y161.5bn, against forecasts at Y520bn and down from Y577.3bn in July. Within the data, trade of goods and services was in deficit of more than Y1tn for a second consecutive month, while income fell to Y1.253tn from Y1.794tn a month before.

My concern, however, is unlikely to be played out over the next few quarters but rather over the next few years as Abenomics is implemented, and so Japan’s external position in the immediate future doesn’t matter. What matters, I think, is that in order to generate growth Tokyo is planning to implement polices aimed at raising both inflation and real GDP, and these policies are likely to force up the national savings rate relative to investment.

What is more, to the extent that these policies are successful in generating higher nominal GDP growth, they create a problem for Tokyo in how it decides to set domestic interest rates. Japan has never really resolved the overinvestment orgy of the 1980s. Instead of writing down bad debt it effectively transferred much of it to the government balance sheet, and now this huge debt burden is itself becoming, I think, a constraint on the success of policies designed by Tokyo to spur growth.

Before addressing the debt constraint, let me start by listing the reasons why I think Abenomics is likely to affect the trade surplus. First is the impact of Abenomics on pushing down the value of the yen. As I discuss in the first two chapters of my January book, The Great Rebalancing, currency depreciation does not affect the trade balance directly by changing relative prices. It does so indirectly by changing the relationship between savings and investment (the difference between the two being the current account balance). A depreciating currency reduces the real value of household income by acting effectively as a consumption tax on imported items. This also reduces the real value of household consumption.

The proceeds of this tax are used implicitly to subsidize the tradable goods sector, which effectively increases production in that sector. Of course as production rises relative to consumption, the difference between the two – the national savings rate – must also rise.

This means that as the yen depreciates, the consequence is likely to be an increase in the Japanese savings rate. If there is no commensurate increase in investment (and I assume that with excess capacity Japan does not need to increase investment much in order to produce higher output), Japan’s current account surplus must automatically rise. In the near term the investment rate is likely to rise, largely in response to greater confidence, but over the longer term downward pressure on the consumption share of GDP (which is the likely consequence of downward pressure on the household income share) will also put downward pressure on investment growth.

Savings is the obverse of consumption

But it doesn’t end there. Japan seems to be taking other steps to force up its domestic savings rate. Here is last Tuesday’s Financial Times:

Shinzo Abe, Japan’s prime minister, pledged to press ahead with the first increase in sales tax for over 15 years despite objections from some of his closest advisers, gambling that measures to address the country’s massive debts would not hinder his attempts to jump-start the economy.

Mr Abe said on Tuesday he would couple the consumption tax hike with roughly Y5tn in new public works spending, cash grants and other stimulus in order to blunt any negative impact on the economy.

…The plan to increase the tax from 5 to 8 per cent next April had been approved by a previous government with the support of Mr Abe’s Liberal Democratic Party. But it was opposed by economists who had helped the premier draft his Abenomics strategy, as well as by some LDP politicians. The last time Japan increased the levy, in 1997, a deep recession followed that shook the party’s grip on power.

The increase in the consumption tax, part of the proceeds of which will be used to increase infrastructure investment, will accomplish many of the same results as the deprecation of the yen. A consumption tax, like a tariff, is effectively a kind of back-door currency devaluation, with a slightly different mix of losers among the household sector and winners among the producing sector.

By boosting production and reducing consumption, however, it automatically forces up the national savings rate in the same way as does currency depreciation. Even if 100% of the proceeds of the tax were used to fund increased infrastructure investment (and the article suggests that part, but not all, of the consumption taxes will be directed towards higher investment), because at least some of the investment spending will go to workers in the form of wages, who will save part of those wages, the net result will be that total savings will rise faster than total investment. Once again this must force up Japan’s current account surplus even further.

So far this all looks like an attempt by Abe to increase Japanese competitiveness and so increase its total share of global demand, but not by increasing Japanese productivity, which is the high road to growth, but rather by reducing the real Japanese household income share of what is produced. Japan (like Germany and China have done over the past decade) is attempting to increase employment by reducing wages, and this means that its workers will be able to purchase a declining share of what they produce. This effectively means Japan will be growing at the expense of its trading partners. As the Japanese become less able to consume all they produce, the excess must be exported abroad.

If the world were in ruddy good health, we might not worry too much about policies aimed at Japan’s pulling itself out of the mess created in the 1980s, but with the whole world struggling with weak demand and with country after country trying to reduce domestic unemployment by selling more abroad – effectively exporting unemployment (with Germany in particular hoping to resolve the European crisis not by increasing its net domestic demand, as it should, but rather by forcing German surpluses outside Europe) – there is a real question in my mind as to how successful the Japanese program of Abenomics is likely to be if it implicitly requires a burgeoning trade surplus.

Remember that if one country increases its savings rate, unless there is a net increase in global investment there must be a commensurate reduction in the savings rate of the rest of the world so that savings and investment always balance globally. There are broadly speaking two ways this can happen. In the pre-crisis days this reduction in the savings rate of the rest of the world occurred mainly in the form of soaring consumption fueled by credit, and in this way unemployment stayed low. Since the crisis – which because of the negative wealth effect saw credit-fueled consumption drop – foreign savings have been reduced by a rise in foreign unemployment

This means that if Japan forces up its savings rate, and assuming that we are unlikely to return in the next few years to a credit-fueled consumption binge, the only way the world can respond to a structural forcing up of the Japanese savings rate is either by higher unemployment outside Japan or, if Japan’s trade partners take steps to protect themselves from higher Japanese trade surpluses, higher unemployment inside Japan.

