It will be complex and messy. Japan can avert the crisis, but it does not seem to want to do what must be done to avoid it OR politicians simply do not fully grasp the extent of the hole they have dug themselves into and continue digging at an accelerating pace. Japan has the potential to cause a global crash that will pale in comparison to the 2007–2008 crisis.
Those who know me and read my texts know that I am not the “end of world” type. I did not call a recession or a major stock correction since 2008. I do not think the end of the world is near and I do not think there is no hope for humankind. I do not like hyperbole and doomsday speak.
I look at data, indicators, and probable and realistic scenarios. But when I look at Japan and the global economy with cartesian logic, I do see a major storm brewing and it is in calm and steady Japan. It can be avoided, but it would take major sacrifices from Japan which do not seem to be considered as options by leaders.
Major global financial crises that cause widespread chaos, long lasting economic problems, and social unrest are rare. There are some that have major-yet-contained consequences such as Latin American and Russian recurring crises, the oil price shocks or the 1970s, “normal” recessions that pass such as those of the early 1980s and 1990s, and even the Asian Crisis of the late 1990s. The 2 “recent” major global crises were the Great Depression of the 1930s and the global financial crisis that started in 2007.
The next major crisis could come from many sources: geopolitical tension and war, trouble in weak Eurozone members such as Italy, Greece, or Portugal, and many more. Those can happen but can’t really be “predicted.” The one that is a brewing storm that we can “see” building is Japan.
1 Growth outlook
Japan has an aging population and its labor force is stagnating, with the number of employed persons hovering just below 65 million and not growing since the turn of the century, even with a very low unemployment rate. Productivity is also flat. Both variables will remain flat and the number of workers will gradually fall over the next 20 years.
An economy grows because of the increasing total “quantity” of goods and services produced and then purchased within the country or by others through exports. The economy can produce more stuff if 1) it has more workers and/or 2) each worker produces more stuff per year, which can be accomplished with productivity growth (efficiency) or working more hours per year.
For Japan, productivity is high, but unlikely to increase dramatically, and total workers employed will gradually fall for the next 20 years. At the same time, there is growing fiscal pressure due to health care, public pension and other social programs, as well as normal government spending such as infrastructure repair and maintenance, etc. This brings us to the harsh truth: the fiscal dynamics of Japan are unsustainable and out of control because the growth outlook is zero and they are spending as if there was potential for lots of future income, as seen by the stratospheric debt-to-GDP ratio of no less than 250% (we panic about 100%!!)… that is the ticking time bomb of global markets, and I will explain what is likely to happen further below — keep reading...
Number of employed workers, Japan, 1950–2017:
Work hours per year per worker, all OECD countries, Japan highlighted in red (the one at the very top is South Korea and the black dotted line is OECD average), from OECD data, 1970–2015:
Population projections going forward, from the National Institute of Population and Social Security Research:
Debt-to-GDP ratio 1980–2017:
2 Structural deficits and interest rate risk
When there is a recession, tax income drops for the government while expenses rise due to various social safety net programs as well as “stimulus programs” destined to prop up the economy so that it gets a short run “boost” that I do not want to debate over. This makes the government budget go into the red and the government borrows by issuing bonds. Although this could be costly, it does not necessarily spell disaster if the long run debt-to-GDP ratio remains under control and it could even help — again, the debate over this is not the subject of this article.
On the other hand, the country has problems of fiscal sustainability when the economy needs permanent “stimulus” in the form of government spending and monetary “stimulus” with massive printing to prop up asset prices and currency depreciation. This can last for 5 or 10 years, but it can’t be a sustainable policy path, yet that is how Japan is implementing it!
Japan has a FALLING labor force and flat productivity. Even if productivity was slightly increasing, it would just offset the falling labor force. So. Mathematically, real GDP for Japan should be roughly flat and probably fall “naturally” due to the specifics of its economy. This also means there should be flat credit creation due to the old population not wanting to borrow, hence flat money creation and zero inflation, even falling prices (aka deflation) due to falling production costs brought by automation. That is the theoretical “normal” for Japan: zero growth, zero inflation, and low unemployment… and that IS what is happening! So what’s the big deal? No unemployment, no inflation issues, very little poverty, and social stability. All good, right?
The problem is that fiscal income is stagnating while government spending rises. This means the government is “in the red” every year and it is NOT due to a short run shock that will eventually pass. The average interest rate on Japan’s bonds is zero or close to zero, which means the debt service is zero, even if the total debt is 250% of GDP: zero times 250% of GDP is zero!
If interest rates were only 1%, the debt service would explode to 2.5% of GDP (1% times 250% of GDP), and that would be a serious problem, because GDP growth is way less than 2.5%… like zero. When the debt service is significantly above GDP growth, you have an unsustainable situation that will eventually make markets stress about the situation. Inflation could help in the short run, because it increases fiscal income due to rising nominal prices and wages, but inflation also causes interest rates to rise and bond demand to fall…
Who lends to the government? Who are the bond holders?
