Will Japan’s economy go belly up?

“As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan’s long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve. In short, Japan’s deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has.”
- U.S. Federal Reserve Chairman Ben Bernanke

EITHER THE BUSINESS of following the movement of money for a living attracts those of a saturnine cast, or the business of following money itself makes people that way. Even in the balmiest of economic climes, they scan the skies for storm clouds while issuing dire warnings about the sooty wisps that only float overhead or dissipate before any rain falls.

In today’s economic climate, however, those who put the dismal in the dismal science are reveling in a saturnalia of pessimism so extreme it’s time for the rest of us to pay attention to the racket they’re making instead of shutting the window. It isn’t just the United States that’s causing the analysts to pour themselves another stiff drink; even the layman senses that the Americans are building another house of cards on the lot filled with the debris from last year’s collapse. What has some money watchers reaching for the bottle this time is Japan and China.

Earlier this month, Ambrose Evans-Pritchard wrote this column in Britain’s Telegraph headlined, “It is Japan we should be worrying about, not America.”

The barman sets them up:

Japan is drifting helplessly towards a dramatic fiscal crisis. For 20 years the world’s second-largest economy has been able to borrow cheaply from a captive bond market, feeding its addiction to Keynesian deficit spending – and allowing it to push public debt beyond the point of no return.

And then pours:

Regime-change in Tokyo and the arrival of Yukio Hatoyama’s neophyte Democrats – raising $550bn (£333bn) to help fund their blitz on welfare and the “new social policy” – have concentrated the minds of investors at long last.

“Markets are worried that Japan is going to hit a brick wall: the sums are gargantuan,” said Albert Edwards, a Japan-veteran at Société Générale.

Here’s the chaser:

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised “a real risk that Japan could end up in a major default”.

“The debt situation is irrecoverable,” said Carl Weinberg from High Frequency Economics. “I don’t see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this.”

“This is incredibly dangerous,” said Russell Jones from the RBC Capital Markets. “The rate of deflation is shocking. The debt dynamics are horrible and there is the risk of a downward spiral.”

The author points some fingers:

Japan’s terrible errors are by now well known.

It failed to jettison its mercantilist export model in time.

It resisted the feminist revolution, leading to a baby strike by young women.

It acquiesced in a mad investment bubble (like China now) in the 1980s, stealing growth from the future.

Some of that’s overstated. China and South Korea use the same mercantilist export model, and none of the three could have succeeded unless the U.S., among others, allowed it to succeed.

Birth rates are falling throughout Europe and East Asia, so if there’s any “baby strike”, the picket lines aren’t just in Japan.

(It also isn’t due to resistance to the feminist revolution, but we’ll be looking at that and the Chinese bubble in some upcoming posts.)

QE was too little, too late, and this is the lesson for the West. We must cut borrowing drastically over the next decade, and offset this with ultra-easy monetary policy.

By QE, he means quantitative easing, or the purchase of national and corporate debt instruments by the Bank of Japan.

Finance Minister Fujii Hirohisa is upset with the BOJ for halting their QE, by the way. The central bank’s justification was concern over rising public debt, but Mr. Fujii wants them to resume.

He says there’s a limit to what fiscal measures can accomplish. He did not mention structural reforms.

Added Deputy Finance Minister Noda Yoshihiko:

With the rate of price increases expected to be negative for a long period of time, we would like the Bank of Japan to indicate a clear stance on how it will deal with the situation.

Remember that it was fewer than two years ago the Democratic Party of Japan, then in the opposition, tried to create a political crisis by rejecting the Fukuda Administration’s BOJ appointments, claiming Finance Ministry OBs were unacceptable.

Their rationale, which has merit and is employed as a general rule of thumb in other countries, is that they wanted to keep fiscal and monetary policy separate.

But opposition parties everywhere have a problem with remembering the things they used to scream about once they’re in charge.

(Incidentally, even when many in the DPJ signaled they were willing to accept some appointees with a Finance Ministry background, the idea was nixed by Big Boss Man Ozawa Ichiro. Mr. Ozawa has always been more interested in politics than in government, and in ruling rather than governing.)