The debt-servicing cost of nominal GDP growth

But there is more, perhaps much more. Japan is struggling with an enormous debt burden, and perhaps this explains why Tokyo is so eager to engage in policies that force up the Japanese savings rate. As long as more than 100% of Japanese borrowing is funded by domestic savings (if Japan runs a current account surplus is must be a net exporter, not importer, of capital), it doesn’t have to rely on fickle foreigners, who might not be satisfied with coupons close to zero, to fund its enormous debt burden.

But the debt burden creates its own very dangerous source of trade instability. To understand why, we need to consider what happens to interest rates in Japan if nominal growth rates rise.

In Japan interest rates are currently very low, close to zero. With total government debt amounting to more than twice the country’s GDP – which puts it among the most heavily indebted governments in the world – it is not hard to see how low nominal interest rates benefit Japan. With interest rates close to zero, there is very little cashflow pressure on the government from servicing its debt.

Some people might argue that nominal interest rates do not matter. We should be looking at real interest rates, they would argue, and with Japan’s having experienced deflation for much of the past two decades, real interest rates in Japan are high and the nominal rate is largely irrelevant.

This is true, real interest rates do matter, but it doesn’t mean that nominal interest rates do not. In fact both real and nominal interest rates matter, albeit for different reasons. Real rates matter for all the obvious reasons – they represent the real cost to the borrower in terms of a transfer of resources from the borrower to the lender. But nominal rates also matter because they effectively determine the implicit amortization schedule of principal payments.

When the nominal rate is zero or close to zero in a deflationary environment, in other words, interest is effectively capitalized in real terms. In fact whenever the real rate exceeds the nominal rate, as it has in Japan for much of the past two decades, the cashflow cost of servicing the debt is lower than the real cost, and the difference is effectively converted into real principal and deferred. In real terms, in other words, Japanese debt is growing by the difference between the real rate and the nominal rate, and this effectively represents a reduction in the cashflow cost of servicing its debt.

When nominal interest rates are positive and higher than the real rate, however, there is effectively an acceleration of real principal payments. This means that as long as nominal rates are very low, the real cost of servicing the debt is low and the principal payments are postponed, with some of the interest even being capitalized. As nominal rates rise, however, the real cost of servicing the debt during each payment period consists of interest plus some real principal.

This is just a long, perhaps pedantic, way of pointing out that even if the real interest rate in Japan declines, debt servicing is likely to be much more difficult as the nominal rate rises. Japan might be paying a lower real rate, but it is also implicitly paying down principle, instead of capitalizing it. Tokyo would need a significant increase in revenues, or a significant decrease in expenditures, to cover the cost.

So what would force Japan to raise its nominal interest rate? In principle the nominal interest rate should be more or less in line with the nominal GDP growth rate. If it is higher, growth generated by investing capital is disproportionately retained by net savers (including mainly the household sector). There is, in other words, a hidden transfer of resources from net borrowers to net savers.

If the nominal lending rate is lower than the nominal GDP growth rate, as is the case in China today and Japan during the 1980s, the opposite occurs. There is a hidden transfer from net savers to net borrowers, and because net savers are mainly the household sector, this will put downward pressure on the household share of income even as it gooses investment growth. This hidden transfer has been at the heart of the rapid economic growth that typically occurs in financially repressed economies during the earlier stages, and is also at the heart of the investment misallocation process that typically occurs during the later stages. We have seen this very clearly in China.

Will Tokyo raise interest rates?

Japan is trying to generate both positive inflation and real GDP growth, so that it is trying urgently to raise the growth rate of nominal GDP. What happens if and when it is successful? For example let us assume that Japan’s GDP is able to grow nominally by 4-5% a year – what will happen to the nominal Japanese interest rate?

Tokyo can either raise interest rates in line with nominal GDP growth rates or it can keep them repressed. In the former case, debt-servicing costs would soar, ultimately to 8% of GDP or more. This would create a problem for Tokyo in its ability to service its tremendous debt burden. It would need a primary surplus of around 8% of GDP just to keep debt levels constant, and it is hard to imagine how such a huge surplus would be consistent with nominal GDP growth rates of 4-5%.

If it were to raise income taxes it would create a huge burden for the household sector and almost certainly force up the national savings rate by forcing down the household share of GDP. Remember that during the 1980s Japan, like China today, generated rapid growth in part through financial repression, and one of the consequences of that rapid growth was an extraordinarily high savings rate along with a huge current account surplus, both of which were ultimately unsustainable. Japan has spent much of the past twenty years rebalancing GDP back in favor of the household sector, and to reverse this process may provide relief in the short term, but it is hard to see how I can be helpful in the medium term.

On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.

Japan’s enormous debt burden was manageable as long as GDP growth rates were close to zero because this allowed both for the country to rebalance its economy and for Tokyo to make the negligible debt servicing payments even as it was effectively capitalizing part of its debt servicing cost. If Japan starts to grow, however, it can no longer do so. Unless it is willing to privatize assets and pay down the debt, or to impose very heavy taxes of the business sector, one way or the other it will either face serious debt constraints or it will begin to rebalance the economy once again away from consumption.

As this happens Japan’s saving rate will inexorably creep up, and unless investment can grow just as consistently, Japan will require ever larger current account surpluses in order to resolve the excess of its production over its domestic demand. If it has trouble running large current account surpluses, as I expect in a world struggling with too much capacity and too little demand, Abenomics is likely to fail in the medium term.

Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t (and this pretense was made possible by the implicit capitalization of debt-servicing costs). Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but if Abenomics is “successful”, ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.

This is an abbreviated version of the newsletter that went out three weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.


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  1. >>Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t…<<

    Well, you're actually saying TWO things: THAT, plus "Krugman is an idiot."

