This blog post was originally posted at Bawerk.net [16]. You may also follow us on twitter @EBawerk [17]
Part I: Toward the abyss
Japan has been in a stable, but unsustainable, equilibrium for years. Its leaders know it is unsustainable and in their immense wisdom, decided to manage the whole system in order to achieve a sustainable development. However, this will prove fraught with danger since moving an unsustainable system away from its steady-state runs the risk of unleashing a gale wave of unintended consequences. The problem of course is that the people now in charge of moving the Japanese system from its current constellation have absolutely no idea on how to get it from where it is back on sound footing. The reason is simple, as with most policy quacks they are taught by other quacks. Some of the teachers even have Ph.D.’s. in quackery to prove to lesser quacks who truly master the art of quacking; we call them economists.
Economists are a group of people that look upon the social structure called the economy with condescension and arrogance. They see it as their task to manipulate other people in order to build confidence. If confidence is high, then economic growth, prosperity and bliss will come automatically. The problem is that when people feel down they do not spend money. And when people do not spend money, economic growth turns into contraction and people feel even worse in what turns out to be a self-reinforcing cycle of less growth, less confidence and even less growth and so on in perpetuity.
This is basically how Prime Minister Abe and his newly installed lackeys at the Bank of Japan see as the situation in Japan today. In the early 1990s people lost confidence for some unexplained reason, and because the supposedly omniscient masters did not do enough manipulation back then, confidence was never regained; which essentially explains the predicament Japan is in now.
The real reason is more fundamental though and we will explain what happened in Japan. Before we do so, it is of the utmost importance for the reader to know what gross domestic production, or gross domestic consumption (GDC) as we call it, really is. It is essentially the amount of money spent on goods and services over a specified period of time. In other, and more “technical terms”, we can say that GDC is comprised of the monetary base * leverage in the fractional reserve banking system * money circulation.
The central bank manufactures monetary base at its own discretion. However, the broader money supply is dependent on a solvent banking system. If banks under the jurisdiction of the central bank are insolvent they cannot increase their balance sheet, or leverage up on the base money. After a financial crisis it is therefore hard for the central bank to create inflation since legacy assets held by the banks will weigh on their ability to create additional demand deposits. In addition, as banks hold back on money creation, transactions will inevitably drop. As you can see, it is actually true that an activist monetary policy can create growth in gross domestic production, but only because the very concept measures inflation of broad money supply and nothing else. From this follows a surprisingly well hidden fact; the debt to GDC ratio is important only because it measures whether debt is created at a rate faster or slower than monetary inflation. This is why it has become so important for the new Japanese administration to create nominal GDC growth. They are desperate to inflate away the big pile of debt they have accumulated of which there is zero chance of ever being repaid. Put bluntly, they want to default covertly through inflationary resource confiscation.
If we look at the monetary breakdown of Japanese GDC we see a negative velocity effect. That means only a fraction of existing money circulates during the period of measurement (one year). However, by raising it to something greater than one – ceterius paribus – Japan could lift its GDC from the current level of Yen500tr to Yen800tr and simultaneously reduce the debt ratio from 230 per cent to 140 per cent! Alternatively, they could double the monetary base and again – ceterius paribus – reduce the debt ratio to around 100 per cent.
Please note that none of this creates any value at all, but only help to redistribute real wealth to the government which can squander it as the ruling class see fit.
Source: Bank of Japan (BoJ), Cabinet Office (CAO), own calculations
The second thing the reader needs to know about economics is that debt can have a positive or a negative effect on wealth creation, depending on what kind of deb. If the debt is made with the intent of making a subsequent sale, id est. a business loan, it will help increase capital accumulation. However, if the debt is taken on to fund current consumption it will decumulate the capital stock and make society poorer. In our work, we usually divide between good, bad and destructive debt. Good debt consists of business loans. Bad debt is defined as household and financial sector loans while government debt fit right into our category called destructive debt. Basically, debt need to have an intrinsic yield high enough to pay back the resources it helped claim from society, plus interest, for it to be considered good. Note, debt that is dependent on others yield or production, such as taxpayers, is not self-sufficient and cannot create prosperity. With this in mind we look at what happened to Japan before and after it crashed in the 1990s
Source: Bank of Japan – Flow of Funds (BoJ), own calculations
Japan in the 1980s and 1990s show a remarkable resemblance to the US during the 2000s. In the midst of bubble finance, the system funded bad debt in droves. This pulled capital out of the system without replenishing it. Conventional wisdom tells you that the 1980s was a decade of spectacular growth for Japan, but truth be told they actually got a lot poorer by consuming capital. When the Bank of Japan (BoJ) felt compelled to raise interest rates sharply from 1989 to 1990 the malinvestments could no longer be funded. The bust was inevitable.
