Tuesday, November 25, 2014

Japan's Hyperinflationary Scenario

Recently, the BOJ came out with an announcement to turbocharge QE when the Japanese central bank was already on pace for the most aggressive monetary policy in decades. Here are posts on the basics of monetary policy/QE and on the impact of QE for those not familiar with the topic in question. I've also discussed the (structural) issues currently facing Japan, which are actually not too different from the issues the country has faced in the past.

As I've discussed, Japan has effectively been stuck in a debt deflation over the past 20-25 years as monetary policy has been very tight. Total debt/income levels have been increasing for Japan over this debt deflationary period. This process has finally led to the BOJ starting is massive QE program in 2013 which was further expanded in November 2014.

It's important to note that Japan's first QE program has succeeded as inflation (measured by CPI) has gone up considerably. However, the inflation created by the BOJ's QE program has primarily resulted in a weaker Yen, asset price inflation, and rising input costs (primarily food and energy). As I've noted several times, Japan imports almost all of its food and energy, which implies that a further depreciation in the Yen would just lead to a relative spike in food and energy costs. The Yen has depreciated over 45% vs the US Dollar during the past two years, which would translate into a relative input cost spike (controlling for shifts in the international price of inputs).

The good part is that commodity prices, energy prices, and even food prices have been in free fall over the past 2-3 years due to the beginning of the reversal process for the international global imbalances built up over the past 30-40 years. This will mean that total input costs for the Japanese economy will not shift very much from the most recent QE announcement and the current Yen depreciation that has followed and is still currently occurring. However, commodity prices will not keep falling forever and will only keep falling until the global imbalances will have finally finished correcting.

The bad part for the Japanese economy is that the Japanese debt and budget deficit has kept increasing. On top of this, Japan has what effectively mounts to flat yield curves across the zero lower bound (ZLB). As Japanese long end interest rates have kept falling over the past few decades, Japanese debt servicing costs kept falling even though the total debt kept rising because previous debt was being refinanced at lower and lower rates. In other words, the debt servicing costs were effectively being capitalized. At around 2011-12, the entire Japanese capital stack was entirely refinanced at 0%. Since that point, the debt servicing cost effectively bottomed. From now on, debt servicing costs will only go one direction (higher) and probably move exponentially. If we take a look at the Japanese budget projection from the beginning of 2014, debt servicing costs have increased 5% while tax revenues were expected to move higher, but the proposed sales tax increase (which is shown to provide revenue on the budget) will not provide any revenue because the sales tax increase was postponed. In other words, the Japanese government will not have as much revenue as it expects while its two largest expenses (Social Security and debt service) will both be higher at the next time step.

The Ministry of Finance (MOF) will be issuing more bonds than they issued last year while the debt servicing costs are higher than they were last year. Japan is currently experiencing no growth and the yield curve is flat while debt servicing costs have bottomed.

In my post on Japan's structural issues, I discussed the Japanese demographic crisis wherein Japan has the most rapidly aging population out of any developing country. What this means is much higher government outlays for Social Security while there'll be less people working to support more dependents. The massive debt of the country is clearly starting to weigh on growth as well. So we're in a situation where debt servicing costs have bottomed and will go much higher very quickly if interest rates increase at all while the large debt and rapidly declining workforce are acting as structural drags on growth. Over the next 5-10 years, we will see Japanese debt servicing costs spike while tax revenues will end up being flat in the best case scenario.

In order to counteract these problems, the BOJ has decided it'll just keep depreciating the Yen and inflating asset prices in order to create growth. Of course, relying on monetary expansion for growth is not a long term strategy and faces sharply depreciating returns on the margin. If Japan only relies on a depreciating currency, it'll be tough in a world with no demand to buy Japanese exports while Japanese import prices spike.

If Japan keeps taking up its current policy, Japan will experience a drop in both productive capacity and real demand. The Japanese economy is already experiencing a rise in relative input costs which places downward pressure on productive capacity while the rising input costs are also placing downward pressure on real demand because inputs are more expensive. What we're likely to see in Japan if the BOJ and MOF do not change course, is falling production that will end up leading to falling real consumption. However, the BOJ policy will make sure that nominal demand will stay level (and it has). In other words, real demand will fall, nominal demand will styay flat or go higher, and productive capacity will fall. What does this sound like? Well, it's stagflation.

The current path for Japan will lead to stagflation. On top of this, there's also the risk of the BOJ creating a feedback loop it cannot stop. How do we stop inflation? In order to answer this question, we must first answer the question, how does inflation start?
1. Inflation is defined as the rise in prices. We get inflation when there's too much money chasing too few goods. Recall that what we use as money comes from bank deposits and recall that loans create deposits. If there's no demand for loans, it's very difficult for an economy to experience high inflation and is likely to experience deflation. This is the situation Japan was in over the past 20-25 years.
2. The BOJ has come in and decided to take on a massive monetary expansion in order to fight off this deflation. Monetary expansion fights off deflation by creating capital outflows that cause the currency to depreciate and by inflating asset prices. However, this policy will cause input prices to rise and reduce real demand. In other words, this will cause the initial stagflationary push.
3. Over time, the yield curve will steepen if the central bank chooses not to intervene as the market will adjust to inflation by shifting longer term interest rates higher. If this process is not stopped, the country will experience a price-wage spiral if short term rates are held flat.
4. Once prices and wages start to rise together, inflationary expectations shift and the private sector will demand more loans. This will increase nominal demand while real demand stays flat or goes negative from rising input costs.
5. This process is stopped when the central bank sharply raises short term interest rates (by sharply contracting the amount of base money). When the central bank sharply constricts the base money supply, it forces banks to call in loans and tighten monetary policy by effectively creating a financial crisis. This process almost always forces the economy into recession, but it will fight off the inflation given time.

However, if Japan raises short term interest rates (or equivalently, sharply reduces the base money supply) the Japanese government will default from the exponentially increasing debt servicing costs. Some would say that inflation will simply increase tax revenues so it won't be a big deal. However, it's important to remember that tax revenues always move linearly to inflation while debt servicing costs move based on the amount of total debt, the shifts in the interest rates, and the maturity structure of the debt. Japan's total public debt/tax revenue ratio is around 25, which is way too high for any sort of major inflationary impact on tax revenues to offset the . The only way out would be if all of the debt was on an extremely long time horizon, but when you have debt/income ratios around 25, it's difficult for a country to sustain and keep its debt serviceable for eternity. Michael Pettis talks about the problems of the Japanese policy here.

So what we've seen is that Japan has no way to stop a price-wage spiral if one takes place. In other words, we're looking at a hyperinflationary scenario for Japan where the Yen goes lower, and lower, and lower. This will go on until the country eventually defaults.

Keep in mind that what I've outlayed is simply a scenario. As I've detailed in my post about Japanese structural issues, the Japanese government does have a lot of public assets and if it were to sell those assets, it'd make the debt burden much more serviceable. However, if Japan continues to go down its current path without selling some of the government's public assets, a default, hyperinflation, and a complete and utter collapse of the Yen will be in store for the country.

1 comment:

  1. I agree with your conclusion on Japan. Here is my reasoning on hyperinflation in general. Be interested to know what you think.