  2. 断末魔の中韓経済
    Bill – 96797450

    This analysis seems to miss an important point which is that in addition to fiscal repression (which honestly is a part of every sucessful sovereign debt workout) there is also the natural rise in tax receipts that accompanies higher nominal growth. Japan for example has a typical fiscal multiplier of 3-4 times, meaning that 1% nominal growth raises tax revenues by 3-4%. Indeed we have already seen this playing out as this years fiscal revenues (from income, corporate, consumption taxes and stamp duties etc) is rising 5-8% versus last year, even more than was expected. In fact did you know that last year 70% of Japanese corporates paid no corporate tax because of accumulated losses (even Toyota, the largest Japanese corporation has not been paying taxes.) so it is interesting that you essentially point out the pro-austerity approach to reducing debt of raising taxes and selling off govt assets while overlooking the substantial rise in tax revenues that is already occurring as we speak.
    In regards to the notion that Japan is pursuing a purely a beggar-thy-neighbors approach, I would respectively disagree. Japan is raising govt investment now (which actually has fallen by 50% since the late 1990s) as part of the fiscal “arrow”. And in fact the trade deficit has been widening recently as one would expect given sustained double digit increases in govt spending and construction recently. So it seems off the mark to say that Japan is seeking to improve its situation soley through the current account surplus (ie that Japan is solely relying on the “monetary” arrow. In fact you in your recent books have commented that the Chinese current account surplus will almost surely rise again, and that “other countries should accommodate this rise to help China rebalance.” So we should tolerate the re-acceleration of current account surpluses in already fast growing countries, but long suffering Japan gets none of this sympathy? Surely if you are concerned about rebalancing the world economy then your conclusion must be the opposite? In fact contrary to popular perception Japan is actually a more closed economy than the US, with gross exports representing only about 15% of the economy.

    On a final note, what is happening in Japan now is really just the inevitable correction of decades of macroeconomic mismanagement – pro-deflation monetary policies (for example the BOJ actually shrunk it’s balance sheet between 2007 and early 2012 even as global peers were more than doubling theirs) and an anti-growth fiscal stance (govt investment spending has shrunk 50% since 1997, the year when the MOF forced through the first consumption tax hike to break the nascent recovery.) Yes Japan is moving in the “wrong” direction in terms fiscal repression – bad if you are an international capitalist/bond holder! But it is most certainly moving in the right direction to expand growth opportunities for its population and whittle away it’s public debt at the same time. It seems odd to argue against Japan’s new policies when many of Japan’s peer competitors (South Korea, Germany) have been maximizing domestic growth through their set of imbalanced policies for years.

    Oh and one last note, the BOJ’s ongoing purchases of 70% of gross JGB issuance is already monetizing and reducing public debt as we speak. If this is a problem, please explain what is the cost? Core-core inflation is 0.0%, the currency has actually appreciated over the past six months, and rates are near zero – it is entirely correct for the BOJ to be monetizing the debt in this way as the market is literally demanding it. The “risk” that inflation rises is actually exactly what policy makers are trying to achieve. And of it truly doesn’t matter and inflation still doesn’t rise, doesn’t that imply that debt monetization is effectively a cost-free exercise from the standpoint of the government?

    • Abenomics is based on the dubious theory that inflation lowers unemployment and creates growth, which is not supported by real world evidence.

    • A 1% move in nominal growth may increase tax receipts by 3-4%, but if nominal rates move by the same amount, debt servicing costs double! A 200 bp move and it’s effectively over. If the contention is that the BOJ can simply purchase JGBs to cover the difference and monetize, we’re effectively saying that debt doesn’t matter. Maybe monetary policy has advanced to a new paradigm, but I cannot think of any country in the past to effectively debase the currency on such a scale and suffer no negative consequence.

    • It’s not clear to me what the point of all this is. Japan has been growing real per capita GDP at 1-2% (falling prices and shrinking population), which is in line with long-run expected productivity. Unemployment is at 4% or something. So where exactly is this desperate economic crisis that can supposedly only be resolved by increasing the supply of Yen?

  3. Great post Michael. Despite being held up as an example by many statist economists, such as Krugman, I think you’ve done a good job of showing how huge quantities of public debt can be a significant burden and ultimately bog down attempts to revitalize the economy.

    I also think Japan’s problems go deeper than government policy. Because of the statist nature of the economy, big established corporations are deliberately empowered at the expense of new upstarts. But there is a cost to doing this, big companies almost always tend to become highly arthritic and have a hard time competing against more nimble companies. Sony is a case study happening right in front of our eyes, the once mighty electronics giant has been losing billions a year since 2008 and has become an also-ran in a business it once dominated. I think Japan in this way as well is a fine example of what not to do.

    By the way, Norton anti-virus has been giving me a malware warning on your blog.

    • I tend to be more optimistic. Japan is already a wealthy country with solid social services and infrastructure, etc. Unemployment is very low, as is income inequality. This was all before Abenomics, so it’s hard to look at this as an abject failure. Further, Japan refrained from massive devaluation during the financial crisis. This allowed the US to continue QE and China to keep printing money, while Japan felt the pain.

      You mention Sony as a case and point of Japanese stagnation, but their screens and camera sensors are in hundreds of millions of smartphones sold every year. Their home appliance division has completely flopped, but they are finding successes elsewhere. Samsung has probably overreached far more than Sony has, and eventually will probably need to pull back or sell off non-core divisions.

      Toyota is still major player and the leader in hybrid vehicles. Suzuki is doing extremely well in India. Canon and Nikon totally control the camera market, while all of these big corps are among the first firms into the new Burmese market.

