I remember it well. That is, the fiscal rectitude of the old Japan.
During early 1981 as the Reagan White House prepared its radical fiscal plan—-what Senate Majority Leader Howard Baker famously called a “riverboat gamble”—-we were visited by a high ranking delegation from the Japanese finance ministry (MOF). It is no overstatement to say that they were absolutely shocked by the administration’s plan to enact a sweeping 30% income tax cut and double the defense budget—while expecting that it would all balance out as a result of surging economic growth immediately and large domestic spending cuts down the road.
The MOF men feared the worst—politely noting the possibility that there would be insufficient economic growth and spending cuts to pay for the Administration’s monumental tax reductions and defense build-up. Then the US would experience an outbreak of massive fiscal deficits—an unprecedented peacetime development that could roil the entire global financial system. In that apprehension the MOF men turned out to be dead right, and not because they were especially clairvoyant.
Back in those benighted times, fiscal rectitude was a widely shared commitment among government financial officials including Congressional Republicans and their conservative counterparts abroad and especially in Japan. Economic policy officials did not have to be hectored about deficits and the fact that there is no such thing as a fiscal free lunch. Indeed, notwithstanding a government led 30-year drive to rebuild their economy from the complete devastation of WWII, Japan’s public debt was only 50% of GDP as of 1980.
That was then. Today Japan’s public debt is 5X greater relative to the size of its economy and tips the scales at 250% of GDP. That is off-the-charts relative to all other large developed economies and has no parallel in previous history. In the interim, of course, Japan succumbed to the Keynesian stimulus disease, betting that after its thundering financial meltdown during the early 1990s it could borrow and print its way back to the prosperity it had known during the period of its post-war economic miracle.
The chart below is thus a cautionary tale of our times. In exactly one generation of leadership, Japan’s fiscal rectitude was lost entirely. As is made clear in what follows, its fiscal equation is now beyond rescue. It is tumbling inexorably into a financial abyss that would not have been remotely imaginable by the MOF men who came to the White House in February 1981 bearing discrete admonitions of fiscal prudence.
The slippery slope leading to today’s Keynesian demise starts with the fact that Japan’s post-war boom wasn’t a miracle at all. From the smoldering industrial ruins left by the allies’ final assault, the Japanese economy had bounded upward for three decades owing to a massive spree of public and private investment and a sweeping mercantilist industrial development and export promotion policy. The former depended upon an extraordinarily high household savings rate and the latter was fueled by blatantly protectionist policies that kept imports out and the yen’s exchange rate far below its true economic value.
Needless to say, neither prong of Japan’s economic miracle was sustainable. By the mid-1980s the Japanese capital goods and export sectors were enormously over-built. This meant that the double-digit growth in fixed asset investment which had powered Japan’s post-war GDP growth was destined for a sharp fall. Likewise, sooner or later its exchange rate repression policies would trigger an explosion of counter-protectionism in Washington, meaning that the drastically undervalued yen feeding its towering export surpluses was heading for a sharp reversal.
That’s exactly what happened after mid-1985 when a new financial sheriff came to the US Treasury. James Baker had matriculated from the Texas School of “America first” economics and did not hesitate to lower the boom on Japan’s export driven prosperity by way of the Plaza Accords of September 1985. Under the pressure of Baker’s concerted global campaign of yen buying by the major central banks, Japan’s exchange rate soared from about 260 per dollar to 130 over the next several years.
Unfortunately, Japan did not use this rather brutal assault on its mercantilist economic model to rebalance and reform its economy. Instead, its government started down the slippery slope of Keynesian stimulus and financialization that has been corroding the foundations of its post-war prosperity for the last 30 years.
In the first round, the BOJ slashed interest rates in early 1986 in order to stimulate domestic expansion, but Japan’s problem was not that the cost of capital was too high or that it suffered from insufficient industrial capacity. In fact, it was already swamped with excess capacity in steel, autos, machinery, consumer electronics and much else.
So what Japan needed at the time was higher market clearing interest rates to thwart its now chronic over-investment in export capacity. Instead, the BOJ’s ultra easy money flowed into the financial sector, fueling a massive bubble in real estate and corporate stocks and bonds.
This initial round of financialization induced businesses to drastically expand their debt loads. Accordingly, non-financial debt in Japan nearly tripled from its early 1980s level. As is now well known, this surging tide of both straight and convertible debt went into what was called “zeitech” or financial engineering. What it really amounted to was rampant speculation in real estate and financial assets–especially the stock of other companies within the Keiretsu groups around which Japan’s state-led development model had been organized. As shown below, the Nikkei stock index went parabolic, rising by nearly 4X during the 50 months after the Plaza Accord.
