Forget Greece and Spain, Look at Japan

While this blog is predominantly interested in long-term structural challenges faced by humanity such as climate change, resource constraints and technological disruption, it is the interface between the short term and the long term that brings such issues directly into people’s homes. For example, the problem of peak oil generally doesn’t move from the abstract to the concrete through the gasoline or petrol queue but rather through helping tip a country into recession (or depression), so eliminating jobs and reducing incomes. Rarely do we see the smoking gun of peak oil at the scene of the crime.

Similarly, my sense is that the unfolding crisis in the eurozone is far less a result of macroeconomic policy failure than the debilitating effects of a change in demography, technology and energy availability in Europe’s southern periphery. True, many of these structural changes are mirrored in the north of the continent; however, Germany, Holland and the other stronger members of the eurozone possess institutional strengths that are sufficient to offset—for a time—trends that are undermining the postwar paradigm of uninterrupted economic growth.

In a previous post I did on Greece, I highlighted the problems the country faces from an ageing population, chronic fossil fuel import dependency and over-specialization within a globalised economy. These critical issues form the backstory to the international media’s preoccupation with the country’s level of debt. Accordingly, we may all be focussing on the likelihood of a near-term Greek default, but in so doing we amy forget that the current situation is a result of long-term structural trends that have suddenly come to a head: in other words, we shouldn’t confuse cause and effect.

Greece certainly punches above its weight in terms of its ability to sap confidence. With GDP of a mere $300 billion (about 0.5% of the global total), its potency is via the potential to spark contagion, and thus drag both Spain (GDP of $1.4 trillion, 2.2% of GDP) and Italy ($2.1 trillion, 3.3%) kicking and screaming out of the euro. Nonetheless, I leave commentary on the eurozone end game to others (for an excellent euro ‘state of play’ see the post at the blog Baseline Scenario by the former Chief Economist of the IMF Simon Johnson and his co-author Peter Boone here).

Instead, I want to focus on the largely ignored issue of how another country of an altogether greater size ($5.5 trillion,  8.7% of global GDP) is also seeing a series of deep-seated structural problems suddenly morph from the long term to the short term: Japan. This country has being doing debt for so long and with so few adverse consequences that it appears to have succeeded in boring the bond market vigilantes and general global punditry into submission. Japan is like an elderly relative who has been on the verge of death for so much time that no-one visits the hospital any more.

Before I show you Exhibit A that something very bad is about to happen, I just want to recap on the three major reasons why no-one currently cares what level of debt Japan accumulates. These arguments are 1) however much debt the country piles up, interest rates don’t (and won’t) move, 2) everything the country owes is to itself and 3) as a large global creditor the country has fresh plenty of ammunition to fight any crisis. My contention is that these arguments are a) plain wrong or b) irrelevant. Further, my belief is that long-term negative trends have reached such a point that they are about to break into the short term. As such, Japan will soon be no longer boring—and for all the wrong reasons.

If you want to understand Japan’s perilous situation then the canonical report to access is the Japanese Ministry of Finance’s annual analysis entitled ‘Japan’s Fiscal Condition‘ and its accompanying ‘Appendix‘. Let’s start within the report with Japan’s infamous level of gross debt. Japan makes the rest of the major OECD countries look positively frugal.

Traditionally, the quick riposte to the burgeoning gross debt was to demand that one look at net debt. However, this defence now looks weak.

Both gross and net debt, though, are stock as opposed to flow concepts. Debt in and of itself does not cause hardship; rather, it is the interaction of debt with income and expenditure. If you face economic distress this is because a) your income doesn’t meet your expenditures and b) you can’t fill the gap with access to credit. Debt is an indirect determinant of both things, but indirect nevertheless. So has Japan faced increasing hardship and what will the future hold? As to the first question, it would appear that the state still has considerable financial flexibility; in response to both of the two recent external shocks—the global credit crisis and the Tohoku earthquake—the government managed to boost spending to record highs.

Note, however, the absolutely extraordinary gap between expenditures and tax revenue in the above chart—the latter being half the former in recent decades. The next chart is the one that I am most horrified with; indeed, after newly viewing each year’s update, I am generally stunned into silence for a few minutes.  Having lived and worked in Japan in the past for many years as an economist, analyst and fund manager, I find it astonishing that such an industrious people could have created such an impasse.

The critical point here is that the government of Japan has been gradually withdrawing from the traditional functions of a modern nation state; that is, to provide such public goods as infrastructure, education and R&D investment. In effect, the budget has turned into one giant debt service and welfare distribution program. But it gets worse.