      Based on reading the professor’s analysis, I’m more concerned now that Japan should NOT be promoting a fast growth policy. Abe might win some friends in export industries, but in doing so he may doom Japanese consumers and cause a domestic debt crisis. Being the prime minster who advocates slow growth and possible deflation is not a winning election strategy, but it might be the best choice.

      • Just a note that Sony doesn’t make screens. (Irrelevant) although they do make sensors for cameras. Japan only has about a 6%-10% market share in high end screens mostly by sharp. The rest are the big 4 of the 2 Korean and 2 Chinese manufacturers. Although Sharp has replaced Sony and Samsung as the screen suppliers for the iPad and iPhone.

      • If you just stick with low growth/deflation, Japan’s real debt burden increases and eventually Japan will implode. The only option is to privatize government assets and use the proceeds to pay down debt, as Prof. Pettis has been saying this whole time.

      • “Japan is already a wealthy country with solid social services and infrastructure, etc.”

        Are you sure about that?

        “Unemployment is very low”

        It’s very easy to obtain lower unemployment if you shut out half you workforce, namely women. There’s also other factors like juking the statistics, wage deflation and an aging population which explain a lot.

        “as is income inequality.”

        How they accomplish this is by destroying entrepreneurial opportunity, much like how the US was before the deregulation reforms of the late 70’s through the 90’s. This also has an interesting knock on effect in that it’s prevented Japan from fully exploiting emerging technologies. Looking at a list of the top 100 biotech companies, 3/4 of them were founded in America. Internet tells a very similar story, again dominated by new American startups. This is starting to haunt Japan.

        “You mention Sony as a case and point of Japanese stagnation, but their screens and camera sensors are in hundreds of millions of smartphones sold every year. Their home appliance division has completely flopped, but they are finding successes elsewhere.”

        I think you missed the point I made about Sony losing billions upon billions every year, that’s not a good sign and they aren’t the only ones, Panasonic and the other electronics giants are also hemorraging cash to the tune of billions a year. Sony is kind of staying afloat, but pretty much entirely from their financial services unit. http://www.eetimes.com/author.asp?section_id=36&doc_id=1287295

        In fact Japan’s electronics decline is systematic, they once had dominant market shares in pretty much from DRAM to DVD players, all of that is gone. They’ve lost their edge and their business models are failing. Semiconductors tells the same story. In 1989 6 of the top 10 companies in terms of sales were Japanese, today it’s down to just 2. Canon and Nikon’s domination of the camera market is largely irrelevant, most people don’t bother with them anymore as their smartphones, mostly Korean and American designed, have good enough digital cameras built in.

        It’s true that Japanese auto companies are still performing very well, but in the coming decades I’d be fairly skeptical as their brothers in other industries have demonstrated.

        The biggest root of Japan’s problems stems from its economic model, which still hasn’t changed much after all this time. A competitive export oriented sector married to an mind bogglingly inefficient domestic economy. This is not a winning formula and until it gets addressed I doubt Japan will go anywhere anytime soon.

  4. Awesome post. It seems to me like Japan is about to be stuck in a major public debt crisis. The Yen could collapse. The problem with Japan is that the Japanese import all their energy and a good portion of their food, so a further devaluation in the Yen could easily worsen their current account balance (and thus their savings rate) by forcing import costs higher. It’s not like you can just stop importing food and energy overnight. The middle class would get crushed with a lower Yen.

    The nonlinearity of debt servicing costs to tax revenues when government debts are high will wipe out the value of the Yen and take the Japanese middle class with it.

    • What bothers me about the notion of a Yen collapse, is the sneaking suspicion I have that the world seems to be increasingly run by a club of central bankers who all have each others’ backs. What should happen and what does happen seem to be diverging to an increasing extent.

      • Wouldn’t that create other unintended consequences? Also, how can any of the other central bankers (or anyone else for that matter) stop a Yen collapse? Japan is the world’s third largest economy and no one is large enough to be a lender of last resort. If the Yen comes under serious selling pressure, that would create a lot of issues.

  5. Indeed, the third way out is not discussed: what if the (new and rolled-over) debt is simply monetised, taking Abenomics to its logical conclusion? Since so much of the debt is held locally, the dangers I see are more along the lines of financial bubbles and reaching for yield than runaway core inflation: it is fairly easy to put the brakes on the real economy if it starts overheating, albeit with a bit of a lag.

  6. I’m a little surprised that Japan’s declining population is not mentioned here. I think any analysis about the effects of Japan’s policies would need to acknowledge that evidence from countries with expanding populations is not necessarily predictive in this case.

    In any event, I don’t disagree that debt matters. Of course it matters. As you indicate, both real interest rates and nominal interest rates matter. Inequality matters as well. It is a usually accepted theory that a distribution from the rich (who don’t spend all their income) to the poor (who usually do) would (at least temporarily) spike consumption and rebalance consumption and savings, which would (obviously from your analysis above) also affect the current account surplus.

    Finally, not that you disagree, but I cannot see how any balanced look at Japan could come to a “more-likely-than-not” conclusion that *any* government policies could achieve a rising *real* GDP in Japan given the population constraints. Talk about hard to imagine. Where would the kind of radical productivity gains needed come from?

    I bet Japan is unlikely to have rising real GDP any time soon. I think this leaves two plausible outcomes. The nominal public sector debt is inflated “away” or there is a fairly radical redistribution from the private to public sectors (possibly as you indicate through privatization, which I agree is more likely, but I sincerely hope happens in a different way).

  7. Applying your analysis to the US, Affordable Care Act is going to force up the savings rate there. So where are the growth areas going to be for Japan? US and EU unlikely. China not likely. Russia? African nations? Iran? Iraq?