The danger here is that central bank purchases of the debt securities of their own government create money, which is known as monetizing the debt.

In addition to putting into circulation specially made pieces of paper with elaborate colored engravings that everyone pretends has value, the process allows politicians to overspend revenues without raising taxes or risking default.

Since the Finance Ministry is agitating for tax increases, and there’s a real risk of default anyway, it would seem that Japan has painted itself into a corner. No wonder Mr. Fujii is concerned.

Credit rating downgrade

The following report came out about a week after the preceding article appeared:

Fitch Ratings warned Japan on Tuesday to keep to its borrowing target or risk a credit rating downgrade as the finance minister acknowledged the problem and tried to reassure rattled investors by saying spending had to be cut.

What’s the problem this time?

The government has said it plans to borrow 44 trillion yen ($490 billion) in the 2010/11 fiscal year starting next April, which would be on top of expected record issuance this fiscal year of more than 50 trillion yen.

But Fitch Ratings said it’s hard to see how the 2010/11 goal will be achieved and borrowing much more than 44 trillion yen would spark a ratings review.

Thus:

“It’s not the sole determinant that will drive our assessment but other things being equal, then I think that would prompt us to review Japan’s current double AA-minus rating.”

Just when you think things can’t get any worse, they get worse.

The Government announced that Japan was again officially in a deflationary period.

Here’s a passage from a website page explaining deflation, and how the lack of Japanese action in the past was deflationary:

Banks have delayed that decision (to collect on the loans), hoping asset prices would improve.

These delays were allowed by national banking regulators.

Some banks make even more loans to these companies that are used to service the debt they already have.

This continuing process is known as maintaining an “unrealized loss”, and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy.

Here’s the suggestion the Deflation page authors passed along for dealing with deflation in Japan:

Improving bankruptcy law, land transfer law, and tax law have been suggested (by the Economist magazine) as methods to speed this process and thus end the deflation.

Those are probably some of the steps Mr. Bernanke had in mind. But what did the government do?

They passed through the lower house—after only eight hours of debate—Financial Services Minister Kamei Shizuka’s plan to encourage a debt moratorium and have the taxpayers guarantee the loans.

In other words, instead of making the banks and businesses assume the risk—which is where it belongs—they’re making taxpayers liable for it.

Maintaining unrealized losses is deflationary.

Therefore, the Japanese government is implementing a measure that will make deflation worse during a deflationary period.

Here’s another straw for the camel’s back:

The government’s loan guarantee program has already used up half of its JPY 30 trillion (US$ 340 billion) budget, and the government says it doesn’t plan to allocate any more money. But how long will they keep singing that tune if too many default on those debts?

Some default is inevitable, which means the government will be throwing the taxpayers’ money away. But what the heck, it’s only fiat money anyway.

That’s the term for the money of the mind created after the debt has been monetized.

Still not worried?

As the old jest goes, if you can keep your head while those about you are losing theirs, perhaps you don’t understand the situation.

Now we learn the Financial Services Agency plans to revise its rules for financial institutions to exclude debts suspended by the moratorium from the bad debt classification.

In other words, the Government thinks that putting the peg in a different hole will hide the debt for the three-year moratorium period.

Then, like Cinderella’s pumpkin, the name changes back and the banks have to write off the bad debts.

If the banks struggle to survive while writing off this debt, there will be inevitable calls for more taxpayer money to bail them out.

Where will the government find the money to pay for all that?

Wasn’t “monetizing the debt” where we came in?

Yet another problem with Mr. Kamei’s economic demagoguery is the moral hazard.

Some of the businesses freed from the responsibility of repaying their debt will either be unable to restructure their finances, or, considering human nature, may not do it at all. That would mean they go bankrupt anyway in three years, while all that fiat money backing the government’s guarantees evaporates with their business.

Still more to come

The banks are also getting the shaft from another direction.

As this report notes

“The Basel Committee on Banking Supervision is expected to raise the level at which financial institutions are required to maintain their core Tier 1 capital as early as 2012. Core Tier 1 capital includes the sum of common shares and internal reserves.”