From around 2010, the interest payment burden inflected despite the continued fall in Japanese interest rates. In the 2000s, the debt burden basically moved sideways as the country was able to roll over debt at a lower interest rate, which compensated for the continually expanding pile of government paper. In 2010, this phenomenon stopped. Now more debt means more interest payments which, other things being equal, means less spending on something else. But Japan can no longer be called ‘the construction state’—the days of building bridges to nowhere and concreting over river valleys are long gone. There is no fat to cut here. The same could be said for education. In fact, non-social service expenditures as a percentage of GDP in Japan are now the lowest among the OECD countries.

Now let me move away from the Ministry of Finance report for a second and look at part of a table taken from a report published by the Japanese National Institute of Population and Social Security Research site (here). The postwar baby boom was a highly concentrated affair with the peak years for childbirth taking place over 1947, 1948 and 1949, after which a quite draconian birth control policy blunted the increase. That bulge manifests itself in the pronounced jump in 65 and overs between 2011 and 2012, which will continue through to 2015 before quieting down somewhat. The absolute numbers don’t really do justification to the speed of demographic change taking place. In the 10 years through 2015, the 65 and over population will have jumped by 7.6 million, or nearly 30%. The working age population by contrast will have fallen by 9%.

Please note that the social security budget was already out of control even before we come into the peak years of demographic stress. Yet up until recently, the system held together because the government could meet its rocketing social security obligations by issuing bonds to late middle age baby boomers (via the post office and banks) who have been furiously saving for their retirement. As the demographic pig has moved through the python, those baby boomers have now turned into net dissavers and are no longer available to pick up all the government paper need to bridge the revenue-expenditure gap. This has dragged down Japan’s overall savings rate. The blip upward below in 2009 is a knee-jerk reaction to Lehman shock and global credit crisis; for 2011, we have trended back down to 2% again.

Faced with the challenge of a falling savings rate as the working population contracts and the retiree population expands, Japan could, of course, resort to the overseas markets. Currently, it holds a healthy net asset position overseas amounting to about 50% of GDP (see here). Nonetheless, the government’s primary balance (excluding debt service payments) is negative to the tune of around Y22 trillion) and its overall bond-dependency ratio is 49%. For overseas investors to pick up the baton of this debt service burden would lead to a rapid build up of overseas liabilities and a commensurate rise in interest rates. With total debt at 200% of GDP even a back of interest rates by 100 basis points (one percent) would have drastic consequences for Japan’s debt service burden.

The only positive in Japan’s favour is that it is not an over-taxed country if you compare it with the rest of the OECD as the chart below shows. Room potentially exists to institute aggressive consumption tax hikes in order to close the income-expenditure gap. Yet Japan is also a country that has struggled to secure growth. The implementation of high powered austerity onto an economy that is undergoing structural decline could presage depression—or at the very least set off negative feedback effects that impact on both income and expenditure as the economy stalls.

There is a second mechanism which makes me more cautious over perceiving tax hikes to be the saviour. In short, retiree behaviour will not remain neutral if you increase the burden of tax on consumption (or for that matter slash entitlements for the old). If the elderly aim to sustain a certain standard of living, they will respond to higher taxes by accelerating dissaving through selling off their government bond holdings, so forcing up interest rates and the state’s debt service burden. (Or rather, banks and the post office will liquidate government holdings in order to raise funds to settle the elderly’s savings account withdrawals.) As a consequence, I think the hypothesis that a massive tax hike can bring the government accounts back into balance is deeply flawed.

Much as with the sub-prime housing market in 2007, Japan’s stability appears an optical illusion. The fact that the bond market hasn’t collapsed is always given as prima facie evidence that it won’t collapse in a type of self-fulfilling argument. This in turn stems from the confidence of an elder generation of Japanese that they can buy bonds in the Japanese government in the belief that they will be able to cash those bonds in tens years into the future and buy a bundle of goods similar to that which could be bought today. The only way the government can deliver on this is by either a) slashing welfare payments to those same seniors, or b) taxing them by stealth through a massive consumption tax hike. Neither, of these alternatives looks politically easy. Alternatively, the government can in effect shrink the size of its seniors’ future bundle of goods though printing money to inflate future value away.

In the meantime, Japan’s growth is also under siege from structural trends such as peak oil and the disruptive impact of new technology that is undermining its corporate giants.

For the last decade, the emperor really has had no clothes but no-one has wanted to be accused of lese majeste through saying as such. The demographics, however, are inexorable over the coming three years. Whether it will take all three years before we have an economic and political crisis in Japan is something I doubt.

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