15 August 2010

Will Japan Surrender Its Economy This Time?

Japan surrendered 65 years ago today, after decades of initially triumphant and then draining military conflict marked by official denial of any possibility of losing militarily until the very day of surrender. A recent op-ed in the Christian Science Monitor by a financial investment researcher suggests Japan is going to lose its formerly triumphant economic "war" in the same way (with lessons for the U.S. and other debt-ridden economies).
Investors are understandably scared of the sovereign debt crisis unfolding in Europe, but they are ignoring a more definite and significantly larger sovereign debt catastrophe that is about to hit the world's third-largest economy: Japan.

The prelude to Japan's current crisis began in the early 1990s when its housing and stock market bubbles popped, leading to recession.

For the next 20 years, using flashy names like Fiscal Structural Reform Act, and Emergency Employment Measures, and Policy Measures of Economic Rebirth, the government cut taxes, increased spending, and borrowed money to finance itself. Once or twice the government found fiscal religion and raised taxes; however, the economy stuttered and taxes again were lowered and the stimulus story continued.

Today, 20 years into endless stimuli, the Japanese economy is beset by the same rot it was then, except that its debt has tripled – the ratio of debt to gross domestic product (GDP) stands at almost 200 percent, double those of the United States and Germany, and second only to Zimbabwe....

A country that has ballooning debt needs to have an expanding economy to help the country outgrow its debt burden. Economic growth is driven by two factors, productivity and population growth. Though the Japanese economy may continue to reap the benefits of productivity, population growth is not in the cards.

Japan has one of the oldest societies in the developed world; every fourth Japanese person is over 65 years of age, and the population is shrinking. Due to cultural mores, workers are largely compensated not on merit but on seniority. Thus, young adults marry later in life, and have kids later.

This helps explain why the Japanese birthrate is one of the lowest in the world, a meager 1.37 per woman, well below the 2.1 figure needed to sustain a population....

Though debt has tripled over the past two decades, government spending on interest payments has not changed; in fact it even declined a little in the mid-2000s. This happened because the government's average interest rate paid on its debt declined from more than 6 percent in the 1990s to 1.4 percent in 2009.

This is about to change. Historically, more than 90 percent of Japanese government-issued debt was consumed internally by its citizens, directly or through its pension system. In the 1990s, the savings rate was very high, pushing the mid-teens, but as people get older, they retire and start drawing down their savings and pensions. Today, the Japanese savings rate is approaching zero, and will probably go negative in the not-so-distant future.

The Japanese economy operates on the (soon-to-be-proved-false) assumption that the government will always be able to borrow at low interest rates. As internal demand for debt evaporates – and it's approaching this level already – the Japanese government will have to start hocking its debt outside Japan.

When it does, it will face a rude shock in the form of higher interest payments. Japanese 10-year Treasuries now yielding 1.0 percent will not stand a chance against US or German bonds of the same maturities that yield 2.89 percent and 2.59 percent, respectively....

Along with China, Japan is the one of the largest holders of US government debt, and its demand for our fine paper will decline. Most likely, Japan will start selling Treasuries. And to make things worse, Japan will start competing with the US, not just in cars and electronics, but for buyers of sovereign government debt. Japan will export inflation, inflation will rise globally, and so will interest rates.

Had I written a similar article five years ago, I would have been "wrong," as today the Japanese economy is still ticking. Timing bubbles – and Japan is in the late stages of an enormous debt bubble – is very difficult, as bubbles tend to last longer than rational observers expect. But every year that the Japanese bubble doesn't burst and debt swells, the eventual pop just grows more catastrophic.

Japan is past the point of no return; its fiscal and demographic problems were created over decades and will take decades to be resolved. In the meantime, its citizens will pay the painful price. Japan is proof that a country cannot borrow itself to prosperity.

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