The bubble was especially acute in the real estate sector. At one point the value of land in Tokyo was equal to the total for the US. In barely a decade, land prices in Japan’s largest city rose by 5X before the spectacular crash of the 1990s. And there is no doubt as to the cause: the BOJ unleashed a monumental speculative frenzy based on cheap debt and the perception that Japan was “different” because its central bank had everyone’s back.
Needless to say, the bubble burst in spectacular fashion. From top to bottom the Nikkei dropped by 80% and real estate values by even more.Yet the painful liquidation of the BOJ’s financial bubble during the early 1990s was only the prelude. What actually happened was that the real economy in Japan went through a drastic downshift in its growth capacity owing to a more realistic exchange rate and the unavoidable disappearance of the double digit growth rates of fixed assets which had accompanied the one-time expansion of its industrial plant during the boom era. Accordingly, its trend rate of real GDP growth fell from 4-8% rates during the boom years to just 1% on average during the 1990s.
This unwelcome slowdown reflected the laws of economics speaking out loud. Japan’s domestic economy was desperately inefficient and feather-bedded; its foreign markets were now crowded with fierce competition; and it was destined to experience a sustained period of sub-normal capital investment and real estate development owing to the vast overhang of capacity from the boom years.
Unfortunately, the mandarins who run Japan Inc did not understand that they had been booming on borrowed time during the post-war heydays. That meant that Japan’s now drastically imbalanced and debt saturated economy would remain stuck in the mud in the absence of a through-going dismantlement of its rigged domestic markets and protectionist trade policies.
Alas, here’s where the Keynesian disease insinuated itself, and it came naturally to a ruling party—the LDP—-that had presided over Japan’s state-driven development model of the post-war years. The machinery of Japan’s politics was all about distribution of construction, credit and corruption among the LDP’s constituencies.
In the halcyon times, this generated roads and bridges to export ports and thereby facilitated growth of production, jobs and foreign markets—even if inefficiently done. But after the post-Plaza bubble crash, it merely churned out roads and bridges to nowhere. Paving the archipelago with cement, Japan’s politicians and bureaucrats did Keynes one better. Instead of digging holes and merely re-filling them, they dug gravel and limestone and turned it into pavement.
The chart below shows the fiscal catastrophe which resulted. During the two decades after 1990, Japan’s government expenditures rose by 45%, while its general revenues fell by 15-20%. Accordingly, a massive permanent fiscal gap was opened that fueled the parabolic rise of its debt ratio, as shown above. And this wasn’t just garden variety fiscal profligacy. As shown below, during most of this century, Japan’s general revenues have not even covered 50% of its expenditures. The math is terminal.
To be sure, the Keynesians would complain that the above chart is not a picture of “runaway spending” as denounced by Republican orators from time immemorial. And no, it is not. Spending growth has averaged less than 3% per year since 1990.
However, that observation is irrelevant to Japan’s circumstances and fails to grapple with the real fiscal driver. Namely, after 40 years of boom and the final BOJ bubble, Japan had reached a condition of “peak debt”. Already by 1990, total credit market debt—public and private—-exceeded 350% of GDP, and by now it has soared to in excess of 500%.
This condition of credit saturation means that nominal GDP growth is stuck in the low single digits, and could be liberated from that plight only by a burst of supply side growth and entrepreneurial productivity that has no chance of emerging in the statist policy and political environs of Japan Inc. In fact, nominal GDP has grown by only 1% per year since 1990, reflecting Japan’s stagnant (and now shrinking) work force and tepid productivity growth.
Needless to say, 1% growth in money incomes did not leave any room at all for net tax reductions, and could not remotely accommodate the spasm of public spending that have characterized Japan’s post-1990 Keynesian debauch. Yet prodded by mainstream economists in the US government and international institutions, Japan had dismantled its tax base in one effort after another to stimulate short-term investment. Its nominal revenues consequently fell continuously for nearly two decades. There is nothing like it in developed world experience.
Stated differently, the LDP politicians took charge of building bridges and the Keynesian economists provided the rationalization for dismantling the tax base. No more lethal fiscal combination is imaginable.
Except…..except that Japan Inc. has found it, and heartily embraced it in the form of Abenomics and its prior variants of QE and open-ended monetary expansion. Based on the lamentable advice of Ben Bernanke and other visiting fireman of the modern school of Keynesian central banking, Japan embraced the “deflation” myth and the destructive notion that the central bank must run its printing presses until inflation is revived to the 2% or so range—–thereby reflating nominal GDP, aggregate demand and the wheels of production and jobs growth in the real economy.