  8. The Japanese Central Bank seems to be the only buyer of Japanese Government Bonds at this point. They are making so much new money to buy bonds that the money supply is increasing around 1.6% every 10 days. It looks like inflation is well over the 0.2% that 5 year bonds pay and rising fast. It does not seem rational for anyone to hold JGBs at this point, so I would expect the rate of selling to increase. This looks like the perfect setup for a feedback loop where the more money is printed, the more inflation there is, and the less anyone wants to hold JGBs. But the less people hold JGBs the more the central bank will have to make money and buy them to hold interest rates down and so the government has cash to operate. This looks to spiral out of control anytime now, making hyperinflation.

  9. The question about monetary policy and its wealth transfer consequences stil unclear to me.

    We see today a decoupeling of wages from productivity growth due to 3 decades of unionisation decline and weakening of worker bargening power, Europe and the US just saw a decade of wage stagnation. Productivity increases are now channeled towards asset price increases instead of wage increases. Some people make the argument that because of that, the price-wage inflation spiral of the 1970’s is not as likely to happen today. Will we simply see asset price inflation as more money is being printed? it seems to me at least that if prices of food and other necessities increase, wages must increase too, so i’m not sure of this.

    Also, the reason i agree with Dr Pettis’s assessement of abenomics, instead of say, stiglitz’s or krugman’s (who at least in their popular writings see Abenomics as a keynesian plan to boost demand) is Mr Abe’s intention to do away with Japan’s very protective labour contracts model.

    I wonder what Dr Pettis thinks about the issue of worker bargening power, has its evolution over the past 3 decades changed anything with respect to central bank monetary policy targets? or is it not much of a changer for monetary policy?

    • I’m not so sure that low wage growth was due to a lack of unionization. The US had the highest wages in the world in the 1870s and there was no unionization of labor prior to the 1870s. Frankly, I find most labor unions in today’s world completely pointless. They usually have a tendency to run excellent companies into the ground.

      • That’s a pretty unfair characterization of unions. German unions are very powerful, and German industry seems to be doing alright. Likewise, the UAW was not responsible for the collapse of General Motors. Non-union engineers and management that decided to make cars no one wanted to buy was responsible for the collapse.

        The original aims of unions, like an 8 hour work day or safer working conditions, are indeed quite obsolete today. But asset prices are flying high while wages are stagnant. Most would agree that this is a real problem. Who will push to change this balance?

        I don’t know the phenomena behind the 1870s wage levels, but it would be interesting to see how this could be repeated today, sans unions. I haven’t seen any other force that is willing to take up that fight.

        • “That’s a pretty unfair characterization of unions. German unions are very powerful, and German industry seems to be doing alright. Likewise, the UAW was not responsible for the collapse of General Motors. Non-union engineers and management that decided to make cars no one wanted to buy was responsible for the collapse.”

          The UAW demanded and received exorbitant wages and benefits that were out of all proportion beyond what most people could consider reasonable. A classic example would be the “Jobs Bank” program, where laid off workers would sit around, watch TV, read the paper, etc and still get paid the same as workers actually doing work. Union work rules also hampered efficiency on the production lines in a big way. For example if a circuit breaker flipped, only people from the electricians union could reset it, even though the person working the line was just as capable of doing that.

          So while certainly the buck stops at management, which in and of itself did incompetently run the company into the ground, to say that the unions did not play a major role in the decline of the American auto industry is quite disingenuous.

          • I guess my problem with this assessment is that we already have control samples like Germany and Japan that do have unions, yet their auto industries did not collapse. Likewise there are other heavily unionized countries that still manage to protect worker interest without seeming to go overboard. What’s so special about the US case?

            GM or any of the others could have moved production to Mexico more rapidly. There’d be a lot of anger for sure, but it wouldn’t stop them from selling cars. Why didn’t they take that route sooner? It might be due to some agreement I don’t know about, but to me that looks like another management blunder. It would certainly be a stronger bargaining chip with the UAW.

            Anyway, no matter how ruinous the pay structures were, they probably could have been sustained had the management not screwed up the car design process. I’ve never worked in a union environment before, but I dislike how they are often made to be the boogeymen. Like blaming the overpaid janitor at the high school for low GPAs.

            @Suvy, actually I agree with you regarding teachers’ unions. Again though, I place a lot of blame on the top level admin – the Dept of Education and politicians who are extremely adverse to any type of experimentation like charter schools.

        • Germany might be better fit for unions than the United States, but unions create all sorts of issues. I actually think teacher unions play a very large role in preventing better schooling in the US. I hate unionized labor and I don’t think it serves a useful purpose any more. I’m all for higher wages, but unionization is the wrong way of doing that.

        • The point i was trying to make is that labour contracts in Japan, which are very protective as well as active unions have offsetting effects to beggar thy neighbour policies the governement might try to impose by compressing wages. Unless the “structural reforms” of Abenomics involve weakening of worker bargening power.

          The unions in Germany stand as an exception to this reasoning howerver; they have been pretty complecent with the shroder reforms and the undervalued Euro. They did not demand wage increases and pretty much approved of the concept of resolving unemployement in Germany through dumping practices on southern Europe.

          We might need to wait for the third arrow to see what Mr Abe is really trying to achieve here.

          • You’re right. The biggest mystery for me is, why do the German unions play ball? Wages are stagnant in Germany. I can’t imagine the average worker is pleased with this, or by the fact that their union doesn’t do much besides collude with the government. Meanwhile you have some very aggressive American unions…why the huge difference between the two systems?

