Friday, April 9, 2010

Japan— Land Of The Setting Sun

¹²Japan— Land Of The Setting Sun

"…the Japanese economy may be thought of as a bug in search of a windshield…"
—John Maulden

By Martin Hutchinson | 29 March 2010

Japan announced this week that it was partially withdrawing its planned Post bank privatization, so that the government would retain a third of the bank's shares. Meanwhile the latest Japanese budget shows a deficit of 10% of GDP, at a time when Japanese public debt exceeds 200% of GDP. Through two decades of economic malaise, I have remained optimistic that Japan would solve its problems and emerge into a new era of rapid economic growth. Alas, that enlarged red sun in the East may now be setting rather than rising.

For the 20 years since the Japanese bubble peaked in 1990, I have been generally bullish on the place. Labor productivity growth continued solid, at 1.92% annually over the 1990-2009 period, according to the Conference Board. That performance, comparable to the much vaunted U.S. productivity growth (1.91% annually in the same period) and higher than that in Europe, showed that the prolonged economic stagnation was not adversely affecting the impressive Japanese economic strengths in manufacturing and technology.

The pro-business Liberal Democratic Party remained dominant in the Japanese political system— there was no move to socialism, although public spending and debt increased much too fast. China grew much faster, of course, [[though perhaps not in the crucial per capita GDP measure: normxxx]] but growth in the Chinese market offered valuable opportunities to Japanese companies, which were able to outsource much of their low-value-added manufacturing to the behemoth next door while retaining the design and research facilities domestically.

The heavy public spending and increased taxation in 1997-2000, together with the collapse of a substantial part of the banking system in 1998, made me doubtful, and in 2000-01 I began to wonder whether Japan's decline might indeed be terminal. Then the advent of Junichiro Koizumi renewed my optimism— indeed at his accession, I dubbed him "Warren G. Koizumi" in reference to the successful recession-conquering efforts of President Harding in 1921-23. Koizumi recognized the error of Japan's traditional Keynesian "stimulus" programs, which had driven infrastructure spending up to twice the level of France, the next most profligate OECD country. He also saw the need to sort out the gigantic blob of bad debts in Japan's banking system.

In retrospect, he was only partially successful in tackling these problems. Japan's consensual politics required him to move slowly and its absurdly frequent rotation of leaders gave him only years in office— the longest tenure since 1972, but still not enough. He sorted out the banks in 2003, with a large infusion of public money.

But even by the time he left, the budget deficit was only slowly declining and the damagingly high level of infrastructure spending had been only moderately reduced. It did however appear at the time that his legacy of privatizing Japan's gigantic Post bank and its associated insurance company might form an economically beneficial legacy, particularly as he had won the 2005 election on the issue.

It was not to be. Koizumi's successors Shinzo Abe and Yasuo Fukuda were both committed to Koizumi-style reining in of the public sector, but each lasted less than a year. Then an old-line "stimulus" believer, Taro Aso took the helm just as the 2008 crisis hit. The crisis gave him license to ramp up Japan's public sector deficit with one useless spending package after another.

The LDP's massive electoral loss to the Democratic Party of Japan on August 30, 2009 was thus well deserved. Initially, it appeared that Yukio Hatoyama's DPJ government might solve the problem. It had promised to cut back infrastructure spending and redeploy resources to transfer payments, less economically damaging. The DPJ's first finance minister, Hirohisa Fujii, was a fiscal conservative and all seemed well.

However, Fujii was forced out in January and his successor, Naoto Kan, is another big spender with close connections to the DPJ "godfather," former LDP bigwig Ichiro Ozawa. The budget for the year to March 2011 thus has record public spending, a record deficit and, for the first time, tax receipts covering less than 50% of public spending. That's not good. The most notorious example of a government whose tax receipts covered less than 50% of public spending in peacetime was the German Weimar government of 1919-1923, and we know how that turned out.

Needless to say, Japan does not appear currently in danger of trillion-percent inflation. It's worth reflecting on why not. Almost certainly, the Post bank, which owns more than $1.7 trillion in Japanese government debt— more than a quarter of the total outstanding— is a key bulwark of systemic stability.