To begin with, of course, Japan has not suffered from anything that remotely resembles honest deflation. In most recent months, Japan’s CPI index stood at about 100—–the exact place it posted 21 years ago in early 1993.
In fact, the only “deflation” that Japan has suffered has been financial sector deflation—–real estate and equity prices and private borrowing—-and exactly so. The heights reached during the 1980s bubble were utterly artificial, unstable and an enormous deformation of capital markets.
Nevertheless, Japan adopted “ZIRP” in 1999 and thereby piled Keynesian central banking on top of its already hemorrhaging fiscal equation. As a consequence, BOJ’s balance sheet has exploded, rising from about 10% of GDP to nearly 50% today. That’s what it took by way of massive monetization of existing financial assets to pin Japan’s money market rates at zero and to push its yield curve outward along the flat line.
This amounted to financial repression on steroids, but it has been to no avail. During the approximate 15 years since it originally adopted ZIRP, Japan’s real GDP has limped along at 0.9% per year. This figure is not significantly different than the 0.7% rate it experienced in the post-crash 1990s before it launched an all-out money printing campaign.
But ZIRP has had enormous and untoward collateral effects that taken together comprise the proximate cause of Japan’s impending fiscal demise. First, Japan’s vaunted household savings rate—-the feature that funded its post-war CapEx boom—has ended up in the dustbin of history. During the last two decades it has dropped from the high teens as a percent of disposable income to a US style 3-4%.Indeed, it has gone from the highest rate in the world in the early 1980s to the lowest at present.
This untimely collapse of the savings rate will prove especially destructive for the retirement colony that comprises Japan’s demographic future. Saddled with towering public debts and rapidly shrinking work force, Japan will swiftly consume its accumulated savings as its retirement rolls soar. A decade or two down the road it will become an international pauper.
If it gets that far. The other collateral effect of ZIRP has been a gigantic fiscal lie. Namely, the delusion that Japan’s massive government debts can be financed at close to zero nominal carry cost for the indefinite future. After all, the 10-year bond now carries a yield of 0.51%—–a rate which is close enough to free for government work. Yet even then, Japan’s interest carry cost has been consuming upwards of one-third of its current revenues.
That’s why the prospect of interest rate “normalization” is such a fiscal nightmare. Were Japan somehow able to stop the inexorable growth of its public debt, the annual revenue take shown above would be consumed entirely by interest payments under a scenario of normalized interest rates.
And that brings us to the folly of Abenomics and the BOJ’s latest round of QE—-a madcap rate of balance sheet expansion that would be equivalent to $250 billion per month at the scale of the US economy. At this rate, the BOJ is absorbing almost all of the available government bond supply and on some days has actually left the private market bidless. Indeed, it is monetizing assets at such a frenzied rate that it has now become a major buyer of ETFs and other equities. In effect, the central bank in Japan no longer merely runs the casino; it has become the casino.
Still, it has only accomplished one thing: In the early run of Abenomics the world’s fast money traders went all-in with the BOJ and drove its stock index from 8,000 to 16,000 in a matter of months. But the excitement is now all over, and the actual results are pitiful—even if you believe that printing money can actually create sustainable output growth and real wealth gains.
The fact is, after the most recent quarter’s GDP wipeout, Japan’s real GDP is only 0.8% larger than it was five quarters ago when Abenomics was installed at the BOJ. And therein lies the frightful future.
Were the BOJ to actually achieve and sustain its 2% inflation target the Japanese government bond market would either collapse, or need to drastically reprice. The former case amounts to disaster now; the latter would entail fiscal collapse very soon as Japan’s revenues would be soon devoured by a surging carry cost on its towering debt.
And that gets to the ragged Keynesian excuse that all will be well once the jump in the consumption tax from 5% to 8% is fully digested. But here’s the problem: this is just the beginning of an endless march upwards of Japan’s tax burden to close the yawning fiscal gap left after the current round of tax increases, and to finance its growing retirement colony.
So there is no possibility that Abenomics will result in “escape velocity” Japan style and that Japan can grow its way out of it enormous fiscal trap. Instead, nominal and real growth will remain pinned to the flatline owing to peak debt, soaring retirements, a shrinking tax base and a tax burden which will rise as far as the eye can see.
Call that a Keynesian dystopia. It is a cautionary tale for our times. And Japan, unfortunately, is just patient zero.