        • The relationship between American companies and unions have been more adversarial. Due to the unique nature of their societies, German and Japanese unions are more accommodating as long as broader social goals are addressed (comfortable not excessive wages, promote full employment). In the U.S. it is more of an individualistic approach. Germany and Japan have histories of authoritarianism and paternalistic societies that promote the greater good.

          During the onset of the recession, U.S. companies quickly cut back the labor force. I believe in Germany the unions agreed to a cut in wages along as employment was maintained. Two very different solutions that would probably not be accepted in the other.

          • I agree with this observation, also what is true about German and Japanese unions is true about their management also.

            Some actions that would be considered normal by US or French management would be seen as irresponsible by German or Japanese managers, the cultural element does in the end have its saying. Most of the countries with high total savings and capital exports (Germany, Japan, but also Singapour and Korea) have this great dose of maturity in labor/management/govrnement relationship. Aside from authoritarianism its the only way a country could pull off a high savings growth model.

            In France we are trying to imitate the Germans, and so far the fail is epic. Unions are getting more and more radicalised against the idea of wage cuts in exchange for maintaining employement; management is not really serious about the maintaining employement part and cares only about short term results and their bonuses, the governement is just watching. The country has lost most of its industrial base. just like in the US.

          • I don’t think it’s fair to compare a country like France or even Germany, Japan, or any of the others to the US. The US is, and always has been, more of an entrepreneurial economy. In a country this entrepreneurial, it makes no sense to have labor unions.

  10. Since Japan has to import virtually all of its resources the only thing it can export is labour. By depreciating its currency is thus selling its labour for cheap. To increase its current account it has to raise the volume of exported labour more than the rate of currency depreciation. With low unemployment, a shrinking labour force and and an increasing dependency ratio it’s hard to see haw this can lead to a much higher current account surplus. I would not be surprised to see it shrinking in the medium to long term.

    The hole strategy is impoverishing the Japanese by paying for their imports with artificially cheap labour.

  11. Hi,

    I have always had this one question about Japan. Since most of the debt is domestically owned, and mostly by their banks, and since low inflation is the main problem, why doesn’t Japan simply default on its domestically owned liabilities. It will wipe out the banking and the pension sector. But Japan can simply print and make full their losses.
    I know this is outright monetisation of debt but if lack of inflation is an issue, why not do it. I know there are risks of moral hazard and who knows how many unknown consequences, but still I keep wondering why this cannot be done. The way I look at it is that the banks will suddenly be flush with cash rather than Japanese bonds and that they could start lending and increasing money supply. But where demand is an issue, I don’t think the broad money will increase and hence, no risk of hyperinflation!!

    • There is no reason to default on the debt and then make full those who lost. It is easier to just have the central bank print money and buy up the debt. This is what they are doing. They are doing it so fast they are increasing the base money supply by about 1.6% every 10 days. There is a big risk of huge inflation. Not long now.

      • Or to put it another way: Rohit, if you were selling to Japan would you be happy to accept and hold yen today, confident that you could redeem them for just as many goods and services after they had printed the equivalent of $10 trillion? If the answer is no, the economy must have inflated and Japan’s standard of living relative to the rest of the world will have fallen.

    • What happens to your currency when you default on your internal debt? If you had a bunch of people dump JGBs all at once, the currency would crash and interest rates would take off while debt servicing costs soar.

      • Thanks for your replies. And I must clarify that I am not an economist or macro specialist so some of my views could come across as pretty naive or uninformed but still .
        May be I put it incorrectly as Vincent pointed out. Lets just assume that Japan monetises all its debt by buying and extinguishing them. From a domestic point of view it may not make too much of a difference given people suffer no losses. The quantity of money will increase surely, but whether inflation will increase tremendously I am not sure given the lack of demand for loans. And if the inflation expectations rise way too much, BOJ can always suck liquidity from the system.

        From an external point of view, I agree that the deprecation of yen may cause tremendous losses to JGB holders and other suppliers of credit to Japan and its companies. And hence, Japan may find itself out of the international debt market. But since Japan is a current account surplus country, and has a positive Net Investment balance against the rest of world, I don’t see too many issues with it. In fact, in a perverse manner, a depreciation of yen may increase the profits of Japanese exporters and bolster the debt equity of those companies which have domestic yen denominated debts but have investments in foreign currency denominated assets (a point made by Prof. Krugman in one of his lectures)

        Again, I know it sounds way too easy and obviously there are questions about moral hazard and unknown unknowns. But this is something that I am trying to understand more completely and so all the views are most welcome.

        • The problem with Japan being a current account surplus country is that Japan imports most of its food and all of its energy. So a further devaluation would drive up input costs and probably worsen their current account.

          Also, who is going to buy JGBs. They have a secular decline in population and the BOJ is basically the only buyer. Remember that the value of a currency in terms of FX is the net PV of the future real interest rate differentials (from the carry trade). If the only way a country can service its debt is by larger and larger negative real interest rates, the currency collapses. Also, the BOJ buying a larger and larger share of the bonds will be priced into the market almost immediately.

        • You may want to read up on J. Kyle Bass, the hedge fund manager who has quite a detailed case against Japan.

          Several points I’d like to bring up:

          1. Integrity is more important than numbers. When someone defaults, he will say “This is a special situation, we won’t default again, ever! I promise!” But who will trust him? Everyone who is defaulting says the same thing.

          So immediately after the default, Japan’s funding costs will be high. Fortunately, the Market has a short memory. So a few years down the road that cost can come down. The initial years will be tough even after a haircut.

