March 19, 2012
The US stock market hit another post-crash high on Friday and it got me thinking not of America but of Japan – one of America’s giant creditors. As the US stock market has been rallying, the Japanese yen has been collapsing. Why might this be?
This time last year, Japan was struck by a tsunami, which shook the country to its very core. Japan flirted with a nuclear disaster as the Fukushima reactor melted down. It is now known that the Japanese interior ministry toyed with the possibility of having to evacuate Tokyo – such was the scale of the threat to civilised life in Japan.
In the end, maybe the lasting lesson of the biggest nuclear near-miss the world has ever seen might be an appreciation of the inherent safeness of Japan’s nuclear reactors. After all, if a nuclear reactor can be hit by an earthquake and a tidal wave and still be controlled by the engineers, it suggests that these installations are pretty robust.
As Japan came to terms with the tsunami, many people also looked anew at the Japanese economy, particularly because the path taken by the rest of the world since the crash has mirrored the road map given by Japan, as it tried to recover from its massive property and credit crash in the early 1990s.
Japan was the first to do quantitative easing; it was the first to expand its central bank’s balance sheet massively and print money. It was the first to engage in real Keynesian counter-cyclical fiscal policy. It was the first to ramp up government spending in the face of a recession. Now its government debt to GDP ratio stands at 225 per cent – by far the highest in the world. In short, Japan is the leading indicator as to how countries tackle debt-induced recession.
It is also the economy which maintained enormous exports throughout its domestic slump and this keeps the economy and its brilliant companies ahead of the rest of the world in all sorts of manufacturing fields. And crucially, in terms of financing, the Japanese have kept long-term interest rates at extremely low levels for nearly a decade and a half, despite the stock of debt skyrocketing.
When you look at the policy of the US and Britain and the EU, some, if not all, parts of the Japanese mix are being used. The EU baulks at the government spending side to the Japanese mix, as does Britain, but on the monetary side the response is identical.
In the US, the mix is more or less identical, except that in Japan they don’t have the constant wrangling between congress and the president over policy.
It is crucial, too, for Ireland to appreciate what happened, because Japan experienced what economists term a ‘balance sheet recession’. This is what is happening here.
The Japanese bet the house on property and lost. So on one side of the balance sheet, Japan had property that was falling in value and on the other side, they had debts, which remained the same.
So Japan was bust.
Its banks were also bust because they were, like the Irish banks, up to their necks in rubbish. Therefore, the people started paying back their debts, if they could. So they were in no mood to spend. The saving ratio rose. Equally, the banks were nursing their broken balance sheets so they were in no mood to lend out money.
The Japanese economy was caught in what Keynes described in the Great Recession as a “liquidity trap” whereby, irrespective of how low the rate of interest went, if people didn’t want to borrow and banks didn’t want to lend, the economy didn’t respond.
In this environment, Keynes dismissed cutting interest rates as being as effective as “pushing on a string”.
He said that when the economy was trapped, the only thing the government could do was replace the spending that the people and the companies didn’t want to do. Otherwise the economy would go into freefall.
By any benchmark, the Japanese have been successful. They managed to prevent the crisis developing into a full-scale depression. They kept the show on the road. But the cost has been a huge increase in their government’s debt position.
Now Japan, two decades after the crash, is at a crossroads. In short, it is running out of money – well, not exactly running out of money, but it has reached the limits of taking the people’s savings and recycling them via government spending into domestic demand.
For the first time in three generations, Japan doesn’t have a current account surplus. It is running out of savings and will either need to sell its overseas assets to keep funding its obligations or it will have to raise interest rates to attract in foreign money to run the shop. This is a totally new dilemma for the Japanese.
For years, Japanese savers, having been nearly wiped out by the stock and property crashes of the 1990s, bought government bonds and as interest rates fell, bond prices rose, giving them a nice return. This reaction is precisely the same one we are seeing all over the western world now as people perceive government bonds to be a safe place to park money. But as interest rates go to zero and debt levels rise, this doesn’t look like something that can go on forever.
Back in Japan, we see that it can’t go on forever. The Japanese current account surplus is being eroded by the fact that the population is ageing. Retirement has come to Japan and the savings they built up for their retirement are now being spent. Savings in Japan as a percentage of household income were 15 per cent in 1992; they are now 4 per cent.
As noted above, Japan is running out of savings. Now this brings me back to the US, because if Japan wants to continue funding itself, it will have to sell some of its overseas investments.
And guess what is the biggest overseas investment of Japan? Why, American government bonds, of course! Japan holds over $1.2 trillion of US treasuries. What will happen when Japan – a huge economy of $5.46 trillion – starts to sell US treasuries to fund its own welfare state and its ageing population?
Bond yields in the US will rise, and one of the central planks of the US stock rally, which is that bullish treasuries and bullish equities complement each other, might begin to look as shaky as a Japanese nuclear reactor in the face of a tidal wave.