When the bubble finally burst as a consequence of the misaligned capital structure, the government stepped in and bailed out the bad debt by adding destructive debt. Of course, this policy benefitted the corporative part of the economy, such as big banks and politically connected businesses, but at the expense of zombifying the economy. Bad investments continued to drain the system of scarce capital, while the government doubled down in a desperate attempt to kick-start money multipliers and velocity.
But money multipliers could not be expanded because the banking system was rendered unable to increase base money leverage since they continued to fund capital projects that bled the economy dry.
In a desperate attempt to rectify the lack of “private sector” initiative the Japanese leaders schooled in Keynesian multipliers knew that their wasteful spending would at one point fund itself through higher tax income. Now, that did not work out as they hoped as spending soared while income kept falling.
Source: Ministry of Finance (MoF), own calculations and projections
Note that bond issuance has been larger than tax revenues since 2009 and under very conservative assumption will continue to be so for the foreseeable future. Japan has ended up in a rather peculiar situation in which revenue abide by the” laws” of deflation while spending reflects that of a system in inflation.
Conclusion
In an attempt to bail out unsound investments, Japan cemented an economic structure that was unsustainable. This lead directly to persistent capital consumption and a “lost decade(s)”
Part II: From quagmire to Abenomics.
Unsurprisingly the policy lead to a massive increase in debt levels. In order to feed the unsustainable system, consecutive Japanese governments threw money at it with the perverted consequence of depriving corporations of capital. Government debt grew inexorably while corporations got squeezed.
Source: Bank of Japan – Flow of Funds (BoJ), Cabinet Office (CaO), own calculations
The central bank reacted by lowering interest rates from a peak of 6 per cent in the winter of 1990/91 to a low of 0.5 per cent in 1995. In addition they expanded their balance sheet by lending to banks against legacy assets. The insolvent banking system and the overleveraged household sector did not crave liquidity for more than refinancing outstanding bad debt, so the increased base money ended up as excessive reserves in the BoJ deposit account. Sounds familiar?
Source: Bank of Japan (BoJ)
Source: Bank of Japan – Flow of Funds (BoJ), own calculations
Now, the initial measures taken may seem tepid compared to what we have been accustomed to today, but these were dramatic and unprecedented steps back then. It is also striking to see how similar the development prior to the bust and response taken after was compared to what we see across the western world today. Needless to say, it does not bode well for the future.
As Japan moved forward in the 1990s and 2000s it became obvious, even to the policy makers, that the situation was unsustainable, with nothing less than a Greek style fiscal Armageddon on the horizon. Tax revenues were dropping and bond issuance rising. New taxes introduced to fund the rapidly growing state harmed private capital accumulation even more. The corresponding spending growth was found mostly in debt service- and social costs. Those two categories account today for more than 50 per cent of total spending, and bar a default or dramatic cut in transfers to a rapidly ageing population, will only continue to eat into the overall budget.
Source: Ministry of Finance (MoF), own calculations
For Japan is not only in a dire fiscal situation, they are also the oldest country in the world. Social spending is growing exponentially and the demographic dividend they enjoyed up to the mid-1990s is now turning against them. There will be many more dependents and far fewer breadwinners as we move forward. The demographics in Japan would overwhelm the country even if their fiscal situation was sound.
Source: US Census Bureau, own calculations
Source: Ministry of Finance (MoF), own calculations
The only thing clueless policy makers could come up with in this dire situation was even more of the same. With the election of Shinzo Abe in December 16th the people of Japan elected a man based on a promise of shake up the Bank of Japan. The resemblance to William Jennings Bryan and his famous “Cross of Gold” speech is eerie. The Japanese would not be “crucified on a cross of gold” any more. They elected a man who promised to free them of the shackles from a strong yen and save the day with creation of paper wealth. This is the perfect recipe for disaster.
Conclusion:
Public debt is reaching ridiculous levels and spending will only grow from here. When big bulges of old people start to retire they will be dissaving and it will be impossible for the big banks to use excess deposits to roll over government debt. Collapse is at this stage inevitable.
Part III has recently been submitted to Bawerk.net [18]