          2. Japan is not one entity. By defaulting, winners and losers are created. Those holding USD win, those holding JPY lose some, and those holding JGBs lose even more. A lot of pension money will evaporate just when Japan has a lot of retirees, so socially it would be horrible. Some banks may go bankrupt as JGBs make up a significant portion of their balance sheet. The net effect may be unpredictable, and contagion can cause a chain reaction, risking even international finance, because Japan is a large component of the global economy.

          3. Inflation isn’t just a function of supply and demand. In cases of hyperinflation, often the “inflation” is caused by the drop in trustworthiness of the currency. People may hold gold or USD instead of JPY, which causes JPY to de-value and JPY interest rate to sky rocket. In that case demand of goods and services has no role, only the lack of trust in JPY.

          Personally, I guess that getting the scissors out and putting a big haircut on JGBs overnight is better than monetizing the debt slowly. If you make it a one-time event, even if you only get back 30 or 20 cents on the dollar, it will eventually be forgotten. If the central bank keeps printing and printing with no end, it may not “hit bottom” for a while, which is very dangerous. The situation can snowball out of control.

      • Currency doesn’t move if people just dumb JGBs internally.

        • Japan has a population in secular decline that’s rapidly aging. There are no more buyers of bonds other than the BOJ. If the BOJ expands its balance sheet to buy bonds, that certainly does devalue the currency.

    • even if there is little consumer demand, government can massively increase spending, and generate demand, and cause high inflation. Hyperinflation happens because of out of control government spending.


      Venezuela looks to be a model of japan’s future, hyperinflation looms as its economy slides into recession.

    • That would in effect only switch one gov liability JGBs to another one (currency/reserves/bank deposit?). How do you proceed is critical because the receiver e.g. pension company wants to get rid of currency/unsecured bank deposits they get against JGBs and the funny part is that you probably need a law to force them to make the switch! If there is no JGBs left they will try to buy something closely similar, not sure what would ensue.

      So why not keep it simple and offer them zero yielding gov papers they are demanding. Only to get rid of the debt because the sheer number is spooking some bloggers is not a good reason…

  12. The issue of augmenting the monetary base faster than credit is to delever. It reduces the ratio of debt to monetary base. If debt rises as fast as the monetary base, there is no deleveraging. So the idea is to play with the numerator (base money) instead of the numerator (bankruptices and write-off). What banks have on the left side of their balance sheet is not at all “monetary aggregates” but simply bank currency created against either base money or credit. If there is too much bad credit and you can not swap the bad credit against base money like the US did, you have cyprus, that is currency deposit fail, but the ECB bank notes do not. So Japan is swapping bad credit for newly created base money. The problem is moved to the central bank from the commercial sector. Since the base money is not redeemable, there is no way to force the Central bank into problems, except when interest rates turn (see the “feral hogs” comment from Fisher from the US Fed, Japan might have serious problem with that but it could take many more years before that happens).

    As for money printing, it does push down the Yen first, it represses interest rates first, next land moves up, next price of all interest bearing securities move up (stocks), next it moves in the real economy at that point the interest rates direction can not be contained anymore (like in the US right now, the higher interest rates are due to the external forces demanding compensation on interest rates for lower currency in absolute terms, i.e. not measured against other debased currencies). It will take a long time to get there in Japan, and the reversal will be violent.

    Henry Thornton, John Fullarton have a good framework to understand what will happen next. Money printing typically result in trade deficits, not surplus, but not initially normally, initially the money printing is the cause of a weaker currency, it does so by affecting financial flows as the newly printed Yens go to bid for other currencies.
    When the newly minted monetary units move in the circulation, (long long time from now in Japan), it will result in trade deficit and inversion in interest rates. At that point the internal prices moving up will make two things happen: Internal prices will rise making Japanese exports uncompetitive against no-printing currencies, and it will also make for a chronically sliding currency as a result of negative trade. What should have happened is a better trade environment as Mr Pettis describes, however when the monetary units move in the circulation, the devaluation effect is lost while the internal prices move up, making the trade balance negative. Strong currency, trade surplus and low internal price movements go together historically. Weakening currencies, trade deficit, high internal price inflation and money printing go together historically. Right now Japan has devaluation and will have for as long as the flow of new yens go to bid for other currencies and does not move in the Japanese economy (note: this move has nothing to do with the modern “velocity” which measures nothing more than credit creation and tell nothing about whether base money based backed bank currency is spent in the circulation).
    The situation of weakening currency will not affect internal price initially. It will do so when interest rates start to rise (Thomas Tooke — Wicksell tried to debunk that but without success). At that point internal price rise in a positive feedback loop (or differential equation if you will). When the monetary units move in the economy, internal prices will drive and trump all the other accounting entities as it has always done.

    Printing money is not about trade, it is about inflating debts away. All economies which had inflation due to money printing lost on the trade as their internal price rise forced sliding currency, but initially Mr. Pettis is correct, the money printing will create a devaluation, and very little inflation at first, except for the imported goods. This will change however but it will take time.

    • If prices start to go up in Japan (CPI is at 1.1% and at 1.4% without imputed rent), what will be the consequences? How can they stop a wage-price spiral if they can’t invert the yield curve? Also, what do you think the time frame will be?

  13. The debt is less of a problem because the Japanese people are savers,and the national debt is mostly owned by Japanese nationals.

    Critically, the Inheritance and Estate tax rates were increased in 2012 – see ,http://www.pwc.com/jp/en/taxnews/pdf/2012-tax-reform-part3-e.pdf
    and are set to rise yet again in 2013 – see http://www.grantthornton.jp/pdf/newsletter/bulletin/bulletin_201303.pdf

    I see the debt as a liability mitigated by Japan’s estate tax – at a rate of 55% currently at a rate of 50% for assets over 300 million yen – with the top rate about to rise to 60%.

