Greetings to you all on Christmas Eve. I think the big deal today is not America or Europe, but Japan. The incoming Japanese Prime Minister is threatening to strip the Bank of Japan, the central bank, of its independence. What Mr. Abe said is that the Bank of Japan needs to set at least a 2% inflation target. And he went further, saying that if they do not, he would “revise the Bank of Japan law and set” the 2% target himself. This is serious stuff. And Abe won the election in a landslide. So he can do this, there is no doubt.
Like a lot of macro analysts, I look to Japan now because they are at the forefront of the debt deflationary revolution we have entered at this end of a debt super cycle. They got to peak debt first. Japan resorted to zero rates first. And these zero rates turned into a permanent policy first – what I call “permanent zero.” Japan also was first to run massive budget deficits to ease the pain of deleveraging, rather than let the economy collapse. And the Japanese were also first to run into a lack of political policy space for their deficit policies, something we have seen in euroland, the UK and are now seeing in the US. Likewise, Japan is first in threatening to strip the central bank of its independence so that it can run an easier monetary policy. We’re not talking about political oversight a la Ron Paul to keep the central bank from printing money, just the opposite.
So this is it. If the Bank of Japan loses its independence and the government gets to set monetary policy, we will effectively have one consolidated government balance sheet for fiscal and monetary policy. I think this will be the end stage for any nation looking to get out of the terminal debt stage. In Japan, what has happened over the least 20 years is that the private sector has started to deleverage and this has caused a big hole to open up in the government’s finances as the economy’s sectors must balance. The Japanese government has accommodated this by-in-large and the government’s debt levels have skyrocketed as a result. Meanwhile, much of the government’s largesse has gone to bailing out banks and industrial companies, even airlines, in order to save jobs. Clearly, this policy has been a socialisation of losses on a massive scale which has taken private debt and essentially converted it into public debt.
Meanwhile the political policy space for such a policy response has waxed and waned. Eventually, deficit hawks get sick of the large deficits and look for government to retrench by raising taxes and/or cutting expenses, something I see as inevitable. And the result every time is recession, further private deleveraging and large government deficits, despite the move toward austerity. This cycle has taken Japan to well over 200% government debt to GDP, twice the levels in the UK, Ireland, Spain and the US, the four housing bubble economies with debt levels now about on par with Belgium and Italy, the only big debtors of Europe before the financial crisis.
A lot of people are expecting this whole fiasco to unwind. Kyle Bass, for instance, has been talking a lot about this. See this hour-long video here and this shorter 7-minute Kyle Bass clip. I take a fairly agnostic approach to this Japanese Armageddon scenario. Those who favour a consolidated government balance sheet in the first place will tell you that there will be no hyperinflation. But clearly, the goal here is to inflate away the problems, particularly because the Japanese Yen has been rising due to Japan’s debt deflation reducing the price level in Japan. Japan’s famous trade surpluses have turned to deficits as the strong Yen has killed Japan’s export industry. What Japanese policy makers want is a lower Yen and a higher price level to both increase exports and reduce debt. And taking away central bank independence is the way to get this.
The best case scenario here is the UK post-World War 2 scenario that I like to use as the model case for countries trying to inflate away systemic debt supercycle problems. See here on UK National debt since 1922. The UK was able to work down its government debt burden through currency depreciation and inflation. The result was not benign; we saw a crumbling infrastructure and the British falling behind countries like Germany and Switzerland and even France and Italy on a per capita GDP level. Only through financialization of the economy has Britain been able to make up some of the lost ground. This is a best case scenario. So there are no good answers here. When debt builds up like this, the result is economic malaise.
But what about hyperinflation? This is a political problem, meaning that you don’t get hyperinflation without a political response that creates it in specific economic circumstances. For example, the dean of Austrian Economics Ludwig von Mises put it this way:
This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in.
What von Mises is saying is that the government COULD allow the expansion of credit continue unchecked, but doing so would create overheating, inflation and eventually hyperinflation – as it did in Weimar and Zimbabwe. But which governments will choose that route? It’s a political decision to do so, caused by a severely restricted political environment in which productive capacity is limited and government believes it must keep the gravy train going, come what may for fear of revolt or revolution. See this post here for how this happens.
This won’t happen in Japan or anywhere in Europe or America. The debt deflation in all those places tells you this. Could policy move 180% away from austerity and deficit hawkery to a hyperinflationary response? It COULD. After all, Abe is threatening moving to the consolidated fiscal and monetary model. However, this is small beer. He is only talking about a 2% inflation target, something that is lower than the Fed’s inflation target. It’s a long way to hyperinflation.
My guess here is that the Yen will depreciate in 2013 because the political winds are blowing toward an aggressive monetary policy to support a depreciation. And this will help the Japanese economy. But yields will remain low and deflation will still be a threat. In my view, there is nothing that suggests we are on the cusp of a Japanese meltdown, something macro analysts have predicted every year for the last twenty. If policy does change substantially where this becomes a possibility, I will change my tune.