In the Weimar Republic, which began with inflation already running well into double digits, nobody wanted to buy government debt at interest rates well below the inflation rate, while the government didn't want to issue debt at market rates, which would have appeared horribly expensive when the interest was subtracted from the budget balance (there wasn't much experience with high inflation then). So the Reichsbank just printed more money and 'lent' it to the government, resulting in hyper-inflation.

In Japan currently, most of the deficit is financed through domestic savings, whether directly or through the intermediation of the Post bank. The Post bank group has $3 trillion in financial assets, more than enough to ramp up its holdings of government bonds. To limit the danger of it running out of money, the government has now doubled the limit on postal savings accounts, to 20 million yen ($220,000) per person. Thus the mechanism by which savings are channeled into the government's coffers is extremely efficient, and in the short term offers no danger of hyperinflation.

But there are two dangers here, both of them very bad news for the Japanese economy. Domestic savings may become inadequate to fund the deficits (currently running at $500 billion a year) even with the help of the Post bank. Even at its current gigantic size, 50% larger than Bank of America, it could finance only 2½ more years of deficits at their current rate before finding itself with 100% of its assets in government bonds and no money.

In that case, since Japan's debt to GDP ratio would then be so high that foreigners would see a severe risk of default, the Bank of Japan would most likely have to monetize the deficit. Very quickly, Japan would be into Weimar territory— in those extreme circumstances it would probably transition from price deflation to triple-digit inflation within no more than 18-24 months. The opposite risk, as the Post bank sucks in private savings so effectively and funds the deficit with them, is that private business could find it impossible to get funding.

After all, with deflation of 1.3% in the year to January, Japan's 30-year government bond yield of 2.27% represents a real yield of 3.57%, high in a deep recession. If the Post bank funds the government and the private banking system [[starved of deposits: normxxx]] cuts back lending, then the private sector is likely to become starved of funding (except for the largest exporters, which can raise money internationally). The Post bank, by sucking in savings and funneling money into the giant deficit maw, would be intensifying the "crowding out" of the private sector.

Bankruptcies throughout the private sector would then follow, pushing Japan into ever deeper recession. This is the true danger of Keynesian deficit spending, kept at a high rate for two decades and then intensified. "Crowding out" of the private sector becomes a truly serious problem and the economy dives into deep recession. The only solution is that found by Neville Chamberlain in Britain in 1931 (when the country, which had suffered a low-growth 1920s, was in a similar position as Japan today).

He devalued the pound and cut public sector salaries by 10%, pushing hard to balance the budget through spending cuts. [[But how exactly does one go about destroying the value of a currency in today's international floating rate system when the other players seem to ignore all atttempts to do so!?!: normxxx]] The result was an astonishing economic boom, by British standards— even while the rest of the world and world trade was deep in depression. In 1932-37, Britain enjoyed the fastest five year growth it has ever enjoyed.

That solution, of a weak yen and sharp cuts in government spending, is the answer for Japan today. Essentially it would be Koizumi's policy, but pursued more vigorously and without Koizumi's hesitation. The policy must be kept in place until full recovery occurs and the public debt is reduced to a manageable level of around 100% of GDP— for at least a decade, in other words.

But, given the dominance of the high-spending forces within the DPJ, and their adherence to Keynesian nonsense, Japan is unlikely to get any such policy from the current government— Fujii, who might have attempted it, is 78 and in poor health. The current opposition LDP is in disarray, and its leadership is mostly "old guard" spending types. However, as prime minister Hatoyama's LDP brother Kunio, former minister under Aso, has just demonstrated, the dinosaurs are showing signs of leaving the LDP either for the DPJ or to form new parties.

In that case, given a decent LDP performance in Upper House elections this year, younger and more free market forces, backed by Koizumi off-stage, may come to the fore. The figure to watch is the former defense minister Yuriko Koike, a protégé of Koizumi, who is pushing free-market solutions and is effectively leader of the free-market faction in the LDP. If the political stars align right, Japan could get a free-market, spending-cutting government within 3-4 years.

It will then need to keep that government for a decade, not wimping out as after Koizumi. Japan needs a lot of political luck— and without it deep economic crisis of either semi-permanent depression or hyperinflation (or both) seems inevitable. East or no East, the sun is currently setting.

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