The central bank will soon hold more than half of all government bonds!! This is unreal! It was less than 10% just 10 years ago! This is drying up the market of JGB (Japanese Government Bonds) and making the non-central-bank bond market less liquid. Less liquid markets are prone to large price swings, especially when the government debt is sky high and freaks out bond holders that also think about the long run sustainability of the debt in the demographic picture of Japan.
The government is “printing” money to finance its debt. It does this by money creation that is used to buy domestic assets such as bonds and stock market related index funds AND foreign assets, which means growing international reserves and “currency manipulation”: they sell jpy and buy usd, eur, etc in forex. There is NO example of History where this ended well. None. Never ever ever. Every single time the State has massively used printing to finance its debt, inflation spiralled out of control and created a market meltdown. It is not currently inflationary because the massive use of printing is, in fact, relatively recent, and also because credit creation is difficult in an aging population… but that only means that all this money creation will land “somewhere” eventually, which means unsustainable asset bubbles and government debt buildup. Japan stopped buying usd, eur, and other global assets due to pressure from EU and USA governments asking that Japan stop trying to prevent jpy appreciation with all this forex manipulation, but they are still printing a lot, as seen by the central bank balance sheet. (the central bank buys assets with “printed money” which it creates freely). Forex manipulation stopped approx in 2012 and printing and massive QE truly picked up shortly after… This is a disaster waiting to happen with such a government debt load and growth outlook.
Japan is in denial and kicking the can down the road, for others to manage. It is unfair to younger generations and irresponsible policy.
Japan is trying to print its way out of its debt hole, but if it finally reaches its official inflation target of 2%, it will have rising pressure on interest rates and on the debt service. Since bond prices and interest rates go in opposite direction, holders of JGB will take a hit and want to sell those assets off. To avoid a rise of interest rates, central banks buy bonds and other assets by the truckloads to pump up asset prices (that is “quantitative easing”), but this approach has its limits.
This can continue as long as inflation is low, which can be years. The Bank of Japan has signalled that it stands ready to buy everything under the sun, so it has essentially cleaned the market of any shorts (sell pressure) as long as inflation does not come up, which would make it harder to continue printing.
At some point, this “kicking down the road” strategy hits a brick wall if inflation rises. With more than half of all JGB at the Bank of Japan, the central bank would take a hit on its assets and would effectively become “insolvent” due to the crash in the value of its bond assets, while a government backing will hardly reassure markets, since the fiscal picture is downright terrible. But that would not matter because the central bank does not really need to be “solvent” because it can print money. Still, an insolvent central bank could make markets panic and cause extra downward pressure on bond prices and extra upward pressure on interest rates, thus adding pressure to the debt service and rapidly deteriorating the fiscal outlook.
At some point, rating agencies would have to acknowledge reality and downgrade JGB, which will just be an extra nail in the coffin, even if many will say the rating agencies are the cause of the troubles — denial is always an option for those who want to believe in magic.
The current approach seems to be eternal printing. Then there is the currency, the wild jpy. To boost economic activity when you have a stagnating domestic demand due to demographics, you can export to growing markets such as China, India, Africa, Latin America, and even the USA. To do this, some countries resort to depreciating their currencies to make domestic exports cheaper in global markets. There are 2 issues with this for Japan. First, it creates inflation and rising interest rates, which then causes a problem about the debt service of that huge government debt. Second, other major countries have specifically told Japan that currency manipulation must stop, as it is unfair trade war via currency manipulation.
The likely conclusion
More of the same. Fudging with the slope of the yield curve, printing to finance the debt, and thinking that hitting some positive number for inflation will suddenly fix things is simply deep Keynesian denial and will end badly or will never end and bring eternal stagnation. I am rather “Keynesian” myself but I also know it has limits and it certainly does not apply to any long run fundamental macro forces that are the realities of Japan. From what I can gather, Japanese leaders are still spinning in the same cognitive capture of printing, currency depreciation, large scale asset price manipulation, and total denial of what is right in their face: the norm is flat growth, zero inflation, low unemployment, and an appreciating currency. Let it happen. Stop fighting it!
Impossible debt loads always end in either of 2 ways: 1) explicit default or 2) implicit default via very high inflation. Review all of History and this is always the outcome. Explicit default or inflation, which is implicit default. Unless future income rises due to positive demographics and other structural forces that allow increasing growth for decades… but this is a low-probability bet for Japan. There is another temporary option that has been happening for 25 years now: eternal stagnation accompanied by denial politics and policies. But that ends at some point.
Japan is the 3rd largest economy in the world. Both forms of default will cause a global panic that will crash markets and economies and could disrupt social order at a time of already-super-low interest rates, already-huge-central-bank-asset-purchasing, and high government debt in most major countries.
When will the crisis happen? I don’t know, but my best guess is “only when inflation increases above 3%.” It will take global inflation and a trigger. It could be next year or in 10 years, so don’t stress about it. But unlike the other potential causes for crises that are hard to “predict”, this one is predictable. Just know that it will happen, and think of me when it does ;) Till then, relax and enjoy the ride, as it can come in 10 years. Like if you liked and found added value in the insights :)