    What’s wrong with Japan is demographics –see – http://www.wilsonquarterly.com/essays/japan-shrinks

    • I believe 90% of JGBs are held by Japanese institutions including the Japan Post Bank Co and the Government Pension Investment Fund. Losses on JGBs would be borne by anyone holding assets with these institutions.
      As you point out, Japan has demographic problems to the extent that the financial sector is now a net seller of JGBs. Will foreign buyers tolerate such low interest rates especially with a falling yen (down 20% this year alone)?

      • See page 4 of the doc linked below for a breakdown of ownership-


        I follow insurers, and the market for life and savings products in Japan is huge.
        Japanese people are savers, the government are spenders, and it’ll pair off because they are the only parties to this trade. Foreigners own under 10 % of the debt.

        • Great paper. Clearly meant Pension sector are net sellers, not financial sector! I’m sure I saw Japanese banks have 900% of the tier 1 held in JGBs. Given that and your point about the domestic sector being such large purchasers, doesn’t this pose a huge systemic (and feedback loop) risk to any JGB default?

  14. Prof P,

    When you refer to interest rate increases, aren’t you referring to the coupon paid on newly issued sovereign bonds? Surely it will take cycling of the current debt stock to change the government’s cost of debt, and this delay introduces a wrinkle that you do not cover in your analysis.


  15. Kudos Michael for acknowledge how the nominal rate will dictate the amortizing of the debt. But that is a technical it doesn’t mean that Japan needs to pay back the principal when nominal rates are higher. It is still free to capitalize the amount it wishes.

    All in all I cannot believe that ppl are trying to explain how Japan will be worse off if the growth takes off. At least I’m expecting to see thorough arguments behind unintuitive result, not just a bunch of unrelated technicalities.

    Yet even if that would be the case, I would like to be addressed why the government cannot keep the rates lower. That is financial repression sure but what are those feared now-obvious consequences and how they relates to repression? I would rather say non-obvious… It was a gigantic private sector blow up, nothing to do with repression in the first place.

  16. Another option is that the government defaults on part of the debt.

    If they could find some 9/11-like event to put the blame on then a default would be the easiest way to clean up the mess whilst keeping face. Maybe they should call their local CIA or Mossad representative for suggestions!

  17. For a few years, I have been following Kyle Bass here in the U.S. on the CNBC TV network and on the internet. He has been articulating for some time the idea that the Japanese economy will fall from the weight of its enormous debt and its aging population. He explains his ideas almost as well Mr. Pettis.



    PS- I respect investors like Kyle Bass who made a fortune betting that the U.S. housing market would crash five years ago, but this was hardly the mystical trade that the media makes it out to be. Many people with enough common sense saw the unsustainable build-up in real estate prices in the 2000s even if Alan Greenspan still can’t understand it.

  18. One thing you leave out is that Japan’s debt is owned by the domestic, private market. They rarely borrow from foreign powers–which is what causes debt defaults.

    Japan’s debt will be paid off in due time. The sales tax increase, which sounds bad on paper but when you crunch numbers, its not so bad, given other nations are doing fine with a 10-15% sales tax (Japan’s tax will be between 6-8% now), and hopefully the stimulus will put more money in people’s pockets to be able to cushion the effects.

  19. Mr. Krugman is Not an idiot, contrary what Mark claims, because some people ignore the other debt which is the”household” debt that Prof. mentioned in previous blogs. In the US consumer portion of the GDP is about 65-70% so consumer debt is very important. What Mr. Krugman emphasizes that we should first solve household debt which creates demand for all corporations to invest and build new facilities to stimulate the economy and thus reduce the government debt through higher tax receipts. No corporation will expand employment until demand increases.

    Consumer debt is not easy to solve except through higher salaries and time. As consumer spends less and payoffs debts, GDP declines and government receipts decline and government debt increases.

  20. Professor Pettis,
    You wrote that when you devalue your currency it causes a decline in consumption as a result of a decline in real incomes for the household sector. But this is not always true. Yes, the pickup in inflation will cause a decline in real incomes for the existing employed. But, as you point out in one of your books, if a country has a very high unemployment rate the pickup in employment can offset those impacts and actually cause a rise in aggregate consumption.
    The important point is that the pickup in employment from devaluation is almost always an offsetting factor to higher inflation’s negative impact on aggregate consumption. The degree to which this is the case seems to be highly positively correlated to the initial level of unemployment. And as we know, Japan has a very low unemployment rate. Therefore, it seems to me that Abenomics will be particularly detrimental to consumption in Japan because the positive effects from an increase in unemployment will be so small relative to the decrease in real incomes for the existing employed? Agree…thoughts?

  21. Prof Pettis, this is a late message, but I hope you see it:

    Could you please tell me (us?) what the objectives of the Trans-Pacific Partnership (TPP) are re the US and Japan (who has just joined), and what effect that will have on Japan & China trade, rebalancing, etc?

    Are the NZ and other small economies that made up the original P4 upset at having their agenda taken over by the US?

    Is the TPP yet another attempt to penalise the household sector to bail out the banks and to subsidise the producing sector?

    Maybe you could do an article on the TPP??

    By the way, I am a hydrogeologist with no training and no interest in economics/investing until circumstances changed in the early 2000’s. Since then I have been on a major learning mission (about all aspects of economy, politics, how the world works, psychology etc – trying to work out its implications for, & investing in, South Africa where I currently live), and of all the many newsletters & blogs that I read, I have learned the most, and the most vital, from your blog and I want to say “Thank you very much” for providing your wisdom to the public like me free of charge.

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